March 1, 2008 (Vol. 28, No. 5)
John L. L. Sullivan
Recurring Revenues, Sale of Cyclical Segments, and Boosted Productivity Curb Uncertainties
With 2008’s world economy suddenly turning unpredictable, many investors wonder about the degree to which the revenues and profits of life science tools and services (LSTS) companies are at risk. We believe that the industry has made great strides in improving its business quality, diversifying its revenues, and reducing its chances of being swamped by an economic downturn.
There are three fundamental changes that LSTS firms have made to lessen their vulnerability to a slowing world economy: increased recurring revenues, divested cyclical business and acquired consumables franchises, and enhanced productivity. Another consideration is the major customer types of the LSTS industry and each group’s inherent cyclicality. Today, we think that economically sensitive customers make up less than 15% of the LSTS industry’s revenues.
Recurring Revenues Sustain the Bottom Line
Traditional life science analytical instrumentation companies like Waters and PerkinElmer have made concerted efforts to create a larger base of recurring revenues in areas such as warranty, parts, related consumables, and service. Others, like Thermo Fisher Scientific, have acquired firms focused on consumable products.
In a slowing economy, we believe that such recurring and consumable product revenues are more likely to be sustained than revenues associated with big-ticket capital equipment. Waters, for example, has steadily grown the recurring portion of its revenue base to the point where today it comprises 40% to 45% of the total, up from 30% just a few years ago. Its progress in this area stems primarily from its work to add related consumables to its HPLC system franchise. Its flagship Acquity UPLC platform is Water’s first product with proprietary consumable LC columns.
PerkinElmer’s approach to increasing the predictability of its business includes adding services to its core spectroscopy instrument franchise. Notably, its OneSource service initiative has grown at a double-digit rate, and is well positioned to take advantage of the global pharma industry’s desire to outsource noncore activities such as lab-equipment management.
Through broad and diverse initiatives, PerkinElmer has raised the recurring share of its revenue base to approach 40%.
Finally, some firms have sought to make acquisitions to gain revenues from consumables or recurring products. The former Thermo Electron took this route in 2006 when it merged with Fisher Scientific. The resultant company, we estimate, derives 70% of its revenues from recurring sources.
Divestiture of Cyclical Assets Makes for a More Predictable Business
In some cases, life science instrumentation companies are seeking to create more predictable revenue streams by divesting segments that are more industrial and therefore cyclical in nature. This leaves the core business associated with healthcare and life science to comprise a larger portion of the company’s pie.
Firms including PerkinElmer, Varian, and Waters have pursued this strategy in recent years. PerkinElmer sold its fluid sciences business, which had a core customer base of airlines and aircraft makers. Varian spun off its electronics manufacturing services business, while Waters divested the magnetic portion of its mass spectrometry business. In each case, investors rewarded management’s action by assigning a higher valuation to the remaining earnings stream.
Improving Productivity Stems Risks
Over the last several years, we think that the companies within the LSTS industry have improved structurally. A resulting benefit is a lowered danger of adverse results during a period of economic sluggishness. These actions range from income-statement improvements like aggressively cutting superfluous operating costs to cash-flow related actions such as improving inventory turns. Frequently, these operating enhancements involve some front-end spending in areas like enterprise resource systems.
We view companies like Thermo Fisher Scientific, Waters, PerkinElmer, and Invitrogen as having made key investments to improve their operating execution and having made powerful execution gains already. In fact, several LSTS firms have increased metrics like inventory turns by 50% in the last several years.
Segment’s Customers Provide Stability
Sales of capital equipment are often at risk in times of economic uncertainty. Big-ticket life science lab tools such as mass spectrometers are bought with the capital budgets of the LSTS industry’s customers. The biggest customers for mass spec, however, are global drug companies, which are less leveraged to changes in the economic cycle than are more industrial customers. We estimate that these customers make up 35% of the industry’s revenues.
In past periods of economic uncertainty, global drug companies have remained good buyers of life science lab instrumentation. Today, these organizations can be fairly characterized as possessing significant cash on hand and financial flexibility while needing the sort of discovery advances that the LSTS segment can provide.
Academic and government labs such as those backed by NIH, which constitut 25–30% of the industry’s revenues, are only economically cyclical in the longest term. In the near term, the federal budgets that fund such facilities are generally reliable. In fact, policy makers view research-lab funding as having an ancillary effect of creating jobs around the country. It is unlikely that during a period of economic stimulus a federal cut in lab-research financing would be seen.
Consumable products for lab research such as kits and reagents for molecular study are the most important for academic and government customers and are among the least cyclical products in the LSTS industry. With average selling prices of just hundreds of dollars and a profile of improving productivity, kits and chemical reagents are likely to remain less affected by economic changes.
Biotechnology companies, which comprise 20–25% of the LSTS industry’s revenues, are also generally noncyclical in nature. A large stratum of the biotech industry, though, is composed of development-stage biotechs; i.e., companies that have yet to create a self-sustaining business. This segment needs a stable stock market to raise capital at reasonable prices. Languid economies can take down stock markets, resulting in poor access to fairly valued capital for small biotechs.
Outsourced research labs, another 5–10% of LSTS firms’ revenue stream, are fulfilling a key requirement for their clients in global pharma and biotech by lowering their commitment to activities with an unacceptable return on capital. We believe that such third-party research labs will be no more cyclical than their customers.
Finally, the last 15% or so of the LSTS segment is made up of what is known as industrial companies. In fact, as much as one-third of these revenues are spent on tools for environmental monitoring, an activity that has a strong regulatory element. We believe that as new rules are passed, the LSTS industry’s tools for environmental monitoring will benefit in a direct and noncyclical way.
Hesitant Investors Will See the Merit of Robust Fundamentals
With sizable investor trepidation about the world economy, stocks within the LSTS industry have recently suffered. We fully expect, though, that business fundamentals for this group of customers will remain robust and will illustrate over the next several quarters the beneficial structural changes that have been made in the industry over the last several years. We expect investors over time to recognize this profile and seek to capitalize on it through share purchases.
John L. Sullivan is an equity research analyst at Leerink Swann. Phone: (617) 918-4875. E-mail: [email protected].