Description

Hamilton Thorne is a leading provider of laboratory equipment, consumables, software, and services to the in vitro fertilization (IVF) market globally.  Due to meaningful long-term tailwinds in the IVF market, recent internal growth initiatives, an active acquisition strategy, and a highly fragmented market, HTL is poised for very significant growth -- 10%+ organic, 20%+ overall -- for the foreseeable future.

Hamilton Thorne is a very high quality business with 20%+ operating margins, 140%+ returns on capital, 60% recurring revenues, a diversified product portfolio (1000+ SKUs), a highly fragmented customer base with very low end customer concentration (1000+ IVF clinics), and high barriers to entry from required geographic-specific regulatory approvals (that can take 1-3 years) and increasingly scale.

Despite the quality of the business and attractive future growth profile, shares currently trade for only ~13x FCF with minimal leverage (~0.6x debt/equity).  The only other publicly-traded, stand-alone IVF company -- Vitrolife -- trades for 29x EBITDA and 40x FCF.  I believe that inappropriately low earnings estimates due to poor modelling and understanding of the seasonality in the business from the company’s sole sell-side analyst, among other factors, has caused the shares to trade at such a low valuation. Furthermore, I believe that the announcement of Q4 results -- either a pre-announcement in February, or a final release in March/April -- should serve as a catalyst for shrinking the current significant discount to intrinsic value.

Shares trade as HTL on the TSX Venture Exchange in Canada and as HTLZF on OTC Markets in the US.

Recent History

I previously wrote-up Hamilton Thorne as an investment idea for VIC three years ago at $0.42.  You can read that prior report if you are interested in more background on the company.  Since that time, the company has almost tripled in size, from a combination of organic growth and, more notably, two major acquisitions.  These acquisitions meaningfully de-risked and improved the quality of the business, but perhaps more importantly, they put in place a foundation upon which I believe the company should be able to drive long-term 10%+ organic and 20%+ overall revenue growth with a very long runway.

The first major acquisition, Embryotech, was in September 2016 and is a US-based provider of toxicology testing services and quality control assays for the IVF market.  The business was acquired for less than 5x EBITDA, has negligible capex, and is 100% recurring revenues.

The second major acquisition, Gynemed, was in April 2017 and is a manufacturer and distributor of various IVF consumables and equipment, the crown jewel of which is a branded cell culture media business with 75-80% gross margins, sticky recurring revenues, and particularly strong growth prospects.  The business was acquired for 6.5x EBITDA, also has negligible capex, and is 80% recurring revenues.  

Gynemed is a particularly impressive business, and you can get a better feel for that if you look at the historical financials disclosed in the business acquisition report.  It’s arguably a much more attractive business than the original Hamilton Thorne operations considering the 80% recurring revenues, consistent double digit organic growth (16% in 2016, 14% in 2015, 21% in 2014, 11% in 2013), and significant geographic expansion potential.

Prior to the two major acquisitions of Embryotech and Gynemed, Hamilton Thorne was essentially a two product line business -- precision laser systems were around 2/3rd of revenues and sperm analysis systems were around 1/3rd of revenues.  Hamilton Thorne now, however, has a fairly diversified portfolio of products and services that they can market to IVF labs globally.  The current mix by product line is roughly:

Precision laser systems ------------------------- 25%

Toxicology services and assays -------------- 20%

Other IVF consumables ------------------------ 20% i.e. pipettes, catheters, petri dishes, syringes, etc.

Sperm analysis systems ----------------------- 15%

Branded cell culture media -------------------- 10%

Other IVF equipment ---------------------------- 10%

In addition to reducing the former product line concentration risks, the two acquisitions also significantly increased the mix of recurring revenues from only 7% to 60%+.  

Most importantly, the combination of the three companies gave Hamilton Thorne the breadth of products and services and geographic reach necessary to start building a direct sales operation that is capable of serving as a one-stop-shop for IVF labs globally.  Furthermore, because there was little-to-no product or geographic overlap between the three businesses, the individual operations were highly complementary to each other and thus possess numerous meaningful revenue synergy opportunities that can now be exploited as a combined entity.

First of all, the addition of Gynemed finally gave HTL a direct sales footprint and strong operations in Europe.  That Gynemed sales footprint can now be further leveraged to sell Hamilton Thorne’s laser systems and sperm analysis systems, as well as Embryotech’s toxicology services.  Secondly, the addition of Gynemed’s cell culture media business, OEM relationships, and Embryotech’s toxicology services to Hamilton Thorne’s original two product lines gives the company a broad enough product and services portfolio to now start building a direct sales footprint to IVF labs in the Americas.  That sales footprint should not only drive increased sales of all of Hamilton Thorne, Gynemed, and Embryotech’s proprietary products and services, but it will be further leveraged to sell 3rd party products like Planar and Panasonic incubators and monitoring systems, Zeiss microscopes, and Halosperm DNA fragmentation kits, among others.

