Thermo Fisher Scientific (NYSE:TMO), a global leader in life sciences supplies and services, recently made a major strategic move with the acquisition of Life Technologies. There are a lot of reasons why the new powerhouse of lab equipment will be stronger than the sum of its parts, but several hurdles could prevent the combined company from reaching its full potential. While integration of the two businesses appears to be on track, let's dig into some additional factors that could stunt future growth at Thermo Fisher.
Competition is in the genes
Thermo Fisher's ecosystem of life sciences devices and supplies and its massive scale are huge competitive advantages in the space. Its consistent revenue streams and expanding margins make it a fairly stable investment, with core businesses looking to grow in international markets. Investors looking for accelerated growth may not find what they're looking for, though.
Clinical genomics is one of Thermo's major growth markets. On the heels of a booming immuno-oncology industry that will require co-developed diagnostic tools, Thermo acquired Life Technologies, a leader in genomics technologies and related lab supplies, and recently struck a deal with drugmakers to design genetic diagnostic tools.
Thermo is certainly not alone in this endeavor, and may already be lagging behind leading genomics innovator Illumina (NASDAQ:ILMN). Illumina, which boasts a commanding 80% market share, is well ahead of Thermo Fisher and is making strides to expand that lead. Though Thermo Fisher spends more on R&D in absolute terms, it is also a much larger company.
Therefore when compared to revenue Thermo Fisher's R&D expense is only about 20% of Illumina's, and is only partially devoted to genomics. That suggests that Illumina is confident in the return its R&D investment will bring in the future, at Thermo Fisher's expense. Illumina's past investments are already paying off, as it recently won the race to commercialize genomic sequencing for less than $1,000 per sequence and saw 24% revenue growth in 2013.
A strength of Thermo Fisher's business is its diversity of revenue streams. From an endless catalogue of products and services to a broad mix of customers, the top line does not rely too heavily on any one revenue stream. In some sense, though, many of Thermo Fisher's customers are exposed to the same risks. 27% of Thermo Fisher's customers, for example, are in academic and government end markets that rely heavily on government spending.
Uncertainty about the public funding environment, especially leading up to and during the sequester, made life in academic labs very difficult. The majority of Thermo Fisher's academic customers receive funding from the National Institutes of Health, which in 2013 was forced to cut its budget by 5%. According to Thermo Fisher's 2013 Annual Report, this resulted in "modestly lower sales to customers in academic and government markets which the company believes was due in part to uncertainty in government funding expectations in the U.S."
Government funding of academic research has recovered somewhat in 2014, with Congress appropriating an additional 3.5% to the NIH budget. Regardless, a large portion of Thermo Fisher's revenue stream remains at the whim of policymakers, introducing a significant risk to top line stability.
Paying off debt
Thermo Fisher has certainly taken advantage of the low interest debt market in recent years, having sold several billion dollars in debt to help fund its strategic acquisition of Life Technologies. While I firmly believe that acquisition will prove important to Thermo Fisher's future, the company is now significantly leveraged with total debt/EBITDA at 4.6.
In its Q2 conference call, CFO Peter Wilver reaffirmed management's commitment to reducing that leverage to 2.5 or 3 times EBITDA:
And we are also assuming that in the second half we'll use the bulk of our free cash flow and the net proceeds from the Cole Parmer divestiture of approximately 340 million to pay down short-term debt.
Total debt has soared 380% in the last five years, while the share price has more than doubled on anticipation of accelerated free cash flow growth. But repayment to the midpoint of management's range could require greater than one-year's worth of operating cash flow, delaying a renewed focus on shareholder value. What's more, organic growth for Thermo Fisher's core business is rather slow, suggesting that growth by acquisition -- and more debt -- may be a recurring theme moving forward.
Thermo Fisher Scientific is firmly anchored as a market leader in the life sciences industry, and I believe it will maintain that position for a long time.
Seth Robey owns shares of Illumina. The Motley Fool recommends Illumina and Thermo Fisher Scientific. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.