Description

Concern about decelerating organic revenue and EPS growth has resulted in severe multiple contraction and an opportunity to buy a very good business at a very good price (~10% FCF yield).  TMO is a great business with 55% ROIC, ~100% Adj EPS to FCF conversion (96% on a LTM basis), leading market positions, and business mix that should hold up quite well in a severe economic downturn.  Management is highly regarded—they have executed well and have the right planning and expense management discipline and mindset to hold profitability in a tough economic environment.

 

For the past few years and until a few months ago, TMO had been a story of solid 5-7% organic growth and margin expansion of about 50-100 bps y/y from the current ~18% level.  Now, in the face of a very tough economic environment, organic growth could drop to 0% and margin expansion could drop to “only” 0-30 bps of y/y expansion.  Nonetheless, earnings should not fall apart, absolute FCF/share should grow, and TMO should be poised to resume growth when the economy normalizes.

 

The main catalyst for TMO will be proving to the market the ability to hold earnings in a very tough market environment.  I believe the current ~9% NTM FCF yield (which went as high as 11% a few weeks ago) is just too low for this company given its high quality and long-term growth.  At some point, the market will become less risk averse and price this company more appropriately (I think a 7% FCF yield is quite reasonable). 

 

In addition, TMO has done meaningful share repurchase in the past and has an active $500mm share repo program.  TMO’s repurchases have been rather erratic: they did $228mm in Q206, $300mm in Q406, $898mm in Q407, and $102mm in Q108.  They did nothing in Q2/Q3 08, but I expect them to buy back $500mm over the next year.  The combination of a high and sustainable FCF yield and continued share repurchase should provide decent support to the stock.  Tuck-in acquisitions are another priority for redeployment of FCF.  I expect TMO do be disciplined and to create value through such acquisitions.

 

The reason TMO merged with Fisher two years ago was to pursue a one-stop-shop strategy.  While many companies fail in the pursuit of such a strategy, I believe it is working well for TMO and the time is right for this in the healthcare space right now.  Many pharma/biotech customers are looking at their costs and efficiency closer than ever, and this is driving vendor consolidation which benefits TMO and its one stop shop.

 

One of the things I like to find are companies that are likely to be acquired.  I would not place a high probability of an acquisition of TMO, especially in the current environment.  Rather, I see TMO as being a buyer of other companies and I think they will create value by doing a series of tuck-in acquisitions.  I believe that TMO’s one-stop shop is working and that the current financial environment and increasing strategic impetus for smaller companies to sell to TMO should put TMO in a good position to do value-creating acquisitions.  In other words, TMO is in a position to benefit from industry change that favors larger companies with scale and the ability to provide a one-stop-shop.

 

TMO generates a smaller portion of revenue ex-US than do many other life science companies.  A big part of this reason is that Fisher was mainly a US distribution business.  Legacy Thermo had a decent international presence, and can use this presence to build out the Fisher side of the business over time.  I believe TMO is showing progress in this area, and continuing to do well in this area will boost growth and the multiple the market is willing to award TMO.

 

To put it simply, TMO is a very good company with a good business mix, strong management, and a strategy/positioning that is working. 

 

It is always important to ask what the market may be missing in a particular stock.  One thing that I think the market may be missing in this case is the way TMO’s business mix has changed since the last downturn.  As mentioned above, prior to the Fisher acquisition, TMO generated ~70% of sales from instrumentation and 45% of sales from cyclical industrial customers.  Now, instrumentation is 30% of revenues, and cyclical industrial customers are 15%.  Even though I am sure the market is aware of this basic fact, the market hasn’t seen what this will mean in the real world in terms of how well the business holds up in the face of a deep economic downturn.  In fact, it takes a decent amount of analysis and research to create a “pro-forma” for what TMO looked like in the last downturn.  It turns out that the Banc of America analyst has done this work and it’s pretty interesting: while reported TMO had -3.6% growth in 2002 and hit -4.6% y/y in Q102, pro-forma Thermo Fisher actually grew 2% during that time.  I will note that I expect the stable pharma/biotech segment that helped drive this positive pro-forma growth in 2002 to grow slower in 2009 and for the next few years.  So, with this in mind, organic growth may slip to 0% or even go slightly negative, but it won’t fall apart in 2009 and should resume a strong enough long term trajectory to warrant a low teens FCF and PE multiple.  In summary, I believe the ability for TMO’s business to hold up well in the face of a bad economic downturn is underappreciated.

