The Case for Buying Becton, Dickinson

Anant Ahuja, MD is an analyst with East Coast Asset Management, where he focuses on global health-care equities. He has prior experience in long/short equities and holds board certification in internal medicine along with an MBA from Columbia Business School. He can be reached at [email protected]. The below investment thesis was originally posted on SumZero, the leading community for hedge fund and mutual fund investment analysts where professional investors share investment ideas exclusively with one another. Through The Motley Fool, select content from SumZero is now available to individual investors. 

Thesis
Becton, Dickinson (NYSE: BDX) is a valuable niche business with a diverse line of products that are well suited to increase in demand with the aging baby boomer generation. It has been oversold due to recent weak sales, unfavorable FX, broader overhang on health care, and concerns over exposure to European sovereign debt (35% of sales in EU), all of which are transient and overstated.

Despite the selloff, the core fundamentals of the business remain unchanged. The company has multiple sources of double-digit revenue growth across high-margin products, has been maniacal about cost-cutting, and benefits from sustainable and competitive barriers to entry. Upcoming catalysts include government stimulus dollars, European legislation mandating safety equipment in hospitals, further expansion into emerging markets, and organic growth in volume due to expansion of access and an aging U.S. population.

It is trading at 8 times EV/EBITDA and 14 times trailing earnings, both well below its five-year averages of 10 and 20, respectively, likely due to myopia from concerns over Europe and fear of a double-dip recession. This is obviously an unjustified displacement given the company's historical success, substantial market share of diversified products, and consistent returns to shareholders. Management has a history of conservatism but recently had their salaries frozen to 2009 levels due to missed revenue targets, leading to unrealistically low revenue guidance for 2010.

In valuing the reproduction cost of assets net total liabilities, the current market cap implies the cost of future growth in free cash flow (FCF) to be roughly d3 billion. This is irrationally cheap for a business that produced $1.2 billion of FCF in 2009 alone and has grown FCF at a compound annual growth rate of 8.3% since 2005. Additionally, it is on track to easily generate a more than 7% FCF yield for 2010. Using more normalized multiples on conservative pro forma estimates for operating income, correlated to the NPV of earnings power based on historical FCF growth rates and ROIC, triangulate to an intrinsic share value of $95-$100.

The business 
The business breaks down into three core segments:

1. BD Medical: Parenteral drug delivery supplies including IV tubing, needles, and syringes (52% of revenue) sold to hospitals and pharma/biotech companies.
2. BD Diagnostics: Blood and urine collection supplies along with diagnostic system technology for microbiology detection (31% of revenue) sold mostly to hospitals.
3. BD BioSciences: Laboratory research machines and reagents/kits (17% of revenue) sold to laboratories and the private sector for drug discovery and basic science research.

More facts about BD's business:

• Approximately 80% of its products are disposable.
• Price points are evenly spread: 30% low-priced, 30% mid-tier, 30% premium.
• 55% of sales are international, 35% from Europe.
• Diversified supplier and customer base, no customer accounts for >10% sales and 60% of all sales are to medical facilities.

The moat
BD benefits from multiple competitive advantages that have helped maintain a formidable moat, making meaningful competition from new entrants incredibly challenging.

• Economies of Scale: BD has a massive and valuable distribution network spanning the U.S., Europe, Asia, Latin America, and Africa. It is well-positioned to accommodate pricing pressure from smaller local low-cost competitors. BD continues to build manufacturing facilities closer to the point of sale, further helping gain local market share. It has a track record of acquiring niche businesses with specialized high-margin products and plugging them into a global distribution network.
• Razor and Blade: BD Biosciences consists mostly of laboratory research equipment in which large machines are complimented with reagents. This currently represents 17% of sales, with 9% revenue CAGR over the previous five years and an average operating margin of 26%. The nature of this business is such that research facilities continue to buy reagents from BD and do not upgrade machinery frequently due to the high upfront cost (>$100,000 per machine). This valuable paradigm of machine-reagents is also present in its microbiology diagnostics business.
• Customer Captivity and High Switching Costs: Approximately 60% of customers are hospitals who typically do not switch to other manufacturers once they have established relationships, given the high switching costs of retooling an entire laboratory. Additionally, BD has been in business since 1897 and there is a high level of brand loyalty among customers.
• Technology: BD has pioneered the use of safety equipment in both drug delivery and diagnostics (blood collection). By selling only push-button collection systems it has set the standard in worker safety. The safety business generates $1.6 billion in sales with 60% gross margins and is the company's fastest-growing segment (>10% annual growth rate). The U.S. has already widely adopted the use of safety technology, but BD still has ample runway to grow sales in Europe and Asia -- where it can build out this higher-margin product upon the existing supply chain.

