Despite the recent drop in price (-41% YTD), I am rating IDEXX Laboratories (NASDAQ:IDXX) a hold at the current price of $372.23 due to the still rich valuation.
There is no doubt that IDXX is an excellent business operating in a sector with growth potential well into the future, as will be shown in this article. However, with a current P/E ratio of slightly above 43 and an FCF-Yield of below 2% based on the LTM Results, IDXX looks more than fairly valued. The price decline may continue further in the near term, opening a rare entry point for long-term investors. The most likely case is that IDXX will be trading sideways for quite some time, allowing the business fundamentals to catch up to the current valuation.
IDXX offers products and services for diagnostics and testing mainly in the companion animal space (91% of sales in FY2021), which are reported under the “Companion Animal Group” (CAG) segment. The other two segments, “Water” and “Livestock, Poultry and Dairy” (LPD), contributed to around 4.5% of sales each.
IDXX has rewarded long-term investors with a total return of 806% over the last ten years, as shown in chart 1.
These outstanding returns are attributable to consistent revenue growth and margin expansion over this timeframe. Chart 2 shows IDXX revenue and the organic revenue CAGR from 2010 to 2015 and from 2015 to 2020. The revenue grew with a CAGR of 9.39% from 2010 to 2020.
This consistent growth resulted from animal companions becoming a more significant part of our lives, leading to more testing and treatment, ultimately benefiting IDXX.
The products and services IDXX offers can be divided into three divisions:
1. In-Clinic Diagnostic Solutions: Analyzers, associated consumables and test kits for real-time in-clinic diagnostic results
2. Diagnostic Laboratory Services: Testing of submitted samples through IDXX network of laboratories
3. Veterinary Software and Services: Practice management, patient management and client communication software solutions as well as payment processing services
Chart 3 shows the interaction/synergies between the segments mentioned above. VetConnect PLUS gathers all of the diagnostic and testing results (from in-clinic analyzers and laboratory services). It allows veterinarians to access all their patient’s data through one single platform. Through this platform, veterinarians can share diagnostic and testing results with peers, specialists or customers, make orders of test kits, order testing of samples at the laboratories and track the status of samples they sent to the laboratories.
Combined with the practice management software solutions mentioned above, IDXX offers services for every step of the patient journey:
- Patient management
- Testing in-clinic through IDXX analyzers and test kits
- Submitting samples to the laboratory
- Patient communication through the treatment process
- Payment at the end of the treatment
IDXX used upselling potential through the synergies between the single offerings in the past, as shown in chart 4.
Customers using the IDEXX Ref Lab (Laboratory Services) and the IDEXX VetLab Station (connects and integrates all in-clinic analyzers) service rose from 33% to 53% from 2012 to 2020. This indicates customer satisfaction with either of the services leading to the addition of other services offered by IDXX, ultimately deepening the relationship between IDXX and the customer.
IDXX reported results for the 1st quarter of FY22 on May 5th, 2022. Reported revenue grew from $777.7 million to $836.5 million (+7.6% YoY) while net income fell from $204.3 million to $193.965 million (-5.0% YoY). In addition, IDXX cut its FY 2022 EPS guidance because of CAG sector trends and projected impacts from the situation in Ukraine. The stock fell from $411.31 to $385.11 (-6.37%) on the day of the earnings release.
Since the stock market tends to look into the future, this “CAG sector trend” was most likely the reason for IDXX stock selloff this year (-41% YTD). After digging deeper into the reasons for this slowdown by reading the earnings call transcript, I noted that the management and analysts came back to the same topic of veterinary capacity throughout the call. The management stated that the guidance cut was mainly attributable to lower clinical visits. IDXX CFO Brian McKeon stated the following:
And so this is a relatively more recent dynamic. I think Jay can go into this more in color, but it’s clearly a significant factor here is the vet capacity. I think that there is a trying to adapt following, a significant expansion of the demand in the industry and just dealing with some of the labor dynamics that many sectors are dealing with in the near term. And we’re still working through these tough year-on-year compares. I think that will continue through the first half of this year in terms of the step-up. So that is the primary factor.
After seeing increased demand throughout FY21, the labor shortage is starting to affect the veterinary clinics, so they can’t keep up with the increased demand. While this is bad for IDXX results in the short term, it also indicates that the demand side is still healthy. In the long-term, this may benefit IDXX since they offer full-service solutions that reduce workflows by bundling many tasks into one single platform.
Future Growth Tailwinds
As stated in IDXX’s last investor presentation (page 27), according to a study by IDXX (which might be taken with caution since IDXX conducted the study), around 80% of Gen Z agreed with the statement “My pet is my best friend” and “I treat my pet like my child” (about 70% for millennials and baby boomers). This leads me to assume that the bond between pets and humans is becoming even stronger in the younger generations, which will benefit IDXX in two ways for years to come. Firstly, pet owners will probably pay more attention to their pets showing any symptoms of being sick, resulting in even more testing. Secondly, as younger generations move up in the income brackets, the capability to spend money on their pets will increase accordingly.
