Description

Immucor (BLUD) is a diagnostics company that has 55% of the blood typing market in the US. They provide reagents and machines to perform both manual and automated blood typing (testing for A, B, O, AB). The stock has been displaced significantly because of soft physician visits this year due to the recession and subsequently lost 300M in mkt share on Oct 7 2010 due to lowered guidance for FY 2011. It has since recovered but is still trading flat YTD at > 50% discount to historical P/E and EV/EBITDA multiples, and is on track to generate FCF/EV yield of 7-8% in FY 2011.

The Business

BLUD currently competes with Bio-Rad Laboratories and Ortho-Clinical (subsidiary of J&J) but are the only commercial provider solely dedicated to blood typing and have acquired 55% of the US market since the company’s inception in 1982. They generate 30% of revenue from international sales from Canada, Japan and Western Europe. Revenue among product lines is distributed as follows:

• Traditional reagents- these are desk top reagents used in the manual method of blood testing. This requires a technician to physically mix a blood sample in a tube with reagents. These currently account for 60-70% of total revenue and are sold at 78-80% gross margins.
• Automated testing machines- BLUD entered the automated testing market in 1998 and since then have established themselves as the undisputed leader in this field. They have two machines on the market with the highest throughput (“GALILEO/NEO”) and fastest turnaround time (“ECHO”). The former is targeted towards large hospitals and the latter towards small-medium sized hospitals. Both are also equipped for STAT (emergent) functionality. These machines comprise 2-3% of total revenue and are sold at 18-20% gross margins.
• Capture reagents- BLUD’s proprietary machines have corresponding capture reagents that are required to process specimens and are only available from BLUD. These reagent sales currently comprise 25-29% of total revenue and have 80-85% gross margins.
• Molecular Immunohistology- In 2008 BLUD acquired BioArray Inc. for $117M in cash. With this acquisition, BLUD gained new technology to provide genotype specific transfusion testing to help prevent alloimmunization (immune reactions to blood transfusions). These sales represent 1% of total revenue and gross margins are near 40%.

The Moat

Razor and Blade

• BLUD currently sells or rents machines (razor) and places multiyear contracts for reagents (blades) unique to those machines. The annual revenue generated from reagents is equivalent to the purchase price of each machine and the 5-7 year contracts with hospitals afford a visible stream of revenue.

Customer Captivity

• BLUD has created a business model that is parallel to cellular phone companies. They sell the machines at very low margins (18-22%) and make the majority of profit on proprietary reagents with much higher margins. This further adds to visibility of revenue as customers who purchase a BLUD machine are locked into BLUD’s products for the life cycle of the contract, which is typically 5-7 years. Additionally, BLUD offers loyalty programs to provide competitive pricing for frequent customers.

High Switching Costs

• For customers who purchased BLUD’s machines, switching to a competitor requires replacing the entire machine. For those who have rented, switching costs still remain high as it requires retooling of the laboratory and retraining of staff on new equipment. The business is also protected by the fact that hospitals are very resistant to change, particularly for services that require 24-7 STAT functionality. 

Technology

• BLUD is the undisputed leader in automated testing. Currently 50-60% of hospitals in the US still use the manual method of blood typing leaving ample room for growth as hospitals acclimate to faster, safer and more reliable technology. They have developed the most technologically advanced machines on the market so hospitals seeking to convert to automated testing have fewer options than in the case of traditional manual testing.

The Economics and Balance Sheet

• Gross margins vary across product lines as detailed above, but the weighted average gross margin = 70%
• Net margin = 25-27%
• ROIC = 20-24%
• Assets/Equity = 1.1
• ttm Operating Income / EV = 11%
• Total Cash and Marketable Securities = 231M
• Total Debt = 0
• 70M shares outstanding; have repurchased on average 750,000 shares per year since 1998 (9.1M in total) and have authorization for 2.2M in share buybacks in FY 2011
• Total insider ownership = 14% and weighted avg strike price of options outstanding = $17.77/share
• Stock has split 5 times since 2002

BLUD accounts for sales of machines in different ways depending on whether the machine is purchased or rented. In the case of a purchase, the entire expense is booked at the time of sale and revenue is deferred over the life of the contract. In the case of rentals, the cost and revenue are prorated and recognized over the life of the contract.

The Displacement/Consensus View

• Hospital volume was down in 2010 and BLUD management guided a persistent slowdown into 2011 and subsequently lowered guidance for FY 2011 on October 7, 2010. The stock had been mostly flat YTD prior to the announcement but lost 20% that day. 

• Capital budgets for hospitals have been squeezed in the last two years and internal laboratories are traditionally high cost centers. Management recently stated that hospitals have been involving CFOs to a greater degree for capital equipment purchases and as a result they have seen a shift towards rentals (75% rental rate in FY2010) of their machines over purchases. Hence the “stickiness” of BLUD’s reagent revenue from these machines has been under question.

• In June 2009 the FDA announced an “intent to revoke” their biologics license specific to two reagent products that were found to have manufacturing issues. The company has since launched an internal initiative to fix the problems but stated on the Oct 8 EPS call that the FDA has still not fully cleared the company after a recent inspection in September.

• There is concern that the clinical practice of blood transfusions has shifted towards using a higher threshold for blood products which would cause an overall decline in the rate of blood typing.