Nondiscretionary products
BD is the antithesis of a one-trick pony. It has diversified its business in products, price points, and geographies and benefits from having a nondiscretionary nature to the core business. The overall market for BD's products is growing due to the aging population in the U.S. and Europe and growing expansion into emerging markets. The revenue stream is very visible and correlates with the global delivery of health care. Although a significant number of its products could be considered low tech (needles, syringes, tubing, etc.), very few competitors have the distribution network of BD and cannot absorb price compression with the same ease. Additionally, none have a safety and quality record spanning over 100 years, making switching to a low-cost competitor potentially risky.

BD Medical
BD Medical consists of drug-delivery platforms such as IV tubing, syringes, and needles for the delivery of parenteral medications. It comprises 52% of revenue, with operating margins averaging 28% over the past five years. BD has carved out a niche in safety products related to medication delivery (needle locks, splash guards) and has the leading market share in the U.S., Europe, and Asia for autoinjectors and safety needles with user-friendly caps. The IV catheter business alone has more than 1,000 SKUs and generates $500 million annually in revenue.

Its newest product, Nexiva, is far advanced to existing catheters and is correspondingly priced 3 times higher than legacy products. As medical centers work toward improving safety and reducing adverse events due to medication error, the demand for these products will continue to grow. Many medical centers have attempted to reduce medication errors by increasing the use of preloaded syringes for potentially dangerous medications (i.e., heparin, insulin), a trend upon which BD is well positioned to capitalize.

BD's total diabetes business is 10% of revenue and is growing at double digits annually. Erratic glucose levels due to errors in insulin dosing are still a very common problem, particularly among the elderly and patients with renal disease. BD has focused on developing pen needles for insulin injection and has grown revenue from this business alone at 12% annually. It plans to launch five new insulin pen products in the next four years and recently introduced the smallest insulin pen needle on the market at 4mm (32 gauge). This is a significant development in the arms race in insulin pen needles with Novo Nordisk (NYSE: NVO), with whom BD is a global duopoly.

BD Diagnostics 
Diagnostic testing makes up 3% of all health-care dollars spent but influences 70%-80% of medical decision making. The growth in the elderly population over the next decade will be a natural boost to BD's diagnostics business. It is rare that a patient over the age of 65 is seen for an ailment without some form of accompanying labwork. The diagnostics business is two-thirds microbiology and with the recent acquisition of HandyLabs, BD has made progress in health-care associated infections ("HAI") such as MRSA, an area of increasing costs and burden to the system. The preanalytics products consist of blood tubes (vaccutainers), push-button needles for blood drawing, and urine collection devices, all of which are used in high volume but with lower margins than other products.

The current global market for HAI testing is estimated to be $1.2 billion and approximately 35% penetrated in the U.S., but with forecasted global growth of 20% per year. That leaves ample runway for BD given its vast manufacturing and distribution network in which it can plug these high-margin products. BD also has a valuable growing franchise in cervical cancer screening with the Tripath product, growing at 10% per annum with significant sales from Asia due to recent trends in legislation mandating pap smears as part of routine health care.

BD only sells push-button collection systems, which are superior to traditional needle caps for worker safety. It has had robust success in the U.S. and has begun to see an uptick in sales in China and India. A recent paper by Frost and Sullivan reported a 77% decline in needle stick injuries following conversion to BD safety collection devices.

