Even if the NIH is drastically cut, we don't see a doomsday scenario for these companies, and some of the industry's stronger players are now trading at attractive valuations.
Jeremy Glaser: For Morningstar, I'm Jeremy Glaser.
We're over a year from the debt ceiling debate, and some of the budget cuts are now planned to happen in January. One industry where this is looming large is life sciences. I'm here with Alex Morozov; he is the director of health-care research at Morningstar. We're going to take a look at the industry and see if there is still any value there.
Alex, thanks for joining me.
Alex Morozov: Thanks for having me, Jeremy.
Glaser: So, let's start with the sequestration; let's start with the cuts. What could these potentially mean for life sciences companies?
Morozov: Well, first of all, let's remember that NIH, while a very important contributor to life science companies in terms of funding, is not the only source for funding. The NIH does account for sizable chunk of academic and government funding that is provided for life science firms, but it's still only a small portion of the overall funding.
In reality, when you look at the life science companies, less than a quarter of total revenue comes directly from academic and government sources. If you drill a little bit deeper, even less than that comes directly from NIH. So, even if NIH is drastically cut, as is quite a bit possible nowadays, it's still not going to be a doomsday scenario for a lot of life science firms.
Glaser: So, this has certainly been one of the big questions: What's going to happen at the fiscal cliff. Will there be some compromise after the election, before January, in order to actually fix it? When you are thinking about these companies, in some respects does it matter if it's fixed or not? Or does is really going to have a huge impact on the livelihood of these companies?
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Morozov: Now, that's a great question. First of all, we have to remember that only about 15% of all grants that are awarded to NIH are awarded for new projects, so about 85% of funding that NIH consumes every year has already been accounted for and committed.
So, really if we see the 7%-9% cuts in non-discretionary spending, as the sequestration suggests we will, it's really going to hit disproportionally new projects. So the question is, will the government effectively shut down new research? And we don't really see that as a possibility.
That said, we have to account for that risk. So, when we look at the life science firms, we say, well, are there any positives or any offsetting factors that really mitigate that risk? One of them is increasing emphasis on applied and industrial spending. What I mean by that is, particularly in emerging markets, more and more emphasis is placed on food and environmental safety testing. And this is what a lot of those life science firms do; they provide the instrumentation that is used to test basic products for contamination, test air and water pollution, and that's the area that has just been growing robustly for a lot of these life science firms.
Glaser: Now, another part of the world that is seeing big budget cuts and will probably see even larger ones in the future is Europe. What kind of impact is that having on these firms?
Morozov: Well, we have to remember that Europe is not as big of a chunk of revenue for life science firms as opposed to some of their more industrial counterparts. At most, maybe a quarter of total revenue comes from Europe, and that's a rarity.
So, while European spending is slowing, we've seen this in several quarterly reports, it has not been devastating for life science firms. In fact, once again, only the government portion of the European spending is slowing. The pharmaceutical and health-care research related expenditures are still steady. In addition, the industrial and applied markets are still doing fine there, too.
But with all that said, it's pretty clear that the European demand that was pretty robust a couple of years ago has come to a screeching halt, maybe even declining, and that's probably not going to be rebounding anytime in the future.
Glaser: So, we have the potential for sequestration in the U.S., the problems in Europe. What makes you bullish about some of these firms? What makes you think that there is potential for good investment returns there?
Morozov: Well, one area I would definitely mention is the emerging markets. The emerging markets are becoming a bigger and bigger story. We've heard pharmaceutical companies talking about emerging markets as one of the key areas for demand going forward.
For life science firms, it's even a bigger piece of the total pie. The revenue from emerging markets has grown north of 20%, and it remains that strong, despite some of the recent slowdown in China.
What drives that? Obviously, the environmental and safety testing is one area. Another area, particularly in China, the government is emphasizing health-care and biotechnology research as some of the key areas for growth in its next five-year plan. Life science firms, particularly the multinationals, have already established a presence in China and are disproportionally benefiting from this increasing emphasis by the Chinese government on health-care and biotech spending.
Glaser: What are some of your best ideas in the space?
Morozov: Well, the companies that we like to recommend are the companies with moats, and we have several of them in the life science space. One of them is Thermo Fisher Scientific. The ticker is TMO and the stock right now is trading at about 25% discount to our fair value.
What we like about Thermo Fisher is its great business model. It's literally a one-stop shop for anything research related. You can get anything from some of the more basic consumables to multi-million dollar instrumentation.
So, Thermo Fisher literally has its tentacles in every aspect of the research process. So, what happens when we see a lot of customers tightening their budgets a little bit, companies like Thermo Fisher benefit from that actually, because what it allows them to do, it allows them to eliminate some of the lower-tier providers to consolidate the customers' purse in a way, to gain market share at the expense of some of the smaller or weaker competitors.
Thermo Fisher Scientific has a great presence in emerging markets. It's been in China for several decades, and it's emphasizing India and other areas of Asia as great opportunities for growth. So, Thermo Fisher Scientific is one of our top picks.
Glaser: And what's another one?
Morozov: Waters: That's a company that actually carries a wide economic moat, and Waters is rarely cheap. This is a great company. It does provide the instrumentation. So, you can probably say, listen, in this tight cyclical environment maybe instrumentation will be the first one to get hit. This really has not happened. Waters has maintained and grown its market share, primarily on the strength of its technological know-how. It is literally the best, the top name in the scientific instrumentation space.
So, we rarely recommend Waters because its shares are simply never cheap, but the company is a great company with returns on capital well north of 40%, and operating margins in the 30% range. So, overall this is a great company.
Glaser: So this uncertainty could be an opportunity to jump into that wide-moat name.
Morozov: Exactly.
Glaser: Alex, thanks so much for your thoughts today.
Morozov: Thank you, Jeremy.
Glaser: For Morningstar, I'm Jeremy Glaser.
