In this episode of Industry Focus: Wildcard, host Jason Moser and Motley Fool contributor Brian Feroldi take a closer look at Ortho Clinical Diagnostics' (OCDX) debut on the public markets to see if this healthcare stock is one worth watching.
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This video was recorded on February 3, 2021.
Jason Moser: It's Wednesday, February 3rd. I'm your host, Jason Moser, on this week's Wildcard episode, we're talking healthcare. We know our listeners out there love healthcare on Wednesday, so we're bringing your Wednesday with some healthcare here. Specifically, we're going to dig into a brand spanking new IPO in the healthcare space. Actually, this was a former subsidiary of Johnson & Johnson. The company's called Ortho Clinical Diagnostics. The ticker is OCDX. Joining me this week, it's Mr. Brian Feroldi. Brian Feroldi, I always do that, Brian. It's Feroldi, it's not Feroldi.
Brian Feroldi: Jason, you can call me whatever you want. As long as you invite me on Wildcard Wednesday for healthcare, you can call me wherever you want.
Moser: Brian, it is great to be back in the virtual studio with you. Like you said, it's been too long.
Feroldi: Yes, it has, and it's always fun to talk about healthcare and it's always fun to look at new IPOs when they come out. To your point, this is an interesting company that just became publicly traded. It was a subsidiary of Johnson & Johnson, and it's been in business for over 80 years. It's going to be interesting to dig into this one.
Moser: We were digging around trying to look at things to talk about in the healthcare space. This was one that really just started trading. I think Thursday is when it really first started trading. This is a brand new IPO. I tell you, when I was looking through the S-1 for this business, I mean, it's got its puts and takes, but it definitely plays in a market I've not given a whole heck of a lot of attention to, but it seems like it would be pretty relevant in today's day and age. Let's just start off with what they actually do, because this is essentially like a testing company, isn't it?
Feroldi: Yes, that's correct. Ortho Clinical Diagnostics is focused on in-vitro diagnostics. They have two primary business lines. The first is clinical laboratory testing and equipment, and the second is transfusion medicine. The clinical laboratory equipment market is used to measure chemicals in bodily fluids. If you've ever gone to a hospital and had your blood drawn, so that it could get tested for everything that could be going on in there, that's what this company does. It makes the machines, as well as the disposables that enable that to happen. That's its primary market. Its secondary market is transfusion medicine, which is where it's testing donor blood and plasma to be screened to make sure there's no diseases or anything wrong with it so it can be used in a transfusion. That's the primary market that this company operates in.
Moser: I was reading through that S-1 and the first thing that caught my eye, when I see the words pure play, I'm immediately like, wow, these guys are really specialized in something, this could be pretty interesting in the pure-play in-vitro diagnostics business. Fun fact here, in-vitro is Latin for within the glass, is when something is performed outside of a living organism. Hey, there's your fun fact for the day. But the credo here, I have a hard time not getting behind a company with this type of perspective. The credo of this business is "Because every test is life." Certainly, over the past year, we've seen the value in robust testing capability. It feels like we've probably learned a lot here along the way that our testing capabilities probably need to get a little bit better. Maybe Ortho Clinical is one of those companies that can help make that happen. You keyed in on something that really caught my attention though, and that is the consumables, the disposables part of the business. Anytime you have a business where that razor and blade model comes to play, that really gets my attention. What do you think about that as an advantage for a business like this?
Feroldi: I completely agree. The business model that a lot of successful medical device companies like this pursue is the razor and blade model, where you place some type of system or equipment with a healthcare provider. You don't make money necessarily off the placement up the system, you make money off of the usage of the systems; that aligns the incentives for, "Hey, use this thing. Make it a part of your clinic," and that's how the company makes more and more and more money. To this company's credit, they've been around for 80 years and they've done a great job at entrenching themselves in the U.S. healthcare system. The associate from Johnson & Johnson was definitely a leg up for this company, but they are in over 70% of all U.S. hospitals and they are a global company too. They do business in 130 countries and they service or test over 800,000 patients per day. Yes, that does include COVID testing that was a recent pivot for the company, but they do testing on all kinds of things. When it comes to diagnostic testing, this is a big player.
Moser: I saw some really impressive numbers. In 2019, the consumables contributed more than 90% of total revenue. Which, to your point there, that's that recurring revenue. You love to see it in any business. I wonder as an investor, from your perspective, when you see a business like this, I mean, not necessarily like this. When you see a razor and blade business model, for example, you see a business that really does benefit from that high consumable as a percentage of total revenue, does that number, does that dynamic of the business model, do you feel like that maybe gives them a little bit more wiggle room in other areas of the business for you? Like, maybe you'll give them a pass in certain areas where you might be a little bit more critical?