BD Biosciences 
This business benefits greatly from recurring revenue due to its razor-and-blade model. BD Biosciences generated 17% of sales in 2009 with an operating margin of 26%. Approximately 50% of sales are to NIH-funded laboratories in the U.S., but it has steadily increased sales in emerging markets such as China, which is investing in basic sciences research and is in dire need of reliable equipment.

The average price of a BD machine is over $100,000, which is followed by sales of reagents and supplies specific to that BD machines. Reagents constitute on average 60% of the sales, while machines are 40%. BD has approximately 65% of the U.S. flow cytometry market, which is a commonly used technique in basic cell research. BD also sells fundamental laboratory supplies such as pipettes, petri dishes, and culture media, comprising 25% of the BD Bioscience sales.

The economics 
Since 2005, BD has improved gross margins 170 basis points, operating margins 370 basis points, and net income margin 370 basis points. It has been maniacal about improving its cost structure and is well-equipped to absorb pricing pressure with minimal impact to the bottom line.

Management has shown an extraordinary focus on costs and makes it a point to discuss cost-cutting efforts in nearly every presentation/conference call they conduct. A key driver to its cost of goods sold (COGS) is resin, which is used in medical plastics manufacturing and is linked to oil prices. BD has set up a supply chain that can easily adjust to fluctuations in resin prices through internal initiatives such as ReLoCo ("Reliable Low Cost"), a cost-cutting program recently unrolled with the goal of cutting 20%-30% of costs in half of all medical-surgical products (impacting 27% of total revenue). The company has also launched efforts specifically toward a more streamlined supply chain for its IV catheter production -- currently a $500 million business -- that should take two to three years to complete. This has been part of the EVEREST program, created for overall cost cutting in supply chains across all product lines.

Management has guided that the effects of this will begin to be seen in the back half of 2010 and into 2011. They have also stated a long-term goal of improving operating margins 50 basis points per year, which, based on historical performance, is likely a conservative target.

BD has an impressive and consistent record of creating shareholder value:

• ROIC average 24% over the past five years
• ROE average 22% over the past five years
• EPS CAGR 16% over the past five years
• FCF CAGR 8% over the past five years
• 37 consecutive years of dividend increases (currently at $0.37/share)
• Consistent and predictable track record of share repurchases, with $450 million allocated for 2010.

The overall strategy 
BD has a long track record of making disciplined acquisitions of companies with specialized products and then plugging those products into its enormous distribution network. Its methodical acquisition strategy involves three key metrics: strategic fit, ROIC, and minimal/transient earnings dilution. Management has stated repeatedly they absolutely will not acquire a business unless all three criteria are met. They set a goal of one to two years for the acquisition to be accretive to EPS.

With regard to other uses of cash, since 2005, BD has bought back $500 million of shares per year, and future buybacks are very likely. The CEO recently stated they do not plan to allow cash to pile up on the balance sheet, and if they cannot identify good acquisition targets, they will return cash to shareholders. Additionally, management has closed high cost-inefficient manufacturing facilities that were not strategically located near point of sale, further helping to reduce costs.

Dedication to sustainability 
BD has an internal Global Office of Sustainability and has maintained its commitment even during recent economic headwinds. BD was recently ranked among the top 25 companies (second among health care) in Newsweek's "Green Rankings" of the 500 largest U.S. corporations. It is also marking its fifth consecutive year of membership to the Dow Jones Sustainability Index, and was recently awarded a 2010 Green Power Leadership Award from the EPA.

Management recently discussed their continued efforts to reduce the amount of plastic per item, and the company has embarked on an ambitious five-year goal to reduce energy and water consumption in manufacturing by 30% and 15%, respectively. BD is an excellent example that sustainability and profitability are not mutually exclusive but instead self-reinforcing.

Management incentives/Corporate governance
BD uses a pay-for-performance system for management compensation that is weighted to factor ROIC, EPS, and true revenue growth (not factoring currency exchange). Management incentives are designed for long-term value creation instead of short-term risk taking, such as ownership minimums, caps at 200% of target for exceeding goals, and equity-based comp that vests over three years. The board members, of whom 12 of 13 are independent, are voted for one-year terms and have minimum stock ownership requirements.

