[TABLE 1]

Business & Thesis

Harvard Bioscience (“HBIO”) is a manufacturer and distributor of life-science tools. The Company recently spun off its Regenerative Science division and now only operates under its Life Science Research Tools (“LSRT”) division. New management came onboard in August of 2013, and a new incentive driven comp plan was scripted last month which gave new management ~800,000 options[1].

Harvard Bioscience produces products for two major application areas: ADMET testing and molecular biology. In ADMET (“absorption, distribution, metabolism and elimination”) testing, HBIO produces equipment that helps researchers analyze the physiological effects of compounds on cells, tissues, organs, and animals – things such as toxicology, metabolism, diffusion of molecules, etc. In molecular biology, HBIO sells spectrophotometers (which lab doesn’t have one?), multi-well plate readers, DNA/RNA/protein calculators, consumables, etc. Most of HBIO’s customers are universities and government funded laboratories, as well as some pharma/research companies.

While we generally shy away from biotech companies, HBIO’s markets are core laboratory products that require high precision, but which generally cost <$5,000 in the case of ADMET and up to $10,000 in the case of molecular biology. These products “generally” have stable end markets, as the equipment is not prohibitively expensive and are core elements to any academic / pharmaceutical R&D. HBIO was built off acquisitions and many of these companies play in niche product segments (behavioral products, surgical devices for animals, etc.). In a majority of cases, HBIO’s competitors are generally small companies and HBIO is the #1 or #2 player within these niche product lines.

Since 2009, the U.S. market has struggled (HBIO’s predominant market) due to budget cuts and sequestration. This is evident in the financials. Going forward, we believe the business may turn due to 1) passage of the current budget deal, which will turn the budget headwind into a tailwind going into 2014 and 2015, 2) spinoff and “shedding” of old management to the sexy but loss-making HART business, and 3) a completely new slate of motivated management that has already begun to cut costs and re-focus on growth opportunities.

Pro forma, HBIO did $9 million in EBIT in 2012, though 2013 is looking to come in below (perhaps quite a bit below) $8 million[2]. Following the recent announcement to rationalize the business and save ~$2 million in SG&A, PF EBIT next year (assuming $8 million base) is ~$10 million. Taking ~$1 million off for interest, net income is ~$6 million. Adding back amortization of intangibles (from acquisitions) and restructuring of ~$3 million gets us to $8-9 million. On a cash earnings multiple, HBIO is trading at ~-15x PF cash earnings (~10x EV/EBITDA). The Company also paid out ~$3.3 million of SBC in 2012. Since LSRT accounts for roughly 90% of the expenses of pre-spin HBIO, SBC should be a “cash source” of ~$2.5-$3 million (bringing FCF multiple to ~10x-11x). We normally wouldn’t give SBC any mind, but given the essential nature of M&A to growth, we think the value of SBC in lieu of cash is value creating.

[Table 2]

HBIO is on the expensive side. However, we believe the business is generally more recession resistant (given comps trade in low 20’s P/E[3]) and the industry intrinsically warrants a somewhat higher earnings multiple. We would not pay 15x cash P/E for a business unless we thought there was realistic potential for earnings to accelerate in the near- / medium-term. In the case of HBIO, we believe that the business can:

