As an investor concerned primarily with fundamentals, I'm always happy when my prudent due diligence pays off. For Foolish investors, that due diligence includes prioritizing the long term. And over the right time frame, a deep understanding of factors like a company's balance sheet, business model, and return on capital can mean the difference between good investments and great ones.
Such is the case with Bio-Rad Laboratories (BIO 2.82%), a global life sciences company that to date has largely flown beneath the radar of investors and analysts alike. The investment case for Bio-Rad includes some interesting economic factors -- for example, its strategic return on capital. Here's why this undercover agent is set to unlock long-term upside for investors over the coming years.
Image source: Getty Images.
A quick recap on Bio-Rad and the industry
Bio-Rad Laboratories manufactures products for the clinical diagnostics and life sciences industries. The life sciences label is actually an umbrella term that covers the fields of biotechnology, pharmaceuticals, medical technology, and biomedicine.
In terms of operations, Bio-Rad's clinical diagnostics business, which sells laboratory devices and instruments, contributes about 50% of its revenue. Meanwhile, its life sciences arm develops a whole bunch of gene, blood, and cell tests, making up the other 50%.
Bio-Rad has a market capitalization of $23.09 billion, placing it at the midpoint of its life-sciences peers; giant Thermo Fisher Scientific, for example, has a market cap of $214 billion, and Compugen is valued at about $550 million.
While tech and cloud-based advancements were taking place in the industry even before the pandemic, COVID-19 accelerated the pace. Global corporate funding for digital healthcare reached $21.6 billion in 2020, up 103% from the year prior. Researchers at Expert Market Research and Industry Research have predicted that the industry could grow at a compound annual growth rate (CAGR) of about 13% until 2030. Both also agree that further technological advancements are imminent in the industry.
Bio-Rad is certainly well-positioned to capitalize on these two market crosscurrents, driven primarily by the newfound digitization of healthcare. And that's cool. But there's one key thing most investors and analysts are missing for this little-known biotech ...
The Sartorius secret
Bio-Rad's equity investment in German pharmaceuticals and lab equipment provider Sartorius AG is a unique value proposition for shareholders that also separates the company from its peers.
It began investing in Sartorius back in 2003 with an initial capital outlay of $10.4 million. By the end of 2004, Bio-Rad held an approximate 23% stake in its German counterpart. The pair's interests align, as Sartorius and Bio-Rad operate in similar and adjacent markets (mechanical separations, for example).
As of 2021, the company's stake in Sartorius has increased to 37%, yielding unrealized capital gains of $4.5 billion to Bio-Rad last year. For context, that's 177% of Bio-Rad's total sales revenue.
So what does all this mean for Foolish investors?
Whilst Bio-Rad has much that's obvious to recommend it, there is a hidden secret here: The gains on its Sartorius investment aren't reflected on the revenue or EBITDA ledgers on its income statement. Rather, they're found further down, under "change in fair market value of equity securities" in the "pre-tax income" section, in between operating income and net income. This is because, according to accounting rules, the position is actually "potential income" Bio-Rad could receive in the future if it were to sell its Sartorius shares.
That means that as the market capitalization of Sartorius expands, so too does the fair value of Bio-Rad's share price. For Foolish investors with a long-term mindset, this ties in nicely to the investment case. We can see the correlation between both share prices on the chart below, in which Sartorius has taken off in recent weeks -- another positive for Bio-Rad.
In addition, the Sartorius position has a positive impact on shareholders' earnings per share (EPS), even though its value is not derived from revenue. That's because one half of the EPS calculation -- net income -- stems from pre-tax income, where we just said the Sartorius capital gains tuck in. As a result, net income and EPS are disproportionately higher for Bio-Rad when compared to operating income and revenue; whereas its Sartorius equity interest grew by 127% between FY 2019 and FY2020, Bio-Rad's top-line revenue growth has actually been quite flat over the past three years, at a CAGR of 5.6%.
Consequently, even analysts and investors who are bullish on Bio-Rad can tend to undervalue Sartorius's contributions. That's because bullish commentary tends to bake revenue and EBITDA growth into the mix, and may neglect these kinds of items lower down.
But will this position continue to be a long-term compounder for Bio into the future? The answer is yes. The remaining 73% of Sartorius is family-owned, and Bio-Rad intends to wholly acquire the company when the family trust expires in 2028. That means the potential for a lot more upside for investors over the long haul.
The valuation equation
Knowing all this, let's reexamine Bio-Rad from a valuation perspective. The company's enterprise value (EV) is about 30 times its trailing-12-month (TTM) EBITDA, which is an approximate 60% premium to its peer group. But the EV calculation contains the Sartorius holding as an equity holding, whereas EBITDA does not. To make an apples-to-apples comparison, we need to calibrate from the top down.
Factoring in its market capitalization, equity value, and debt, then subtracting cash and equivalents found on its balance sheet, we get a current EV for Bio-Rad of $22.7 billion. Stripping its 37% Sartorius stake out of the equation, however, gets us to an EV of $14.05 billion, meaning that after we adjust our calculations, Bio-Rad is trading at just 19 times TTM EBITDA. Far from being overvalued, then, Bio-Rad actually presents as a value proposition -- that valuation is well in line with peers including Thermo Fisher Scientific, with a valuation of about 18 times TTM EBITDA, and the industry median of 18.6.
Most investors -- and analysts -- miss this fact as well, meaning Bio-Rad tends to fly under the radar. Which is terrific for those investors seeking hidden deep-value propositions with a competitive edge.
Due diligence pays off
Foolish investors know that true investment success comes from prudent due diligence and a long-term mindset. Bio-Rad is a prime example of how these elements can combine to skew the risk/reward calculus in the diligent investor's favor. Knowing what we do now about Sartorius's true value and the historical relationship between the stocks' performance, and considering that Bio-Rad's management is calling for 10.5% growth in revenue next year and Sartorius predicts 44%, it's easy to conclude that the rewards for Bio-Rad's shareholders are likely to continue.
