BECTON DICKINSON & CO BDX
March 19, 2010 - 8:59pm EST by
lordbeaverbrook
2010 2011
Price: 79.00 EPS $4.95 $5.10
Shares Out. (in M): 246 P/E 0.0x 15.5x
Market Cap (in $M): 19,160 P/FCF 0.0x 0.0x
Net Debt (in $M): 235 EBIT 1,695 1,776
TEV ($): 19,395 TEV/EBIT 11.4x 10.9x

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Description

Here is an idea which should prick your interest.

I believe that Becton Dickinson (BD, ticker BDX) is a rare opportunity to buy a superior business franchise at an average company price.  To begin with, BD is a well above average company.  I say this because BD 1) has above average growth prospects in the medium-term 2) has exposure to positive health care demographics but with less regulatory risk than other medical device companies, 3) possesses a high barrier to entry "franchise" business, 4) manages a superior balance sheet, and 5) is lead by a senior team which has generated impressive financial performance in the past.  Mid-point guidance for FY 2010 is $5.10, so BD is trading for 15-16x current year earnings.

I am using $6.40 as my estimate of calendar year 2012 earnings power.  Capitalized at 18x and with dividends, this generates $120 in expected value, 50% above where the common stock can be bought today.  In my view, this generates more than an adequate return given the quality of the business.

BD is a medical device company.  BD's medical devices include diagnostic test equipment and lab equipment.  The majority of its business, however, and the core of its franchise, is related to manufacturing and selling "sharps," particularly needles, syringes and related equipment.  These systems are used for either putting drugs and fluids into the body or taking blood and other samples out of the body. Products include needles, syringes, intravenous catheters, pre-filled syringes, pen needles (for diabetics), and blood and other specimen drawing systems.  I estimate that $4-5B of BD's $7.2B in total revenue is selling of a system involving either a needle or a syringe, or something closely related.

This core business of products related to needles and syringes can be broken down into several "platform" businesses with varying geographies, customers, competitors and pricing dynamics.  For instance, BD sells $1B worth of needle-syringe combinations to pharmaceutical drug companies, who pre-fill the syringes with specific single dosages and in turn sell them to distributors, hospitals and other users.  This is known as the "pre-filled syringe" business in the industry.  The pre-filled syringe business, in turn, can be broken down by geography and material, such as glass and plastic.  Geography matters for logistical and regulatory reasons, creating distinct markets.  For example, in the pre-filled glass syringe market in Europe, BD has very high market share (e.g. 50%+) in an oligopoly industry (one of four producers of size).  Entry into the pre-filled glass syringe market appears possible but only over a long period and if the entrant is offering something new and differentiated. BD appears advantaged due to: 1) scale in sales and manufacturing, 2) quality and brand reputation for a product with no tolerance for errors, 3) regulation and approval process which ties the injector to the drug.  A decade from now, I would be very surprised if BD did not continue to produce the lion's share of pre-filled glass syringes in Europe.  

Pre-filled glass syringes in Europe is only one example; BD's franchise is the summation of many of these "platforms." While all these needle/syringe sub-markets are unique, several traits repeat themselves over and over: 1) BD has large market share in oligopoly structure businesses, 2) barriers to entry appear high with stable participants, 3) pricing has been "disciplined" and volumes are growing.  In my view, this core business is a true franchise business. And this franchise benefits from the attractive demographics and industry dynamics of the health care industry, while somewhat mitigating the risk of health care regulation.  The price points of many of BD's products are quite low, and therefore less likely to have their price determined directly through regulation.  And BD has demonstrated it can make attractive margins in more regulated and government paid health care environments; over half of its revenue today are outside the US.

Balance sheet
The balance sheet is very strong with $250 in net debt and $3.7B in hard book.  One surprising element is the relatively large amount of invested capital in this business, $4.3B as of year-end 2009, and roughly half for machines and equipment.  With this $4.3B in invested capital, BDX generated $7.2B in revenue and $1.2B in net income in 2009, a 28% return on invested capital.  Unlike some other medical device manufacturers, BD's business requires substantial investments in machinery and equipment to mass produce needles, syringes and other products cheaply.  In my view, this raises the barrier to entry.  To try to enter BD's needle/syringe business, it requires more than a new, innovative product, a sales strategy that breaks through high switching costs, and a reputation for quality in an industry with life, death, and litigation consequences for errors.  It also takes a lot of capital!