IVF Market

IVF is a highly attractive market with significant long-term growth tailwinds globally.  

In developed markets, an increasing maternal age of first pregnancy (i.e. couples waiting longer to have babies) has and continues to fuel growth in demand as fertility issues become increasingly common (now one in six couples).  Furthermore, due to the strong demand but high cost of IVF, there is a trend towards greater reimbursement.  Also, there is a growing awareness and cultural acceptance of IVF that is causing it to increasingly be sought out as an option for couples with fertility issues.  

In developing markets, a rising middle class is both increasingly following the trend of later births that is prevalent in developed markets and is increasingly able to afford IVF.  While there is scant data on the industry, the IVF market is generally thought to be growing at 5-10% annually with much faster growth in developing markets than in developed markets.

Hamilton Thorne’s segment of the market -- equipment, consumables, software, and services for IVF labs globally -- is thought to be around $1.0 billion in annual revenues, which is a small percentage of the annual ~$15 billion spent on fertility services.  This market is particularly attractive as it is still highly fragmented with 170+ companies and no dominant players, and further benefits from an even more fragmented customer base of ~4500 IVF clinics globally.

Although fragmented today, the industry is consolidating and Hamilton Thorne has now put itself in a strong position to be one of the eventual industry leaders.  To give you an idea of the consolidation trends, when I wrote the prior report Hamilton Thorne’s core laser business had two main competitors, Research Instruments and MTG/Octax.  Since that time, Research Instruments was acquired by CooperSurgical/Origio and MTG/Octax were acquired by Vitrolife.  With the recent acquisitions of Embryotech and Gynemed, the addition of new products and services from internal development, and a strong intent to rapidly expand the current portfolio both through acquisitions and organically, Hamilton Thorne has put itself on a course to very quickly be an industry leader alongside Vitrolife and CooperSurgical/Origio.

Most of the industry is private (or in the case of Origio a small business unit in a large public company) and so market share information is hard to come by.  Based on what I have read and been able to piece together, however, market share among the larger companies is roughly:

Vitrolife ----------------- 12%

CooperSurgical ------ 12%

Cook Medical --------- 5%

Irvine Scientific ------- 4%

Kitazato ---------------- 4%

Hamilton Thorne ----- 3%

Although leading the market with around 12% market share, I would note that Vitrolife has significant product concentration with cell culture media comprising around 60% of the business.  And so although they have been very successful in this product area, particularly in Asia, they are hardly a dominant force in the industry in serving as a one-stop-shop for IVF labs at this point.

As for CooperSurgical/Origio, anecdotal comments I have heard regarding the company from people in the industry have been fairly negative and they appear to have a poor reputation.  Criticisms have been centered on poor logistics and customer support and so I suspect that they may be struggling with integrating various acquisitions.  I have little doubt that they will continue to also grow larger via acquisitions, but I suspect that these future acquisitions also have the potential to result in overall market share losses and thus present opportunities for HTL to further gain market share.

Organic Growth

Organic growth has been roughly 5-7% (my estimates) over each of the past two quarters, but due to a large number of near-term growth initiatives, I expect this organic growth rate to ramp up to 10%+ by the fourth quarter of this year.

With 5-10% organic growth in the IVF industry and a highly fragmented market with myriad subscale distributors and single-product suppliers, I believe that HTL is now setup for sustained 10%+ organic growth with a very large runway.  Hamilton Thorne’s emerging position as a one-stop-shop for all of an IVF lab’s needs should allow it to take market share from the highly fragmented competition as the leaders reap the benefits of scale and increasingly control distribution to the IVF labs through comprehensive, bundled offerings.

One of the biggest organic growth opportunities is the cell culture media business that they acquired with Gynemed.  Gynemed’s cell culture media has a significant competitive advantage in having a shelf-life of six months vs 6-10 weeks for every other cell culture media that I have come across.  As you can imagine, a difference of that magnitude can make a big difference to an IVF lab, especially when a decent portion of those 6-10 weeks can quickly be consumed just in the logistics of getting it to the lab.

