With Quiver Quantitative’s recent institutional holdings data, we can see that hedge funds and asset managers have been increasing their holdings in IDEXX Laboratories Inc. (NASDAQ: IDXX). Firms such as Amundi, T. Rowe Price, and State Street have all added to their IDXX positions recently. Most notably, asset manager Amundi increased shares held by nearly 17% (as filed on 6/30), bringing their total IDXX holdings to 582,476 shares worth around $283.3 million dollars at current market prices. With this in mind, we took a closer look at some of the reasons why many investors may be bullish on IDEXX Laboratories.
Earlier this month, IDEXX Laboratories Inc. (NASDAQ: IDXX) posted strong second quarter earnings results for fiscal year 2023. IDEXX Laboratories recorded 10% revenue growth in the second quarter, largely driven by CAG Diagnostics recurring revenue growth. The business also achieved record second quarter global premium instrument placements, supporting a 11% annual installed base growth rate. In addition to these promising results, IDEXX Laboratories also raised guidance. IDEXX Laboratories is now guiding FY23 revenue between $3,660 - $3,715 million dollars, and FY23 EPS between $9.64 - $9.90, a 20% increase YoY. With these strong second quarter earnings results in mind, we believe that IDEXX Laboratories is an interesting investment opportunity.
IDEXX Laboratories Inc. develops, manufactures, and distributes products and services for the companion animal veterinary, livestock and poultry, dairy, and water testing industries. IDEXX Laboratories also provides human medical point-of-care and laboratory diagnostics. The business operates under three main business segments that include the Companion Animal Group (“CAG”), Water quality products, and Livestock, Poultry, and Dairy. The business’ primary products and services include point-of-care veterinary diagnostic products (comprised of instruments, consumables, and rapid assay test kits), veterinary reference laboratory diagnostic and consulting services, practice management and diagnostic imaging systems and services, health monitoring, biological materials testing, and laboratory diagnostic instruments and services, diagnostic and health monitoring products for livestock, poultry, and dairy, products that test water for certain microbiological contaminants, and point-of-care electrolytes and blood gas analysers.
IDEXX Laboratories competes with a host of companies, ranging from large human and animal health pharmaceutical and medical diagnostics companies to small businesses focused on animal health. The companion animal veterinary diagnostic products and services segment competes with both reference laboratory service and in-clinic product providers. Management acknowledges that their business competes in different business areas and regions. For example, they may compete with academic institutions, government agencies, and other public and private research organizations that can research and develop similar products, directly competing with IDEXX Laboratories. Competitive factors vary based on their business segment, with each segment having unique competitive factors.
IDEXX Laboratories and their products are often subject to comprehensive regulation by U.S. and foreign government and regulatory entities. Many of IDEXX Laboratories’ products are regulated by U.S. regulatory bodies such as the FDA, USDA, APHIS (Animal and Plant Health Inspection Service), EPS, and NCIMS (National Conference on Interstate Milk Shipments). IDEXX Laboratories’ products and services are under the scope of government regulation on the basis of product approvals and registrations, manufacturing, import, export, and manufacturing, distribution, marketing and promotion, labeling, recordkeeping, environmental compliance, workplace safety, product storage and disposal, product quality, and product testing. As we can see, IDEXX Laboratories is often in the cross-fire of government regulation, which can usually be a red flag for investors. However, it should be noted that this government regulation is not unique to IDEXX Laboratories, and that their competitors face similar risk factors. One unique aspect of IDEXX Laboratories’ business model is that they are very diversified, which makes their exposure to government regulation greater than most competitors. While this can be a large risk factor for many investors, we believe that it can largely be mitigated by entering into a position in the business at a higher margin of safety compared to other businesses with little regulatory risk.
Management is solid and their capital allocation priorities align well with shareholder interests. In 2022, IDEXX Laboratories repurchased 1.98 million shares. Additionally, IDEXX Laboratories repurchased 1.28 million and 779,000 shares in 2021 and 2020, respectively. Management acknowledges that share repurchases are a favorable way to return value to shareholders, while also offsetting the dilutive effect of their share-based compensation programs. As of the end of 2022, there were approximately 3 million shares remaining that were available for repurchase under the current share repurchase authorization. As we can see, management prefers share repurchases as a way to return value to shareholders and to offset the dilutive effect of their stock based compensation programs. While management repurchases shares, they also acknowledged that there were no plans now or in the future to offer a dividend.