• Continue optimizing costs, as management in the past had targeted operating margins of ~20%. While this seems to be a far stretch from the current ~10% EBIT margins (post SG&A reduction), current management believes there is opportunity to “improve them from where they are today”[4]. Competitors in the industry run at margins of mid-teens to ~30%. If we can get to the lowest end of that range in the next 3-5 years, we would be trading at ~7.5x EBITDA and ~10x cash earnings, given flat revenues. The recent move to slash $3 million (~3% EBIT margin) in redundant personnel (50 positions, with 20 reinvested primarily in Asia) is an indicator that the business needs optimizing. We spoke with management recently and the team was honest in their depiction of the fat that the business had accumulated over the past few years. The $3 million in costs were “low hanging fruit” which could be trimmed easily without any impact on sales (they would not “jeopardize” 2014 sales).  Management told us that past acquisitions made by HBIO were left to run as stand-alone operations. As such, the company had many overlapping functions that needed to be reduced (five customer service departments, recently reduced to one. Sales personnel from different sub-divisions contacting the same customer, as there was no collaboration of customer coverage). Management is continuing to look at costs (inventory management, procurement) and believes they are just getting started right-sizing the cost structure. While we can’t speculate what more could be done to reduce costs, we do take note that all their production facilities are located in expensive areas of the world.
• Continue making acquisitions at attractive valuations (“what we found over the years is that the prices we pay for these acquisitions have been fairly consistent at around six times operating profit throughout the booms and busts.”[5]). HBIO has been a serial acquirer in the past (though acquisitions have been minimal in the last 2 years as focus was on the spin-off) and the numbers, later presented, suggest that acquisitions have been done below <6x EBITDA (after eliminating G&A) and perhaps in the 4-5x range. The Company has a pipeline of acquisition candidates. Our conversations with management suggest that the business may be shifting its focus towards larger and more strategic acquisitions. It seemed that past acquisitions were in divisions nearing end-of-life cycles, which helps explain the lack of organic growth. Going forward, the opportunity for consolidation in the industry remains great and HBIO indicated that they could potentially get to $200-$300 million in revenues through acquisitions in short order (management is comfortable levering up to 3x cash flow). While we won’t be able to gauge the success of new acquisitions until they happen, we were partially assuaged by management’s confirmation that acquisitions must have strategic reasons (synergies, cross selling, new go to market strategy), that they do not believe in paying for synergies, and that IRR’s must be in the mid-teens.
• Return to organic growth as sequestration subsides and as growth shifts to China and emerging countries (every competitor has bathed in the glow of massive R&D increases in emerging Asian countries). The industry overall has performed quite poorly post-recession – the immediate effects of the downturn were largely unfelt, but the budget crises following thereafter has drawn out the decline. 2013 will be a particularly hard year for HBIO with revenue projections down 6%, somewhat worse than the 5% cut to NIH budgets during the March sequestration. It is looking likely that the sequestration will be lifted in 2014/2015 for R&D funding. Management states that they are seeing a 3% uptick for 2014 NIH funding.

We do not fixate on comps for exit multiples and acknowledge the very real risk of P/E contraction given the high multiple of 15x cash. However, brushing aside the vicinity of comps trading at 20x – we think HBIO could earn mid to high teen IRRs over the medium term if management can stabilize the organic business (as is their primary goal in 2014) and/or increase EBIT margins to offset any revenue erosion. If the base EBIT is stable, HBIO is can utilize its ~$12 million in SBC adjusted cash flow to acquire up to $2 million in EBITDA a year (~$1.5 million in cash earnings) at 6x EBITDA (if this continues to be a good proxy for acquisitions).

This equates to mid-teens growth on EBITDA as well as cash earnings. While it is difficult to presume whether “base” EBIT can be stabilized, we believe a new management focused on EBIT margins and a new 2014/2015 R&D budget with increased funding give us a good chance to do so. In particular, management believes we can return to organic growth in 2014 due to the hiring of a VP of global sales that will oversee the sales function (the company had the first 3 day global sales marketing meeting to share experiences, best practices, and customer leads), a strong concentration on the Chinese market (HBIO has already built out a sales team and say distributors in Asia are already interested to sit down and talk due to the Harvard brand recognition there), and a return of NIH funding.

Not to harp back to the glory days, but from the 2007 10-k: “From 1997 to 2007, the revenues from our continuing operations grew from $11.5 million to $83.4 million, an annual compounded growth rate of approximately 22.0%.” Perhaps with some focus we could re-ignite growth and get us back on HBIO’s old pre-regenerative medicine roadmap.

Underperforming

[table 3] 

HBIO has not been performing well since the recession. Besides the decline in R&D funding following the Great Recession (and largely through the past decade), the problem has also been idiosyncratic. Fx-neutral organic growth between 2006 and 2012 was negative 0.5%, and new management guided to another 6% decline in 2013. While the 6% ostensibly isn’t too far from the sequestration cut of ~5% across all R&D spending, HBIO’s competitors have not done nearly so poorly (BDX had negative U.S. bioscience revenues in 2012, but is seeing ~3% growth in 2013). Part of the problem is a slowdown in orders from GE Healthcare (a large partner, which now accounts for ~4% of revenues, down from nearly 25% in 2005) as inventory remains high. HBIO predicts ~1/3 to half the decline this year will be from reduced GEH sales, but the remaining revenue has stabilized. HBIO has reduced its reliance on GE and increased its internal direct selling opportunities because GE’s sales personnel weren’t motivated to push HBIO’s products in particular, given the myriad of products they sell. (HBIO has its own distributor called Denville Scientific).