Feroldi: It definitely does. To me, recurring revenue is something that a company almost must have at this point for me to be interested in it. Because there are so many fantastic businesses out there with recurring revenue. To me, it's almost like, "Well, why bother with the ones that don't have it?" So to your point, once this is in a clinic and it's part of the healthcare system or the hospital system. Of course, they're going to use it again and again and again. That's almost like an annuity on not only revenue but high-margin revenue for this company. That can cure a lot of other ills that a business might have.
Moser: Yeah, for sure. Who are their customers directly? I mean, you and I, as patients, we're not buying their services, or are we? How exactly does that work?
Feroldi: No, their customers are primarily the clinics and hospitals. As I said, they're in over 70% of hospitals in the U.S. and they do have a global footprint with about just under half of their revenue coming in the U.S., and about more than half coming in international markets. They're primarily selling to hospitals and hospital systems.
Moser: I feel like with a business like this, when you see that razor and blade business model, to me, that's a competitive advantage. Maybe it's not as great of an advantage as it used to be, because I think you're right. I think a lot of companies are really homing in on the benefits of that type of model. It's almost becoming like, if you're starting a business today, you better figure out a way to start a recurring revenue business, because that gives you a leg up and in so many other ways, but beyond the business model itself, or other dynamics of the business model, what are some of the advantages of this business? What are some of the competitive advantages that you find in a business like this?
Feroldi: Well, to your point at the top of the show. I think one of the big advantages is that they are a pure-play on the diagnostics market. Just the fact that they've been around for over 80 years really speaks to how entrenched this company has become in so many facets of the healthcare system. I love the stat that they pull out: the average clinical laboratory has been a customer of theirs for over 13 years, and the average transfusion medicine customer has been a customer for over 15 years. That's on average. In 2019, their revenue retention rate was 99%. So, it's very hard for companies like this to land a customer, to get their foot in the door, but once this company gets its foot in the door, man is it hard to get rid of.
Moser: Yeah. It feels like that time tells you a lot right there. Of course, it tells us that clearly they are doing something right, and that's always good to see, but also what comes with that, I think overtime really, seems like there will be some switching costs to develop from that.
Feroldi: Tremendous switching costs, I think. On top of that, they also call out that they really promote the accuracy of their product, they really promote the speed of their product, the testing breadth of their product. Within the last couple of years, they've introduced five new products, new assays, I hope I'm saying that right, to expand their product offering. They're in there and they're constantly innovating and putting new tests on the system, which just increases the need to keep this in your clinic. Why bother switching when it's so useful?
Moser: Yeah. I bet you, this is one of those chip companies. We'd probably see this as more time plays out and we get a better view of their financials as a publicly traded company. But I'd imagine keeping an eye on research and development, that R&D expenses as a percentage of revenue, that's one of those things where a company like this is going to have to continue to invest in itself. It's not the type of company that you just come up with a couple of good tests and then call it a day.
Feroldi: They have done just that. One of the things they tout in their S-1 is how much they've been investing in their IT capabilities, and the research and development, and launching new products. But yeah, to your point, this is a company that you don't want to skimp on research and development. They need to maintain their edge.
Moser: Yeah. One more thing I did notice too, and I think this is the case with a lot of these types of companies, but the instruments are closed systems, they noted. In other words, you basically have to purchase their consumables in order to be able to have that stuff working with their equipment, and it reminds me of a company like, you look at a company like IDEXX for example. Masimo I think is the one that really stands out for me. Masimo has done a great job of protecting their intellectual property in that regard and it seems like in this case, Ortho Clinical, they too. If you're going to use their stuff, you've got to use all their stuff. It's not like you're going to go out there and buy cheaper knockoff tests to be able to run through their equipment.
Feroldi: Yeah. They need to defend their turf and they have spent a great deal of time building up their turf. They have over 20,000 of their systems installed globally. That figure seems to grow in the low single digits each year, about 5%. Again, it's very expensive for this company to go out to acquire new customers, to convince these hospitals to switch to them. Once they're in there, they better do a good job of hanging onto them.
Moser: [laughs] Well, let's talk a little bit about some of the weaknesses here with this business, because, I mean, every dog has a full-year too. I'm not calling this company a dog, but you get what I'm saying. No company comes without its weaknesses, and I wonder if there's anything that stands out to you with a business like this, either in regard to the business model or the financials or management, something like that. What are some of the weaknesses you found in this business?
