Description

This $1.6bn manufacturer of molecular biology and cell culture consumables represents an attractive investment opportunity due to the following factors: 1) leadership position in niche markets, 2) ~100% recurring revenue, 3) growing end markets, 4) definable growth prospects, 4) strong free cash flow (both in terms of net income conversion and FCF yield), 5) strong balance sheet with $8.50 of net cash that is not reflected in current valuation, 6) P/E and FCF multiple too low relative to 5-year growth prospects, 7) beneficiary of weaker dollar, 8) 2003 guidance is conservative and beatable, and 9) the company has been aggressively buying back stock and plans to buy back $6 per share of stock over the next 3 years.

IVGN can be described briefly through the following splits:
Pdt Split: 70% molecular biology (MB) pdts / 30% cell culture
End Mkt Split: 60% Academic - Government / 40% Pharma - Biotech
Geographic Split: 60% US / 25% Europe / 15% Japan - Asia

IVGN's valuation can be characterized as follows:

IVGN currently trades at 17.5x TTM EPS and 20.5x TTM FCF. The company trades at 15.21x 2003 EPS, and I estimate that 2003 FCF will be close to 100% of net income (with a ROIC of 50%, IVGN has the ability to grow the top-line at 10% and generate FCF nearly approximates EPS).

Importantly, IVGN has $8.50 of net cash on the balance sheet, which is generating EPS of 3c per share on an annualized run-rate basis. Adjusting for this, the 2003 P/E is ($31.19 - $8.50) / 2.00 = 11.35x.

I believe that IVGN has the ability to growth the top-line 10%+ over the next 5 years. In 2002, IVGN's reported growth rate was impacted by several severe distortions that masked the true underlying rate of growth. This factors will be eliminated in 2003 and 10%+ reported growth should result.

In 2002, IVGN's reported growth was only ~3%. However, this growth was distorted by two important factors. First, IVGN did a big acquisition in 2000 and there were a number of pdts from the acquisition that were eliminated in 2002. Also, IVGN had two problem business lines within the molecular biology segment that were down 20% and 50% respectively (the oligonucleotide synthesis business and the genomic services business). These two trouble segments represent <5% of IVGN's total revenues each and should not provide the drag to 2003 growth that they provided in 2002 (i.e. I expect them to grow y/y in 2003 from the depressed 2002 base).

IVGN reported two key numbers in 2002 that provide the best proxy for the company's underlying growth rate-- cell culture sales excluding discontinued pdts and core molecular biology pdts excluding disc pdts. Those grew 12% and 16% in 2002. I expect growth of 10%+ for both of these segments in 2003.

There are several ways to look at IVGN's long-term growth rate. The first is to consider the growth rate of its served end markets.

The academic market has been growing in the mid teens for the past 5 years, but I expect that growth rate to slow to 7-8% after 2003 due to an anticipated slowdown in the growth rate of the NIH budget as we enter the "post doubling era"-- (the budget was doubled from 1998-2003 in a special 5-year doubling initiative, but the return of budget deficits and a sense that the NIH already got a nice bump will temper growth going fwd).

I expect pharma and biotech R&D spending to growth 10%+ and I expect molecular biology reserarch to gain share of the discovery budget as we enter the "post sequencing era" and companies focus on "functional genomics."

I expect cell culture to grow 8-10% and molecular biology to grow 10-12%.

As I said before, IVGN grew cell culture 12% in 2002 and core molecular biology 16% in 2002. These growth rates will probably slow down going forward due to several factors. Cell culture growth rates were boosted in 2002 by an increase in a key raw material (fetal bovine serum) that IVGN passed through to its customers. This artificially boosted the growth rate by ~4% so the actual growth rate was more like 8%. However, the growth rate going forward should be faster due to improved mix (the faster growing pdt line is becoming a bigger % of the business) and the fact that 2002 was a slow year for biotech production due to a lower-than-normal # of biotech drugs approved by the FDA.