The decline in gross margins has been more than the decline in revenues. While there may be pressure in terms of pricing due to the weak R&D funding environment, it would appear that most of the acquisitions done in the past 5-6 years have had lower gross margins. As such, it is not surprising that gross margins have declined at a faster pace than revenues, particularly when more than 100% of the growth in revenues has come from lower gross margin acquisitions (acquired margins become “organic” in the next year).

[table 4]

We think part of the underperformance has been self-inflicted. HBIO appears to have been neglecting its LSRT division, having focused on the sex appeal of its regenerative medicine division. As mentioned previously (and to summarize):  

• The recently announced 13% elimination of its global workforce to “create organizational efficiencies and better position the Company for growth.” The cuts pertained to “redundancies across several sites,” and totaled ~$3 million in personnel costs and expenditures (33% of reported EBIT)
• As re-iterated in the 8k, “we will also be focusing on increasing growth, expanding in Asia and other emerging markets, building stronger channel capabilities…” We re-iterate the massive growth competitors have had internationally (particularly in china), as evidenced by 20% growth at Thermo Fisher in China.
• In the latest call, Jeffrey Duchemin stated, in response to a sales and marketing efforts question, that “it’s going to be a strong emphasis of…integrating the acquisitions that have been made over the years, creating maybe better synergies in terms of how we utilize relationships in the field.” 

Having laid out the thesis, we turn to an exploration of the main drivers of the thesis:

Research Funding & Organic Growth

R&D spending, particularly related to medicine and health (non-defense discretionary budget) has been headwind as it has been since 2009. Going forward, we are hopeful that the new budget will bring more predictability back to institutes like NIH and provide more clarity to research grants. In this case, R&D budgets for 2014/2015 will become a tailwind for HBIO. Furthermore, international growth, which has been stagnant over the past few years, could pick up if management makes progress on its goals.

HBIO has repeatedly stated that the federal budget has impacted the demand for life science instruments, a point which seems to be re-iterated by other sources[6] [7]. More broadly, between 2009 and 2012, federal funding (which accounts for 1/3 of US research spending) of R&D fell 18%[8], and the 2013 sequestration will cut off another ~5%.  Prior to 2009, science funding grew modestly at ~.7% since 2004[9]. Meanwhile, nations like South Korea and China have grown their R&D budgets ~10% a year, giving credence to HBIO management’s emphasis on international growth going forward.

The NIH (National Institutes of Health) budget has declined by 22% over the past decade, inflation adjusted[10], and the outlook does not appear to be particularly rosy[11]. “In a survey of more than 3,700 US scientists released on 29 August by the American Society for Biochemistry and Molecular Biology in Rockville, Maryland, one-third said that they had laid off researchers, and close to two-thirds had seen their funding fall since 2010.[12]” Success rates for NIH grants are down to 15% from 30% a decade ago[13]. NPR has a great broadcast on the American science struggles from the budget cuts (highly recommended)[14].

The decline in revenues does not seem to completely idiosyncratic. While everyone has been affected, Harvard Bioscience is underperforming all its peers in 2013:

• Becton, Dickinson, and Company reported negative 2012 bioscience revenues in the U.S. due to reduced research funding and lower demand for high-end instruments. Between 2009 and 2012, BDX’s US bioscience division performed in line with HBIO (“We had a very challenging 2011 and 2012 based on the first jolts of sequestration and NIH funding cuts”. However, there was a large delta in 2013 as BDX saw increases in US bioscience while HBIO is projecting a 6% decline.

 [table 5]

• Danaher’s disclosures are less useful due to its overweight exposure to international sales and non-breakout of U.S. sales. However, 2012 had weaker year over year sales performance in North America and Europe (offset by strength in China), though 2011 was relatively strong across all geographies. Danaher achieved a 20.7% EBITDA margin in 2012.
• Bio-Rad laboratories reported a difficult year thus far in their life sciences division as well. “Sales of our life science products continue to be hampered by constraints in the global academic and government spending environment.” Organic currency neutral growth declined 4.4% in Q3 after climbing 2.5% in Q2 and falling 1.6% in Q1. Encouragingly, the CEO reported no significant changes in competitiveness between products and said Life Sciences would “turn first” in a recovery. Re China: “So, in general, I think China is still a nice upside. But I would say I'm of the school that the growth is going to be probably more tempered at a market growth around 10% to 12% versus may be 14% to 17%.”
• Thermo mentioned in their Q3 2013 call: “Starting with academic and government, because it is probably top of mind, this end market was somewhat softer in Q3 given the environment in the US. As a result, we were down here in the low single digits. Our customers continue to feel the effects of sequestration along with the added uncertainty leading up to the budget standoff late in the quarter.”

