All about converts

IVGN Analysis – May 11, 2005

I think the 2.25% converts are a good buy because I believe the credit is solid and the stock could go to $100 in the next 12 months if the company can execute.

1)      IVGN is very diversified with thousands of customers. The company is leverage to an increase in biologics without the risk of any one drug being approved.

2)      Research and production for biologics should have strong long term growth in the 10-15% range even if the industry faces some short term fluctuations in government grants and pharmaceutical spending.

3)      Since CEO Greg Lucier took over in 2003, he reaccelerated R&D spending and focused on integrating acquisitions which should yield more new products in the near term.

4)      The company has $660M in cash, $1.3B in debt and is expected to generate $200M in free cash flow in 2005. My credit spread estimates are 150+L for the 2.25% convert and 250+L for the 2% and 1% converts. The convert market may imply a higher spread due to takeover concerns.

5)      Risk to the equity include IVGN making a big acquisition or new products failing to drive growth. The risk to the credit is IVGN making a big acquisition by issuing more debt. Even in that scenario, IVGN’s steady free cash flow generation of $200M per year should create a floor for the credit.

Business Model

IVGN operates two segments – BioDiscovery and BioProduction. The BioDiscovery segment includes sales of consumable chemicals and enzymes for the R&D community. This segment is fragmented with many competitors including Affymetrix, Applied Biosystems, and Fisher Scientific. The BioProduction segment includes sales of cell culture used by biotech companies for production and research and academic institutions for research. This segment is fairly concentrated with IVGN as the dominant player.

The BioDiscovery segment went through a mini-boom cycle from 1999-2001 and has pulled back from the peak. The BioProduction is the higher growth segment driven by more biologics in the market. IVGN has pricing power in both BioDiscovery and BioProduction due to high switching costs. IVGN is not leveraged to any particular drug and will benefit as long as research and production in biologics continue to grow.

IVGN has grown by acquiring companies and integrating them into its existing business. Some investors are concerned that organic growth for the company is slowing. The company needs to deliver higher organic growth by introducing new products in order to drive the stock price higher. IVGN reaccelerated its investment in R&D in 2003 (new CEO) after a couple years of under investment and should be able to deliver new products in the coming years.

BioDiscovery

IVGN manages this unit as three segments – Life Technologies, Molecular Probes, and PanVera. Over the last year, growth for the BioDiscovery division has slowed due to a lack of internal product launches and fewer acquisitions. IVGN’s management is refocusing efforts on internal growth for this division by hiring new scientists and spending on R&D.

Life Technologies (75% of unit sales) focuses on genomics by providing consumables for scientists to conduct laboratory experiments. The main products are PCR enzymes, DNA ladders, cloning reagents and specialized cell lines. This segment has slowed in recent years along with the genomics market but there is potential for reacceleration in 2005 due to new product launches.

Molecular Probes (13%) offers specialized reagents and chemicals for research. These reagents are labeled with a fluorescent tag, which allows scientists to track molecular changes for key metabolites. Molecular Probes has market share approaching 80% and has continued to grow in the mid-teens.

PanVera (9%) offers high throughput screening products and services to pharmaceutical and biotechnology companies.  Within this division, Sequitur researches, manufactures and sells RNAi products to the research market. The RNA oligo-syntheses market is still in its infancy at $40M but it is growing at 25% per year.

Competition in this segment has increased as the industry matured. Fisher Scientific has been buying up companies (Perbio, Dharmacon and Apogent). The market experienced a bubble in 1999-2001 due to fund raising and R&D spending in the life sciences industry.

BioProduction

This segment consists of Cell Culture and Biological Testing. Cell Culture is a special liquid culture media containing essential nutrients used to grow cells in a laboratory environment. Users include research and production. Suppliers segment cell culture products into three categories: media (40%), reagents (30%) and serum (30%). Media is a water-based broth that contains the basic components for cell viability such as salts, amino acids, sugars, and vitamins. Reagents contain minerals and antibiotics. Serum is a mixture of components including growth factors, lipids, and protein derived from animal blood. A typical culture mix consists of 85% media, 10% serum and 5% reagents including the one used to produce Amgen’s Enbrel and Epogen.

