Tuesday, July 14, 2009

High margin, low or reasonable capex businesses (part 1)

One of the lessons Charlie Munger taught and influenced Warren Buffett is looking beyond investing the Benjamin Graham way - the cigar-butt manner. Berkshire Hathaway and Warren Buffett would never have attained the current success had Buffett stuck to his gun. Business purchases like Sees' Candies and Scott Fetzer arose from Munger's original influence. He taught Buffett not only looking beyond the book value, not just focusing on intrinsic value, but also great businesses have a goodwill that is more valuable than any other tangible assets that are reflected in the books. The other thing is goodwill is the friend of inflation, as Buffett says, "in times of inflation, goodwill is the only gift that keeps giving." So the objective here is to identify potential great businesses that need little in the way of tangible assets, low or reasonable need for capital expenditure, and preferably a high profit margin. Below are two examples.

Business : IMS Health is the leading global provider of market intelligence to the pharmaceutical and healthcare industries including product and portfolio management capabilities: commercial effectiveness innovations; managed care and consumer health offerings; and consulting and services solutions that improve productivity and the delivery of quality healthcare worldwide. IMS has operations in over 100 countries.

Competition : While IMS has no competitor that provides the geographical reach or breadth of their services, IMS competes in the countries in which they operate with other information services companies, as well as with the in-house capabilities of their clients. Generally, competition differs on a country-by-country basis.

Financials (in $'000,000):

Net profit311.25234.04315.51284.09285.42
Profit margin as a % of revenue13.36%10.67%16.11%16.19%18.19%
Total asset2087.142244.21906.591973.021890.71
Return on asset14.91%10.43%16.55%14.40%15.10%
Net cash provided by operating activities420.65466.89356.12309.15400.27
Capital expenditures-36.35-61.18-27.49-52.02-22.46
Free cash flow384.3405.71328.63257.13377.81
Diluted no. of shares183.61198.67206.6232.48237.71
IMS sells for about $2.2 billion.

Comments : IMS Health's operating environment is likely to remain challenging for some time. Dynamics are changing in the drug business causing industry players - which are primarily IMS's customers - to come to grips with the prospects of slower growth. Big pharmas are facing patent expiry to many of their blockbuster drugs in the coming years. New drugs and potential drugs in the pipeline do not seems to be enough to fill up the gaps left behind. There are few product launches and higher generic competition. In the foreseeable future, the industry is poised for slower growth. In 2008, IMS has undertaken an organization restructuring leading to a leaner cost structure. This will likely soften the impact. The past five years show that net profit has been in a holding pattern, reflecting the dynamics of the drug industry, and that earnings on a per share basis have advanced largely due to the result of an active share-repurchase program. Even though with the economic headwind faced by the industry, this issue's current price may compensate for the reduced growth prospects.

Business : Stryker Corporation is a medical technology company which develops, manufactures and markets Orthopaedic Implants (59% of business) and Medical Surgery Equipment (41% of business). Orthopaedic products include hip, knee, trauma, spinal and craniomaxillofacial implants. MedSurg includes powered instruments, endoscopic systems, other operating room devices, specialty stretchers and maternity beds business.

Competition : In the Orthopaedic business, Stryker competes with Medtronic, Synthes Inc., Smith & Nephew Orthopaedics (a division of Smith & Nephew plc), Zimmer Holdings, Biomet and DePuy Orthopaedics (a division of Johnson & Johnson). In MedSurg business, Stryker competes with between 1 to 6 principle competitors in its various divisions, including Medtronic, GE Medical Systems, Smith & Nephew, Conmed Corporations, and others.

Financials (in $'000,000):

Net profit1147.81017.4777.7643.6440
Profit margin as a % of revenue17.08%16.96%15.11%13.96%10.95%
Total asset7603.373545873.84992.54120
Return on asset15.10%13.83%13.24%12.89%10.68%
Net cash provided by operating activities1175.91028.3867.3833.4559.5
Capital expenditures-155.2-187.7-209.4-261.8-180.5
Free cash flow1020.7840.6657.9571.6379
Diluted no. of shares413.6417.2411.8410.8409.3

Stryker sells for about $16 billion.

Comments : Stryker's first quarter result was dampened by the recession. Sales in the March quarter fell short of year-ago period, reflecting a weak capital spending environment and also negative foreign currency translation. The MedSurg group which accounted for close to 40% of business in the quarter, was off 5% because many of its products carry higher price points within the capital equipment market. However, hospitals can only defer equipment purchases, such as surgery tools, beds and stretchers for so long, and as the year progresses, there should be an increase in volume. In the medical device industry, new product development augurs well for long-term prospects. While Stryker has cut back on R&D spending, product introductions are on tap for the year ahead. Recent rollouts include the 1288 Endoscopy camera which offers wireless transmission capabilities. Another is Impression, a new entrant in the 400 million surfaces market, which aims to minimize skin damage to prone patients. The rollout costs related to these new launches will weigh on near-term profitability but over the long haul, sales should be enhanced. This issue is more of a buy & hold for investors with a longer view term. The company's diverse line of products will also offer a buffer to current conditions. The strong balance sheet provides opportunity for potential acquisitions at reasonable valuations that ought to boost earnings. If not, it can be used for share repurchases.

Both IMS Health and Stryker share some commonalities: 1) high profit margin; 2) high return on asset; 3) low capital expenditures and; 4) strong free cash flow. Basically, both tell the story of a strong fundamental (moat) where the company product commands the pricing power will lead to all sorts of good things down the road.

Anyway, more companies to come in the coming postings.

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