- Over the last 5 years, PerkinElmer has gone through a substantial make-over, fundamentally changing the profile of PerkinElmer from a 3-4% organic growth business to a 5-6% organic growth business.
- Free Cash Flow conversion has fallen from historic 90%-100% levels to mid-70%. We are convinced that the new CEO can bring FCF-conversion back to former levels.
- We believe this is a business that will be able to grow its EPS at a double-digit CAGR for the next 5 years.
- The latest quarterly earnings support our thesis.
PerkinElmer (NYSE:PKI) is a company that has manufactured analytical, scientific instruments in all of its 80 years of existence. Yet, over the last 5 years the company has gone through a substantial make-over. This puts the business in the enviable position where today no less than 70% of revenue comes from consumables, services and software, no less than 40% of turnover is generated in the emerging markets and no less than 75% of the business is geared towards the highly favorable diagnostics and life sciences end markets.
Our take is that this has fundamentally changed the financial profile of PerkinElmer from a 3-4% organic growth business to a 5-6% organic growth business. This growth is supported by several tailwinds that we explain throughout the article: a shift to gene editing, the rise in autoimmune diseases, expanding the new-born screening assays in emerging markets, new product launches, etc. This makes that the growth is truly high-quality since it is not only significant in terms of quantum, but also highly diversified in terms of drivers.
Complementing this growth with a very clear path of margin expansion, we believe this is a business that will be able to grow its EPS at a double-digit CAGR for the next 5 years. We therefore think PerkinElmer is a buy at current levels for the long-term investor.
Source: Bloomberg; Author's own calculations
PerkinElmer was founded in 1937 by Richard Perkin and Charles Elmer as an optical design and consulting company. Throughout its history, the company has always manufactured scientific, analytical instruments, yet for a wide range of end-markets: from optical components for the Hubble Space Telescope to photonics, fluid sciences and clinical labs all the way to computer manufacturing. Today, the company's end-markets are confined to diagnostics, life sciences, food and environmental.
We use the below charts to demonstrate how much the company has changed (for the better) over the last 5 years. We are using data up to 2018 because the company has significant exposure to China (20% of revenues) and we want to exclude any numbers that were impacted by COVID-19. Given that the Chinese operations already saw a small impact in Q4 2019, we have opted to use data up to 2018.
Source: Company filings
Source: Company filings
Source: Company filings
The simple insight from this is that PKI's growth potential has increased significantly (due to both its emerging markets exposure as well as its end-market mix) and its revenues are even more recurring than before.
PKI reports along two segments: Discovery & Analytical Solutions ("DAS") and Diagnostics ("Dx"). In turn, the DAS segment consists of Life Sciences, Food and Environmental & Industrial. Above we have thus already shown that 60% of sales are generated in the DAS segment and 40% of sales in the Dx segment. However, Dx's margin is significantly higher and therefore, the earnings split between the two segments is 50/50:
Source: Company filings
Having outlined which activity accounts for which amount of profits, we turn to what these business lines actually do and what their respective drivers and growth potential are.
Diagnostics - 50% of group operating income
Both the Diagnostics and the Life Sciences activities produce analytical instruments that are used in a healthcare environment. The difference between the two is best explained by their setting: Diagnostics relates mostly to testing of blood samples whereas Life Sciences relates to instruments used in labs for drug discovery.
Diagnostics represents c. half of group earnings. We have estimated that this 50% can be further subdivided in three big chunks: "reproductive health" represents c. 22% of group earnings, immunodiagnostics represents c. 20% of group earnings with the remaining 8% generated in applied genomics. We will now in turn describe these business lines in more detail.
Reproductive health is probably the first business line that PKI is generally associated with, given their very dominant position here. Put simply, reproductive health performs all testing related to fertility, pregnancy and new-borns:
Source: Company Presentation
Reproductive health represents the crown jewel in PKI's portfolio and it essentially boils down to prenatal screening and new-born screening.