 

Other Positives / Positive Change

1)    Market underestimating key boosts to 2009 operating margins: TMO has an opportunity to get close to 100 bps of OM expansion in 2009 even with minimal organic growth.  TMO took pricing in Aug 2008 to offset the pressure they had seen from raw material inflation (resin, oil, etc).  This full year impact of this pricing in 2009 should boost margins by 25 bps.  Furthermore, the costs of these raw materials have reversed dramatically since Q308.  They pressured margins by about 30 bps in 2008.  The dramatic drop in raw commodity costs could very well create a 50 bps boost to margins in 2009 (this is a rough guess; disclosure is limited in this department; timing is also a question given potential hedging and contracts).  Unlike food companies that have greater pressure to pass savings to customers, TMO has a decent amount of pricing power and can pocket much of this windfall.

 

2)    Fisher’s main competitor VWR has been losing share year after year to Fisher and remains hobbled.  VWR is owned by private equity and is heavily indebted which limits their flexibility.  VWR’s focus has been on maximizing pricing to maintain cash flow to pay debt.

 

Risks / Negatives

 

Economic downturn worse than expected: TMO should perform relatively well in an economic downturn, but there is some economic sensitivity.  If we enter an extremely deep recession, organic growth will be pressured further and a scenario with 5% organic revenue decline becomes a possibility.  But, if this is the case, other industrial and economically sensitive companies should be hit even more relative to current expectations. 

 

Margin Expansion Flattens:  In April 08, management promulgated a 3-year outlook/goal of 4-6% organic revenue growth an 100 bps of annual margin expansion (from 18% to 21%).  The market’s implicit expectations for growth have dropped since then due to the worsening economic outlook.  TMO currently trades at a ~10% FCF yield, which suggests to me that the market expects little if any revenue growth or margin expansion.  In fact, the current valuation suggests to me that the market fears that margins could in fact fall.  If TMO can continue to expand margins even with minimal growth (as management says they can), TMO’s stock should do very well.  If, however, volume leverage and a strong demand environment played a bigger role than management has acknowledge or the market believes, TMO will disappoint.  I am in the camp that believes that TMO had hold or slightly improve margins.

 

Will Cyclicality be Greater than Expected?  TMO generates 15% of revenue from cyclical industrial end-markets that include such areas as petrochemicals, basic materials, and coal fired plants.  About 1/3 of revenue from this 15% comes from service and should be steady or grow even in a severe downturn (as firms cut back on their own headcount and outsource more service and keep machines longer).   The remaining 2/3 of revenue is mostly capital equipment and will decline with CapEx budgets.  There is a big replacement component to the demand (it is not just driven by new capacity spend), so my guess is that that portion could decline 30%.  Thus, 10% of TMO’s revenue could decline 30% which creates a 3% drag to growth.  I think TMO’s cyclicality will prove to be much worse than is feared by the current stock price. 

 

Lower Asset Values Pressure Endowments & Academic Spending: Thermo generates 20% of revenue from the academic/government research segment.  There has been some concern amongst investors that endowment market losses will hurt spending by this segment.  Any slowdown would impact the 30% of revenues that TMO gets from equipment sales the most (consumables & service sales would also take a hit, but that would be more in the form of the growth rate slowing down versus actually turning negative).  According to the NSF and Morgan Stanley Research, institutional funds (i.e. endowments) represent ~20% of US academic R&D.  ~60-65% comes from the federal government where the NIH is the primary driver.  NIH funding boomed during the Clinton years, but has been flat during the Bush years.  It looks like NIH funding is poised to accelerate under Obama and that this area could be a beneficiary of his fiscal stimulus plans. I believe that for the academic/govt segment, the positive NIH backdrop will largely offset the impact of lower funding from the endowment-driven sources.

 

Lower Pharma/Biotech R&D Growth Rate: Pharma/biotech represent 25% of TMO’s revenue.  I don’t have hard data, but “emerging biotech” companies are probably 3-5% of revenue and the rest comes from large cap pharma & established biotech (like AMGN, DNA, BIIB, etc).  Large cap pharma/established biotech has been growing R&D > 10%/year for the past 5 years.  It is reasonable that as profit growth for pharma growth is pressured by patent expirations & other issues over the next few years, the rate of R&D growth could fall into the low single digits.  Also, the “emerging biotech” segment has been hit by the credit crunch and is currently facing severe funding challenges.  This should mostly hit capital equipment sales into that segment. 

