Thermo Fisher Scientific May Be Hard Pressed to Outperform

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To be clear from the outset, I'm a fan of Thermo Fisher Scientific Inc. (NYSE: TMO  ) , and I believe the company's impending acquisition of Life Technologies Corp. (UNKNOWN: LIFE.DL  ) will be a transformative deal for a company with a long history of strong M&A moves. With this deal, Thermo Fisher will operate on a scale that the likes of VWR, Merck KGaA, Agilent, and Waters cannot match, and the company will have the resources to challenge companies like Illumina (NASDAQ: ILMN  ) , Becton Dickinson, and Danaher in their growth markets to the extent management wishes to invest.

The question is price. This has been a good year for anything "bio", but Themo Fisher has outperformed almost everybody else in the sector with a 70% jump in the last twelve months. Even with a double-digit multiple to EBITDA and/or strong long-term mid-single digit free cash flow growth, it is hard to call these shares a bargain. Thermo Fisher has a good history of drawing more value than expected from its M&A transactions, but that seems to be the base case assumption here rather than the upside.

Adding life to organic growth
Thermo Fisher has had challenges with organic growth for a while, and has often turned to M&A as a means of improving its growth prospects. Dionex added complementary assets in chromatography, sample prep, and consumables, while Phadia expanded the company's opportunities in vitro diagnostics.

The huge deal for Life Technologies takes all of those and turns them up to "11". Life Technologies brings a wide range of products to Thermo Fisher, including reagents, PCR products, sample prep materials, and so on. While it takes a back seat to more gaudy business lines, the synergies that Life brings to Thermo Fisher in terms of bioproduction, sample prep, forensics, and food safety will be invaluable.

In fact, European regulators have already told Thermo that they will have to divest its cell culture, gene modulation, and magnetic beads businesses as a condition of deal approval, as the combined company would have had nearly 50% market share in cell culture (well ahead of Sigma Aldrich (UNKNOWN: SIAL.DL  ) ). There are also significant operating synergies to be had from the combination. Life Technologies generates a substantial portion of its revenue through its e-commerce platforms, and this is a channel that Thermo should be able to leverage to its own advantage after the deal closes.

Will thermo go for growth?
I will be curious to see the extent to which Thermo Fisher will invest to capitalize on the growth potential its M&A transactions have brought to it. Life Technologies has the well-publicized Ion Torrent sequencing business, a business which has emerged as a real threat to Illumina in the benchtop sequencing space and has logged strong revenue growth for Life Technologies.

The question for Thermo is whether its wants to invest the resources necessary to push Ion Torrent further into next-generation sequencing and sequencing-related diagnostics applications. Illumina routinely spends around 20% of its revenue on R&D and Life Technologies has historically spent about 10% of its revenue on R&D, while Thermo Fisher is consistently in the low single digits.

In fact, Life Technologies has outspent Thermo Fisher in R&D in two of the last three years. Without ongoing R&D investment, I believe it will be difficult for Thermo to maintain Ion Torrent's technological competitiveness and Thermo has a tough choice to make in how to maximize growth and margins.

So too with diagnostics. The combined company will have a strong share in cell culture, bio processing, and bioproduction, as well as pathology and microbiology. The question again is how much the company wants to push into growth markets like molecular diagnostics and specialty assays, and how much it's willing to pay. Running with Becton Dickinson or Danaher is going to require meaningful ongoing R&D commitments.

The bottom line
Between Thermo's large self-branded/self-manufactured catalog and Life Tech's e-commerce channels, I see significant opportunities for margin-generating operational synergies. I also believe that Life Technologies will improve Thermo Fisher's revenue growth for the next five years. But, the question of how much long-term growth Life Technologies will add really does depend on Thermo's commitment to ongoing R&D.

For now I have a hard time finding much undervaluation in the shares. If I use a 12 times EBITDA multiple on the combined company 2014 EBITDA (a multiple well ahead of the likely high single-digit growth rate), I only get to about $90 in fair value.

Likewise, even a long-range free cash flow model that assumes Thermo can produce free cash flow margins in the very high teens only gets to about $105 in fair value. That suggests to me that a lot of optimism is already factored into the shares, and I'd be cautious about making a big new purchase at these levels.

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