Prenatal screening consists of one or more blood tests which will tell you the chance of your baby having a chromosome abnormality such as Down syndrome, trisomy 18, neural tube defects, etc. Prenatal screening can occur through either biochemical screening (80% of current market) or NIPT (non-invasive prenatal testing, 20% of market). The difference is simply that NIPT is even less invasive than biochemical screening, e.g. by studying placental rather than fetal DNA. PKI has a strong position in prenatal screening with 50% market share in biochemical screening and an emerging presence in NIPT. The appeal of this activity is straightforward: PKI has a dominant position in a lucrative market with high barriers to entry. In addition, the company has now launched its Vanadis platform, which is a state-of-the-art NIPT solution, which will allow PKI to further gain market share by entering the NIPT market, further increasing its dominance in the prenatal screening market overall.
New-born screening consists of a simple blood sample collected from the infant's heel between 24 hours and 7 days after birth. PKI holds a global market share of >70% in new-born screening, an activity we find particularly appealing for two reasons. First, it is simply the case that EM penetration is extremely low: babies born in China today are only tested for 4-6 disorders in big cities, a number that drops to 0-2 disorders in more rural provinces. This stands in sharp contrast to the developed world where 20-30 indications being tested is the norm. To put things differently: 40% of the world's population lives in China and India whereas these two countries make up only 10% of the global diagnostics market. PKI is an excellent play on this trend as it is one of the biggest players in EM diagnostics.
Source: Industry reports
The second reason we are a fan of new-born screening is related to the wave of pharma companies that are increasingly focusing on gene editing as a more efficient means to tackle disorders as opposed to traditional treatment methods. Because gene editing is a completely new way of tackling disease (many compare it to turning off the faucet while traditional methods were simply mopping up the floor), it is not only proposed as a more effective alternative to current treatment standards, but also able to tackle many disorders that were previously untreatable.
The first big wave of such untreatable disorders are so-called "monogenic" disorders. Monogenic disorders are diseases where a single gene is the cause of disease and thus much easier to tackle with gene editing as opposed to more complex disorders where there are mutations in more than a single gene (e.g. cancer). We could call monogenic diseases the low-hanging fruit of gene editing if you will. Examples of such diseases are cystic fibrosis, Duchenne muscular dystrophy, hemophilia, sickle cell anemia, etc. There are >10,000 monogenic diseases affecting millions and millions of people.
The bottom line is that this is great news for PerkinElmer, since it now finally makes sense to screen at birth for these disorders as we can finally cure them. Take spinal muscular atrophy ("SMA") for instance, a disorder where Novartis (NVS) has brought a successful cure to market using gene editing. SMA is a terrible disease where 90% of children will pass away before the age of 2. In the past, SMA was never included in new-born screening as it made no difference since there was no cure. Hospitals were not very keen on telling newly minted parents their child would almost certainly die within the next two years from a disease they could not treat. SMA is but one of the many disorders that will in the future be treatable through gene editing and PKI will benefit greatly from this through more and more need for thorough new-born screening. There are a couple of things we particularly like about this:
- Unlike investing in pharma companies, we don't have to predict who will be the winner in which kind of disease, we simply surf the gene editing trend which we believe is real and significant.
- The big pharma companies take care of all the lobbying: the amount of indications screened is largely a political decision, at either the country or state level. Every time a new treatment is developed, big pharma will lobby hard to add the indication to mandatory new-born screening. This also happened with SMA, where Novartis has to date convinced 30 U.S. states to screen for SMA.
- Through early detection, prevention and treatment, new-born screening aids in lowering healthcare costs vs. more traditional methods where you had high annual bills to mitigate symptoms rather than tackle the true source. Early detection of these diseases makes a huge difference in terms of costs as well as treatment success. We like new-born screening because it simply makes a lot of sense.
Immunodiagnostics is the second big piece of the Diagnostics segment, representing a further c. 20% of group earnings. As the name suggests, it relates to diagnostic testing for autoimmune diseases. Put simply, autoimmune diseases are maladies where the individual's immune system mistakenly targets own cells rather than foreign cells. Instead of guarding against germs and bacteria, it mistakenly attacks healthy cells of e.g. the skin or joints of its host body.
