Harvard Bioscience is a life science research tools business that provides “picks and shovels” to the scientific research community worldwide.  The company began at Harvard Medical School in 1901, hence the name, and was re-constituted in its current form in a management buy-out in 1996.  The company has been a stellar grower in the recent past, partially due to its history of making small tuck-in acquisitions of undersized companies and then growing the revenue after acquisition.  Since starting its life as a publicly-traded company in 1996 with $11 million in sales, the company grew the top-line approximately 10-fold to $111 million in revenue as of the end of 2012, for a CAGR of about 17% over that period.

The current opportunity to invest in this business comes as a result of the decision by its (now former) management, beginning in 2008, to launch an internal R&D project to re-grow human organs in bio-reactors for life-saving transplantations – truly an audacious goal.  The company has devoted significant resources to this project, and the expenses associated with this effort have effectively masked the normal double-digit profit margins produced by the core life sciences tools business.  In fact, in recent years as the regenerative medicine business has progressed, the costs involved have nearly utilized the profitability of the core business entirely.  

However, that changed on November 4, 2013 when HBIO separated the businesses by way of a spin-off of the regenerative business, called Harvard Apparatus Regenerative Technology, or HART.  Now that the core HBIO business is freed from the ongoing investment in HART, the underlying profitability should become evident within the next couple of quarters.  Furthermore, HBIO has been somewhat hampered in its ability to fully execute on its classic acquisition strategy – buying undersized product companies for 4-6X operating profits – because its financial statements no longer demonstrate the true profitability of the business. As a result, HBIO has not been able to tap cheap credit markets to fund deals as it might otherwise be able to do were it demonstrating consistent cash flow. Given that the financial statements of HBIO’s business post-spin should soon reflect its true cash cow nature, HBIO should easily be able to borrow money if it wishes to fund accretive acquisitions.  

At the current price of ~$4.30, HBIO trades at a market cap of $130M or so, or roughly 1.25X expected 2013 sales.  Based on my best guess of what HART was costing HBIO in terms of profits, HBIO appears to be capable of generating $12-15M in FCF annually, such that equity investors have the opportunity to purchase a very high quality 100-year old business at around 8-12X FCF, depending on exactly where FCF comes out in 2014. 

Let me take a few minutes to review HBIO’s core life science tools business.  The strategy at HBIO is to offer a broad range of relatively inexpensive products, with a high percentage (about 1/3) of them being consumables. Average order sizes for HBIO’s customers tend to be about $1K.  This provides the opportunity for high operating margins and low business volatility as compared to expensive capital equipment.  Examples of the kinds of products HBIO offers includes syringe pumps (which HBIO invented in the 1950’s and in which HBIO has 70% market share today), organ test systems for toxicology studies by pharmaceutical companies, and molecular biology research lab consumables, as well as spectrophotometers and various gear for analyzing and purifying DNA and RNA.  HBIO’s business does entail some proprietary technology, and the company has roughly 400 patents filed to protect its inventions. HBIO manufactures most of the products it sells (67% of revenue), but also distributes products manufactured by third parties under its own brands (23%) and bundles in other complementary products from other companies in order to provide added convenience to the customer (10%).

Customers tend to be research scientists at major colleges and universities, med schools, and government laboratories as well as pharmaceutical and biotechnology researchers. HBIO’s Harvard Apparatus division publishes a catalog, updated twice yearly, that runs nearly 850 pages, and which is now also available online. HBIO’s products are also available through life science distributors.  HBIO also has internal sales teams in the US, UK, Germany, Sweden, Spain, and other countries.  HBIO has its own manufacturing facilities (all of which are leased) scattered throughout Western Europe and the US.

HBIO at one owned time a small medical capital equipment business unit, but sold it off in small pieces from 2005 to 2008.  GE Healthcare is the single largest customer (6% in 2012) and serves as a distributor that re-sells equipment to health science customers around the world.  But customer concentration is not a major risk here, as HBIO has several thousand customers and other than GE has no customer that accounts for over 5% of sales.  However, there are many distributor arrangements in addition to GE, such that direct sales to end users comprise roughly 57% of total sales and sales to distributors are roughly 43%.  HBIO isn’t really a seasonal business, but Q3 tends to be the weakest quarter and Q4 the strongest quarter given holiday schedules in Europe and the spending of research budgets by universities and research departments in Q4.  Roughly 40% of sales come from outside the US in non-dollar currencies. 

The core HBIO business is a very high quality, reliable business. The company has only had two or three down years for revenue in its history since 1997, and in many cases that has been the result of currency effects rather than true sales declines.  As a litmus test, the recession years of 2008-2009 had little effect on HBIO’s business. While the organic growth rate in the industry has been low, HBIO has historically done snap-on acquisitions (they have done 25 in total through year-end 2012), usually of very small ($1-5M in revenue) businesses that are under-sized but have good products.  HBIO has been able to pay modest multiples (usually 4-6X operating earnings) and then gain synergies through cost savings and enhanced distribution after the acquisition.  This has been a powerful model for growth in the company’s history, but HBIO has not been very active on the acquisition side recently due to its engagement in the regenerative health business.  Management believes its business can grow at a low single digit rate organically, but at a low double digit rate assuming two or three well chosen acquisitions per year. 