HBIO has suffered more so than its peers because it was a laggard in attuning to the global shift in R&D towards Asia. As a result, R&D dollars followed this transition and HBIO was left out of the game. This has been a main component of HBIO’s re-ignition strategy ($1 million in Chinese sales team, led by a seasoned Chinese veteran Yong)

 I won’t waste your time (or at least, too much of it) on the macro, but there seems to be hope that the new budget deal will provide temporary relief from sequestration, restoring half the cuts in 2014 (non-defense discretionary spending will increase ~4.8%[15]), and ~25% in 2015[16]. This may provide some tailwind in the short run, but the issue of stagnant R&D funding could persist into the future (though there are a number of research pieces suggesting that life science instruments are likely to grow in the mid-single digits for the foreseeable future[17]).  

If the sequestration is alleviated and non-defense discretionary spending for R&D increases from 2013 levels, then stays flat in 2015 (as is the current proposal), I think it is believable that organic growth in the U.S. should be positive, and the subsiding headwind should allow HBIO to generate positive organic growth. There are not enough data points map out meaningful incremental margins, but we think it that incremental margins should be quite a bit higher than corporate margins, since gross margins are shy of 50% and the only additional expense to be incurred would be in SG&A, which has historically been around ~15% of revenues. As such, incremental margins should be ~30%. This has not been the case historically, and so we hesitate to apply this kind of margin. It probably is not unrealistic to assume ~15-20% incremental margins (if we take pro forma the $3 million in cost savings to 2012 EBITA, then incremental margins between 2009 and 2012 would be just over 20%). Hence, any return to organic growth would be doubly as powerful on the bottom line.

Acquisitions

Below we lay out some of the major acquisitions done of late and our estimate at their post-synergy valuations. As a word of caution though, management may no longer be pursuing these lower multiple, end of life businesses, and so perhaps this analysis is somewhat dated:

 [table 6]

This probably takes some explaining. In the 10k’s HBIO breaks out the impact of acquisitions on revenues, gross margins, SG&A, etc., but they are rather opaque in their wording. For example, in the 2012 10-k, we are told revenues increased $3.4 million due to CMA and ANH acquisitions. However, CMA was acquired in July of 2011, meaning that the 2012 revenue numbers should only be “inorganic” so far as the first 6 months of the year for CMA (then we lap our date of acquisition). I believe this should be implied, but broke out both “Assuming partial years” as well as “assuming full cost.” Under Partial years, the purchase price of the acquisitions are pro-rated for their length of contribution to revenues that year, while under full cost the entire acquisition price is used regardless of the length of contribution.

To give an example:

• In 2012, CMA and ANH contributed $3.4 million in revenue, -$0.20 million in EBIT, and $0.60 million in adjusted EBITDA if we strip out acquired G&A (HBIO has been adept at doing this)
• The acquisition price was $2.6 million for ANH and $5.2 million for CMA. ANH was acquired in February 2012, so contributed 334 days of revenue/costs. CMA contributed 365 days, but was acquired July of 2011, so “acquired” revenue/costs should only have been impacted for ~182 days of 2012 (January to June).
• As such, if we adjust the acquisition price to pro-rate for the contributions, we essentially acquired $0.60 million of  adjusted EBITDA for $4.95 million (~11/12 x $2.6 million for ANH + 6/12 x $5.2 million for CMA), for a higher multiple of 8.3x EBITDA
• For “full cost” valuation, we take the assumption that HBIO lumped 100% of revenues from the acquisitions in previous years into their breakout, so take 100% of the cost of acquisition (in this case, CMA at $5.2 million) into the acquisition price. This gives us a multiple of 12.6x

While the 2012 acquisitions were pricey based on historical standards, it seems that HBIO has historically done acquisitions relatively cheaply, once we strip out the G&A costs associated with the acquisitions. On partial year calculations, they have ranged at 4-5x EBITDA (and 5-6x EBIT, in line with management guidance), and even on more conservative full year calculations, the multiples have been ~6x EBITDA, with exception of the latest year acquisition which we presume was impacted more severely than anticipated. While there’s always a risk that we overpay, we are assuaged from the multiples acquired in the past, by new management’s focus on right sizing the ship, and by the reflections in the transcripts about the consistency of acquisition multiples through boom and busts. In addition, sales and marketing have continuously increased over the years from acquisitions, though one would presume that cross-selling would be an area of synergies. This will likely be an area of further improvement.