• Management stated they lost market share in traditional reagents sales in 2010 due to customer service problems. 

The Catalysts/Variant View

• The total market for blood testing in the US alone is $1.2B and 51% of all blood typing done in the US is for cardiac or orthopedic surgery. The demographic makeup of this population is typically a 55+ year-old patient. The coming decade will see growth in the number of baby boomers who will drive up demand for cardiac bypass and hip and knee replacements. The temporary slowdown in volume is related to a drop in elective surgeries which is directly linked to unemployment and lack of insurance coverage. Utilization of health services will increase due to increased demand and broader access to healthcare, and blood typing is a fundamental component of most any hospital visit. Assuming the near-term forecasted slow-down reflects deterioration in the fundamentals of the business is myopic and ignores basic epidemiology of an aging and growing population.

• The shift to rentals over purchases does not imply hospitals will be switching to BLUD’s competitors. The cash outlay for their machines is between $50-120k, and which come with the benefit of price guarantees. CFOs of hospitals are likely looking at the near term financial impact of purchasing and have opted for making budgets in the short term over stable pricing in the long term. Salaries and bonuses have been frozen and in some cases decreased across many hospitals over the past two years, so putting off major capital equipment purchases is not surprising. Additionally, the runway for growth in automated testing is large. Hospitals will be looking to trim costs more aggressively under the new health reform act as reimbursements have come under pressure on top of existing precarious budgets. Switching to automated testers is cheaper, safer and more efficient and BLUD has firmly established itself as the industry leader in this area. Tethered to these machines are BLUD’s high margin capture reagents which will continue to see growth regardless of whether hospitals purchase or rent machines. Additionally, as of end 1Q:2011 (Aug 31, 2010), BLUD had backorders of 142 ECHOS and 49 GALILEOS/NEOS which had yet to come “on-line.” This is in addition to an existing base of 735 ECHOS and 657 GALILEOS/NEOs currently on-line and generating normalized run rate revenue from reagents. Despite a slowdown in the business, BLUD still generated 18% YOY growth in sales of capture reagents (specific to their machines) in 1Q:2011, reflecting the continued industry shift towards automated testing despite tight hospital budgets.

• The FDA has not suspended any part of BLUD’s manufacturing. They have had ongoing inspections and have told management that despite noted improvements, they still had “deviations” on the last inspection in September 2010. Management provided the FDA with their plan for remedying the remaining “deviations” and was told the plan was adequate. BLUD has allocated resources and attention towards correcting the issues and if the FDA were to shut down manufacturing, they would likely have done so by now. It is also important to note the implications of temporarily ceasing BLUD’s manufacturing. While management won’t explicitly state it, they likely know the FDA will not shut down a business overnight that supplies 55% of all blood typing across the US. They do not sell an esoteric biotech drug as in the case of Genzyme, and their well-publicized manufacturing issues, but provide a core staple need to any hospital visit. Taking BLUD products off the market overnight would leave hospitals little time to accommodate and would result in significant delays in blood typing, with potentially catastrophic outcomes. While this is certainly an issue to watch closely, the sell-off has been overstated relative to the likely outcome.

• The demand for blood typing will continue to grow. There are always updates to clinical guidelines related to transfusions (i.e. recent research that patients with end-stage renal disease were being “over transfused”). BLUD’s revenue does not depend on a patient receiving a transfusion but instead on the potential alone that patient may need a blood transfusion. Blood typing is included in the vast majority of routine lab work on a hospital admission and in 100% of patients going for any type of surgery. Any adjustment to clinical guidelines for specific conditions will not move the needle relative to overall demand.

• The loss of market share in traditional reagents is worth watching closely, but does not indicate a fundamental erosion of their competitive advantage. Management has stated an internal initiative towards recapturing these customers. Additionally, these sales are historically the least “sticky” and as the industry continues to convert to automated testing the market for traditional reagents will shrink.

The Valuation

Management is projecting a drop in volume of 3-4% for FY 2011 on top of the existing drop in volume of 3.5% in 2010. They lowered revenue guidance to 320-332M for FY 2011 (essentially flat YOY revenue growth) and fully diluted EPS to $1.08-$1.18. Based on 1Q2011 revenue of 84M and EPS of $.30, they are tracking to meet revised guidance despite the forecasted drop in volume. 

Since 2004, P/E has averaged 38x and EV/EBITDA has averaged 20x. At current share price, the stock is trading at 17X ttm P/E and 8x ttm EV/EBITDA- a greater than 50% discount to historical trading range. In accounting for excess cash on the balance sheet (no debt) the core franchise is trading at only 15x P/E.

Assuming revenue and operating income meet the low end of management guidance, and D&A and CAPEX remain in line with historical averages, the business should generate 86-94M in FCF for FY 2011. (FCF defined as EBIT less BLUD’s normalized tax rate of 34% + D&A/noncash expenses – total CAPEX). This translated to a FCF/EV yield of 7.3-7.8%.

In accounting for the robust growth prospects beyond FY2011 via a recovery to normalized hospital visit rates, expansion of automated testing and overall increased utilization of healthcare services, the current share price is yielding an IRR between 15-18%.

Catalyst