On the topic of acquisitions, HBIO often used modest financial leverage back in the high growth years in order to do acquisitions; today the company is essentially unleveraged, with only about $5 million net debt after contributing $15M in cash to HART with the spin-off.  Clearly, HBIO could leverage up to 2X EBITDA/ net debt without much problem in order to make acquisitions now that the company’s EBITDA from HBIO will not be reinvested into HART’s business and could be used to service debt. HBIO ended Q3 with $34M in cash and $24M of debt, but this is before the $15M has been carved out to go with the HART business.  As such, I’m using $5M as a net debt figure. Approximately $20M of HBIO’s cash is held in the European subsidiaries, which shouldn’t be a problem since there are plenty of small acquisition opportunities outside the US for HBIO to pursue.  In recent years, the company has in fact been making European acquisitions; the limitation to pursue deals has largely been limited to the US.  The last two materials deals were the acquisitions of CMA Microdialysis of Sweden for $5.2M in 2011and AHN Biotechnologie of Germany in 2012 for $2M.  The last major US deal was a $22M acquisition of Denville in 2010, which explains the jump in sales from 2009 to 2010.

2013 was an unusually soft year for HBIO. Recent revenue has been negatively affected by sequestration in the US related to government research activity.  Also, HBIO’s distribution business fell off with GE in the last couple of quarters, which the company characterized as simply due to GE having a little bit of inventory in the channel that needs to be cleared. GE is only about 5% of total company revenue, but apparently GE ordered very little product in Q2 and Q3.  Q3 revenue of $25.1M was down 3.7% from the prior year, with organic revenue down 3.8%.  The company broke out the EPS contribution of the two businesses for Q3, with the core business contributing 5 cents versus 8 cents the prior year.  So far in the first nine months of 2013, sales were $77.3 million versus $82.9 million in the year-ago period. This was a decline of 6.8% from the prior year.  EPS from the core business was 19 cents for the first nine months of the year, versus 28 cents in the first nine months of the prior year.   HBIO is now expecting roughly $104M in full year 2013 sales, or roughly $28M for Q4.  This will be well below the sales level of the last three years ($108M in 2010 and 2011, $111 million in 2012).

HBIO will clearly benefit in a number of obvious ways by the separation of the two businesses, most notably by the removal of the losses of HART from HBIO. In addition, HBIO will be able to utilize NOLs from the investments in HART over the past several years, which is roughly $12M, thereby reducing cash taxes and improving near-term FCF over and above what would have been the case simply by removing the expenses from HART.   Second, if HART is successful, the IP associated with the regenerative medicine business has been granted to HBIO, which will presumably have a new and growing market to sell into. So HART’s success as a stand-alone company has a chance to benefit HBIO.

There are some other “soft” factors that I think will ultimately show up in HBIO’s favor due to the split beyond simply removing the expenses associated with HART.  First of all, I think that HBIO’s core business has likely been under-managed in recent years.  The prior management team of HBIO, CEO David Greene and CFO Thomas McNaughton, are leaving to manage HART.  I think this speaks volumes about where the management’s interest has been the last several years.  In fact, in the call back in December 2012 when HBIO originally announced plans to separate the two businesses, Chairman Chane Graziano listed a number of benefits from splitting the two businesses. He specifically mentioned the CEO David Greene had devoted “the vast majority” of his time to HART over the prior two years. In short, I suspect that HBIO hasn’t received full management attention due to the management’s efforts to succeed with its regenerative business and that it should be producing better results than it has been.

On that front, HBIO has announced a new CEO, Jeff Duchemin, who spent 16 years with Becton Dickinson before his unit there, BD Biosciences, was acquired by Corning Life Sciences. Duchemin comes over from Corning, and appears to be primarily from the sales side, which strikes me as exactly what HBIO needs.  Duchemin has brought in a new team of senior executives with him. Robert Gagnon, 39, has been brought over to be CFO.  Gagnon comes from Clean Harbors, but prior to that was at biotechnology blue chip Biogen Idec for several years.  Two other executives were highlighted on the Q3 call. Yong Sun has been hired for the position of VP of Global Strategic Marketing and Business Development, and is a native of Beijing but has 25 years working for leading US companies. My guess is that he will be looking to help HBIO make some inroads to Asian markets.  Yong and Gagnon are both graduates of MIT Sloan business school.  The other new exec is Yoav Sibony, who will be the VP of global sales.  Duchemin has worked with both Sibony and Sun in the past and clearly sees them as key hires to expand HBIO’s global sales and distribution capabilities. 