Unfortunately, autoimmune diseases represent a group of disorders that has shown significant growth over the last decade, hinting at the fact they may be related to environmental factors such as infections or exposure to chemicals or solvents. Women are twice more likely to develop autoimmune diseases than men, with the disease usually starting during a woman's childbearing age. The most prevalent autoimmune diseases are multiple sclerosis, type 1 diabetes, rheumatoid arthritis, psoriasis and lupus.
The combination of high and growing prevalence, very few treatments currently successful and advances in biology/genomics has generated increasing interest by pharma companies to spend R&D on autoimmune diseases, a trend that is likely to persist for many years, which obviously bodes well for immunodiagnostics.
PKI's presence in immunodiagnostics is relatively novel, with the acquisition of EUROIMMUN which closed back in December 2017. EUROIMMUN has extensive expertise in the fields of immunology, cell biology, histology, biochemistry and molecular biology. It produces test systems for the laboratory diagnosis of autoimmune and infectious diseases, allergies, and for gene analyses. We think that EUROIMMUN is a fantastic asset and below list a couple of reasons why:
- EUROIMMUN is the global leader in immunodiagnostics with 200 assays, a breadth representing 2x the nearest competitor.
- No less than 90% of its turnover comes from reagents, with the remaining 10% from instruments. This razor/razorblade model is typical for diagnostics, making revenues highly recurring.
- It has German roots, but has been extremely successful in China, which now makes up c. 45% of the business. It is very small in the U.S., which provides PKI cross-selling opportunities given its roots and strong commercial force there.
- The business has grown at c. 15% per year historically and is expected to grow c. 12% per year for the foreseeable future.
Put simply, EUROIMMUN is a high-quality play on a great theme, with the right geographical footprint.
Applied genomics represents the remaining 8% of group earnings generated by the Diagnostics segment. It is one of the highest growing fields in diagnostics, as this is where the major advances have been made over the past couple of years. Next-generation sequencing refers to deep sequencing techniques where now the entire human genome can be sequenced within a single day, a feat unthinkable not so long ago.
Applied genomics is a relatively new activity for PKI and they have mostly started doing this upon the request of their clients in the new-born setting. If PKI's new-born screening yielded positive results (i.e. an abnormality was detected), the baby had to be further tested to verify the results, often triggering whole genome sequencing tests. This was pretty much the only step of the "reproductive health" cycle that PKI didn't offer yet, and clients wanted to go through the whole cycle with only one party. These skills are now broadened to be used in more and more settings, as the applied genomics market is claimed to grow at 25% per year currently. This very high growth is of course fueled by the shift in healthcare trying to use our increased understanding of DNA and biology in order to develop treatments.
Conclusion on Diagnostics segment: the two big drivers of Diagnostics are EUROIMMUN and reproductive health, both great assets with dominant positions, high barriers to entry and various secular growth tailwinds. In Applied Genomics, PKI is more of a challenger, but we see them able to participate in the high growth this market is currently seeing. Overall, we think Diagnostics is an enviable business, carrying high margins, demonstrating strong long-term growth potential and stickiness given that 75% of turnover comes from reagents.
Life Sciences - 28% of group operating income
As we have stated earlier, the Life Sciences activities (part of DAS segment) manufacture analytical instruments used in laboratories for drug discovery, finding their way to pharma, biotech and academic institutions. Within Life Sciences, we find three main activities: Life Sciences Research Solutions, preclinical imaging and OneSource.
Life Sciences Research Solutions manufactures a wide range of instruments used in the lab setting, e.g. through pathology imaging: the visualization of cells and tissue and their reaction to various treatments, as well as phenotyping of immune cells, visualization and measurement of biomarkers, etc. More info as well as a video can be found here: Life Sciences Research Solutions.
