Cepheid's (CPHD) signature product, the Genexpert System, can be used on a wide range of samples in multiple therapeutic areas. Its key instruments currently have an extensive menu offering laboratories tests that most other companies need multiple instruments to run. In addition to the already extensive menu, the company plans on adding 10-20 tests this year and next. This company already is making a major impact in the industry and I, like many, believe it will continue to make a huge impact going forward.
The question with Cepheid isn't whether or not the company will be successful going forward. The question remains: Is the stock overpriced?
The 4 Ps:
The Genexpert Systems can perform a wide variety of tests in reference labs and hospitals in multiple areas such as HAI (hospital acquired infections), critical infectious disease, oncology, genetics, and women's health. The Company's platform is sort of a "catch all" tool, a huge advantage over its competitors such as Roche (RHHBF.PK), Abbott (ABT), Qiagen (QGEN), BD (BDX), and GenProbe. The system is currently placed in about 20-25 percent of labs in the US already despite only having about 9 tests commercially available to date. Variations of the Genexpert System are being used in both large and small laboratories in developed and developing countries. Its product is very commonly used in HAI testing (I believe the most used product). The SmartCycler system is another product that provides the Company revenue. Overall the products get rave reviews and are some of the top in the industry.
The market potential for Cepheid's products is vast given its menu contains tests used in so many different indications. The market potential for the IVD (in vitro diagnostics) segments in which Cepheid operates was 4.5 Billion in 2010 and expected to grow to 9.5 Billion USD in 2015. Given that the company already finds its initial instruments placed in so many different laboratories and in so many different countries, the potential is one of the highest in the molecular diagnostics (MDx) sub industry. Given a small ~6 percent penetration rate, the company's revenue can still grow at over 20 percent through 2015.
I see penetration rates as high as 10-15 percent in the next 5-10 years. This means a CAGR of 35%+, while not likely, is still a very possible scenario.
Pipeline and R&D is absolutely crucial to the long term success of molecular diagnostics companies and most life science companies in general. Typically we can see management's "bullishness" by their willingness to develop. I tend to use it as a forward indicator of sales. The R&D spending hasn't slowed down and I believe justifies estimating a high growth rate long term.
Figure: In Thousand USD
The potential is there and the company believes in its products.
The CEO John Bishop is definitely qualified to run the show having experience in the industry for many years. I've seen him present and discuss the company at a few conferences and he's one who knows the industry and where it's going. Since taking over the role as CEO in 2002, the company's stock has grown at a very healthy 25%+ CAGR.
The negatives are equity positions of the insiders. Management receives fairly normal compensation but I prefer companies that are more heavily insider owned. Sell offs by management come on a fairly regular schedule. I don't necessarily see this as a negative sign because it appears like scheduled diversification from a stock that has value tied up in future uncertain cash flows. Looking through ownership forms, I didn't see any recent significant insider buying. Overall I'd say that managements' abilities slightly outweigh the lack of insider buying.
Cepheid uses a disposable based business model where consumables are expected to follow instrument sales. To date, over 3000 instruments have already been placed. We can expect revenue to follow as customers can reasonably be expected to use the system once it's in place. The menu should expand to over 30 tests in the next 4 years. Even given the longer time frame, we can reasonably expect sales to increase as the menu expands. We can also expect revenue growth to be somewhat aligned with the growth of the molecular diagnostic industry. Overall the company is pretty predictable.
After identifying the 4Ps and seeing the company has major potential, now we must identify what risks can stop Cepheid from becoming the biggest player in molecular diagnostics.
While there is not one company that does what Cepheid does, there are many that do some of the things that Cepheid does. These firms are well capitalized and will see the overall 10-15 percent annual growth in the MDx industry as an opportunity. These firms like Qiagen, Roche, and Abbott have more sales and marketing infrastructure as well. Overall, despite the competition, I believe the Company has a pretty good competitive product and is positioned very well.
As noted in the 2012 2nd Quarter conference call, hospitals continue to be cautious with spending. This affected Cepheid's guidance for the year. This can be a long-term issue that can affect instrument placement which results in lower consumables in future years. While this is a real concern if it lingers, I don't see molecular testing experiencing too many slowdowns anytime soon. Its benefits outweigh the costs and in some cases reduces long term costs.