To put it as simple as possible, IDXX’s most significant tailwind in the past and the future is that pets can’t talk. Your cat or dog won’t tell you that it is sick, so testing is the only possibility to check your pet’s health. Now here comes a problem. How do you know if your pet may be sick (so you visit a veterinary to get it tested) when it can’t tell you? The CEO of Zoetis (ZTS), Kristin Peck, stated the following during ZTS 4th quarter FY2021 earnings call:
We are also trying to provide tools for pet owners to be able to know when their cat is in pain. Cats do a great job of hiding it. So, that’s really been a focus on videos to show them what it looks like, so they can sort of notice it, giving a big awareness campaign…
ZTS is a leading company in animal health medicines and vaccines. Growing awareness of the pet’s owners regarding their pet’s health condition is an important part of growing IDXX (and ZTS) business. Jonathan Mazelsky, President and CEO of IDXX stated the following on the 1st quarter FY2022 earnings call:
So from a customer engagement standpoint, I think we have a pretty well-defined playbook. It’s really been honed and optimized over the years to be able to drive and inspire diagnostics adoption and utilization, both through creating awareness and education and ultimately, trialing.
This leads me to assume that IDXX is well aware of this and has been actively trying to increase awareness on the pet owner level in the past.
Lastly, to get a sense of the future growth opportunities of the market IDXX operates in, chart 5 shows the growth drivers and opportunities in the animal health market according to ZTS featured company presentation as of May 21st, 2022.
ZTS expects the diagnostics space, IDXX’s main business segment, to grow double digits in the future. This is in line with IDXX revenue growth in the past ten years of 9-10%, as shown above, indicating there are no signs of the overall growth story slowing down.
Return on capital employed (ROCE)
The first (and, in my opinion, most important) metric I look at to value the quality of a business is the ROCE. A consistent high ROCE indicates that (a) the management has shown an outstanding ability of deploying capital to grow the business and/or (b) the business has such a wide moat that it has very low capital requirements to generate high returns.
|Capital Employed $M||618||596||709||767||1,107||1,712||1,674|
Table 1 (data source: IDXX 10-K reports)
Table 1 shows the EBIT, Capital Employed and ROCE of the last seven years. The average ROCE was 53.7%. Note that I do not deduct intangibles from the capital employed. This would favor companies just throwing cash into M&A activities, leading to a significant goodwill position on the balance sheet (in my opinion, Salesforce (CRM) is a great example). With an average ROCE of above 50%, I am pretty confident that IDXX is an outstanding business.
Another metric I like to look at is the operating margin. As can be seen in chart 6, IDXX’s operating margin increased by approximately 900 basis points over the last ten years. As noted earlier, this was a driving factor of shareholder returns in the past, so the question is how much room for further margin expansion can be assumed for the future.
As part of the latest investor presentation (page 83), IDXX set a target of 50-100 bps of operating margin improvement per year over the next five years. While this is a bit lower than the margin expansion rate in the past, a margin improvement of 75 bps alone would lead to 2.5% bottom-line growth. Adding the low double-digit percentage annual revenue growth IDXX has shown in the past and will most likely show in the future (chart 3) would lead to around 13% annual earnings growth going forward (not considering share repurchases or dividends).
I also like to look at the number of earnings that end up as cash in the business. For this, I look at the cash conversion rate (free cash flow divided by net income).
|Free Cash Flow $M||144.8||288.9||298.9||284.3||304.2||541.1||636.0|
|Net Income $M||192.1||222.0||263.3||377.0||427.7||581.8||744.8|
Table 2 shows the annual net income, free cash flow and cash conversion rate over the last seven years. The average cash conversion rate over the last seven years was 92.0%, so the profits are mostly cash and not just “accounting earnings”.
According to S&P Global Capital IQ (Source: TIKR Terminal), IDXX had net debt of $968.8 million as of the end of the latest quarter, as shown in chart 7.
The TTM free cash flow amounted to $614.6 million. IDXX could repay all debt in about 1.5 years. There does not seem to be any need for concern for IDXX’s financial condition in the near future.
At the end of the latest quarter, 85.56 million diluted shares were outstanding. At the current price of $372.23, this translates to a valuation of $31.85 billion. The TTM net income of $734.5 million and the TTM free cash flow of $614.6 million lead to a current P/E of 43.36 and an FCY-Yield of 1.93%.
The valuation is the primary and most important risk of investing in IDXX at its current price. While I do not doubt that IDXX is an excellent business, I think that the future growth prospects, as have been shown in this article, are more than priced in at the current price. IDXX will probably grow well in the future. However, long-term shareholders may still be looking at underwhelming returns if the valuation returns to a more reasonable level.
While IDXX is an outstanding business, the valuation has probably priced in all of the future growth prospects for the near future. For long-term investors already holding IDXX, I see no reason to sell since the company’s overall story is still intact. For investors looking to initiate a position, I would advise keeping IDXX on their watchlist in case a further drop opens a buying opportunity.
I would consider buying IDXX for the long term at a P/E of around 35 or an FCF-Yield of above 2.6%, as such a premium seems reasonable for such a quality business. This would translate into an entry price of around $275 to $300. At the current price of $372.23, I rate IDEXX a hold.