HBIO’s Chairman is Chane Graziano, a co-founder of the public company dating back to March 1996, and Graziano has also served as CEO in the recent past.  Graziano is in his 70’s and so while it is good to see him engaged as the Chairman, I think this company is wise to bring in new management in order to ensure a smooth succession. Graziano owns nearly 14% of the stock, so he is very heavily invested in the business.  Former CEO David Greene also owns 9% of the stock. In total, officers, directors, and former officers own 26.8% of the shares outstanding.

The company’s cash compensation packages for the new hires feature reasonable base salaries and bonuses to be based on the Board’s annual targets, with formulas for revenue growth, profit growth, and profit margins. HBIO has also granted options as an inducement to the new management: 500,000 to CEO Jeff Duchemin, 150K to CFO Robert Gagnon, 100,000 to Yong Sun and 50,000 to Yoav Sibony, for a total of 800,000 options.  At roughly 2.7% of the current shares outstanding, it isn’t egregious so long as it is one-time in nature, and the options are struck at $4.31 so these are at-the-money options. Duchemin’s options vest all at once three years from the grant date, while the options vest ratably over four years for the other guys. 

In December, HBIO announced a cost-cutting re-organization that appears to be designed to bring costs in line with revenues in order that HBIO can get its profit margins back into the mid-teen range that the business model should support.  The global workforce will be reduced by ~13% by eliminating “certain redundancies” with annual savings of $2 million per year beginning next year and an immediate reduction of personnel costs and expenses of $3M, of which the company will reinvest $1M in growth initiatives.  HBIO will take a $1.5M charge in Q4.  This is pretty modest all things considered, and the first full quarter of a management’s tenure is a good time to do it.  I expect that HBIO will soon resume its efforts to find acquisitions to tuck into its business and drive some top line growth.

The major risks are that the new and somewhat unproven management team fails to return HBIO to its former growth trend or to restore its historical profitability.  I suppose there is the potential that HBIO does a large acquisition that turns out poorly.  My view is that the presence of Chane Graziano will help mitigate the risk of any terrible capital allocation decision on the part of the new executive team.  Graziano was the CEO prior to David Greene and managed the company during some of its stronger growth years, so he should be able to help the new guys manage the growth playbook reasonably well. As the Chairman and largest owner of the company, I would expect him to be fully engaged here.

As far as the negatives are concerned, HBIO does issue more options than I like to see, and have been running roughly 2-3% of shares outstanding per year. At year-end 2012, there were 28.8M shares outstanding, but the diluted share count also included 625K restricted stock units. There are roughly 5.6M options that were exercisable at Dec 31, 2012 with a weighted average price of $4.33, of which 3.55M options were in the money.  There are more than 8 million options outstanding. I am hoping some of those options go with HART in the spin-off. HBIO also has some pension obligations for some of its subsidiaries, where it shows a deficit of roughly $5M. I have chosen to ignore this liability in my valuation work below.

As far as valuation is concerned, at the current price of about $4.30, HBIO is valued at roughly $130M, or about 1.25X sales (on what I consider to be a low year for sales).  I expect net debt to be roughly zero in the next couple of quarters; net debt was about $5M as of Q3 adjusted for the spin.  Given any kind of benefits from a renewed focus on sales growth under the new management team as well as any acquisitions, I think that HBIO should be able to recover its prior sales level and grow sales to something like $120-125M within a couple of years.  HBIO has maintenance cap-ex requirements of something in the range of $1-2M per year, so the business itself doesn’t require much capital.  More importantly, with the one-time expenses related to the spin-off and downsizing likely flushing through in Q4 and with the help of NOL’s reducing cash taxes for the next few years, I would be surprised if HBIO can’t reach a FCF margin of 12-15% fairly quickly.  This implies that HBIO should be able to generate $13-16M in FCF even off its current sales base; if the company can grow revenue to $125M by 2016 and generate a 15% FCF margin, the FCF would be about $18.5M per year.  If the market were willing to pay 15X FCF for this business, which in my view is not unreasonable, the market cap would be $275M.  Even assuming the share count swells to 33M due to options (and forgetting for a moment the cash value from option exercises) we’d be looking at a stock price of $8.33.  So there’s a clear chance for a double in value from here over the next 2-3 years if new management just gets the business back to where it was in 2011 and can demonstrate to the market that there are growth opportunities going forward.  I think that is a pretty safe bet. 

In summary, HBIO appears to be an interesting special situation investment.  The long thesis is that HBIO will benefit dramatically from the recent separation of its development-stage regenerative medicine business from its high-quality core research tools business, which has probably been under-managed during the course of the last three years as the management team was heavily focused on HART.  Also, I have no doubt that HBIO would be a great acquisition for many larger firms, most of which are valued at a higher multiple to sales and would likely pay at least $5-6 per share for this business if it were put up for auction.  The biggest problem with the HBIO thesis is the small float; the huge insider ownership makes it difficult for a large fund to establish a meaningful position.  

• Removal of the expenses from HART will reveal the underlying profitability of the business
• Recent cost structure initiatives should push HBIO towards a 15% net margin / FCF margin 
• The ability to increase M&A activity should help grow the top and bottom lines.
• Acquisition by a larger firm in 2-3 years