IDXX - IDEXX: Future Seems Bright But It's A 'Hold' For Me

2023-11-05 07:58:25 ET

Summary

• IDEXX Laboratories specializes in diagnostic products and services for veterinary and water testing markets, which usually present a high recurrence.
• The pet healthcare market expects solid growth in the coming years and has qualities that make it resilient to crises.
• Despite the quality of the business, a bullish valuation shows us an unattractive return from current prices. That is why I decided to assign a hold rating.

Investment Thesis

IDEXX Laboratories ( IDXX ) is a company that excels in two of the most promising investment sectors : medical diagnostics consumables and pet care.

While the company boasts a top-tier business model and its share price has seen significant appreciation, the market appears to have priced in all potential positive scenarios, resulting in a current valuation that doesn't seem particularly compelling. For this reason, I have chosen to assign a ' hold ' rating. In this article, we will delve into IDEXX's business model and conduct a valuation to rationalize why I consider it to be overvalued at this time.

Business Overview

IDEXX Laboratories specializes in providing diagnostic products and services for the veterinary and water testing markets. They offer a wide range of products and services, including veterinary diagnostic equipment and tests for the detection of various diseases in animals, as well as water testing solutions for the detection of contaminants in water sources.

Below we will delve into the three main segments of IDEXX, which in addition to having good margins and potential markets, also have recurring revenues, which gives a higher degree of quality to the company.

Companion Animal Group ((CAG))

In this segment, the company offers diagnostic and laboratory services to veterinarians who treat companion animals. Their offerings encompass a wide range of products and services, including diagnostic tests for diseases, laboratory services for diagnosing chronic illnesses, and veterinary software for managing patient records and diagnostic results.

This division plays a significant role in generating recurring revenue , largely due to products like IDEXX VetLab consumables and SNAP rapid assay test kits. These products are integral to the daily operations of veterinarians, much like Thermo Fisher or Danaher's offerings, but within the animal sector.

Revenues in this sector have exhibited an annual growth rate of 12% . Notably, EBIT has grown at even higher rates, leading to an increase in margins from 17% in 2015 to the current 26% and currently already represents 90% of company's revenue.

While we'll delve deeper into the intriguing dynamics of the pet market later, it's evident that a significant opportunity for international expansion exists, especially given the company's relatively limited presence outside the US.

In concrete terms, the company envisions a potential market of $45 billion , a stark contrast to its current revenue of just $3 billion.

Water Quality Products

This segment, although representing 5% of the company's revenues, has seen its share in total sales diminish over the years. In this segment, the company offers testing solutions for the precise detection and quantification of microbiological parameters in water. These solutions are widely used by government laboratories, water utilities, and private certified laboratories for testing drinking water to ensure compliance with regulatory standards.

Revenues from this segment have consistently grown at a rate of 7% annually, and it maintains robust margins, with EBIT at 45% . Similar to the test kits in the CAG segment, there is a degree of recurring purchases of these tests.

However, the company's primary focus remains on companion animals, driven by factors such as recurrence, growth potential, and the expanding market.

Livestock, Poultry and Dairy (LPD)

This segment provides diagnostic testing and related instrumentation to manage the health status of livestock and poultry, as well as to ensure the quality and safety of milk and feed.

LPD products are primarily purchased by public and private laboratories, which, in turn, offer testing services to veterinarians, livestock producers, and processors. As is customary in the company's segments, recurring income is a prevalent feature since disposable tests must be continuously utilized in the quality control laboratories for each agricultural product.

While the revenues of this segment have not exhibited recent growth, the EBIT margin has displayed some fluctuation, yet it averages around 17%.

Animal Healthcare Market

As we previously mentioned, there is a significant rise in households that have pets, especially among younger age groups. The reasoning behind this is quite simple: the estimated cost of taking care of a child in their first year typically falls in the range of $12,000 , whereas the cost of owning a pet, like having a dog, for example, averages between $1,135 to $5,155 for the first year. Consequently, more people are choosing to have pets as companions, leading to a sharp increase in the demand for veterinary and healthcare services.

As a result of these factors, the Pet Care market is expected to witness an annual growth rate of 5%. Moreover, this market is already substantial, especially in the United States, where in 2022, approximately $136.8 billion was spent on pets, including expenses for veterinary care, medicine, and food.

In addition to expected growth in favorable economic conditions, it's worth noting that Americans often prioritize their pets when it comes to personal expenses. They may cut back on dining out or cancel gym memberships before reducing spending on their beloved pets. This resilience to economic downturns strengthens companies in the pet sector.

Moreover, as pets' quality of life improves, they tend to live longer, necessitating more extended periods of medical care. This longer lifespan benefits companies like IDXX and others in the sector.

Key Ratios

Overall, the company has experienced an annual revenue growth rate of 10% over the past decade. Year-to-date, the growth stands at 6.5%. Notably, the CAG segment, being the most significant, has demonstrated an impressive organic growth of 8%.

Furthermore, the company has seen an expansion in margins, driven by a higher proportion of recurring revenues and services in the sales mix.

The Free Cash Flow margin varies depending on the allocation of CapEx, which typically falls in the range of 4% to 5% of sales. While the company does not always provide explicit details on how CapEx is utilized, it can be inferred that the allocation likely supports the expansion of consumable factories and the laboratories where R&D activities are carried out.

The company boasts remarkable profitability, with Return on Capital Employed (ROCE) ratios consistently hovering around 50%. This not only underscores its effective utilization of invested capital but also serves as a testament to its formidable competitive position within the sector.

In terms of debt, the company has moderate leverage of 0.7x LTM EBITDA, so this will not be a problem in the current environment with high interest rates.

Valuation

The company's recently released Q3 results provide valuable insights into the growth and margins that each of its segments may experience in FY2023. Below, I will outline my estimates, which I anticipate will be on the optimistic side:

• The CAG segment could continue growing at rates of 10% annually, maintaining constant EBIT margin expansion.
• For the Water segment, I estimate growth of 8% annually, around the average of the last decade and according to what grew during Q3 2023. EBIT margins would be at the average 45%.
• LPD grew 5% in the last quarter, of which 4% was organic, so we will assume constant growth at this same rate. Regarding the EBIT margin, YTD is 6%, but I estimate that they can return to their average of 18%.

This projection suggests an annual growth rate of nearly 10% in the coming years, a prospect that appears highly attainable to me. Furthermore, for FY2023, they are expected to achieve a growth of 9.6%, exceeding the guidance range of 8 to 9%. As previously mentioned, my assessment is bullish .

Finally, we will consider an EV/EBIT multiple of 20x, but it's important to note that between 1999 and 2013, when interest rates were not as close to zero, it was not uncommon to see companies like IDEXX trading for multiples lower than 20x during ordinary years.

This projection yields an estimated share price of $470 USD in five years, resulting in a relatively modest return of 2% annually , and this valuation is by no means conservative. I want to emphasize that this assessment is on the bullish side, underscoring the limited margin of safety at this price point.

Final Thoughts

The company boasts a highly resilient business model with dependable, recurring income that is resistant to economic crises. Moreover, the sector is poised to benefit from strong tailwinds in the coming years.

However, it's crucial to maintain a pragmatic approach and avoid getting overly attached to companies, as an unattractive valuation can result in a significant opportunity cost. With this in mind, I've opted to assign a ' hold ' rating to IDEXX, while remaining vigilant for potentially more favorable pricing in the future.

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