Preclinical imaging is the visualization of living animals for research purposes. Changes are observed at either the organ, tissue, cell or molecular level in living animals undergoing treatment in pre-clinical test settings. Imaging is usually multimodal, making use of a combination of MR, CT, PET and SPECT techniques. So as an example, PKI's instruments will for instance continuously monitor and visualize the size of a cancer tumor in a mouse undergoing a new treatment in a phase I pre-clinical study.
OneSource Laboratory Services relates to a suite of software solutions that allows lab owners to optimize the yield of their operations, by maximizing uptime, lab analytics, compliance reporting, asset utilization and workflow solutions. The main goal is simply to maximize the yield of R&D labs, while reducing maintenance costs. Important to know is that OneSource not only does this for PKI products but for the entire lab, including products of competitors. PKI alone has 500,000 assets installed globally and a force of 1,700 service engineers.
Environmental & Industrial - 15% of group operating income
The Environmental & Industrial activities sound complex, as the main products here relate to chromatography, mass spectrometry and liquid particle counters. In essence, it always boils down to the same thing: PKI's products measure the content of certain compounds in various products/settings, e.g.:
- Testing for presence of toxins, pollutants and microplastics in water
- Air and soil pollution
- Determine elemental content of chemical products
- Measure carbon, hydrogen, nitrogen, sulfur and oxygen content in organic materials
- Study reaction of polymers to heat
- Measure mass of a sample while temperature changes
Out of the 15% of group earnings, we estimate 10% are generated in industrial end markets such as oil & gas, general industrial, semiconductors and chemicals with the remaining 5% in environmental settings. Due to ever more stringent regulations, these are growth markets through the cycle, yet they certainly represent the most cyclical aspect of PKI, making it the least prioritized business line as well as the one most likely to be divested at some point. As the environmental side of things is mostly focused on drinking water, we think the needs (especially in EM) are high and cyclicality remains decent. This makes that we can posit that only c. 10% of PKI's earnings are cyclical.
Food - 8% of group operating income
The Food segment is relatively similar to Environmental & Industrial, also using spectrometry techniques to measure the content of certain substances, such as gluten quantity, milk components, protein content, hormones, antibiotics, natural toxins, microbial and industrial contaminants, etc.
A large part of this is tied to grain and dairy testing, where there are strict regulatory standards. PKI does testing for both the food as well as the feed sectors, working for 9 out of the 10 largest global food producers. Contrary to Environmental & Industrial, Food is a defensive, high growth segment where PKI is investing heavily. It has e.g. devised full workflow solutions for cannabis testing, as it tries to be the pioneer in this burgeoning sector, where marijuana or cannabinoids are increasingly finding their way to food and drinks in the U.S.
Below we plot the historical organic sales growth of PKI.
Source: Company filings, Author's Own Graph
Rather than historical growth figures, we think it is far more important to contemplate how much PKI's inherent growth profile has changed given the acquisitions and divestitures the company has done, significantly altering its end-market mix away from industrial towards diagnostics and life sciences. We think this change, in large part due to the EUROIMMUN purchase has changed the group's growth profile from 3-4% organic to 5-6% organic. Taking into account EUROIMMUN's growth, their entry into applied genomics as well as the Vanadis launch in reproductive health, we think this is realistic and above all prudent.
Taking a look at what the consensus growth figures for the next three years were before the COVID-19 virus broke out, we can see that the sell side analysts share this view.
The 2020 growth rate was a bit higher but this is because Bloomberg consensus obviously reflects nominal, not organic growth and PKI has done a couple of small acquisitions in 2019. Subtracting this 1-2% nominal growth from acquisitions, all three years were in line with our organic forecast. This reassures us in the sense that we view this as achievable, we would be worried if consensus had too high expectations. We realize that these growth rates have changed due to the outbreak of the COVID-19 virus but the whole point of this exercise is to demonstrate that the underlying growth profile of PKI has changed.
