Emphasizing Telecom and Biotech [Fool on the Hill] June 29, 2000

FOOL ON THE HILL: An Investment Opinion
Emphasizing Telecom and Biotech

By Warren Gump (TMF Gump)
June 29, 2000

Summary: While it has only reported one quarter of year-over-year growth in the past two years, Thermo Electron is nearing completion of a major restructuring that will leave it streamlined and focused on its measurement and detection equipment business. Reinvigorated research and development spending should allow the company to more fully participate in the fast growth inherent in the telecommunications and life sciences sectors.

Thermo Electron (NYSE: TMO) composes a large portion of both my personal and hypothetical online portfolios. If you look only at reported earnings per share, you'd probably wonder why -- reported year-over-year results have improved only once in the past eight quarters. Well, hold your breath no longer... my interest is primarily related to the company's efforts to restructure and focus on supplying equipment to faster-growing telecommunications and life sciences research markets, as well as traditional customers like food and beverage producers. Since my last major commentary on the company in August, the stock has moved up 36%. This may only be the beginning of things to come.

Thermo Electron (Thermo) has been a conglomeration of wholly owned and majority-owned subsidiaries that have been involved in a wide array of businesses. A restructuring effort announced in January (and expected to be complete within the next nine months) will focus the company on its analytical and monitoring instruments business, which serves a wide array of industries such as biotechnology, telecommunications, and the packaged food business.

The Restructuring
The Thermo family included 23 publicly traded companies in August 1998, as the company spun out minority interests in successful enterprises to encourage innovation. While this strategy proved wildly successful for many years, it created an albatross of a company that few on Wall Street wanted to analyze or invest in. To overcome this challenge, the company embarked on a restructuring plan to simplify its structure.

Over the past couple of years, the company has announced several revisions to its restructuring plans. The latest version, the boldest to date, was announced in January. Under this proposal, Thermo will buy back or divest its interest in almost everything except the measurement and detection business. The company has already completed many of the buyouts and some of the divestitures. It plans to have the entire restructuring, including the total spinoff of Thermo Fibertek (AMEX: TFT) and a new medical products company, completed by early 2001.

Research and Development
Thermo has ramped up its investment in research and development (R&D) spending to enhance its new product pipeline. R&D spending jumped up 27% to $48 million during this year's first quarter. Accounting regulations require that companies immediately charge R&D expenses against income, meaning Thermo's bottom line suffered from this increase. The incremental R&D expenditure reduced earnings by about $0.04 per share at the quarter's 44% tax rate. Quarterly net income from ongoing operations dipped down to $0.12 per share from $0.13 a year earlier. If you add back the increased R&D spending, that drop turns into an increase.

R&D spending doesn't mean anything unless it results in new products and increased sales. Unfortunately, it's too early to tell whether last quarter's spending will improve performance as it takes a while for products to make it through the development cycle. As investors wait for new products to boost sales, we can take some solace that constant-currency internal sales growth (from existing operations, excluding acquisitions) has moved into positive territory and should continue to rise based on bookings.

Earnings Guidance
Earlier this week, the company issued earnings guidance for the next year and a half. According to a Bloomberg interview with CEO Richard Syron, the company hopes to achieve earnings per share (EPS) of $0.63-$0.67 this year and $0.85-$0.90 in 2001. Cash earnings, which take out goodwill amortization and unusual charges, should be 20%-25% higher than reported EPS.

The company hasn't previously given year-out earnings guidance, so it's difficult to say whether management estimates are conservative or aggressive. Nonetheless, these figures show what management believes to be achievable. (The aforementioned numbers exclude earnings from the Thermo Fibertek and medical products spinoffs.)

Balance Sheet and Cash Flow
The company had net debt of about $0.9 billion at the end of the first quarter (total debt of $1.9 billion offset by about $1 billion in cash and marketable securities). This represents 45% of equity, which seems reasonable for a company like Thermo. A good portion of this debt is convertible and has low interest rates.

Divestitures will bring in a nice chunk of cash, but this will be partially offset by the money Thermo will need to pay for repurchasing its subsidiaries for cash. (Quite a bit of this has been completed in the second quarter.) It wouldn't be surprising to see any excess cash proceeds redeployed into acquisitions related to the measurement and detection business.

Thermo's cash flow statement is complicated by its restructuring, but its continuing businesses have generated positive free cash flow for the past three years. These funds have been redeployed into acquisitions, including the excellent Spectra-Physics purchase last year. Having listened to the company's conference calls over the past few quarters, it's clear that the company continues to be focused on improving working capital management.

When you buy shares of Thermo today, you are not just getting the measurement and detection business. Embedded in today's shares are Thermo's stake in Thermo Fibertek and its entire ownership of a medical products company that will be spun out by early 2001. Results from these entities have been excluded from all of the above figures since Thermo hasn't given detailed information about their compositions. I view these basically as "freebies" for buying into the Thermo story.

Thermo's stake in Spectra-Physics Lasers (Nasdaq: SPLI), the only publicly traded unit that the company hasn't decided to divest or spin-in, is a potential "hidden" gem. This company makes lasers, including some used in fiber optic networks. Thermo owns 13 million shares of this company (just under 80%), which were worth $940 million at yesterday's closing price. This value could be way too high since Spectra-Physics Lasers float is so small and investors are ebullient about fiber optics, but Thermo's stake is worth noting. (Thermo consolidates Spectra-Physics into its ongoing results, but I have separated the valuation since it is so much higher than a traditional company would achieve.)

Thermo itself is poised for solid growth over the next two years as it benefits from being a simplified, focused organization and its increased R&D spending. With more emphasis on the life sciences research and telecommunications markets, the company should be able to achieve sustainable double-digit profit growth over the long haul. As the company begins posting these results and analysts realize that the company is much easier to understand, other investors might become much more interested in the company.