Molecular biology grew 16% in 2002, but I actually expect that growth rate going forward to decelerate. This is for several reasons. First, I expect the NIH budget to slow from 15% to 6-8%. Second, IVGN has been spending only 5% of sales on R&D when a number closer to 10% is ideal. IVGN is planning to boost the R&D/sales ratio to 10% over the next 3-5 years while using scale on SG&A and anticipated gross margin expansion to maintain operating margins at the 23% level. However, IVGN's pdts generally have a 3-year ramp and lower new pdt introduction today can impact the growth rate going forward for several years. The net impact is I expect the growth rate in molecular biology to slow but still remain healthy.

I have done a lot of work on IVGN and can discuss numerous issues that surround the company at length. However, for the initial recommendation, I will summarize by view by saying that my DCF analysis suggests the company is worth $40+ using what I belive are conservative assumptions. Clearly, any company that is trading at 11.5x 2003 adjusted cash EPS (adjusted for net cash on the balance sheet and the interest income that it generates) that has a leadership position, recurring revenue, definable prospects, top-line organic growth of 10%+, and the ability to generate free cash flow while pursuing this growth is worth more than 11.5x EPS.

Now, the market isn't stupid, so I should probably take a moment to discuss why I think it is currently according IVGN a low valuation and why I think this reason will not hold down IVGN's valuation forever. IVGN currently has $21 per share of gross cash on the balance sheet and $8.50 per share of net cash. I do not think the market is giving IVGN full credit for its net cash position and is in fact assuming that the $21 of gross cash will be deployed in a way that destroys significant value. The reason for this is that the company has made some dubious acquisitions in the past (IVGN did several expensive deals using its stock for currency when the company was trading 2-3x higher than the current stock price) and recently made a small acquisition that cost only $10mm net of cash but that was dilutive because the business was and will continue operating at a moderate loss.

One sign that there is a "use of proceeds" discount in IVGN's current valuation is that IVGN stock price took a significant dip after the most recent dilutive acquisiton was announced. Numerous people voiced concerns that IVGN would be doing a strong of dilutive deals like that one. Since the time of the last deal, IVGN has said that they do not have an appetite for dilutive deals and they have suggested that they are close to completing two deals which will be acretive and should be better received by the market. I believe that the completion of one of these deals could serve as a catalyst for the stock by providing the market with more confidence on how the company will deploy their cash position going forward.

I should note that IVGN currently has a stock buyback authorization for $300mm (close to $6 per share). The company plans to buy the stock back over the next 3 years and has been buying stock already at a pace that is consistent with at least $100mm per year of buyback.

Another issue that surrounds IVGN right now is that the founder and CEO of the company recently announced that he was leaving as of Dec. 31st. I believe that this change came abount because this person and the board of directors did not see eye-to-eye on strategic direction. I also believe that a number of investors in the company did not feel that the entrepreneurial skillset that allowed this person to lead the company so successfully to date was the best one to lead the company going forward. Rather than write about this change in management at length, I will simply say that I believe this change is positive because 1) I do not believe it reflects severe problems in the past that have yet to surface, and 2) I think it could result in IVGN attracting a leader who can run the company with more of an operational (vs. visionary) focus.

The key risks that I see to IVGN are 1) my concern that the 2003 NIH budget approval could be delayed beyond late Jan 2003 due to the situation with Iraq and other issues that are delaying the budgeting process, 2) new pdts are critical to maintaining growth and margins and I might be underestimating how much IVGN's lower-than-ideal investment in R&D over the past two years will drag down the growth rate, 3) biotech customers represent about 15% of revenues and the portion of sales that comes from "emerging biotech" instead of "big biotech" is at risk as many emerging biotechs have less than 1 year of cash on their balance sheet and the capital markets are not receptive to futher funding.

Note-- Some people who are not familiar with IVGN will look at the GAAP EPS and see a big difference in EPS vs. my figures above. IVGN has to be looked at on a CASH EPS basis given the large amount of intangible amortization.

Catalyst

1) company could announce 1 or 2 acquisitions that will be viewed favorably relative to the last dilutive deal that sent the stock down
2) the recent drop in the dollar vs. the euro and yen should provide positive 2003 EPS revisions
3) delivering on 10%+ organic top-line growth will defy the skeptics who do not believe that this growth is achievable (I do)