I found a nice analysis of Becton Dickinson which was performed by East Coast Asset Management. Buffett has been actively accumulating and this might help us understand why.
East Coast Investment Thesis Summary
Becton Dickinson is a valuable niche business with a diverse line of products that are well suited to increase in demand with the aging trend of the baby boomer generation. It has been oversold due to weak 2009 sales, unfavorable FX and concerns over exposure to European sovereign debt (35% sales in EU), all of which are transient and overstated, respectively.
. The company has multiple sources of double digit revenue growth across high margin products, has been maniacal about improving margins through cost cutting and benefits from competitive barriers that are sustainable.
Upcoming catalysts for the business include US stimulus dollars, European legislation mandating safety equipment in hospitals, continued expansion into emerging markets and organic growth in volume due to expansion of access and aging population.
They are trading at 8x EV/EBITDA and 14x trailing earnings, both well below their historical 5 year averages of 10.1 and 21.3, likely due to myopia from concerns over Europe and fear of a double dip recession. From a free cash flow perspective, they are essentially trading at a ~4% premium to intrinsic value assuming no future growth in free cash flow. This is obviously an unrealistic scenario given their historical performance, substantial market share and diversified nature of the business.
In valuing the reproduction value of assets (or current market value) upon which BD operates, the market has valued the franchise itself at just over $1.8B, a slight premium to last year’s free cash flow alone. Management has a history of conservatism but recently had salaries frozen to 2009 levels due to missed revenue targets, leading to unrealistically low revenue guidance for 2010. Using conservative proforma estimates of growth in free cash flow and revenue correlated to historical ROIC,
THE BUSINESS
1. BD Medical: Parenteral drug delivery supplies including IV tubing, needles and syringes (52% revenue) sold to hospitals and pharma/biotech companies
2. BD Diagnostics: Blood and urine collection supplies along with diagnostic system technology for
microbiology detection (31% revenue) sold mostly to hospitals
3. BD BioSciences: Laboratory research machines and reagents/kits (17% revenue) sold to laboratories and private sector for drug discovery and basic science research
ï‚· Approximately 80% of their products are disposable
ï‚· Price points evenly spread: 30% low priced, 30% mid-tier, 30% premium
ï‚· 55% of sales are international, 35% from Europe
ï‚· Diversified supplier and customer base, no customer accounting for >10% sales
THE MOAT
BD benefits from multiple competitive advantages that have helped maintain a formidable moat which makes meaningful competition from new entrants incredibly challenging.
ï‚· Economies of Scale: BD has a massive distribution network spanning the US, Europe, Asia, Latin America and Africa. They are well positioned to accommodate pricing pressure due to smaller local low cost competitors. BD continues to build manufacturing facilities closer to the point of sale further helping to reduce costs. They have a track record of acquiring niche businesses with specialized products and then plugging those products into a global distribution network. Their bulk purchasing of raw materials, much of which is resin, also helps to insulate them from fluctuations in costs.
ï‚· “Razor and Blade”: BD Biosciences consists mostly of laboratory research equipment in which large machines are complimented with reagents. It currently represents 17% of sales, with 9% revenue CAGR over the previous five years and an average operating margin of 26%. The nature of this business is such that research facilities continue to buy reagents from BD and do not upgrade machinery frequently due to the high upfront cost ($100,000+) per machine.
ï‚· Customer Captivity and High Switching Costs: Approximately 60% of their customers are hospitals who typically do not switch to other manufacturers once they have established relationships as there are high switching costs due to retooling of their entire laboratory. Additionally, there is a high level of brand loyalty among their customers due to quality assurances from BD.
