Description

Thermo Fisher is a fantanstic company with strong structural advantages in the markets it operates. I believe it is ideally positioned for the next 5-8 years in capturing the innovation coming into the biotech/medtech space and that it provides a high risk adjusted return for patient investors. The idea was written up in 2010, but the company has changed significantly since. I will detail the business as it is today below, and then summarize how I view the investment opportunity.  

A. Business Detail

1.1. Segmentation by Product Groups

Thermo Fisher has 4 major business segments as follows. 

                                                           % of Revenue 2018           Operating margin

a)   Laboratory Products and Services          $ 10.1 bn                              12.5%

b)   Life Sciences Solutions                         $ 6.4 bn                                34.5%

c)   Analytical Instruments                          $ 5.5 bn                                23.2%

d)   Specialty Diagnostics                            $ 3.7 bn                                25.5%

 Total                                                   $ 25 billion                           16.2%

The businesses are each individually strong players in their respective space. The market size is estimated at $ 160 billion by TF.

Laboratory Products and Services includes: (1) lab equipment like freezers, pipettes and other consumables, as well as a CRO business. Part of this is CAPEX and part is OPEX business and its lower margin than the other businesses, but still a solid business. In fact, there are exciting parts of this with unique capabilities like the Brammer acquisition for viral vectors. Michel Lagarde leads this division.

Life Science Solutions refers to genetic testing (molecular diagnostics) equipment as well as bioproduction reactors business i.e. like Sartorius. This is the highest margin business in the TF lineup and an excellent business.

Analytical Instruments refers to mass spec and electron microscopy and chromatography equipment, which is an oligopoly market, where TF has a good position and has good equipment. It’s a good business.

Specialty Diagnostic includes their IVD platform, Phadia, as well as their NGS technology. Patrick Durban heads this business. It is really the traditional razor razorblade machines and tests. This is a good business and they are a leading player here. They have both an OEM business and a biomarker business here.  

1.2 Customer Segments

                                             % Revenues           

a)   Pharma & Biotech                       39%                   

b)   Academic & Government             22%

c)   Diagnostic & Healthcare              20% 

d)   Industrial & Other                       19%          

As you can see, the biggest group is Pharma and biotech companies at about 40% of total revenues. But overall, its very balanced an there is no customer segment concentration. 

1.2 Geographical segmentation

                                    % Revenues           

e)   North America              50%                   

f)    Europe                         25%

g)   Asia-Pacific                   22% 

h)   Other                           3%            

As you can see, the primary geography is still the US/Canada, but Europe and Asia are both large and well developed markets for TMO. In China, TMO is doing very well and that is 11% of total revenues for the group.

This is both an opportunity and a short-term risk.

2.1 Customers

Customers span across academic institutions (labs) to small to large pharma and biotech companies. They also include diagnostic laboratories. Basically they are involved across all kinds of clinical and research labs, as well as production facilities.

Customers include both buyers as well as scientists. One key is that the customers are quite fragmented with around several hundred thousand customers world-wide.

2.2 Sales

Thermo Fisher has direct sales force in most regions. They will sell specific areas of products. They also have a strong online/ecommerce offering, where they sell products and consumables directly on their website.

3. Competition and Competitive Advantage

3.1 Key Competitors/Market Structure

This depends on the specific business.

In the laboratory business, for products its people like Beckman, Qiagen, Eppendorf. In NGS, it could be Roche, Oxford Nanopore, or Illumina, where they work as competitors but also partners. In CRO, it is small companies doing services as well as CRO companies like Charles River. In Life Sciences solutions like in bio processes, it could be Sartorius.

In Analytical Instruments, its everyone like the diagnostic players. Dan Shine, the group MD spoke about them have a strong portfolio spanning from chromatography, to mass spec, to electron microscopy to chemical analysis tools. This gives them a bit more tools than most of their competitors, but they are essentially in oligopoly markets in most of these.

Overall, TMO is mostly in markets where they are one of the leaders if not the leader in a market where there are just several players. 

3.2 Structural Differences with Competitors/Moat

In some areas, they are simply entrenched as a company with consumables products people trust, where you wouldn’t take a chance or a risk to switch i.e. pipettes or freezers. In other areas, like some of the equipment/tools for CRISPR or molecular diagnostics they have one of the only credible offerings, so they have a strong competitive advantage. Cryo-EM in their analytical business is another example.

Often there is IP also involved, but the key is that they have strong incumbent positions in some areas, and do not compete 1v1 directly in many other areas.

I would rate that their structural advantage is strong in businesses that account about 50% of their revenues, with fair advantages in the other 50%. They also have some ability to cross sell.

4. M&A

TMO has had an excellent track record of M&A. They have created a lot of value in the past. On slide 21 of the Analyst Day presentation dated May 22^nd 2019, it shows how TMO has been able to transform the organic growth of the last 5 businesses acquired from mid-single digits to high single digits.

B. Why Invest?

1. Sustainable Growth

One of the most important factors in selecting an investment should be being able to reasonably predict the future growth prospects of a company. For TMO, I believe we have all signs pointing towards that they will be able to continue growing earnings for many years at high single/low double digits. 

Company has been able to grow at a CAGR of 11% in the last 5 years for revenue, CAGR of 15% for income. The growth has come from both international success and new business technologies.

On the business area front, the key drivers are that they are well positioned in the equipment and consumables and technologies for gene therapy and NGS and all these new developing fields in biosciences for example. I believe the growth in the latter new areas, where TMO has considerable strength will accelerate. In the area for example of immunotherapy or personalized medicine, breakthroughs are now starting to happen, whther its curative treaments for oprhan diseases or companion diagnostics. I find investing in companies like Exact Sciences or Kite or some of those innovaters very risky given their valuations and hype, but TMO should equally benefit, but do so in a technology agnostic way. Moreover, even their other not cutting edge businesses like biologics or equipment should benefit with relatively little technology risk, providing significant downside. 

EPS growth has been 14% in the last 8 years, and I would expect the company to be able to grow this also above 10% going forward, and possibly to exceed this significantly. 

2. Ability to Compound

If you take out the PPA and Goodwill, then you get an after-tax return on capital of the business in excess of 25%. This has been also the case historically, and allows the business to really compound well. TMO requires only a fraction of its free cash flow to grow organically and uses the rest to do M&A, which has been done very well historically. 

3. Proven Management Team

Marc Casper the CEO has been CEO since 2009 and has been part of Thermo since 2001, so he has been vested with the company. He has over this time proven a good track record of value adding acquisitions and prudent capital management. This has been reflected (fortunately/unfortunately) in TSR to shareholders over 20% p.a. 

All in all, TMO seems like a fantastic business fitting to my criteria of long-term structural growth that underpins extremely consistent revenue and earnings growth.

All summarized together, I believe TMO to be an exceptional business. The current valuation at 25x adjusted earnings for 2019 and roughly 22x next years' earnings make it not a cheaply valued company.

Still, i believe due to the solid growth prospects, its strong structural advantages, and its low exposure to cyclicality, that it provides a very compelling risk adjusted investment opportunity.

Catalyst

Accelerating growth due to innovation in Laboratory Products & Services and and Life Sciences Solutions.