2023-04-22 03:41:17 ET
Summary
- QuidelOrtho presents with attractive business economics.
- After a strong growth period, the firm is now focused on strategic investments to maintain profitability.
- If correct, my numbers suggest the firm could attract a substantial re-rating to the upside.
- Net-net, rate buy.
Investment Summary
Initial Thoughts
All growth is not created equally. This is a core tenet intelligent investors must keep front of mind when prescribing to both growth and value-orientated investment biases. High growth, and high value, at a low cost? Now you're talking. The ambiguity - what's the price-value gap, and does the market agree. For investors of listed equities, the investment return is based on solving that conundrum. That is, how big is the [perceived] price-value gap, and how fast will it be closed.
The method of buying securities at prices below their future value is certainly not new. Although, its practitioners have always been few. So few, that Buffett narrowed the populous as those from "Graham-and-Doddsville", in an efficient market hypothesis rebuttal back in 1984. Moreover, the concept of investing in long-term value has become distorted over time, with market friction now at all-time lows [Figure 1].
Fig. 1 - Average holding period of NYSE listed equities, 1930-2020
Data: Reuters, "Buy, sell, repeat! No room for 'hold' in whipsawing markets"; Saikat Chatterjee, Thyagaraju Adinarayan, August 3, 2020.
And so, how to assess a firm's ability to create future value, is the overarching theme for long-term investing. If you look at stocks as equity ownership in a company, like I do, then you'd want to have some way to measure the company's ability to grow its share price. This is both an internal and external affair. External, because market quotes are a function of buyers and sellers. But, it is the internal factors - those related to the company itself, including revenue growth, margins and capital productivity - that attract the attention of both participants.
For corporations, growth requires investment. And if the investment yields a return above the cost of capital, it creates shareholder value. The market will reward its share price by paying higher multiples. A firm that generates high return on its existing capital, will also attract a high intrinsic valuation. That said, you could classify the value calculus as such:
Valuation = contribution from existing operations (steady-state) + return on capital premium + contribution from growth.
The growth/value axis is most easily identified via the relationship between revenue growth, margins, and returns on incremental capital. Any decisions that can increase organic growth at a high ROIC will be attractive for intelligent investors. Further, fast-growing companies always benefit from lateral effort on increasing ROIC to create shareholder value.
In that vein, thoughtful analysis must be performed on understanding a firm's business economics. That is, what are the value triggers (sales, growth investments), and what are the value factors (ROIC, operating leverage, investment efficiencies). Only then can we extrapolate the full value proposition that is on offer.
Investment Thesis
There is tremendous value in the existing and growth prospects of QuidelOrtho Corporation (QDEL) in my informed opinion. After an outsized growth period in FY'22, the firm generated $3.26Bn in revenues $548mm in annual operating income and management looks to hit $3.1Bn in top-line revenues this year, a notable forecast given the macro-volatility plaguing global equity markets (tight money, rates vol., inflation, geopolitics, commodity supply).
Given the attractive business economics I will discuss here today, I simply cannot overlook QDEL when it's priced at 5x trailing (non-GAAP) earnings, and Wall Street has it priced at 34x forward earnings and 1.15x book value, all whilst trading at a 10% trailing FCF yield. The firm is primed to create substantial shareholder value in FY'23-'25 in my estimation. I believe the firm could generate $3.16Bn in turnover this year and could generate $1Bn in operating income on 32% YoY growth in earnings, despite management's cautious projections on the Q4 earnings call.
I am seeing very attractive value in QDEL over the coming 12-24 months, backed by robust evidence of the firm's compounding NOPAT at alluring rates of growth. It would be shear lunacy to overlook this opportunity, at a 73% discount to the broad health care sector. QDEL could throw off ~$700mm in cash to investors this year, despite more NWC and CapEx density, and the economic profit this might deliver has me dancing to in-lockstep with this catchy investment tune. Santa Claus is still 8 months away, but I cannot help feel QDEL is a festive gift from Mr Market at these unjustified, compressed valuations, when my own numbers have the firm valued at 62x FY'23 consensus earnings.
