Stratec Biomedical — Update 4 April 2016

Stratec has excellent technologies and deep expertise in engineering design, optics and software, with an efficient assembly and testing operation in Germany and Switzerland, where systems are constructed from modules according the client orders. The supply chain from module producers, usually in Asia, takes about six weeks and is tightly managed. There are two subsidiaries that have their combined sales noted in the annual report: one in middleware – laboratory management software based in the UK; and the other in nucleic acid purification based in Berlin. A US subsidiary has optical expertise, essential for precision measurements in diagnostics. Most system design occurs in central Germany in the Black Forest. The menu of diagnostic tests is provided by clients. Some issues were reported with clients having an incomplete launch menu, which therefore reduces the initial commercial appeal to their customers. Diatron, acquired in at the end of March 2016, has OEM and some direct sales of blood cell analysis instruments and chemicals. It is based in Hungary with a US sales operation located in Florida.

Stratec had previously guided that revenues in 2015 were likely to be relatively flat relative to 2014, but with increased profitability. The revised Edison forecast by revenue stream, including initial Diatron forecasts, is shown in Exhibit 1.

Unaudited FY15 revenues of €146.9m were slightly lower than our November 2015 forecast of €148.4m, but EBIT at about €26.9m was as expected due to a higher EBIT margin at 18.3% vs 18% forecast. The increase in EBIT seems to have been due to service part sales comprising 24%+ of the revenue mix. Service part sales are much higher margin than manufactured systems. It seems probable that the number of systems shipped fell slightly in 2015; management has disclosed that sales shifted towards higher-value systems with a fall in older systems shipped.

There was no disclosure of the level of recognised development revenues. We estimated these at €14m, but they contribute nothing to EBIT as they are exactly offset by amortised costs; the costs recognised equal the client payments received. Development revenues often do not cover the cost of development as Stratec uses its own IP. These recognised development revenues and costs may be slightly higher in 2016 and 2017. This is because of the high level of ongoing development work and the number of development contracts that will move into the client market launch and construction ramp-up phases. Margins on systems are generally lower in the initial ramp-up phase as production is optimised. However, this is impossible to assess numerically. Unrecovered development costs are amortised against profits from system construction. A further factor affecting EBIT margins is the extent to which development work is capitalised as incurred, although Diatron revenues will damp down these arithmetic fluctuations. A higher capitalisation rate will improve EBIT, but it is not possible to forecast this accurately as it is contract dependant.

The bulk of the core EBIT margin comes from service part sales, disclosed as just over 24% of the 2015 revenues and estimated at about €35.4m in Exhibit 1. This was substantially higher than the reported 2014 value of €33.8m (our 2015 forecast was €34.5m) and it led to a much higher EBIT margin, particularly as product sales were slightly lower at an estimated €96m vs €97m forecast.

It seems possible that the number of system units shipped in FY15 decreased as management indicated that the average sale price increased due to currency effects and a move towards more complex systems in the mix. The number of units will be disclosed in the annual report on 14 April.

Product sales include the two operating subsidiaries. The UK middleware company gained a substantial contract from Roche in 2015, which enabled it to produce a maiden EBIT contribution.

Looking forward to 2016 and 2017, the increased volume due to the two scheduled major launches is still apparent, but at a lower level and much more weighted towards 2017 – and so potentially volatile though hopefully upwards. Although we expect the EBIT margin to remain above 18%, it is possible that it will slip down slightly as the growth has to come from system sales, which are lower margin than service part sales. Exhibit 3 shows a scenario for overall revenues and Exhibit 4 shows EBIT. This does indicate that Stratec should continue to have robust cash flows, which will underpin the proposal to raise the dividend from €0.70 to €0.75 in respect of 2015, despite the limited sales growth, and enable rapid repayment of the bridging loan for Diatron.

At this stage, there is no visibility about the likely sales trajectory from 2018, although it could accelerate markedly if clients resolve their China conundrums and as current development projects reach the launch phases. Management has indicated that a more cautious and short-term guidance will be given. Revised guidance, including Diatron, will be given with H1 results on 21 July.

Diatron, a Hungarian company, was founded in 1989. The first US sales were in 2012 with FDA approval of the Abacus 5 and Abacus 3CP haematology analysers. Diatron has a range of differential haematology analysers (Exhibit 5) selling at about 25% of the typical Stratec system (about €8k); Stratec states that it is a leading OEM manufacturer, with unit sales of €21m a year targeting smaller laboratories at lower test per hour rates. The Diatron website states it has sales in more than 110 countries through its distributor partner network and US subsidiary. Most sales are OEM but this is undisclosed.

Each analyser requires some bulk chemicals to run tests with 2015 sales of about €9.5m; these are standardised products available from multiple suppliers. There is also a small range of clinical chemistry systems generating about €3.7m sales per year, about 11% of total revenues.