ï‚· Technology and Innovation: BD has pioneered the use of safety equipment in both drug delivery and diagnostics (blood collection). By selling only push button collection systems they have set the standard in worker safety. The safety business generates $1.6B in sales with 60% gross margins and is their fastest growing segment (>10% annually). The US has already widely adopted the use of safety technology but BD still has ample room to grow sales in Europe and Asia where they can build upon their existing supply chain
NONDISCRETIONARY PRODUCTS
BD is the antithesis of a one-trick pony. They have diversified their business in products, price points and geographies and benefit from having a nondiscretionary nature to their core business. The overall market for BD’s products is growing due both to the aging population in US and Europe and their growing expansion into emerging markets. The revenue stream is very predictable and correlates with increases in global healthcare delivery. Although a significant number of their products could be considered commodities (needles, syringes, tubing etc) very few competitors have the distribution capacity of BD and cannot absorb price compression which the same ease. Additionally, few competitors have the safety and quality record of BD, making switching to a low cost supplier potentially risky.
BD Medical
BD Medical consists of drug delivery platforms such as IV tubing, syringes and needles for the delivery of parenteral medications. It comprises 52% of revenue with operating margins averaging 28% over the past five years. BD has carved out a niche in safety products related to medication delivery (needle locks, splash guards) and has the leading market share in US, Europe and Asia for autoinjectors and safety needles with user-friendly caps. The IV catheter business alone has over 1000 SKU’s and generates $500m annually in revenue. Their newest product, Nexiva, is far advanced to existing catheters and is correspondingly priced 3x higher than older products. As medical centers work towards improving safety and reducing adverse events due to medication error, the demand for these products will continue to grow. Many medical centers have attempted to reduce medication errors by increasing the use of preloaded syringes, which is an area in which BD has excelled.
BD’s total diabetes business is 10% of revenue and is growing at double digits year over year. Erratic glucose levels due to errors in dosing are still a very common problem, particularly among the elderly, leading to hospitalizations and high costs to the healthcare system. BD has focused on developing pen needles for insulin injection and has grown revenue from this business at 12% annually. They have five new insulin pen products they plan to launch in the next four years and at 4mm (32 gauge). This is a significant development in their arms race in insulin needles with Novo Nordisk, with whom they are a global duopoly.
BD Diagnostics
. The growth in elderly population over the next decade will be a natural boost to BD’s diagnostics business. It is very rare that a patient over the age of 65 is seen for an ailment without some form of accompanying labwork. The diagnostics business is 2/3 microbiology related and with the recent acquisition of HandyLabs, BD has made progress in healthcare associated infections (MRSA), an area of increasing costs and scrutiny. The preanalytics products consist of blood tubes (vaccutainers), pushbutton needles for blood drawing and urine collection devices, all of which are used in high volume but with lower margins than their other products. The diagnostic systems business has more pricing power as it focuses on more complex samples and testing.
Leaving ample room for profitable growth given their vastmanufacturing and distribution network in which they can plug these high margin products. BD also has a valuablegrowing franchise in cervical cancer screening with their Tripath product, growing at 10% per annum with significantsales from Asia due to an increase in legislation mandating pap smears as part of routine healthcare.
BD only sells push button collection systems which are far superior to traditional caps for worker safety. They have had ample success in the US as evidenced by the chart below and have begun to see an uptick in sales in China and India. A recent paper by Frost and Sullivan reported a 77% decline in needle stick injuries following conversion to BD safety collection devices.
BD Biosciences
This business benefits greatly from recurring revenue due to its razor-and-blade nature. BD Biosciences generated 17% of sales in 2009 with average operating margin of 26%. Approximately 50% of their sales are to NIH funded laboratories in the US but they have steadily increased sales in emerging markets such as China, who are investing in basic sciences research and are in dire need of reliable equipment. The average price of a BD machine is over $100,000 which is followed with sales of reagents and supplies specific to BD machines. Reagents constitute on average 60% of the sales while machines are 40%. BD has approximately 65% of the flow cytometry market in the US, which is a staple process in basic cell research. BD also sells basic laboratory supplies such as pipettes, petri dishes and culture media, comprising 25% of the BD Bioscience sales.