The High Burden Developing Country (HBDC) program allows Cepheid to enter into markets that need its products the most: Particularly with its TB test. While this program provides another avenue for its products and social good, it does come with risks; Namely unpredictable payment schedules, sales uncertainty, and decreased margins. The agreement reached with the Gates Foundation this week definitely helps eliminate some of that uncertainty.
The recent foreign exchange rates, the Company cited in the last call as a major culprit in the top line miss and cautious guidance for 2012. While this is a short term risk, Its long-term effects should be limited. While the US dollar may experience some continued strengthening, long-term Fx is always a random walk with no drift. With exposure to all currencies, the Company's revenue should even out in the long-term.
Healthy Gross Margins:
When moving from instrument placements to selling consumables, we should see margins expand. We will probably see two opposing forces going forward: Expanding margins because of consumables and contracting margins because of sales in HBDCs and smaller hospitals. Going forward I am modeling the company to have margins north of 55%.
Revenue growth between 2006-2011 has been phenomenal, growing at a healthy 26% CAGR. It saw a little slowdown during 2009 but other years have seen huge growth.
Figure: In Thousand USD
I believe without question that the growth will be there for Cepheid. My main concern is EBIT margin. Can it control it's costs and give money back to the shareholders? Right now it's trending in the right direction. COGS and profit sharing will continue to shrink. SG&A will be the question mark going forward. Management is targeting 10% but it might be difficult.
After looking at its 4ps, key financial figures, and risks, it appears like Cepheid needs a premium valuation.
For valuation purposes I used a multiple stage DCF with the two sensitivity factors growth and discount rate. I'm going to assume a short term high revenue growth rate of between 20-35 percent for 5 years declining to 4 percent gradually starting at year 2018. FCFF assumptions are working capital increase at 2 percent of revenue, Capex at 5 percent of revenue and depreciation and amortization at 4 percent. Playing with a reasonable range of discount and growth rates, I get values roughly between $26 and $35 dollars a share.
Although I absolutely despise most accounting based multiples, they are a reality check and good for communication and context purposes. The best comparables would be fast growing instrument and consumable molecular diagnostics companies with market caps between 1-5 Billion. There's no perfect comparable, so I used above average growth general molecular diagnostics companies with market caps between 750 Million and 10 Billion. These names are Genomic Health (GHDX), Life Technologies (LIFE), Luminex (LMNX), PerkinElmer (PKI), Myriad Genetics (MYGN), Qiagen and Hologic (HOLX).
I used the averages of these companies' metrics and adjusted them upwards. P/S and P/E I adjusted upward because of higher growth. PEG, which technically is not supposed to be adjusted, I adjusted because of placement barriers created by Cepheid. For EPS in 2013, I expect somewhere around $.50 per share.
Figure Notes: Genomic Health trades around 170x 2013's earning dramatically shifting the industry P/E ratio. The ratio without Genomic Health is just 17x. I believe it's high growth characteristics make leaving it in justified.
Averaging out these comparables Cepheid would be worth roughly $28 per share. $28 dollars fits into the lower-middle range of the DCF model and seems like a reasonable price for the stock.
In order to get to its current value of around 2.5 billion, I had to adjust my model to 30%+ revenue growth, a long term EBIT margin of 40+% percent, with a 7 percent discount rate. While none of these scenarios are impossible, I believe these are very high case scenario numbers, even for an industry superstar like Cepheid.
I believe there are two possible culprits for the DCF and comparables being so far below the stock price as of today. The first major culprit is acquisition rumors and the second is the market pricing in a close to perfect scenario. While I believe Cepheid is a whole 35 percent overvalued, I hesitate to suggest a short position. This is due to a low but reasonable enough likelihood of an acquisition and the high amounts of value tied to future cash flows.
Cepheid has all the Ps: people, product, predictable, and potential. There are limited business execution risks in the short and intermediate terms and its product is positioned well. I like almost every single thing about this company. The one exception: stock price.