As a final and important point, we are happy to see that future growth is well-diversified: it will come from life sciences, the Vanadis launch, EUROIMMUN, applied genomics, gene editing increasing the breadth of new-born screening, investments in food, etc. So it is reassuring to see that future growth is not dependent on one or two main product launches, but nicely diversified across different end markets and geographies.
We want to understand how much upside there could be to PKI's margins or whether they potentially have already peaked. Taking a look at the company's margins vs. peers, it looks like there could be some upside left.
This is always a tricky exercise, however, as every company is different. Therefore, we look at various ways in which PKI plans to increase its margins, other than being a growth business and exploiting its operational leverage. It plans to do so via 3 avenues:
- First of all, it believes it can bring EUROIMMUN's margins from the low 20s to the high 20s, a substantial difference. EUROIMMUN was a private business and PKI believes it can run this a lot tighter. Bringing it to the high 20s would approximate PKI's own margin in Diagnostics which stands at 30% so this definitely seems feasible.
- Secondly, PKI has been criticized in the past that it could do a better job integrating acquisitions and extracting cost synergies. The company admits this as it currently has 180 sites across the globe and wants to cut back on this. Paris, e.g., has 3 plants where they will bring this together in 1 plant. In other words, the company believes factory productivity to be the second big driver of margin expansion.
- Third, PKI has made substantial investments in SG&A which are now paying off in terms of a revamped sales force. This organizational change was mostly executed by the prior COO who has now become CEO. So the third driver is SG&A leverage, where they believe that SG&A will grow at a substantially smaller clip than sales in the next couple of years.
A final margin driver that we would add is that the Diagnostics segment grows a lot faster than the DAS segment. The former carries 30% margins whereas the latter has 20% margins, so mechanically this also helps the group margin as long as Diagnostics grows faster than DAS, which we believe will remain the case.
These actions are bearing fruit, as margins have been on an upward trajectory: the group saw margin improvement in each of the past three years and initially expected to improve margins by 80bps in 2020 (pre-COVID-19). The new CEO at that time also stated that the company would pursue further margin improvement in the years after 2020, which makes sense as the initiatives we outlined above are relatively new.
In terms of free cash generation, PKI clearly has some cleaning up to do. Over the past years, the focus was entirely on shifting the company towards different end-markets (as we have discussed in this article) through various acquisitions and divestitures. This has made that working capital management has suffered, amongst others because EUROIMMUN has different working capital dynamics, because of the investments in SG&A and the general priority of refocusing for growth.
Now that this strategic realignment exercise has been successfully fulfilled, PKI is intent on tightening its working capital management and bringing FCF conversion back to 90-100% of adjusted net income.
Source: Company filings
In terms of valuation, we think it is important to highlight that PKI's financials are somewhat similar to pharma, as their main expenses are personnel and R&D, which are all expensed and not capitalized. This then results in the fact that EV/EBITDA multiples always look high, as your net income, EBIT and EBITDA will be closer to one another than is the case for more traditional companies due to the absence of meaningful D&A.
Because of this, we have always thought it to be most appropriate to value the pharma/wider healthcare space primarily through a P/E multiple, with a check that the company does not carry too much debt. The latter is not a big concern, as virtually no major pharma company carries significant debt and neither does PKI.
Below we plot the P/E, EV/EBITDA and FCF yield for the peer group we also used to benchmark margins, with the exception of Roche Diagnostics (SWX:RO). All metrics are forward metrics for full year 2020.
With the usual caveats that no company is the same and relative valuations have many pitfalls, our observations are below:
- Encouraging to see PKI is the second lowest on P/E, which is the metric we prefer. Most competitors are trading at significantly higher multiples.
- Somewhat surprising to see PKI score relatively well on FCF yield, as we believe FCF to be one of the main working points for the company. This being said, FCF yields for the sector are relatively similar and in general fairly low, which reconfirms the current positive attitude of investors towards the diagnostics theme.
- Qiagen is being acquired by Thermo Fisher (TMO) which makes these trading multiples less relevant than the other peers.