In addition to sound capital allocation priorities, management is also incentivized well, with a compensation structure that prioritizes shareholder value creation and aligns shareholder and management interests. In 2022, the base salary represented 10% of CEO and 20% of NEO total direct compensation. The annual performance-based cash bonus represented 12.5% of CEO and 15% of NEO total compensation, whereas the rest of their total compensation opportunity came from equity-based long-term incentives, which made up 77.5% of the CEO’s total compensation opportunity and 65% of NEO’s total compensation opportunity. This compensation structure puts a large portion of the total compensation structure in equity-based long-term incentives, which have a one-year minimum vesting period. This large portion of total compensation towards equity-based incentives not only retains executive talent long-term, it also allows executives to build ownership in the business, further aligning management and shareholder interests. The Compensation and Talent Committee determines the financial metrics used to calculate financial performance factors and their weightings. In 2022, the financial performance factor included an organic revenue growth rating (40% weighting), an operating profit rating (20% weighting), a diluted EPS rating (20% weighting), and a ROIC rating (20% weighting). The financial factor makes up 60% of the annual cash bonus, with the remaining 40% being determined by qualitative factors. In 2022, the non-financial performance factor (with a 40% weighting in the annual cash bonus formula) included five strategic priorities, set in February of 2022. These priorities included: innovate for continued long-term growth, enhance our global commercial presence and execution, deliver a differentiated customer experience, strengthen and engage our talent, and advance our commitment to corporate responsibility and sustainability. Annual equity rewards are evaluated based on a number of factors, including performance, long-term leadership potential, equity holdings, and a competitive assessment of the market and each executive’s responsibilities. As we can see, these management incentives and compensation structures do a good job of aligning shareholder and management interests, while also retaining executive talent and leadership.
IDEXX Laboratories is a very efficient business. IDEXX Laboratories currently operates with a LTM ROE of 102.1% and LTM ROIC of 46.5%, showcasing the business’ capital efficiency and ability to generate high rates of return on cash reinvested back into the business. With a WACC of 11.2%, IDEXX Laboratories operates at a ROIC to WACC ratio of 4.15x, further showcasing the business’ ability to generate high returns on capital reinvested back into the business. Looking further at efficiency metrics, we can see that ROIC has expanded within the last few years. In 2013, IDEXX Laboratories operated with a ROIC of 27.2%, compared to today where the business operates with a LTM ROIC of 46.5%. This relatively high and continuously expanding ROIC figure can possibly show a strong moat that IDEXX Laboratories may hold within their industry.
Analyzing IDEXX Laboratories’ income statement, we can see some stellar sustained growth in revenue, gross profit, and earnings within the last decade. Since 2013, IDEXX Laboratories has grown revenues at a CAGR of around 10%, growing gross profit at a CAGR of around 11% in that same time frame. The growth rate in gross profit over the last decade can largely be attributed to incrementally expanding gross margins. In 2013, IDEXX Laboratories operated with a gross margin of 54.9%, compared to today where the business operates with a LTM gross margin of 60%. As we can see, IDEXX Laboratories is a high margin business, with a 10-year average gross margin of 56.5%. In terms of earnings, IDEXX Laboratories has grown EBITDA at a CAGR of 13.7% since 2013, with EPS growing at a CAGR of 18.3% in that same time frame. The growth in EPS over the past few years can largely be attributed to share repurchases. IDEXX Laboratories is a cannibal, decreasing shares outstanding by around 20% since 2013.
Looking at IDEXX Laboratories’ balance sheet, we can see that the business operates in good financial health. IDEXX Laboratories currently holds around $132.8 million dollars worth of cash and equivalents on hand, compared with nearly $700 million dollars of long-term debt and $264 million dollars worth of short term borrowings, bringing net debt to around $1 billion dollars (which includes other debt obligations as well). While some investors may be wary of this debt level, we believe that it is very manageable. Adding credence to this point, IDEXX Laboratories currently operates with an EBIT/ Interest Expense (interest coverage ratio) of 21.7x, signifying that the business generates $21.70 dollars of earnings before interest and taxes for every dollar of interest expenses that the business accrues, showing the business’ runway to comfortably pay off its debt obligations.
Looking at IDEXX Laboratories’ cash flow statement, we can see some stellar sustained growth in net income and free cash flow, showcasing the business’ operational efficiency and ability to generate cash from its operations. Since 2013, IDEXX Laboratories has grown net income at a CAGR of 15.5%, with free cash flow growing at a CAGR of 13.4% in that same time frame. The growth in free cash flow over the last decade can largely be attributed to expanding free cash flow margins. In 2013, IDEXX Laboratories operated with a free cash flow margin of 12.2% of revenue, compared to today where the business operates at a LTM free cash flow margin of 16.9% of revenue, showcasing the business’ ability to generate cash from revenue, which IDEXX Laboratories can then use to repurchase shares, offer dividends, or reinvest back into the business at high rates of return, rapidly compounding intrinsic value and handsomely rewarding shareholders.
After conducting a reverse discounted cash flow analysis, we can see that IDEXX Laboratories is trading at share prices that imply a 27.25% growth rate in free cash flow over the next ten years, using a perpetuity growth rate of 3% (largely in line with US GDP growth) and a discount rate of 10%. While IDEXX Laboratories is a high quality business, we believe that this growth rate is very high and unsustainable in the long-term. IDEXX Laboratories grew free cash flow at a CAGR of 13.4% over the last 10 years, and we see no indication that the business will be able to grow free cash flow twice as fast over the next 10 years. If IDEXX Laboratories is able to incrementally expand free cash flow margins over the next 10 years, and revenue grows at a reasonable pace, this growth rate in free cash flow implied by current share prices may be attainable.