As an analogy, look at Gillette's ROIC metrics in 2004.  Similarities between razors and needles include: 1) low-price per unit product with high switching costs, 2) significant capital to mass produce cheaply, 3) high ROICs, and 4) high margins.  Different customers, different businesses, but the similarities are enticing!

Management
CEO Ed Ludwig is a BD lifer and has been CEO since 2000.  EPS growth from 2003-2009 has been 17%.  He owns 250K shares, with options or stock grants for a further 1.2MM more.  He has been selling shares (boo!), but his share sales appear uniform and go back many years.  

Deflation, safety products, and cheap entrants
Needles/syringe system pricing varies widely.  At the very low-end, simple disposable needles and syringe plungers can be bought for pennies and are produced around the world, including by "low cost Chinese producers."  BD does produce basic needles and is moving some production to lower cost domiciles to lower its costs.  But basic needles are not high margin and not a significant source of BD's income.

BD has had 48-52% gross margins for the last decade because it produces higher-end "systems" which often include safety features.  Safety features, such as a needle which retracts after use, can only be used once, or includes a safety cap which can be closed on the needle after insertion, are sold at a premium.  In the US, safety features became mandatory by law beginning with the AIDS epidemic. While Europe has been slower to legislate safety requirements, it is cathing-up with US standards.  It is helpful to review the documentation for products such as Nexiva and Vacutainer on the BD website to get a sense of the way these systems have become quite clever and safe, and differentiated. High volume users, such as nurses who frequently draw blood, become adept at using a particular system. Forcing them to change systems to save cents per usage is penny-wise but pound foolish.   

That being said, like many mass produced goods, the individual products are deflationary over time on an apples-to-apples basis.  BD has been able to more than compensate for this deflation pressure and grow revenues 7-8% for the last two decades from overall volume growth (we are all getting more tests and shots), and up-selling users to improved products (convincing them to buy oranges rather than apples).  Revenue growth may exceed or fall short of the past based on this dynamic of volume, deflation and innovation, but I would be surprised if revenues do not continue to grow at something near the historical growth rates.

Earnings and valuation
Management says that long-term revenue growth can be 7-9%, based on underlying market growth of 6-9% and tuck-in acquisitions.  Repurchases of common stock net of issuances increase the sales per share growth by one point.  BD has bought back near 3% of outstanding stock each year but has given back about half to employees as compensation.  

Management further hopes to grow EPS by a point or two a year due to operating margin expansion, as they have over the last decade.  Margins are already high, however, at 22-23%, so further margin expansion would be a happy outcome, but is not required to make an attractive return.  The GAAP tax rate is a little low at 27.0-27.5% due to the difference in foreign tax rates.

Therefore, with BD, we have a superior franchise for which EPS grows perhaps 8-11%.  If an average company is worth 15x earnings, then I believe BD is worth 18x earnings (5.6% earnings yield versus 6.7%).  

2009 may be somewhat of an abnormal year, with the swine flu benefitting earnings and the recession hurting earnings, particularly for the non-needle businesses.  2008 appears to be a reasonable approximation of normal earnings with $4.42 in earnings from continuing operations.  Grown at 8-11% would generate normal earnings power of $6.00-$6.70 in fiscal year 2012.  My estimate is $6.25 for fiscal year 2012 and $6.40 for the calendar year.  One can play with ones own assumptions of regarding revenues and margins, but if the future looks like the past, then this earnings range is very reasonable.  

Please see if you can poke holes in my thinking.  But BD looks to me like a bloody good business.

Other notes
The history of BD is interesting and worth considering. BD's business of manufacturing needles and syringes dates back to the early 1900s. For nearly a century, BD has had large market shares in syringe production. The development of the industry has had several inflection points, such as the development of mass production, the development of disposable products, and the emergence of safety engineered products. Some of these transitions appear to have been "revolutionary" and led to a turnover of industry participants, but BD has always managed each shift and maintained its franchise.

At one time, the company was family-owned. Two generations of Bectons and Dickinsons have led the company. While it transitioned to professional managers in the 1970s, it appears to have maintained elements of a family-run business culture, particularly a long-term focus.

60% of the revenues come from outside the US, mitigating possible domestic health care legislation impacts.


