Thursday, February 7, 2013

Idexx Labs Equity Research and Analysis

It’s not often I start an article by discussing the evaluation of a stock before even writing about what they do, but in the case of IDEXX Laboratories (NASDAQ: IDXX) I don’t think it can be avoided. It’s a company I’ve looked at from time to time and never felt comfortable with its evaluation even if its prospects are very attractive. Sufficed to say that the market doesn’t really care what I think and has taken the stock higher over the years. It currently sits on a PE of nearly 30 and an EV/EBITDA multiple of 16.3x so is it worth just walking away at this point?

IDEXX Growth Drivers

Obviously if the answer to that question was ‘yes’ I would spare you the pain of reading any further! However, I think there are some strong long term drivers here and the stock is worth watching closely. I can’t bring myself to buy at this price and I think it might take a hiccup or two to break the back of the optimism that’s around the stock but stranger things have happened.

The exciting thing about the company is its Companion Animal Group and specifically its point of care diagnostics solutions. From a company execution perspective, it is the usual razor/razor blade model of a diagnostics company. In other words, expand lower margin system sales in order to establish scale and then sell higher margin reagents into the installed base. With that said, instrument revenues were lower than it had expected them to be in Q4, but the size of accounts was described as ‘upgraded.’ Moreover, customers tend to be very loyal and have driven demand for consumables forward at a mid teens pace. Similarly, IDXX expects 11-13% growth in consumables in 2013.

In addition, there is somewhat of a shift in revenue recognition occurring thanks to its move towards a rental reagent program that typically lasts five years and ensures recurring cash flow revenues for the firm. In a sense, this program is really about tailoring a solution to the needs of the customer in order to drive consumable revenues in the future.

Idexx also has the benefit of two world class distributors in Henry Schein (NASDAQ: HSIC) and MWI Veterinary Supply (NASDAQ: MWIV). The latter is another highly rated company (30x earnings) and for good reason. It recently announced earnings and guidance that beat expectations. Revenues increased 24% in the quarter with operating income up 26.4%, and analysts have mid teens earnings growth penciled in for the next two years. This is a strong industry. As for Henry Schein it is more of a dental products distributor, but its Global Animal Health sales were up 19.2% in the last quarter and it gained market share. This is a good indication that it is looking to focus on this division in order to generate growth.

And if anyone is in any doubt as to how highly rated the sector is right now then consider the surge in Zoetis (NYSE: ZTS) after the recent IPO. It was oversubscribed by as much as 20x according to sources, and as a Pfizer stockholder I consider that they sold it too cheaply. Zoetis has significant exposure to both companion and livestock markets.

Hospital Visits and Lab Revenues

While point of care diagnostics represents the growth platform at IDXX, the larger part of its revenues come from reference laboratory diagnostic and consulting services. The way to think of these revenues is as being a function of practice visits and revenues. The evidence is that people do hold back on taking pets to the vet in difficult times so there is an element of cyclicality here.

I’ve graphed IDXX’s estimates for these key metrics in 2012:

It looks like a sequential decline, but the company stated that Q4 growth was impacted by Sandy. Otherwise, it suggested patient visit growth would likely have been closer to 3.5%. This is not indicative of a strongly growing economy, but the US economy looks better in 2013 and IDXX is expecting key contributions from international expansion. With that said, organic growth in reference labs was an impressive 7.6% with a further 3.1% coming from acquisitions. IDXX can expand profits even with low single digit growth in patient visits.

Key Demographic Trends

All of these growth drivers are impressive, but to buy the stock you will need a lot of confidence in its abilities to meet its numbers, and this will depend on an assessment of its demographic drivers. I think they are very positive. An increasingly aging demographic implies more pet ownership, and with the incredible increases in divorce rates prevalent in the US it is self evidently true that there will be more single people at an age where they have disposable income. Moreover, birth rates remain low by historic standards. All of this is pointing towards the ongoing supplanting of the lack of children and a partner by buying a companion animal.

We can all disagree on the causes of this (for me it is feminism mainly), but the trends in society are clear and I don’t think they are going away anytime soon.

Where Next for Idexx?

Putting all of this together leads to analysts modeling Idexx with an accelerating free cash flow conversion rate in the future as consumables revenues grow with a high degree of confidence in its prospects for hitting these targets. All of which is wonderful, but it still leaves me uncomfortable with a stock on a forward PE of nearly 27x.

There are probably better ways to invest in the sector and, trust me, I am looking for them.

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