IDEXX LABS INC IDXX S
December 14, 2012 - 2:07pm EST by
Dodger123
2012 2013
Price: 96.00 EPS $0.00 $0.00
Shares Out. (in M): 57 P/E 0.0x 0.0x
Market Cap (in $M): 5,443 P/FCF 0.0x 0.0x
Net Debt (in $M): 13 EBIT 0 0
TEV ($): 5,456 TEV/EBIT 0.0x 0.0x
Borrow Cost: NA

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  • Competitive Threats
  • Veterinary
  • Medical Devices
  • Pet Care
  • Pets

Description

Summary Thesis:
  • I believe IDXX stock price will decline by at least 30% over the next six months as the market adjusts to the recent changes in the industry.  IDXX’ main value driver, its companion animal business, is facing intensifying competition that should lead to near term pressure on both market share and margins.  IDXX has historically dominated the veterinary clinic diagnostic market due to its exclusivity with the “big 3” distributors that make up the vast majority of vet clinics’ purchases.  However, a recent consent order by the FTC requires IDXX to open up one of the national distributors (MWI Veterinary Supply or “MWIV”) for competition as of January 1, 2013.  While the market has shrugged this off as a non-event, I believe it will lead to near-term share losses and, subsequently, it has the potential to disrupt the exclusivity arrangements that IDXX has with the other two distributors.  Secondly, IDXX’ main competitor, Abaxis (“ABAX”), entered the reference laboratory business in late 2011.  The reference lab business has historically been a cozy duopoly between IDXX and VCA Antech (“WOOF”).  While ABAX has only launched one lab thus far (vs. ~80-90 domestic labs between IDXX and WOOF) its strategy is to cherry pick the less time sensitive, high margin specialty and esoteric tests.  ABAX is aggressively bundling the reference lab service with its point-of-care diagnostics which has the potential to initially disrupt the pricing/margins in the reference lab business and/or potentially lead to share losses over time.  Despite some ominous signs on last earnings call (e.g., declining instrument sales in 3Q) the market has been largely complacent on IDXX and is betting on the status quo.  The stock trades 5% off its all-time high and in the high end of the historical P/E range.
Business Description:
  • While IDXX has four operating divisions, vast majority of revenues (83%) and EBIT (79%) are made up by Companion Animal Group (“CAG”).  Through CAG, IDXX offers veterinarians a host of products and services including in-clinic diagnostic tests, reference lab services, and practice management software.  IDXX divides the CAG revenue into four categories:
    • Instruments and Consumables (39% of LTM CAG revenue).  IDXX sells analyzers (instruments) and the related consumables to vet clinics that use these devices to diagnose various pet diseases and conditions.  Majority (~80%) of consumables come from chemistry tests.  IDXX has a worldwide installed base of 32k chemistry analyzers which compares with ABAX at 12k.  Roughly 90% of vet clinics have a chemistry analyzer (some have two).  Hematology accounts for the remaining 20%.  Hematology analyzers are used to assess the blood components.  The installed base for IDXX here is ~12k units and roughly 60% of vet clinics have hematology analyzers (rest will send to reference labs).
    • Reference Laboratory (38%).  The vet clinics send patient samples to reference labs either for routine bloodwork or pathology testing.  The ~$750 million North American diagnostic lab market is a duopoly between IDXX and VCA Antech (both have ~40% share each).  In this business, IDXX collects samples from vet clinics on a daily basis, processes them in local labs, and sends results back in 1-5 days depending on the complexity of the test. 
    • Rapid Assays (16%). These are marketed by IDXX under the SNAP product line.  Rapid assays are simple, single use test kits (similar to home pregnancy tests) and can run and interpret a test without instrumentation (e.g., Lyme disease and heartworm).  These tests have very high gross margins ~80% vs. CAG average of 52%.
    • Practice Management Systems and Services (8%).  IDXX sells software and hardware to vet clinics.  The main product is called Cornerstone which allows a virtually paper free office.  Cornerstone plays into IDXX’s integrated offering as it can communicate with all IDXX instrumentation.  IDXX has currently ~6k Cornerstone customers.
Valuation Summary:
  • Over the last ten years, IDXX has traded at 27x forward EPS, on average.  Over the last five years, IDXX has compounded Revenues, EBIT, and EPS at 11%, 13%, and 15%, respectively.  I believe the stock has commanded a premium multiple relative to the growth performance due to the perceived quality of the business model and the predictable growth.  Based on consensus estimates, IDXX currently trades at 16.5x ‘13E EBITDA and 27.8x P/E, slightly above its historical averages.  The consensus numbers imply 7.5% revenue growth and ~12% EPS growth for ’11-‘14E.  In short, IDXX seems to be valued slightly above historical averages while growth expectations are slightly below past performance.  However, IDXX appears significantly overvalued in light of my high single digit EPS growth projection (’11-‘14E).
Why the mispricing exists and how it will correct:
  • Why the stock price will decrease: Given the increased competition in both point-of-care diagnostics as well as the reference lab business, IDXX’s growth outlook will be revised downwards as competitors start gaining share in 2013.  As the competitive share gain becomes evident, the premium multiple of IDXX will also be at risk.  IDXX has historically enjoyed premium valuation relative to its growth prospects due to its dominating market position.  As the growth prospects of the business are downgraded and the new vulnerabilities of the business model are exposed, the multiple on the business should shrink substantially.  The opening up of MWIV to competition may also disrupt the current balance between Patterson Webster and Butler Schein (the other two national distributors) especially if MWIV gains meaningful share on its competitors.  The risk of losing distribution exclusivity would likely weigh on sentiment heavily. 
  • When the stock will decrease: The first signs of the competitive pressures were already evident on 3Q12 earnings report (though ignored by analysts).  IDXX reported 14% YoY decline (and flat sequential growth) in chemistry analyzer placements.  Management brushed this off as “one-time” due to aggressive promotions and a hard compare in 3Q11.  However, I believe this could be the first sign of a pause in the market as customers wait for the ABAX product to become available through MWIV in 1Q13.  The instrument revenues/placements are a leading indicator for consumable sales as you need the installed base in order to sell the consumables.  Looking at the competitors, ABAX reported 13.5% YoY growth in chemistry placements and 28% sequential growth on 3Q12.  A smaller competitor, HSKA, reported 95% YoY growth in chemistry placements and stated that company has already sold 130% of 2011 units during the first three quarters of 2012.  Both HSKA and ABAX will be distributed by MWIV beginning January 1st and neither has yet received any orders (the first channel fill orders are expected in December according to ABAX).  As a result, I believe ABAX and HSKA are well positioned to gain share in the near term at the expense of IDXX.  This will probably manifest itself as soft instrument sales for IDXX during the 4th and 1st quarters and decelerating consumables growth during 2013.  I would expect that by the time IDXX reports 1Q13 earnings in late April, the share loss story will have gained some credibility causing the stock to be de-rated.
  • The misperception and the associated catalyst that will cause the stock to decrease:  There are several misperceptions that are creating this opportunity for excess return:
    • Opening up of MWIV distributor will intensify competition.  Historically investors have placed a premium multiple on IDXX due to its strong competitive position.  The exclusive distribution relationships combined with loyal customer base made it difficult for ABAX to gain meaningful share despite a competitive product offering.  The market has been complacent about this risk and bulls have taken comfort of IDXX’ high market share and integrated nature of its product offering.  ABAX is pricing a competitive product aggressively and has been gaining share despite not having access to the “big 3”.  Now, by having access to 80% of IDXX’s customer base, ABAX is in a position to significantly take share from IDXX or, at a minimum, cause IDXX to lower pricing in order to improve retention.
    • Rapid assay revenues/margins will be under pressure.  As discussed earlier, rapid assays are relatively commoditized single use test kits.  These kits carry ASPs ~$10 and have very high gross margins (~80%) and have little associated opex.  Rapid assays make up ~25% of CAG gross profits and they are mainly sold through distributors so associated SG&A is low.  Assuming opex contribution at half the rate of overall corporate average, the rapid assay gross profits would account 40% of consolidated EBIT.  While ABAX and HSKA currently have low share in rapid assays, they have been building up their capabilities and will likely aggressively price their tests in order to gain market share.  Currently 50% of IDXX rapid assays have a competitive product by either ABAX or HSKA.  As an example, IDXX SNAP 4Dx Plus heartworm test currently sells for $13.15 per assay (a box of 30) whereas ABAX’ Vetscan canine heartworm assay is ~$3.75 per assay (a box of 100). 
    • Reference lab competition.  The IDXX bulls have dismissed ABAX’ entry into the reference lab business as largely meaningless given it has only one lab.  While one lab is unlikely to make a dent on market share in the near term, it should be noted that the lab is focused on the high-margin specialty and esoteric testing.  ABAX’ strategy is to essentially cherry pick the high margin volume from WOOF and IDXX.  While WOOF will be the immediate share loser (as it does not have diagnostics to bundle with its lab services), IDXX will probably be forced to be more price competitive in order to maintain share.  ABAX has been very aggressively bundling the reference lab business with the diagnostics.
Risks:
  • New MWIV deal may initially inflate margins.  The new consent order with MWIV allows IDXX to pay 10% margin (as opposed to 15%) to MWIV.  Over the estimated revenues of ~$100 million, this amounts to ~$5 million in savings or $0.06 of EPS.  In the near term, this windfall, albeit small, may mask some of the pricing deterioration elsewhere in the business.  However, instrument sales do not go through distributors and should IDXX post another quarter of disappointing chemistry analyzer placements, the markets will get worried about the implications to consumables growth going forward.
I do not hold a position of employment, directorship, or consultancy with the issuer.
I and/or others I advise hold a material investment in the issuer's securities.

Catalyst

Continued weakness in chemistry instrument placements (4Q report)
IDXX fails to take its annual price increase in reference lab business in January
Reports of MWI/ABAX share gains in January as the new MWI contract starts
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