Feroldi: I think the business itself is actually pretty darn strong. I really like how entrenched this company is. I really like the razor and blade model. Their gross margin companywide is about 47%. That's not as high as I was hoping it would be, given that this company has essentially 100% blade at this point, but that's not necessarily a terrible number. One of the things that I would knock this company for is that it is not a high-growth company by any stretch. I mean, when you've been in business for 80 years and you already have 70% of the hospitals in the U.S., it's really hard to eke out growth. This company's top line is very predictable. However, it only grows in like 2%, 3%, 4% range over the last five years. In 2020, because of all the disruption that we saw in hospitals, the company's top line is expected to fall about 2%. That's not something that's a good thing, of course. It's even more surprising considering that this company does offer COVID testing. To me, a lack of organic growth is a weakness for this business
Moser: Yeah. No doubt about that. I wonder too, you'd think with a business like this, clearly the healthcare system is involved to say the least. Given that their customers are really the hospitals and the health systems, and those customers are generally beholden to the third party payers, Medicare or Medicaid insurance, I mean, they don't necessarily always get to dictate their terms on how much they're getting paid.
Feroldi: Yeah. There is definitely a negotiation in there. Again, this company has been involved with healthcare for 80+ years. The other side of that too is, this company has obviously achieved at scale and it's obviously gotten out there. Having a lower gross margin does protect it from the competition, because it won't be easy for somebody else to come in and say, switch to us, we'll save you money, because this company isn't gouging its customers as it is. It is just something worth noting. The real big knock against this company that I have though is its balance sheet. To understand its balance sheet, you need to backup a little bit. Again, it was a part of Johnson & Johnson. It was actually sold to the Carlyle Group several years ago and Carlyle Group really seemed to lever this thing up with debt, as we've seen, private owners do sometimes. This company is estimated to have $3.7 billion in debt as of January, and one of the reasons that it's going public is to just knock down that debt load. It raised $1.2 billion at the IPO, and they said right in the documentation, we plan to use $1.1 billion of that to knock down our debt load. Even then, this company is going to have $2.6-$2.7 billion in debt. This is a $4 billion company. That is still, even after dropping $1 billion, that's still a huge number.
Moser: It is. I agree. I control F and I search use of proceeds immediately in those S-1 and just get right down to it. That's something listeners and members always asking me, when companies go public, what are they doing with this money? Oftentimes, they're taking that money to grow the business. But that's not always the case, and in this case, it's not. Just like you said, they are using this money to pay down debt, essentially to pay down other folks who had investments in this business, and ultimately pay down the debt load of the business. It's not money that necessarily is going to grow the business. I agree with you. It's one of those things, whenever I see that, it's not something that makes me run in the other direction, but I definitely take note, it makes me think.
Now the flip side of that, of course, and we've addressed that here thus far is, it does have a fairly reliable business model and that annuity. I guess, that's one of those things and that's why I asked you earlier, because to me, I do give them a little wiggle room there because of the business model. But by the same token, I would like to see a track record of knowing that they can take these money that they are generating and grow the business, do more with it and be responsible with that balance sheet, because it does feel like right now that balance sheet is a little bit of a headwind. Most balance sheets are the responsibility of management. What have you found out about management with this company?
Feroldi: The CEO here is a guy named Chris Smith. I always like it when companies like this, at least have, obviously the founder is not involved in this business, but I always like seeing at least the CEO has come up through the ranks and has been with the business for a long period of time. That's not what we have here. We have the CEO, his name is Chris Smith. He was hired in September of 2019. Now, he was the CEO of another healthcare company called Cochlear Limited. He seems to check all the boxes from what you want in a medical device executive. But I really don't like that he's brand new to this business. There's obviously a deep bench of people behind him, but make no mistake, he's the CEO, he is the most important character. As part of our due diligence, where we go over to Glassdoor. I like to check that, the ratings there were OK. The company got 3.8 stars out of five, and Smith got a 73% as CEO approval rating. That's on the OK range. That's not great. That's certainly not terrible. From an ownership perspective, he is going to own about one million shares of stock. At current prices, that's worth, say, $18 million. But the Carlyle Group is still the primary shareholder here. They still, even post IPO, own 61% of this business. Whatever they say and whoever they want in charge [laughs] is really what matters.
