Eurofins Scientific SE (ERF.PA)

IDEA

Eurofins is a global leader in the Testing Inspection and Certification (TIC) industry, exclusevily focused on providing testing services for food, pharmaceuticals, and the environment. Founded in 1987 by Frenchman Gilles Martin, Eurofins has grown from a small French family business into a company that performs more than 450 million tests each year through successful acquisitions. As a listed company, Eurofins is one of the real success stories among European listed companies. Since its IPO in 1997, the share price has multiplied 366 times, resulting in a compound annual return of 26% over a 25-year period.

Eurofins has become a market leader in a fragmented industry with attractive long-term growth potential, both organically and through M&A. During the Covid-19 pandemic, Eurofins laboratories quickly established a network of PCR testing centers, which gave an extra boost to revenue and growth. However, the recent misalignment of prices and cost inflation, in addition to the drop in Covid-19 testing-related revenues, have negatively impacted earnings and caused the share price to drop more than 50% from the peak. Despite these challenges, we believe that the valuation is attractive for a market leader in a resilient business segment that benefits from long-term growth drivers.

BUSINESS

Eurofins is a global leader in analytical services with a vast network of approximately 900 laboratories and over 61,000 staff in 61 countries, offering more than 20,000 analytical methods. The company performs tests to improve health, safety and the environment across markets, continents and industries. Their testing ensures that the food we eat, the air we breathe, the medicines we need, and the products we use are safe. Eurofins companies perform over 450 million tests annually, evaluating the safety, identity, composition, authenticity, origin, traceability, and purity of biological substances and products, as well as provide innovative clinical diagnostic testing services.

While Eurofins is part of the TIC industry, the company is exclusively involved in testing. They collect samples and test them in a laboratory. Testing is a local business due to differences in local regulations and the short turnaround times required by clients. Approximately 75% of the cost structure are fixed costs such as the lab and personnel. Thus, building out local scale is key for profitability. Quality testing with fast turnaround times, IT platforms connected to customers’ in-house systems to optimize information sharing, and competitive pricing determine the commercial success of the labs.

Eurofins operates a decentralized structure of entrepreneur-led companies. The broad geographical spread of the Eurofins network of laboratories, as well as the hub and spoke network inside a country or a region, enables different laboratories operating in the same country or region to share significant synergies among each other. Economies of scale and the large cost advantages available to the market leader versus competitors explain Eurofins’ superior operating margins.

Demand for Eurofins’ services is resilient and benefits from long-term growth drivers. Testing services continue to be essential, regardless of economic conditions, as the need for safe food, water, and pharmaceuticals, as well as environmental protection, remains resolute. This is evidenced by the company’s track record of positive organic growth even through the financial crisis of 2007-2009 and during the COVID-19 pandemic.

Eurofins’ markets are highly fragmented with many smaller and medium-sized laboratories offering a limited portfolio of testing for a regional customer base. The company strives to be the number one or two provider in every niche laboratory testing market in which it operates through a combination of organic growth and acquisitions. They leverage their scale advantage to position themselves as a first-choice provider based on quality, innovation, and breadth of offering. Being the most efficient operator allows for market share gains in addition to growth opportunities from M&A.

Assessing the market size for Eurofins’ services can be challenging, as it is the sum of many small markets. In-house testing, for example by large pharma companies, further complicates market sizing. However, Eurofins estimates the food and environmental testing markets in Europe and North America at approximately €2.5b each. The company generates €600m revenue in food and environment testing in Europe and €400/500m in each of these markets in North America. This translates into approximately 30% market share in Europe and above 20% in North America.

GROWTH

Bioanalytical testing is a growing market that presents significant opportunities for third-party service providers like Eurofins. Rising average wealth and life expectancy, along with consumer demand for higher-quality goods and services, are key drivers of growth. Additionally, new technologies are opening up new applications in the pharmaceutical, food, and environmental markets. Globalization and complex supply chains have increased the need for regulatory testing, and there is a trend towards outsourcing testing activities so that companies can reduce costs and better focus on core competencies.

