By David Krempa
In 2010, Nordion (NYSE:NDZ) shed two business units and refocused its efforts on its three radiation-related segments. Now that it has narrowed its focus to its three strongest businesses, we believe the firm's many competitive advantages in the radiation industry warrant a narrow economic moat. This overall narrow moat is based on a combination of the wide-moat sterilization business, narrow-moat isotope business, and no-moat targeted therapies business.
Because of the nature of the radiation business, a number of key competitive advantages are present throughout Nordion's three business units. The small number of nuclear reactors limits global supply of radiation products. Given safety and security concerns, very few governments are eager to develop new reactors. Nordion's access to existing reactors, through strong relationships and exclusive long-term contracts, is a significant advantage. Also, governments operating nuclear reactors want to be sure that they are dealing with trustworthy customers who will safely and securely use and transport the reactor's products. Nordion's long industry record is another significant competitive advantage.
Nordion signs long-term contracts with the reactors it purchases from and also with the customers it sells to. Similarly, development activity takes a long time. Building a new reactor or outfitting an existing reactor for production can take years. For instance, cobalt-60, the isotope used for sterilization, must be exposed to a reactor for years before it possesses the necessary amount of radiation. Any competitor looking to enter the market would need a significant up-front investment and would not see any benefit for years. In addition, the short half-lives of products forces customers to constantly replenish supplies. They cannot stockpile excess product.
Nordion's business model requires very little capital, which creates very high returns on invested capital. The firm does not own reactors, so it does not have many fixed assets on its books. Nordion is largely a middleman with expertise in transportation and logistics of radioactive material. In the case of the isotope and cobalt businesses, Nordion transports the product from the reactor to its customers, so it has minimal capital tied up in the business. The firm's liver cancer treatment also earns very high ROICs. Research and development was largely completed more than a decade ago, so it is not recognized on the balance sheet.
Our $11 fair value estimate is based on a discounted cash flow valuation of the business, but we also did a sum-of-the-parts valuation to identify the value of Nordion's various assets. Our-sum-of-the-parts analysis highlights the significant value of the firm's sterilization business, which we believe is worth about half of the entire firm's fair value. It is worth noting that the medical isotope business only makes up $2 of our valuation. We believe that one of investors' biggest concerns about the stock is the aging National Research Universal reactor and the uncertainty surrounding the future of that segment. However, even if the NRU reactor were to have further issues and halt production of Mo-99 and the medical isotope business were to be completely eliminated, our fair value estimate would still be $9 per share. Nordion is working to get its backup isotope supply in Russia up to full capacity by 2016, so we believe the chance of the segment being permanently worthless is very slim. We believe investors should be much more focused on the sterilization business and rapidly growing targeted therapies business.
Sterilization: 40% of Sales; 50% of Fair Value
Nordion's sterilization segment sells gamma sterilization machinery and radioactive compound cobalt-60, which is used in the machines. Gamma sterilization is used to sterilize medical supplies like gloves, syringes, and bandages, as well as food and other consumer products.
This business is Nordion's cash cow and benefits from a wide economic moat. The firm sells expensive irradiation machines, but makes significantly more money supplying the radioactive cobalt-60 isotope required to operate the machines. The segment consistently posts operating margins in the mid-40s and requires minimal invested capital.
The firm was a pioneer in gamma radiation technology and is now the entrenched leader in the small sterilization market. Although Nordion's sales of cobalt-60 were just $97 million in 2011, its global market share is estimated to be around 75%. The size of this market is not large enough to attract a new entrant.
A new competitor would first have to find a reactor willing to irradiate cobalt for it, but most operators do not want to make any adjustment to their reactors. The small amount of profit that would be allocated to the operator is probably not worth the hassle. If the competitor were able to find a reactor, it would need to invest a significant amount of capital to equip the reactor. Then it would need to let the cobalt irradiate in the reactor for four years before it is ready for sale. It could easily be more than five years after the firm's initial investment before it is able to sell its first batch of cobalt.
Even if a firm were to navigate those hurdles, it would have a very difficult time stealing customers. Nordion has a record as a reliable source of cobalt, so customers would have no reason to switch to a new and unproven competitor. In addition, Nordion's staggered, long-term contracts means that only a fraction of customers would be up for renewal at a time, and a new competitor would need to wait for existing contracts to expire.
Sterilization is the firm's most valuable segment, accounting for around half of our fair value estimate. Its annual revenue is similar to the medical isotope segment's revenue, and many people often see them as equal components. However, we value the sterilization business at more than twice the isotope segment. The sterilization business boasts better margins, less uncertainty, more sustainable competitive advantages, and better prospects. Since the market is mature and slow-growing, we expect just a 3% long-term growth rate for the business.
Medical Isotopes: 38% of Sales; 19% of Fair Value
The medical isotope segment transports and processes medical isotopes to be used in cardiology and oncology tests. Nordion harvests Mo-99 from Canada's NRU reactor, transports it to its processing center, and then delivers it to the Lantheus generator, which converts Mo-99 to technetium-99, which is used in hospitals.
The lack of Mo-99-producing reactors in the world and Nordion's significant geographic advantage gives the segment a narrow economic moat. The firm has an exclusive supply agreement with the NRU reactor, which is the only Mo-99-producing reactor in North America. This gives Nordion a significant advantage in serving the estimated 50% of global demand that comes from North America. Competitors must source Mo-99 from reactors in Europe, Africa, or Australia. The reactor's location allows Nordion to save significant money on transportation costs versus competitors, which largely contributes to the segment's impressive 35% operating margins.