• The CEO, Ed Ludwig, owns 1.1 million shares, the most of any insider; total insider ownership equals 1.4% of CSO.
• BD has a clawback provision for internal groups that surpass financial goals if it is later realized it was done through nefarious means.
• Compensation for non-management directors was changed in 2006 to replace stock options with restricted stock units, not to be distributed until completion of their service on the board.
• 2010 salaries for senior management were frozen at 2009 levels due to missed revenue growth target.
• Equity-based compensation in 2009 for the top four executives ranged between 61%-70%.

Recent dislocation
A few of the factors causing a slumping price of late:

• 35% of sales are from Europe. BD had some exposure to Greece's sovereign debt problems and when factoring unfavorable FX (a stronger dollar), revenue growth was only 1% in 2009. BD has historically hedged its currency exposure with futures, but beginning in 2011 it will cease to hedge currency exposure because it felt it was not a wise use of capital. The Street is concerned about additional weakening of the euro and the potential impact it could have to the top line without these currency hedges.
• 2009 was a year of frozen budgets, facility closures, and layoffs for many medical centers in the U.S., with little to no capital expenditures or upgrades to existing equipment. BD was impacted significantly by this -- 60% of sales are to hospitals.
• High unemployment in 2009 translated to a drop in preventive care due to loss of health insurance coverage. As a result, physician visits were down, along with ancillary testing and medication administration that go in tandem to those visits.
• Much of the BD Medical franchise consists of prefilled syringes that are sold to pharma and biotech companies, both of whom suffered in 2009.
• The winter of 2009 saw a 9% drop in infectious disease testing due in large part to a very mild flu season. Not only did this impact testing directly related to flu, it also impacted other things that are tethered to a sick visit such as blood draws and medication delivery.
• The broader Healthcare Index has been down or flat year to date, and concerns over health-care reform, prolonged unemployment, and a double-dip recession persist.

Catalysts
And a few of BD's catalysts:

• Increased health-care infrastructure development and expansion of access to basic health care is a trend in both developed and emerging economies. Companies such as BD that have nondiscretionary health-care products and valuable franchises will greatly benefit from this natural growth in demand. Predicting currency fluctuation, or the next country in Europe to default, is speculative and ignores core fundamentals of the business.
• As part of the federal stimulus, $10 billion was allocated to NIH laboratories, which are projected to increase purchasing of capital equipment in the second half of 2010 and into 2011.
• The European Union passed a mandate on March 8, 2010, requiring safety devices for the administration of medication and collection of blood for any member state hospital. It has set a requirement that all facilities must be converted by 2013. Most European health-care facilities are heavily government-funded, so it is likely this requirement will be met in order to secure future assistance. BD's safety business, spread across medical (drug delivery) and diagnostic (blood collection) is currently a d1.7 billion business with gross margins of 60% and is the company's fastest-growing segment. This regulatory catalyst will further fuel growth given BD's substantial presence in Europe (35% of sales).
• Approximately $1.3 billion in annual sales comes from China, India, the Middle East, Africa, and Latin America; however, China will likely be the most significant source of future growth. China is experiencing the largest urban migration in the history of the world, with one new city with a population greater than 1 million being created every year. These "tier two" cities (Chongqing, Wuhan, Guangzhao) will likely see the most growth in health-care infrastructure because they are well behind more established cities such as Shanghai, Beijing, and Hong Kong. China is also underway in a three-year health reform to build 2,000 hospitals and fully insure 90% of the total population. BD's continued expansion into these countries will help it capitalize on this explosive growth in health-care infrastructure in emerging markets.
• BD is growing revenue across all three lines of business, but its highest-margin business, safety ($1.7 billion), is the fastest growing. It is also growing the global diabetes business ($700 million) and health-care-associated infections business ($1.1 billion) at double digits. Along with continued cost-cutting efforts, the trend toward higher-margin products and away from legacy commodity products will help expand margins at an even greater rate than historical averages.
• BD falls into the category of high-quality health-care businesses that are suppliers of nondiscretionary products and services, which, due to a broader overhang, have been oversold this year. BD is the baby that has been tossed out with the bathwater.
• Management has a history of conservative guidance. The company is on track to beat Street expectations and its own guidance for year-end revenue growth (6%). This is likely multifactorial, but could be due to their incentives, which include revenue growth as a target. Management exceeded its EPS threshold in 2009 but largely missed revenue growth targets. The forward threshold for payout for 2010 revenue growth was subsequently lowered to 7% from 8.5%. The bonus weighting for revenue growth was also increased to 70% from 60% in 2009. In light of frozen 2010 salaries, it is likely that management's conservative revenue guidance for 2010 is partially linked to their desire to earn their payout given it was missed last year.