The market size is $850M and growing at 10-14% annually. The top 6 suppliers account for 80-90% share with the rest split among niche players.  Sales to academic and industrial research labs account for 60% of total cell culture sales, while large-scale biomanufacturing account for 40%.

The main driver of cell culture sales is biomanufacturing. As long as biotechs continue to develop new biologics, there will be growth for cell culture. Once a cell culture is selected for a particular drug, switching cost is high because the FDA must approve any changes.

One of the key concerns in the cell culture market is the impact of higher animal sera prices. Serum is made from beef products, which is affected by cattle pricing. When mad cow disease was discovered inCanada, prices for serum increased by 50%.

IVGN also participates in BioProduction through its BioReliance unit (acquired in 2004), which sells testing and outsourcing services. About 45% of BioReliance sales are related to cell culture with the remainder coming from toxicology and development and manufacturing. Competitors are Charles River Laboratories, Covance, and Inveresk Research Group. BioReliance’s product offerings in the very early stage development allow IVGN to establish relationships for its cell culture products before clinical trials start.

Takeover Risk

CEO Greg Lucier is 40 years old and joined IVGN in 2003 from GM Medical. The CEO probably wants to continue running the company and make his mark. There is still takeover risk if another company comes in and makes a great offer such as GE’s recent acquisition of Amersham. Logical buyers could be 3M, Philips, or Siemans. However, these companies are more likely to buy a more industrial healthcare company like Waters or Millipore. Analysts believe an LBO is unlikely because management is committed to running the company.

Dividend Risk

IVGN needs its cash to grow and is not likely to issue any dividends in the near future.

Capital Structure/Credit

IVGN will likely call the 2.25% bonds in 12/20/05 if interest rates remain a these levels. They would like to replace this issue with a long-term straight bond issue. Their interest rate expectations will ultimately determine whether they call the bonds in 2005 or wait until it matures in 2006. In 1Q05, IVGN bought back $125M of the 2.25% bonds under par.

IVGN has $660M in cash, $1.3B in debt, and is expected to generate $200-$225M in FCF in 2005. Management will likely use the free cash flow to make more acquisitions.

IVGN is not rated by agencies but its credit metrics imply a rating of BB. There are some concerns about the company making more acquisitions and perhaps issuing more debt. IVGN has a diversified customer base and good pricing power but could still be affected by biotech and pharmaceutical spending.

I estimate the IVGN credit spread to be 250 over Libor for the 2% and 1.5% converts; and 150 over Libor for the shorter term 2.25% convert. The convert market is currently implying 200 for the 2.25% and 300 for the 2% and 1.5%. Investors could be pricing in some takeover risk.

Equity Valuation

At $76, IVGN trades at 19x 2006 EPS of $4.04. IVGN is growing organic revenues in the 8-10% range and EPS in the 15% range. The main driver of IVGN’s share price appreciation will be the ability to reaccelerate organic growth in its core businesses, especially Life Sciences. The company could trade up to the mid 20s PE ($95 to $105) if it can execute its business.

Risks

IVGN makes a big acquisition

Equity investors want the company to focus on organic growth so any large acquisition would create risk that would take management away from its main focus. Any acquisition that the street does not understand would hit the stock. IVGN would also need to successfully integrate any acquisition and has a good track record of doing so. 

IVGN does not deliver enough new products

Equity investors are looking for new products to drive organic growth and will be disappointed if the new products fail. However, IVGN has invested heavily in R&D over the last few years and should be able to deliver.

Budgets of customers could decline

IVGN is leveraged to the R&D budgets of academic institution, pharmaceuticals, and biotech companies. A slowdown in government grants or lower R&D budgets from pharmaceutical companies would hurt sales. If these budgets get cut, IVGN sales could be at risk. However, IVGN’s products are more basic consumables and should be less vulnerable than instruments and equipment.