 

Summary of End Market Issues:  In my view, TMO is a very well managed company.  I think the biggest risk to TMO’s stock performance will come from end-market issues as opposed to company specific execution.  I think TMO’s management team is very good and that they will do as good as job as any with the cards that they end up being dealt.  The key risk that TMO cannot control is how well their end markets will perform in 2009 and over the next few years.  As mentioned in the three points above, I see a number of pressures that are going to result in subdued growth in 2009.  I also see the long-term growth rate in the pharma/biotech segment downshifting from 10% to low single digits.  If I am right about this, TMO was overvalued a few months ago when it traded at $60/share and close to 18x fwd EPS/FCF.  Now that TMO is at $33 and close to 10x EPS/FCF, I think these issues are now overly discounted.  As long as the future brings positive growth to TMO and its end markets, the stock will prove to be an attractive value at current prices.

 

Competition / Missing Pdt Cycles: TMO competes in several niche businesses that are good businesses as long as you maintain your competitive edge.  If TMO were to miss a major product cycle or a competitor were to come up with a product that supplants TMO’s offering, TMO could be adversely impacted.   TMO has done well to date in this department, but this is a risk to monitor.  Competitive offerings are released at trade shows such as PittCon and ASMS and we as analysts should have visibility on emerging threats.

 

General Market Pricing / Risk Aversion: It is possible that risk premiums could go up further and the required FCF yield could go even higher.  I find 10% to be quite attractive.

 

 

Business Description

 

Shares Out:             420.2                        Price:                         $35.4

Mkt Cap:             $14.9bn            Net Debt:             $1.1bn                        EV:             $16.0bn

 

EPS History / Forecast

	2006	2007	2008	2009	2010
Adj EPS *	1.82	2.65	3.11	3.22	3.56
y/y Growth		45.6%	17.4%	3.5%	10.6%
PE (based on Adj EPS)	19.4	13.3	11.4	11.0	9.9
GAAP EPS	0.95	1.72	2.23

 

• TMO reports an “Adjusted EPS” figure which excludes acquisition-related intangible amortization, restructuring and acquisition-related charges, and one-time gains and tax benefits.  This figure does include options expense.  I believe “Adjusted EPS” is indeed the figure that best tracks underlying business profitability.  Analyst expectations are keyed to “Adjusted EPS”
• Acquisition-related intangible amortization has driven the majority of the difference between GAAP and Adj. EPS in 2007 and 2008 and currently impacts EPS at a 92c annual run-rate.

 

Thermo Fisher is a leading supplier of scientific instrumentation and consumables.  The current Thermo Fisher was formed form the Nov 2006 merger of Thermo Electron with Fisher Scientific.  Prior to that merger, both Thermo Electron and Fisher had several important portfolio changes including the merger of Fisher with Apogent and Thermo Electron’s divestiture of Spectra Physics.

 

Prior to the fisher acquisition, Thermo Electron generated about ~40% of revenue from cyclical industrial customers and ~70% of sales from capital equipment.  Now, after the Fisher acquisition and divestiture of cyclical businesses like Spectra Physics, industrial exposure is closer to 15% and capital equipment is only 30% of sales (70% is from consumables, services, and software).

 

Thermo’s business can be broken out the following ways:

·      Geographic      63% North America, 26% Europe, 11% Asia/ROW

·      Business  Line      43% Analytical Tech, 61% Life & lab sci

·      Pdt type            54% Consumables, 30% Instrumentation, 16% Software/svc

·      Customer type      25% Pharma/Biotech, 20% Academic/govt lab, 25% Healthcare

35% Industrial, Environmental, Safety (estimate 20% related to food pdt safety testing & environmental monitoring such as air/water quality and 15% related to cyclical industrial)

• Pharma includes Big Pharma, CROs, Spec Pharma, and  Generics
• Healthcare segment chiefly comprised of consumable sales to hospitals & clinics (unlike GE /Siemens/Philips, TMO does not sell medical imaging equipment or other large medical systems)

 

About 1/3 of revenue comes from the distribution of 3^rd party products

 

Thermo has a highly regarded management team that has executed well and delivered well on past promises.  Many managers come from a GE/Honeywell background and the company uses sophisticated and intelligent metrics for M&A and internal decision making.

 

TMO is a very profitable company with strong cash generating characteristics.  In 2008, TMO operated at a 41.4% gross margin and a 17.8% operating margin.  Operating margins have been growing 60-100 bps y/y for the past year and many analysts believe there is the potential for margins to continue growing 50-100 bps per year for several more years until they hit 21%.  Management says that operating margin expansion can happen even without the organic growth backdrop and associated fixed cost leverage of the past few years, but it remains to be seen how well margins can perform if organic growth drops to 0 or goes slightly negative.

Catalyst

Upward revaluation form current 9% forward FCF yield to more fair 7% level; proving resiliency of EPS and FCF even with a severe recession; stock buyback; potential for value creating tuck-in acquisitions