Also, a 66-hour half-life makes it critical for Mo-99 to reach technetium-99 facilities, which are located near end users, as quickly as possible. Competitors using overseas reactors are able to reach the North American facilities in sufficient time to be viable, but Nordion can offer customers greater reliability, because it has a much larger margin of safety in case of weather or transportation delays.
There are just five Mo-99-producing reactors in the world. Nuclear reactors have to be specially equipped to produce Mo-99, and given the safety and national security concerns, most governments are very apprehensive about adding new reactors. Even if a competitor were able to get a new reactor approved, it would take years to get it up and running. Also, the short half-life of the isotope ensures that hospitals will need a fresh daily supply of isotopes. If a hospital overorders or patients cancel procedures, it cannot stockpile excess inventory.
In addition, transferring hazardous materials across the globe as quickly as possible is no easy task. Nordion and competitors have to be in constant communication with reactors, transportation vehicles, cargo aircraft operators, air traffic control centers, customs and border patrol agencies, and more. The relationships and procedures that Nordion has established would be difficult to replicate.
On the negative side, the 54-year old NRU reactor has become increasingly unstable. In 2009, it was forced to shut down for 15 months to repair a water leak. This combined with problems at another reactor sparked a global shortage of Mo-99, sending prices soaring and driving competitors to focus on increasing capacity. The shortage reinforced to customers the need to diversify their sources of Mo-99, and some had to sign long-term contracts with Nordion's competitors while the NRU reactor was down. Hospitals reacted to the shortage by implementing procedures to conserve isotopes and reduce their overall usage.
Atomic Energy of Canada Limited started to develop two new reactors, which would have put in place a sustainable long-term North American source of Mo-99 for Nordion, but it abandoned the project. Nordion had invested more than $350 million in the project and is currently engaged in a lawsuit against AECL. A legal settlement could force AECL to continue development of the project or pay Nordion damages, but we are not optimistic about the probability of the firm securing a long-term Mo-99 source in North America.
Nordion has since entered into an agreement with a Russian reactor that is expected to reach full capacity in 2016. However, shifting to this reactor would eliminate Nordion's geographic advantage, and the firm would face significantly higher transportation costs.
The medical isotope business produces similar sales to the sterilization business. However, we value it significantly lower, given its lower profit margins and our expectations for declining profits. The firm expects a 3%-6% revenue decline in 2012 because of pricing pressure. We expect this pricing pressure to persist, as even after a 3%-6% decline in Mo-99 supplies, prices will still remain much higher than their preshortage levels. In addition, the NRU reactor's age leaves a significant possibility of issues and another prolonged shutdown. We assume Nordion will have to eventually rely on the Russian reactor, which will require higher transportation costs and weigh on the segment's profitability. We expect the business segment to decline at a long-term rate of 4%.
Targeted Therapies: 23% of Sales; 20% of Fair Value
Nordion's targeted therapies segment is largely made up of liver cancer treatment TheraSphere, but also includes a small portion of contract revenue. TheraSphere is a radiation treatment for inoperable liver cancer. Through a catheter, microscopic radioactive glass beads are released directly onto the tumor. Since the radiation is targeted directly to the tumor and radiation exposure is localized, patients can be given a very strong dose and face milder side effects.
TheraSphere has not yet gained the widespread adoption necessary to warrant an economic moat. Doctors are still largely using chemoembolization or kinase inhibitors to treat inoperable liver cancer. Administration of TheraSphere is a little more complex than other treatments and does require training. Many physicians will be unmotivated to learn a new treatment option until they are faced with compelling clinical trial data showing that TheraSphere is significantly superior. In the radioembolization market, Nordion faces competition from Australian firm Sirtex, which makes a very similar product, but we think the market will be large enough for two successful players.
The targeted therapies business will provide nearly all of the company's growth going forward. The segment only made up 23% of sales in 2011, but vast growth opportunities make it extremely valuable. TheraSphere sales have grown at a compound annual rate of nearly 40% over the past five years, and we expect the rapid growth to continue. Small studies have shown that TheraSphere may be more effective than transarterial chemoembolization. However, even if Nordion's clinical trials do not show superiority to transarterial chemoembolization, we think it can continue to take market share. TheraSphere is slightly more complex to administer, but it can be given as an outpatient procedure whereas chemoembolization typically requires a two- to three-day hospital stay.
Option Value of Litigation
With the NRU reactor aging, Nordion had entered an agreement with AECL to develop two new nuclear reactors to secure a reliable long-term supply of Mo-99. Nordion contributed more than $350 million toward the project, but AECL abandoned development after it faced cost overruns and delays. Nordion is suing AECL for $1.6 billion, the estimated damages from AECL backing out of the 40-year contract. A ruling on the matter is expected later this year and will determine if AECL will be forced to honor the contract. If so, we would not be surprised to see the two parties reach a financial settlement instead of renewing the project. The Canadian government has expressed its desire to exit the medical isotope business, preferring to let other countries pick up the production.
Given our inability to predict the outcome of Nordion's litigation with any degree of certainty, we have not included any potential benefit in our fair value estimate. However, considering the size of the lawsuit, any positive ruling could have a substantial impact on the shares. If Nordion receives a positive ruling and the two parties reach a settlement, we would not expect the firm to receive the full $1.6 billion. Rather, we think the firm could receive an amount near the $350 million it had invested, which is more than $5 per share.
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