This is extremely stimulating to my investment cortex . Net-net, I rate QDEL a buy.
Contribution From Existing Earnings
Even though I'll focus on revenue growth, margins and earnings here, you might be surprised how QDEL management view the strategy. Per CEO Doug Bryant on the Q4 earnings call:
I think it's important for investors and the broader market to recognize that I view QuidelOrtho as a growth company and we will continue to manage our business as such.
This isn't too far off the mark, I'd say. The firm is now sporting >100 R&D and clinical projects and is therefore looking to monetize its R&D looking ahead. Top and bottom line fundamentals are improving and this is coupled with terrific returns on existing capital. Focally, these 3 product lines are the keystone to existing operations, in my opinion:
- Sofia immunoassay analyzer
- Savanna multiplex PCR platform
- Vitros platform.
The Sofia segment has been particularly effective to date. The U.S. customer base increased 600bps to 21,400 in FY'22. Importantly, it held up well with Covid-19 tailwinds/contracts diminishing. I'd point this out - 82% of the Sofia instrument line run both influenza and Covid-19, but only 8% run Covid-19 alone. These are attractive unit economics, illustrating the crossover from Covid to influenza (and non-reliance on Covid-19). Further, there are now >85,000 Sofia analyzers installed throughout the globe. Of these, ~90% are contracted out for several years ahead.
As a further breakdown of the distribution:
- Around half of the installed base are in physician office labs ("POLs"), with an average 2.7 instruments at each POL.
- Another 23% are in hospitals, with 7.5 instruments per average hospital.
- 17% are placed in urgent care facilities, average 3.4 per facility.
- The remaining 10% are allocated to corporates.
QDEL could certainly do $3.1Bn in turnover this year in my opinion [Figure 2] and pull this down to $877mm in NOPAT ($1Bn when adjusting for R&D investment). My numbers call for $2.2Bn of non-respiratory sales, with another $700-$800mm in respiratory revenue. Of this, I'd still expect ~60% of respiratory turnover to be Covid-related.
However, the diminishing contribution from Covid-revenues is beneficial on numerous points. First, it is typically a lower-margin segment, so gross-operating margins will likely benefit. Second, the reduced OpEx and CapEx requirements will flow through positively to earnings growth, so capital can be reallocated away from Covid-related inventories to more productive means. Third, it will free up expenditure for QDEL to grow its Sofia, Savanna and Vitros platforms.
Fourth, QDEL has a history of generating generous operating leverage from its annual revenue growth [Figure 3]. Operating leverage has averaged 2 turns from each turn in revenue since FY'18 and my numbers have the firm to generate 3x across FY'23-25'. The leaner cost structure and lower capital intensity is supportive of this. This could see earnings of $730mm this year and c$900mm the next, in my estimation. Collectively, I believe these points can see QDEL rebound in FY'24 and hit 8% top-line growth on a 40% operating margin, generating $12 in EPS for the year [using current shares outstanding, so this figure could roll over/under].
Fig. 2
Fig. 3
Return Premium, Growth Contribution
QDEL advised its main focus for allocating growth capital will be 1) upside in the three segments outlined above, and 2) installing two further manufacturing lines to meet pent up demand in its labs division, where it produces immunoassay systems and slides. It had a backlog of ~650 instruments in this segment, but the production lines will be specifically to chomp through demand for slides. Not only that, it has partnered with Shanghai Runda Medical to develop its Vitro assays in China.
From that data, these three points informing my guidance:
- Better cost structure from China production, decompressing margin pressure
- Increased capital productivity from the new production lines
- Tailwind from backlog revenues.
The points on capital efficiency are particularly valuable, in my opinion. With this strategic investment, along with new growth capital, it is not unreasonable to see NWC requirements increase by $630-$700mm this year, but see the overall capital investment requirement pare back by ~$2Bn, before a $1.8Bn reinvestment in FY'24. I see CapEx at ~$270mm this year with the above mentioned strategic initiatives. With that, my numbers estimate QDEL's invested capital turnover to ratchet up above 1.2x over this time on a NOPAT margin of c.40% [Figure 4].