Valuation
NPV of Earnings Power: FCF has grown at a CAGR of 8.3% since 2005. Assuming FCF continues to grow in the near term at 8% per annum and ROIC continues to be 23.5% (in line with average historical ROIC), the NPV of earnings power is $95 per share. Additionally, at current prices, the FCF yields for 2010, 2011, and 2012 are on track to be 7.0%, 7.6% and 8.0%, respectively.

Pro Forma and Normalized Multiples: Pro forma estimates using reasonable growth and margin assumptions reflect a company trading at a significant discount to intrinsic value. Assigning a 15 times P/E and 10x EV/EBITDA (conservative for a company of such high quality) to 2012 estimates also triangulate to a $95-$100 stock. This is not factoring in share buybacks, multiple expansion, or dividends.

Balance Sheet: BDX is a heavily capitalized business. In adjusting the asset base for current reproduction value (from a new entrant's perspective) it is clear the true value of assets is grossly understated. While book value suggests total assets to be worth $9 billion, the true value of these assets (adjusting for more than 100 years of brand, technology development, and distribution channels) is closer to $18 billion on a reproduction basis. Net total liabilities, the business is trading just slightly above adjusted book value.

Present Market Value of Future Growth in FCF: At a current market cap of $17.5 billion, the adjusted value of equity implies the cost of future growth in FCF to be roughly $3 billion, which is simply unjustifiable given the historical annual growth rates in FCF (8%) along with the fact FCF in 2009 was $1.2 billion. At its current valuation, the total cost to an investor for growth in FCF is roughly $13/share, meaning the price paid for growth in FCF should be completely returned in 2.5 years.

Risks
BD has some risks, detailed below:

• Low-cost competitors in China, India, Brazil, or other rapidly developing emerging markets.
• Ethane prices, which could drive up the cost of polyethylene used in manufacturing.
• Rising oil prices, which would drive up the cost of resin, a substantial portion of COGS. The time to flow through to the P&L would be approximately three to six months as they use FIFO inventory.
• Medical Device Excise Tax of 2.3% to go into effect January 2013 -- still unclear what portion of the business this will impact, if any.
• Difficulty in continued margin improvement with a forecasted 30 basis point increase in R&D expense. BD has historically lagged in R&D relative to its competitors, which management stated will close over the next three years as they move into higher-margin products, which are R&D-intensive.
• Further sovereign debt exposure from Europe. It is not hedged to the euro beginning in 2011.
• Delays in distribution of federal stimulus dollars to NIH.

Conclusion
We think the current share price is a result of macro fears and a lack of granular clarity in the short term. Our underlying investment strategy with BD can be described quite simply: Be greedy while others are fearful. The current share price offers a margin of safety that is rare for a business of this quality. BD is what we categorize as a high-quality compounder franchise. It has year-over-year increases in its dividend, improving profitability, increasing ROIC, and increasing free cash flow all while maintaining, most importantly, a healthy and transparent balance sheet.

BD has a valuable combination of internal innovation and high value acquisitions. In combination with a vast, efficient, and growing international distribution network, we see a combination of attributes that will further differentiate this company from its competitors -- essentially, the strong will get stronger. Additionally, BD's dedication to sustainability is something we highly value at East Coast Asset Management.

We also have comfort in observing other prominent recent buyers of this stock, including Ricky Sanders of Eminence Capital, Lou Simpson of Berkshire Hathaway, and David Einhorn of Greenlight Capital.

We are a long term shareholder of BD and see this opportunity as providing an attractive IRR of 15%-17%.

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