Haematology analysers are a competitive and mature market. MarketsandMarkets, a research company, forecasts a $3.1bn market by 2019 with a CAGR of 5.2%. There are a wide range of systems and innovations in improving speed and accuracy. Examples of Japanese suppliers are Sysmex, Nihon Kohden and HORIBA. In the US, Beckman Coulter, Bio-Rad and Abbott are dominant and, in Europe, Siemens, Boule and Roche Diagnostics. In China, there is Mindray Medical. The units are used in diagnostics laboratories and general practice and in clinical settings when a result is required within minutes, as for blood transfusions.

Stratec has disclosed approximate Diatron sales of €34m for the last financial year. Diatron, was sold to Stratec for “less than” two times sales, €67m assumed, by a US private equity company (Riverside) in March 2016; Riverside acquired Diatron in 2005. The EBIT margin is stated to be double digit and similar to Stratec. In our initial modelling of the acquisition impact, we have assumed a €67m purchase price which is half debt funded (a short-term bridging loan), increasing interest to over €1m per year, an interest rate of 2.5% is assumed based on management statements. The growth rate is stated to be just above Stratec’s so we assume 7.5% and the EBIT margin as 17%. The acquisition price may include a significant debt repayment as US private equity tends to be rather fond of leverage but details are not disclosed. There are 194 employees. No other financial details are available other than the cost structure is similar to Stratec’s.

Stratec management indicated its intent to acquire a business that will enable it to broaden its offering to its client base (requiring a strong IP portfolio) without being EPS dilutive, implying a profitable target business at a reasonable price (implying overlooked or early). Diatron is the first to complete of several acquisitions being considered by Stratec management (as disclosed on the 24 March conference call). The other might complete over the next few months.

The Diatron acquisition adds to EPS by use of cash and short-term debt, but might be slightly EBIT margin dilutive. Stratec intends to use Diatron to diversify into new markets and gain synergies in development, manufacturing and sales. The two companies share two major OEM customers so there may be some cross-selling synergies and Stratec might use Diatron to enter volume, lower priced markets with additional development options for current clients. In the US, Stratec will now also sell some systems direct to end-customers. Diatron has the big advantage of not competing directly with Stratec’s current clients, since although some (like Abbott and Siemens) are in haematology, they sell high-volume, upmarket systems.

The broader strategic dilemma faced by Stratec remains that most margin comes from service part sales, which are at the longer-term end of the value chain and have proved to be inherently volatile over the last few years. Diatron bulks out revenues and so adds diversity and reduces volatility, but adds exposure to a lower-margin, mature technology sector, not Stratec’s traditional focus. Nonetheless Stratec was keen to observe that Diatron was not boring relative to its current high technology, high-throughput systems.

Given that most core manufactured systems are built to a custom client specification, Stratec has relatively weak construction OEM pricing power. The immediate impact of negotiating a new development contract is often cash negative; such contracts are at best cash neutral over the one- to three-year project. Yet Stratec has 50% of its staff, and fixed costs, in development. Once “launched”, volumes ramp up over a few years. During this ramp-up period, margins can be lower and the client ramp-up can be slower than expected. This is impossible to quantify externally.

Further broadening the base into new, value-added diagnostic markets, such as cell-free DNA or cancer cells used as tumour prognostic markers (2014 annual report), would give a springboard to develop new core products and markets. New technologies might be a focus for further acquisitions that management states are anticipated by early July. Stratec seems willing to increase the debt level to perhaps €70-90m to fund these acquisitions; this is about two times the cash flow.

It is difficult to provide a realistic valuation of Stratec because of the diverse and unpredictable nature of the revenue streams and long-term growth rates, as discussed above. Recognition of development revenues depends on undisclosed project progress and philosophically intricate accounting, leading to a complex balance sheet. Diatron adds extra sales, probably slightly reduces EBIT margin but, unless it can be developed by new technology and diversified products, may add little to growth. The reagent stream should be solid but these are commodity products, although cost of goods should be low. The Diatron tax rate is “slightly lower”.

Stratec’s shares are now on a historic P/E of 20x and a prospective 2016 forecast P/E of 17x, relative to a core revenue growth rate of 2.5%, possibly rising to 7% or more in 2017 if management expectations of a CAGR of 6% (based on 2013 revenues) are correct. The 2016 prospective revenue to capitalisation multiple post the acquisition is 2.9x, indicating strong long-term growth expectations – this now seems unlikely before 2018. The proposed dividend increase to €0.75/share from €0.70 lifts the yield to 1.8%. In our update note of November 2015, our forecasts, using the former 8-12% CAGR management guidance, assumed a 2016 P/E of 19.5x. In January 2016, at the share price of €62.50, the historic 2014 P/E was 29x.

The share price is sustained by the large founding family shareholding of 43% and by the low trading volumes. A share premium, in our view, is justified by the very strong core competencies and expertise of the business, its strong IP position and its core brand within the industry. The Diatron acquisition diversifies the business and provides a close fit to current operations.