Fig. 4
Data: Author, QDEL 10-K's
From here is where my analysis revealed the most attractive economic characteristics for QDEL. Looking at my assumptions for the firm's capital requirements looking ahead, I estimate it will complete a $487mm incremental investment to generate NOPAT growth of ~$460mm over the coming 3-year period (FY'23 included). My numbers also have QDEL to print $3.8Bn in cumulative NOPAT over this time [Figure 5].
This is extremely attractive to me and fires up my investment cortex. To illustrate:
- If the assumed $487mm capital investment were to generate an additional $457mm in NOPAT growth, this translates to a 94% return on incremental capital.
- If it can generate the $3.8Bn in cumulative NOPAT, even better, because it would only need to reinvest 12.7 cents of each dollar of income to hit these growth numbers.
- Subsequently, QDEL could methodically turn earnings growth into free cash flow attributable to shareholders (owner earnings).
On that point, QDEL has observed exceptional return on existing capital the past 3-years, ranging from 20%-66%. I forecast the firm to hit 19-21% return on existing capital this year. In this vein, it can continue generating high ROICs, whilst simultaneously treating itself as a "growth company" and drive up revenue + earnings growth at the same time. Investors would pay a high P/E for this in my estimation.
Fig. 5
As such, given the impressive ROIC forecasts observed above, you can see the value QDEL would create for shareholders above the market's rate of return, and/or its own cost of capital. This is integral. Investors need a medium of data to correlate to a firm's potential performance. In the private markets, those firms generating high ROIC and revenue, earnings growth attract high multiples on earnings in a buyout. The same is true for public equities. So, the belief QDEL will maintain a positive spread above the cost of capital from the yield on its growth investments means it can continue to focus on growth without jeopardising the cash it can throw off to shareholders.
There is simply no more of an attractive set of business economics in my estimation, and it's no wonder the Street is valuing the stock nearly 600% higher than its trailing P/E of 5x.
Fig. 6
Data: Author, QDEL 10-K's
Valuation & Conclusion
I thought I was hallucinating when a note saying QDEL was priced at 5x tailing P/E came across my desk. How can the market undervalue a company with remarkable growth in turnover and earnings, strong margins, operating leverage, and spectacular returns on capital? Moreover, QDEL trades at 1.15 book value and with my numbers pointing to a 19.5% ROE this year the investor ROE is still ~17% if paying that multiple. Further, my assumptions point to QDEL sitting on 20-22% ROE over the coming 3-years, which is attractive value by all means.
Further, I believe QDEL can throw off $736mm in cash to shareholders this year even with ~$968mm NWC and CapEx requirements required to grow its 3 focus areas. Looking out to FY'28, to reduce forecasting risk, my growth assumptions pull favourable results. My conclusions on QDEL's valuation are:
- Discounting the cash assumptions QDEL could throw off to shareholders at 10%, the firm would be fairly valued at an $18.5Bn market cap, ~200% upside at the time of writing.
- The stock would trade fairly at 20x my FY'23 earnings estimate. This translates to 64x consensus estimates.
- Investors would receive a 12.4% FCF yield at the time of writing.
- Even at a 15% hurdle rate (pricing in top-line risk), I still see the company valued at $11.8Bn or $208/share.
- This is because of the spectacularly high returns on existing and new capital above the hurdle rate (Figure 6) that QDEL could produce over the coming years, should my numbers be correct.
The dislocation in current price to these growth assumptions is an incredibly bullish feature in the QDEL investment debate, and supports a buy thesis.
Fig. 7
Net-net, I rate QDEL a buy and believe there is scope for it to generate 200% upside potential if my growth assumptions are correct. This is incredibly attractive, and there's reason to believe it could get there based on the factors discussed here today. Rate buy.
For further details see:
QuidelOrtho: 5x Earnings Is Borderline Offensive, Rate Buy At 20x