What’s most interesting about this growth opportunity is that Gynemed had largely been just selling it in the EU, and the product has been so successful that it has already completely dominated the competition in their core markets.  In Germany, Austria, and Switzerland, an astounding 173 of 175 total IVF clinics now use Gynemed’s cell culture media.  Furthermore, cell culture media is a big market; Vitrolife alone does $65 million in revenues here, whereas Gynemed still has less than $3 million in revenues.

In the near-term, I expect Gynemed’s cell culture media to continue taking market share in the EU.  Furthermore, they have started selling the product into large, fast growing, unregulated/less-regulated markets like India, Thailand, and Vietnam.  And they have started selling into another huge market in Japan, where 5% of births are via IVF vs. 1% in the US.  In the medium-term, they will look to expand the cell culture media business into the US; the regulatory process, however, could take 12-18 months for approval.  In the longer-term, the biggest opportunity is getting their media into China; the regulatory process there, however, could take 2+ years.

In addition to Gynemed’s high margin cell culture media, there are numerous cross-selling opportunities that have resulted from the combination of the three businesses that I alluded to previously, which I expect to fuel organic growth going forward.  Gynemed, for example, can now sell Hamilton Thorne’s laser systems and sperm analysis systems, as well as Embryotech’s toxicology services and assays.  

More significantly, with a broader portfolio Hamilton Thorne has now set up direct sales operations to IVF labs in the Americas.  This should enhance the sales of Hamilton Thorne’s equipment, allow them to expand Gynemed’s products into the US (starting with micropipettes), and allow them to start selling certain 3rd party products that they weren’t selling before.  There was a press release in October that detailed some of this that you can read for reference here: https://globenewswire.com/news-release/2017/10/30/1159887/0/en/Hamilton-Thorne-Announces-Expanded-Product-Offerings-to-Serve-the-Assisted-Reproductive-Technologies-Market.html

Finally, internal development of products and services should help to fill gaps in the portfolio and be a meaningful contributor to organic growth going forward as well.  Over the last year or so, Hamilton Thorne has been investing more heavily into new product development, and the fruits of those efforts are starting to materialize.  They just launched in August TrakJector, which is a micromanipulator system -- a critical piece of equipment for an IVF lab.  They have also disclosed that Embryotech will be expanding their suite of endotoxin testing services.  Other internal development projects includes things like a next generation laser system, slides, stains, software modules, etc.

Acquisition Growth

In addition to the double-digit organic growth that I am expecting, Hamilton Thorne has the potential to grow very significantly via the acquisition of complementary businesses at low valuations.  

I think it’s fairly remarkable how little Hamilton Thorne paid for Embryotech (<5x EBITDA) and Gynemed (6.5x EBITDA) considering the attractiveness of their businesses.  Management has a list of ~170 companies in the industry that they follow and they are actively looking for additional acquisitions.  I believe that one of the reasons they’ve been able to pay such low purchase prices is that they’ve focused on buying very complementary businesses, rather than ones that overlapped with existing operations in various areas, where the acquisition rationale is based more on cost-cutting.  There were apparently other buyers offering more for Gynemed, but the owners understandably didn’t want the large layoffs / cost-cutting that those alternatives would have entailed.

While I have not modelled any future acquisitions into my numbers, I think it’s important to realize that future acquisitions are highly likely, and they have the potential to create fairly material incremental value.  Hamilton Thorne’s management team is very experienced with acquisitions and integrations from prior businesses, and their first two major ones at HTL looking like big successes provides a bit of confidence in their efforts here.  Furthermore, with only 0.6x debt-to-EBITDA and a stable, high quality business, the company has plenty of capacity for additional acquisitions.  I’ve treated the convertible debt as equity in that leverage ratio as it is in the money and highly likely to convert as it’s owned by the equity-oriented former Gynemed owners.

A $12 M cash acquisition at 6x EBITDA, for example, would only increase the leverage ratio to ~1.7x EBITDA and would increase FCF per share by over 20%.  I think an acquisition of this nature is more a matter of when than if, and it should serve as a catalyst when it happens.

Significant mispricing exists due to a combination of factors

I believe Hamilton Thorne has become significantly mispriced due to a combination of factors.

First of all, the company is essentially a recent amalgamation of three businesses.  There’s simply a low investor understanding of Gynemed and Embryotech.  Gynemed, in particular, is a stellar business and is over 40% of EBITDA, but because its historical performance was really only disclosed in the business acquisition report -- a filing often neglected and easily overlooked by investors -- I believe that the attractiveness of Gynemed’s business has likely been largely lost on the market.