Below we show the historical breakdown of acquired costs. We can see HBIO has been quite successful in eliminating G&A shortly after acquisition (the breakdown of acquired costs stops pre-2007, so we only have more clear data in the last 5 years). The only permanent increase in G&A was following the large Denville acquisition (though it was “organic” and not attributed to the acquisition).

 [table 7]

Economically, it also makes sense to acquire the brands and customer relationships of smaller businesses, and eliminate the general and administrative overlap. To us, this business model makes a significant amount of sense, and G&A margins have fallen from 17.2% of sales in 2008 to 15.7% in 2012. The latest investor presentation can be accessed here: http://files.shareholder.com/downloads/HBIO/2862251999x0x319371/30726C2A-DECD-4C30-A84A-46C507180003/Latest_HBIO_Investor_Presentation.pdf, where the business lays out components of targeted 15-20% EPS growth.

While it’s not difficult to look at the acquisitions and analyze them individually as being strongly accretive, we have to ask why EBITAR (before amortization and restructuring) has been flat since 2008, and only increased ~$2.2 million since 2009 despite $35 million in acquisitions. The explanation is probably twofold, both of which are discouraging:

1. The organic decline of the business has been more than enough to mostly offset all the gains from acquisitions. If we assume transactions are indeed done at roughly 6x ebitda, that means 35 million in acquisitions should have resulted in ~$5.8 million in EBITA (assuming D is minimal). This would assume organic headwinds were over $3.5 million. Either way, it means acquisitions were worse than 6x, or organic headwinds are quite significant. Our worries were somewhat confirmed by management telling us some of these acquisitions were end-of-life products. We were assured that HBIO would concentrate on acquiring synergistic growing product lines going forward, though potentially at higher multiples if we assume a mid-teen IRR.
2. When we observe the components of cost as % of revenue, it becomes apparent where we are losing. While we have repeatedly cut G&A from new acquisitions, sales and marketing continue to climb faster each year. S&M have increased ~4% of revenues since 2008. This is troubling since HBIO emphasizes its distribution and direct sales channel as strengths which tuck in acquisitions can leverage. However, with the latest announcement that $3 million of S&M ($1 million to be reinvested for growth), can be cut due to redundancies, sales and marketing decline from 16.5% of revenues to 13.8%, in line with 2008 levels.

Assuming that this $3 million was failure on previous management’s part to concentrate on optimizing the sales team for HBIO, the $2.2 million in EBIT increase +$3 million in redundant S&M and some gross margin decline would put the pieces in place. In general, we think the historical numbers don’t capture the economics of the business until we see some of the reduced costs hit the P&L.

Going forward, we expect management to focus on containing costs. Furthermore, in the latest call, Jeffrey Duchemin noted that he was looking “forward to working with Rob [CFO] and the management team to look at strategic acquisitions for the business in 2014.” Our call with management reinforced our conviction that HBIO will continue to deploy capital for growth.

Conclusion

In conclusion, we recap the investment rationale for HBIO:

• Though 2013 will likely surprise to the downside, we think with a recovery in sequestrated funds in 2014/2015, we should see some organic growth rebound into the business. Assuming we get back to 2012 levels, and taking into account the cost cutting measure reported this month, the Company is trading at 15x cash P/E and 11x FCF. This is a discount to its larger peers, despite what we believe could be a business with higher growth potential
• Assuming 0% organic growth and acquisitions done at historically guided (and seemingly accurate) 6x operating profits, we could acquire ~ $2 million in EBITDA or so each year. Fully taxes this might come out to $1.5 million in cash earnings (amortization will serve as a tax shield). With PF cash flow between $9 and $10 million currently, this is 15%+ CAGR on EPS and EBITDA. This in itself should warrant a multiple at least in line with current trading statistics
• Upside remains if HBIO executes on new strategies post spinoff, either through increasing EBIT margins from low teens to mid-teens (finding synergies, cost cutting), or through successful expansion in international markets, which have been growing much more rapidly than the U.S. markets.
• New motivated management with significant options granted in the low $4’s gives HBIO new focus, rather than being left as a footnote under the excitement of HART.

Appendix:

CIH 2013 Budget: http://officeofbudget.od.nih.gov/pdfs/FY13/FY%202013%20Full-Year%20CR%20Operating%20Plan%20Posting.pdf

http://www.prweb.com/releases/2013/9/prweb11125744.htm

http://www.photonics.com/Article.aspx?AID=44336

http://www.marketsandmarkets.com/Market-Reports/life-science-chemical-biotech-instrumentation-market-38.html