RECENT DISCLOCATION (Street View)
ï‚· 35% of sales are from Europe. BD had some exposure in receivables to Greek’s sovereign debt problems and when factoring unfavorable FX (stronger dollar) revenue growth was only 1% in 2009. BD has historically hedged its currency exposure with futures, but stated that beginning in 2011 it will cease to hedge currency exposure as they felt it was not a wise use of capital. The street is concerned about additional weakening of the Euro and the potential impact it could have to the top line without these currency hedges
ï‚· 2009 was a year of frozen budgets, facility closures and layoffs for medical centers. There were little to no capital expenditures or upgrades to existing equipment. BD was impacted significantly by this as 60% of their sales are to hospitals
ï‚· High unemployment in 2009 translated to a drop in preventive care due to loss of health insurance coverage. As a result physician visits were down along with ancillary testing and medication administration that go in tandem to those visits
ï‚· Much of the BD Medical franchise consists of prefilled syringes which are sold to pharma and biotech
companie, both of whom suffered in 2009
ï‚· The winter of 2009 saw a 9% drop in infectious disease testing due in large part to a very mild flu season. Not only did this impact testing related to flu, but also impacted other areas that are tethered to a physician sick visit such as blood draws and medication delivery
ï‚· The broader Healthcare Index has been down over 9% year-to-date
UPCOMING CATALYSTS (East Coast View)
ï‚· Factoring currency fluctuation, or the next country in Europe to default, is difficult and ignores core fundamentals to the business and the natural boost from higher volume will add to the top-line
ï‚· As part of the Federal Stimulus, $10B was allocated to NIH laboratories, which are forecasted to increase purchasing of capital equipment in 2H:2010.
ï‚· Most European healthcare facilities are heavily government funded so it is likely thisrequirement will be met in order to secure future assistance. BD’s safety business, spread across medical (drugdelivery) and diagnostic (blood collection) is currently a $1.7B business with gross margins of 60% and is thefastest growing segment of their business. This regulatory catalyst will further fuel this growth given theirsubstantial presence in Europe (35% sales).
ï‚· Approximately $1.3B in annual sales come from China, India, Middle East, Africa and Latin America but China will likely be the most significant source of volume growth. . These “tier two” cities (Chongqing, Wuhan, Guangzhao) will likely see the most growth in healthcare infrastructure as they are well behind more established cities such as Shanghai, Beijing and Hong Kong. China is also underway in a three year health reform to build 2000 hospitals and insure 90% of the total population. BD’s efforts to move manufacturing closer to the point of sale will help them capitalize on this explosive growth in emerging markets.
ï‚· BD is growing revenue across all three lines of business, but their highest margin business (safety $1.7B) is actually the fastest growing. They are also growing the global diabetes business ($700M) and healthcare associated infections business ($1.1B) at double digits.
ï‚· We define high quality earners as having high earnings, stable earnings and low levels of leverage. BD falls into this category of high quality healthcare businesses that are suppliers of nondiscretionary products and services, who along with the broader healthcare index have dropped in price this year. BD, however, is the cheapest and highest quality earner in comparison to its three leading competitors. Its current debt/capital, although not the lowest, is inline with previous years and has shown little variation year-to-year.
CONCLUSION
We think the current share price is a result of macro fears and lack of granular clarity in the short term. Our underlying investment strategy with BD can be described quite simply as being greedy while others are fearful. The current share price offers a margin of safety that is rare for a business of this quality. BD is what we categorize as a high quality compounder franchise. They have year over year increases in dividend, improving profitability, increasing ROIC and increasing free cash flow all while maintaining, most importantly, a healthy and transparent balance sheet.
BD has a unique and valuable combination of innovation and distribution. They achieve innovation through a combination of internal R&D and acquisitions. In combination with a vast, efficient and growing international distribution network, we see a lethal combination of attributes that will further differentiate this company from its competitors- essentially, the strong will get stronger. Additionally, their dedication to sustainability is something we value. East Coast firmly believes that sustainability and profitability are not mutually exclusive but in fact selfreinforcing.
The market, in its predictable myopia, has oversold BD out of concerns and speculation over matters that are not implicit in the underlying metrics of the core business. Given our long term investment philosophy, we see this opportunity in a 2-3 year holding period at a minimum.