Eurofins' increased focus on BioPharma, Genomics, and other Life Science activities, as well as expansion into faster-growing Asian markets, are driving the company's recent upgrade of its mid-term organic growth objective from 5% to 6.5%. Eurofins has a strong track record for M&A since its founding in 1987. Last year the company completed 59 acquisitions for total annual sales of €270m. Eurofins aims to achieve revenue growth of 3.5% annually through self-funded acquisitions, and in a fragmented market the opportunity set for acquisitions remains large.

OPERATING MARGINS

Eurofins is committed to creating long-term value by building leadership positions in niche life science-focused laboratory testing markets with strong growth opportunities. To achieve this, the company continues to make strategic investments in innovation and R&D, start-up laboratories, acquisitions, infrastructure and IT systems. Management prioritises long-term investment opportunities over short-term financial results. However, these investments negatively impact margins and cash flow generation in the short term.

In recent times, Eurofins' operating margins have been affected by the misalignment of price increases and cost inflation, as well as volume declines in some of its core markets. Contracts with clients do not include an inflation adjustment clause, resulting in a timing mismatch with cost inflation when inflation rises rapidly. Historically, Eurofins was able to build expected inflation into its price increases, but in the current environment of high inflation, clients are pushing back on significant price increases based on uncertain inflation expectations. The negative impact of high inflation is expected to be temporary and disappear when inflation stabilises.

Eurofins has been affected by the economic situation in Europe, with a negative impact on testing volumes in food leading to overcapacity. High inflation and the energy crisis have had a larger impact on consumer sentiment in Europe compared to the US, resulting in European consumers purchasing cheaper products and reducing variety. This has impacted Eurofins in two ways: generic brands are prepared to take more risk and test less, resulting in lower testing volumes, and food companies have reduced R&D expense as growing their portfolio is no longer a priority considering consumer behavior. While food testing in Europe had been growing at 6% p.a., the lack of growth implies a reduction of €30 to €40 million in sales in a business with high operating leverage. However, this is expected to bottom out at some point, and volumes will pick up again.

Over the medium term, Eurofins' profit margins should benefit from efficiency gains from IT investments and the implementation of a hub-and-spoke model for the testing labs. The company aims to improve the adjusted EBITDA margin from 20% in FY2023 to 24% in FY2027. However, the speed of improvement toward the 2027 adjusted EBITDA margin objective will depend on the timing of the bottoming out of food and consumer product end markets and how fast pricing can be aligned to cost inflation, as well as the speed of execution of innovation, productivity, digitalisation and automation initiatives.

VALUATION

Eurofins shares have fallen from their peak of €124 in September 2021 to €60, representing historically low multiples of 20x trailing earnings and 21x NTM. However, this comes at a time when the company has increased its organic growth targets and has a credible path to margin improvement. For FY 2023, Eurofins aims to achieve revenues of €6.6bn-€6.7bn, adjusted EBITDA of €1.35bn-€1.4bn, and FCFF (before investment in owned sites) of €700m-€750m. The company's medium-term objective is to achieve revenues of €10bn by FY 2027 with 24% margins and FCFF (before investment in owned sites) of €1.5bn.

If management can achieve these targets, there is potential for a return of over 20% per year at an exit multiple in line with the historical mean (10-year mean EV/EBITDA: 13x).

RISKS

 We may need to moderate our outlook for organic growth as this industry is difficult to assess due to its fragmentation and lack of clear economic or market indicators.

High operating leverage implies that lower volumes have a significant impact on earnings.

CONCLUSION

Eurofins has many characteristics of an exceptional business: 

-Resilient, non-cyclical revenues

-Eurofins has a durable competitive advantage

-It holds a leading market position in niche life science-focused laboratory testing markets with strong growth opportunities.

-The company has a strong balance sheet

-There’s potential for value-accretive acquisitions.

-The owner-operator has a track record of creating shareholder value.

Recent issues that have negatively affected revenues and margins are likely temporary and the outlook for organic growth has improved due to changes in the business mix and faster growth in Asia. Combined with a share price at a historically low multiple this makes for an interesting risk-reward.