As a conclusion to valuation, by no means would we claim that PKI is cheap. We would actually prefer for it to trade below 20x P/E (on normalized earnings) prior to taking a position. On the other hand, we are confident of this company generating very nice earnings growth for a very long period: the tailwinds we discussed in this memo extend for a lot longer than just the next five years. Prior to the COVID-19 outbreak, PKI itself had said it could grow organic sales at high-single digits and EPS at mid-teens. We think this is somewhat ambitious and believe that normalized EPS growth is around 10-12% per year.
Robert Friel has been the Chairman and CEO of PKI for the last 10 years, handing over the reins to Prahlad Singh as of Jan 1st, 2020. Friel joined PKI in 1999, having served in the COO and CFO roles prior to becoming CEO. We think he has done a relatively good job, especially the last few years, repositioning the company for the better. We also think it is time for some fresh blood at the top.
Prahlad Singh joined PKI in 2014 as head of the Diagnostics business, which has thrived under his leadership given the growth, EPS growth and EUROIMMUN acquisition under his tenure. In 2019 he became COO, where he was able to roll out group-wide many of the best practices he had established in the Diagnostics unit. Prior to joining PKI, he has served in various leadership roles at GE Healthcare (GE), Philips (PHG), DuPont Pharmaceuticals and Bristol-Myers Squibb (BMY). What we like about the new CEO is that he has been around for some time at PKI (with success) and that he has an operational rather than a financial background: we think this serves the company well at a juncture where integration of the acquisitions and better working capital management are crucial.
First Quarter Earnings
PerkinElmer reported the results of the first quarter of this year after the market close on the fifth of May. PKI managed to beat market expectations on both revenues and EPS.
Some of the highlights of this very strong earnings report were:
- While full-year guidance has been withdrawn, the management commentary combined with the Q1 results makes us believe that the earnings hit for this year will remain limited. Main reasons for this are the recurring high-margin nature of 75% of revenues, relatively high variable costs, very diversified business in terms of both geography and service offering and certain business lines benefiting from the COVID-19 outbreak.
- PKI is benefiting from the COVID-19 outbreak in 2 ways: The diagnostics segment is benefited by the COVID-19 tests that the company has developed. The second positive impact comes from the R&D race in the search for a vaccine. PKI delivers key services to pharma R&D labs.
- While it is early days, we see strong confirmation of our FCF-conversion improvement thesis in these quarterly results. This was one of the strongest quarters ever in terms of cash generation for the company.
A very important thing to note was that most sell-side analysts were amazed by the COVID-19 tests developed by PerkinElmer. These tests are more accurate and reliable than a lot of those developed by renowned diagnostics players. This is important because PKI is almost never mentioned in any industry primer on diagnostics and very often isn't even included in the peer groups that sell side analysts compile, despite PKI being a key player in this industry. If PKI's COVID-19 tests put the company on the radar, then maybe PKI will soon be rewarded with a multiple more in line with its peers.
PerkinElmer is one of those companies whose transformation went unnoticed by the market. A smart M&A strategy and exposure to secular growth industries have transformed the financial profile of PerkinElmer from a 3-4% organic growth business to a 5-6% organic growth business. This growth is supported by several tailwinds that we explained throughout the article: a shift to gene editing, the rise in autoimmune diseases, expanding the new-born screening assays in emerging markets, new product launches, etc. This makes that the growth is truly high-quality since it is not only significant in terms of quantum, but also highly diversified in terms of drivers.
Given the fact that management is very confident that it can meaningfully improve both the operating margin and the free cash flow conversion, we believe that PKI can compound EPS at a double-digit CAGR in the coming years.
PKI has not received that same generous trading multiple that the market has given to other diagnostics players but the recent COVID-19 tests developed by PerkinElmer may force some investors and sell-side analysts to review their stance on the company.
While we do not believe that the stock is cheap, we have high conviction that this is an attractive entry point for investors with a 5+ year horizon.
This article was written by
Analyst’s Disclosure: I am/we are long PKI. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
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