Secondly, this is a niche market (only $1 billion in revenues) and there’s only one stand-alone, publicly-traded comparable in Vitrolife, who is based in Sweden, well off-the-radar of most North American investors.  As a result, I think there’s likely a lack of appreciation in the North American stock markets for how attractive the long-term fundamentals in the IVF business are.

Third, and perhaps most importantly, there’s only one sell-side analyst (from Bloom Burton) covering the company, and I believe that he’s done a particularly poor job at modelling the combined business and estimating forward earnings.  I believe that his earnings estimates are far too low, and given the complexity of forecasting the recent combination of three businesses, I believe many if not most investors have unfortunately relied upon them for determining the company’s valuation.  This has of course made the company appear more expensive and thus less attractive to current and prospective investors.

The Bloom Burton analyst’s Q4 estimate for EBITDA, for example is only $1.4 million.  The company reported $1.4 million in EBITDA for Q3 and my only explanation is that he seems to have assumed that this is the new “run-rate.”  I don’t think he realizes, however, that there is seasonality in both Hamilton Thorne’s original equipment business as well as in Gynemed.  If you study HTL’s historical financials, they have fairly consistently had a surge of business in Q4 that adds around $300k in EBITDA over Q3.  Furthermore, if you study the financial disclosures on Gynemed you can see seasonal patterns there as well -- including a lull in Q3, ostensibly due to Europeans having extended vacations during those months -- and management even specifically cited the seasonal softness in Gynemed on their Q3 call.  

This sell-side analyst may have also looked at the year-over-year numbers and not realized that last Q4 was unusually weak for HTL’s equipment sales -- revenues declined organically by around 9% by my estimate -- and thus this quarter was a huge negative outlier.  As a result, the company now has a very easy “comp” in Q4 and should post very strong organic growth, which may have been overlooked by the analyst if he didn’t appreciate the extent of the weakness last year.

I modelled out the business and have come up with $1.9 million in EBITDA for Q4, which is 35% higher than BB estimates.  The magnitude of this gap is particularly significant when you consider that this is a fairly stable, high margin business which should generate reasonably predictable earnings.  Now the company may certainly come in lower than $1.9 million in EBITDA, but with a 35% margin of safety I feel fairly confident that they are poised to materially beat the expectations of the market, which should serve as a catalyst for the stock.

Fourth and finally, the share price is denominated in CAD, whereas the financials are in USD.  Many investors seem to either not notice this or otherwise forget to convert the financials to CAD when calculating valuation ratios which makes the company appear 25% more expensive than it really is.  While this might seem unlikely, I’ve encountered enough analysts that have made this exact mistake to strongly feel that this has contributed to the mispricing.

Valuation

Using fairly conservative organic growth expectations for 2018 (a slow ramp in organic growth up to 10% in Q4), I am expecting $7.5 million in EBITDA, $900k in capex, $550k in interest expense, and $500k in taxes, thus yielding $5.55 million in FCF.  Converting over to CAD, that would be $9.3 M CAD in EBITDA and $6.9 M in FCF.  With a market cap of around $90 million and an EV of $95 million, the valuation is therefore only 13x FCF and 10x EBITDA, which is far too low for a business with such strong growth prospects and economic characteristics.  

Vitrolife, for comparison, trades for 40x FCF and 29x EBITDA based on 2018 estimates.  At 29x EBITDA, Hamilton Thorne would trade for $2.15 per share.  

I think that Hamilton Thorne is conservatively worth at least 20x FCF (15x EBITDA), which yields a price of ~$1.15, which is 58% higher than current prices.

Risks

Potential risks include:

• Competitors releasing superior products that take market share from individual HTL products
• New products and services are poorly received
• Increased competition for acquisitions driving up purchase prices
• Poor acquisitions where the target’s financial performance degrades after acquisition

Catalyst

• Announcement of Q4 results (either a pre-announcement in February or a final release in March/April) should serve as a catalyst as I expect Q4 results to beat analyst/market expectations by a meaningful margin.
• Announcement of future acquisitions is likely to serve as a catalyst as the past two acquisitions have been very successful, and thus future ones when they happen should be looked upon by the market favourably.
  
• Listing on a major US exchange.  As a US business on a Canadian exchange, management has acknowledged that this is only a matter of time.  This would eliminate the issue of investors forgetting that the financials are in USD but the share price is in CAD.
  
• Additional analyst coverage.  There’s still only one analyst with coverage and businesses with aggressive acquisition plans tend to attract a lot of attention from sell-side analysts for obvious reasons.  I think additional coverage is inevitable and should help to get more investor attention on the company to shrink the current large discount to intrinsic value.