Risks
The elements of risk I am watching most closely are 1) adoption of safety products in Europe, 2) regulation impacts, 3) low-end entrants and their impact on overall competitive dynamics, and 4) the possibility of a step-change in transdermal patch and inhaler technology.

 

Catalyst

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    Description

    Here is an idea which should prick your interest.

    I believe that Becton Dickinson (BD, ticker BDX) is a rare opportunity to buy a superior business franchise at an average company price.  To begin with, BD is a well above average company.  I say this because BD 1) has above average growth prospects in the medium-term 2) has exposure to positive health care demographics but with less regulatory risk than other medical device companies, 3) possesses a high barrier to entry "franchise" business, 4) manages a superior balance sheet, and 5) is lead by a senior team which has generated impressive financial performance in the past.  Mid-point guidance for FY 2010 is $5.10, so BD is trading for 15-16x current year earnings.

    I am using $6.40 as my estimate of calendar year 2012 earnings power.  Capitalized at 18x and with dividends, this generates $120 in expected value, 50% above where the common stock can be bought today.  In my view, this generates more than an adequate return given the quality of the business.

    BD is a medical device company.  BD's medical devices include diagnostic test equipment and lab equipment.  The majority of its business, however, and the core of its franchise, is related to manufacturing and selling "sharps," particularly needles, syringes and related equipment.  These systems are used for either putting drugs and fluids into the body or taking blood and other samples out of the body. Products include needles, syringes, intravenous catheters, pre-filled syringes, pen needles (for diabetics), and blood and other specimen drawing systems.  I estimate that $4-5B of BD's $7.2B in total revenue is selling of a system involving either a needle or a syringe, or something closely related.

    This core business of products related to needles and syringes can be broken down into several "platform" businesses with varying geographies, customers, competitors and pricing dynamics.  For instance, BD sells $1B worth of needle-syringe combinations to pharmaceutical drug companies, who pre-fill the syringes with specific single dosages and in turn sell them to distributors, hospitals and other users.  This is known as the "pre-filled syringe" business in the industry.  The pre-filled syringe business, in turn, can be broken down by geography and material, such as glass and plastic.  Geography matters for logistical and regulatory reasons, creating distinct markets.  For example, in the pre-filled glass syringe market in Europe, BD has very high market share (e.g. 50%+) in an oligopoly industry (one of four producers of size).  Entry into the pre-filled glass syringe market appears possible but only over a long period and if the entrant is offering something new and differentiated. BD appears advantaged due to: 1) scale in sales and manufacturing, 2) quality and brand reputation for a product with no tolerance for errors, 3) regulation and approval process which ties the injector to the drug.  A decade from now, I would be very surprised if BD did not continue to produce the lion's share of pre-filled glass syringes in Europe.  

    Pre-filled glass syringes in Europe is only one example; BD's franchise is the summation of many of these "platforms." While all these needle/syringe sub-markets are unique, several traits repeat themselves over and over: 1) BD has large market share in oligopoly structure businesses, 2) barriers to entry appear high with stable participants, 3) pricing has been "disciplined" and volumes are growing.  In my view, this core business is a true franchise business. And this franchise benefits from the attractive demographics and industry dynamics of the health care industry, while somewhat mitigating the risk of health care regulation.  The price points of many of BD's products are quite low, and therefore less likely to have their price determined directly through regulation.  And BD has demonstrated it can make attractive margins in more regulated and government paid health care environments; over half of its revenue today are outside the US.

    Balance sheet
    The balance sheet is very strong with $250 in net debt and $3.7B in hard book.  One surprising element is the relatively large amount of invested capital in this business, $4.3B as of year-end 2009, and roughly half for machines and equipment.  With this $4.3B in invested capital, BDX generated $7.2B in revenue and $1.2B in net income in 2009, a 28% return on invested capital.  Unlike some other medical device manufacturers, BD's business requires substantial investments in machinery and equipment to mass produce needles, syringes and other products cheaply.  In my view, this raises the barrier to entry.  To try to enter BD's needle/syringe business, it requires more than a new, innovative product, a sales strategy that breaks through high switching costs, and a reputation for quality in an industry with life, death, and litigation consequences for errors.  It also takes a lot of capital!

    As an analogy, look at Gillette's ROIC metrics in 2004.  Similarities between razors and needles include: 1) low-price per unit product with high switching costs, 2) significant capital to mass produce cheaply, 3) high ROICs, and 4) high margins.  Different customers, different businesses, but the similarities are enticing!