Moser: Yeah. That's a good point, and very well noted there. That certainly will play out on the shares that trade on the open market, the float. Yeah. It sounds like, at the end of the day, you're still just going with whatever Carlyle says. If there's a point where Carlyle is looking for an exit strategy and perhaps that is the case, as time goes on, it will be interesting to see how their ownership stake in this company evolves. If it's something that they maintain, or if it's something that they start to whittle away at overtime, just remains to be seen. Brian, let's just try to whittle this down then to an ultimate takeaway here from an investment perspective. When it comes to IPOs, I personally tend to be a little bit more careful and I like to give them a little bit of time to establish themselves, develop a track record as a publicly traded company. To me, this is a neat business. It's interesting in a lot of ways. I do love the razor blade business model. Still, I would put this business in that category of, 'You know what? It's interesting to me, but I want to give it a little time before I actually feel comfortable making a call one way or another on it.'
Feroldi: Yeah. For me, this is definitely a no-go. I mean, I agree with you completely. I really like the entrenched nature of the business. I really like that it's a blade model, that the revenue is extremely dependable. I like that they have a new test that they're coming out with, and they seem to have made the case that they have decent growth prospects. They're basically saying that the entire market for our products is growing about 5% annually, due the aging of the global population and the increased need for diagnostic testing. I buy all that, and I think this company has a legitimate chance to continue growing its top line at a moderate top pace. The thing I really don't like about this company is just its capital structure. I mean, all of the proceeds from this are going to pay down debt, which they need to do. For example, in the first nine months of 2020, the company made $48 million in operating profits. But all of that and more was overwhelmed by the interest expense on the debt, which was $150 million. This company has actually been losing money on the bottom line for the last five years. At this stage of the game, I would expect this company to be ridiculously profitable, if not a dividend aristocrat at this point. If they were able to use a lot of the proceeds and really clean up the balance sheet and get some modest growth in there, as well as if you could give me a really cheap purchase price, I would be interested in it. But given what we know right now, this is a business that I'm taking a pass on.
Moser: Yeah. I guess you answered my final question there is, what would it take for you to be interested in this? Your concerns I think are all really spot on. It makes sense to me, and price, it seems, is just difficult to figure out at this point. But to your point there, it is concerning the profitability. A really cheap price would be a great start. [laughs] That never hurts. I guess at the end of the day, we'll just have to wait and see, watch how this business develops. Certainly, one worth keeping an eye on, I think, but not one I would put there at the top of the list as far as these are IPOs that you need to get out there and really be a part of early on. Because while there are a lot of positive aspects to the business, clearly, there are some things that investors should keep an eye on, and I feel like we've made pretty good note of that today thanks to you. I appreciate you taking the time to dig into Ortho Clinical for us, and then teach us a little bit more about this testing business and its potential. Hey, we'll see, right?
Feroldi: Any time, and it's always good to even dig into companies like this that don't necessarily fit your criteria, just to show that you have to be picky as an investor, and you can be picky. Even if there's things about this company that you really like, you have to take the whole picture into consideration and not all the companies are going to pass your checklist.
Moser: Yeah. I like that point you made there. Be picky. It's really OK. The neat thing about doing this, and the reason why I like digging into these IPOs and even 10-K, just when it comes to new businesses is it really teaches you how to dig into a company in a short period of time. How to hone your process, how to really sharpen your skills and teach yourself to look for the things that matter the most to you as an investor. That'll be different for every one of course. Hopefully, we are able to give all of our listeners some ideas along the way. But really, it is about being able to give that business a look and not sink too much time, so that you then feel almost obligated to like the business. Oh, I just researched this business for six hours and in hour five, I found something that just really turned me off. All of a sudden, you start thinking, well, those sunk costs man and they can sway your decision-making very quickly and then you sometimes don't even realize it. I think these are great drills for us to practice as investors, and really hone our skills and finding those disqualifiers, those things that matter most to us. It sounds like you've certainly been able to find the things that matter most to you here.
Feroldi: Yeah, that's right. To be clear, this could be an interesting business someday, and it's definitely not priced at some insane number. We've seen so many IPOs come out and just pop like crazy. This stock actually went down on the first day that it was trading and it's basically been trading sideways ever since. Even now, it's trading at about two times sales and only five times gross profit. If the company's capital structure was fixed over time, this could be an interesting investment. But for me, just right now, it's not.
Moser: Well, we will see, and Brian, I promise you a Wildcard Wednesday in the future, we will circle back on this thing and take a look at it and revisit.
Feroldi: Sounds good.
Moser: All right, man. Well, remember, you can always reach out to us at Twitter on @MFIndustryFocus or you can drop us an email at [email protected]. As always, people on the program may have interest in the stocks they talk about, and The Motley Fool may have formal recommendations for or against, so don't buy or sell stocks based solely on what you hear. Thanks, as always, to Tim Sparks for putting the show together for us. For Brian Feroldi, I'm Jason Moser. Thanks for listening and we'll see you next week.