    Management
    CEO Ed Ludwig is a BD lifer and has been CEO since 2000.  EPS growth from 2003-2009 has been 17%.  He owns 250K shares, with options or stock grants for a further 1.2MM more.  He has been selling shares (boo!), but his share sales appear uniform and go back many years.  

    Deflation, safety products, and cheap entrants
    Needles/syringe system pricing varies widely.  At the very low-end, simple disposable needles and syringe plungers can be bought for pennies and are produced around the world, including by "low cost Chinese producers."  BD does produce basic needles and is moving some production to lower cost domiciles to lower its costs.  But basic needles are not high margin and not a significant source of BD's income.

    BD has had 48-52% gross margins for the last decade because it produces higher-end "systems" which often include safety features.  Safety features, such as a needle which retracts after use, can only be used once, or includes a safety cap which can be closed on the needle after insertion, are sold at a premium.  In the US, safety features became mandatory by law beginning with the AIDS epidemic. While Europe has been slower to legislate safety requirements, it is cathing-up with US standards.  It is helpful to review the documentation for products such as Nexiva and Vacutainer on the BD website to get a sense of the way these systems have become quite clever and safe, and differentiated. High volume users, such as nurses who frequently draw blood, become adept at using a particular system. Forcing them to change systems to save cents per usage is penny-wise but pound foolish.   

    That being said, like many mass produced goods, the individual products are deflationary over time on an apples-to-apples basis.  BD has been able to more than compensate for this deflation pressure and grow revenues 7-8% for the last two decades from overall volume growth (we are all getting more tests and shots), and up-selling users to improved products (convincing them to buy oranges rather than apples).  Revenue growth may exceed or fall short of the past based on this dynamic of volume, deflation and innovation, but I would be surprised if revenues do not continue to grow at something near the historical growth rates.

    Earnings and valuation
    Management says that long-term revenue growth can be 7-9%, based on underlying market growth of 6-9% and tuck-in acquisitions.  Repurchases of common stock net of issuances increase the sales per share growth by one point.  BD has bought back near 3% of outstanding stock each year but has given back about half to employees as compensation.  

    Management further hopes to grow EPS by a point or two a year due to operating margin expansion, as they have over the last decade.  Margins are already high, however, at 22-23%, so further margin expansion would be a happy outcome, but is not required to make an attractive return.  The GAAP tax rate is a little low at 27.0-27.5% due to the difference in foreign tax rates.

    Therefore, with BD, we have a superior franchise for which EPS grows perhaps 8-11%.  If an average company is worth 15x earnings, then I believe BD is worth 18x earnings (5.6% earnings yield versus 6.7%).  

    2009 may be somewhat of an abnormal year, with the swine flu benefitting earnings and the recession hurting earnings, particularly for the non-needle businesses.  2008 appears to be a reasonable approximation of normal earnings with $4.42 in earnings from continuing operations.  Grown at 8-11% would generate normal earnings power of $6.00-$6.70 in fiscal year 2012.  My estimate is $6.25 for fiscal year 2012 and $6.40 for the calendar year.  One can play with ones own assumptions of regarding revenues and margins, but if the future looks like the past, then this earnings range is very reasonable.  

    Please see if you can poke holes in my thinking.  But BD looks to me like a bloody good business.

    Other notes
    The history of BD is interesting and worth considering. BD's business of manufacturing needles and syringes dates back to the early 1900s. For nearly a century, BD has had large market shares in syringe production. The development of the industry has had several inflection points, such as the development of mass production, the development of disposable products, and the emergence of safety engineered products. Some of these transitions appear to have been "revolutionary" and led to a turnover of industry participants, but BD has always managed each shift and maintained its franchise.

    At one time, the company was family-owned. Two generations of Bectons and Dickinsons have led the company. While it transitioned to professional managers in the 1970s, it appears to have maintained elements of a family-run business culture, particularly a long-term focus.

    60% of the revenues come from outside the US, mitigating possible domestic health care legislation impacts.


    Risks
    The elements of risk I am watching most closely are 1) adoption of safety products in Europe, 2) regulation impacts, 3) low-end entrants and their impact on overall competitive dynamics, and 4) the possibility of a step-change in transdermal patch and inhaler technology.

     

    Catalyst

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