Life Science Tools: Secular Growth Drivers in a Pressured Health Care Market
There has been much adverse publicity regarding the challenges with health care spending in the United States. With health care now representing more than 17% of total GDP and spending increasing at a faster rate than GDP, we are at a point where there are numerous efforts to cut costs but no clear consensus on the best way to do so. Daily headlines about potential changes to Obamacare that affect coverage for millions of Americans and outrage about the price tactics of biopharmaceutical companies has created a lot of uncertainty in the sector. The life science tools and diagnostics (LST&D or tools) industry provides a relative safe haven from headline risk that is also leveraged to many health care growth drivers.
U.S. Health Care Spending as a Percentage of GDP, 1960-2010
This segment of health care includes advanced microscopes, equipment to test substances like blood and air, equipment to improve water quality, high throughput genetic testing equipment, and other types of tools used in a scientific lab. In the pharmaceutical industry, tools are used to discover new drugs, validate production processes, and ensure the quality of drugs. In the clinic, tools are used to aid medical diagnosis. Industrial and food production companies use tools to ensure quality standards are met. High-tech industrial processes require precision instrumentation to monitor and control production. LST&D are widely used in science and industry, but remain invisible to the average person. These tools are just like the ones you get at your local hardware store – there’s one to help you do whatever you need.
When you think of tools, you may think low tech and low barriers to entry – a hammer is a hammer. But just like power tools, there are some life science tools that are precision-engineered and will last a lifetime, and others that are cheaper and designed for less demanding tasks. Generally, companies in the LST&D segment are highly innovative, developing differentiated products with patent protection to create high barriers to entry for new competitors. These companies service a number of end markets such as biopharmaceuticals, academia, industrials, health care providers, and governments. This broad base of business dampens cyclicality. Also, tools companies sell directly to other businesses, so they are largely exempt from reimbursement risk. Often, tools play a critical role and have a high cost of failure – we depend on tools to ensure our clinical diagnosis is accurate and that our food and drugs are safe. These qualities make LST&D companies an indispensable partner in the value chain.
The tools segment is an area of health care where growth is not dependent on pricing, but volume is a key driver. LST&D companies’ growth is being driven by several secular trends including lower-cost genetic testing, expansion of the middle class in emerging markets, and increasing use of biologic drugs.
We are at the tipping point of a significant increase in genetic testing to personalize modern medicine. When the first genome was sequenced in the early 2000s, it cost $100 million; but with the price of genetic testing decreasing at a significant rate, a genome can be sequenced today for less than $1,000. The previously high cost meant that sequencing had limited usage, largely driven by research labs; however, the reduced cost is driving mainstream adoption. Today, genetic testing is routinely used during cancer diagnosis, and with a number of ongoing population studies, we can expect to see an explosion in clinical genetic testing. There is also a strong economic argument to be made for increased genetic testing, with earlier diagnosis being associated with a decrease in overall health care costs. Each genetic test not only requires instrumentation but also reagents and other consumables, driving long-term growth across the tools sector. Reagents are the chemicals used in the experiment, and consumables are defined as disposable equipment such as a pH strip or pipette tip.
Growth in the LST&D industry in emerging markets is being driven by increased regulation as well as increased penetration of health care for the middle class. Additional regulations are being introduced in emerging markets, including new air and water quality standards, pharmaceutical safety and efficacy regulations, and improved food quality standards. Each time new regulations are enacted, there is an increase in demand for the necessary tools to ensure standards are being met. Testing and quality control in emerging markets requires capital to buy additional lab equipment as well as the ongoing use of reagents and other consumables. Health care is also being modernized in many markets which increases the need for tools solutions. For example, blood tests that are routine in the U.S. are only just penetrating the Chinese market.
Until a decade ago, new drugs generally took the form of a small, white pill to be taken orally. Once the chemical pathway was discovered in the lab it could be fairly easily scaled up to mass production. Pharmaceutical companies have largely commercialized these chemically synthesized drugs and at the same time, our understanding of biological processes has increased, which means new research is often focused on biologics. Biologics are drugs that are synthesized using a biologic process, such as fermentation or cell culture, rather than a chemical one. In 2007, biologic drugs represented 15% of total drug sales, but today represent 25% with an even greater percentage of biologics in the pipeline, implying long-term growth. These drugs have a more complicated discovery and manufacturing process and therefore an increased need for LST&D companies to provide equipment, consumables, and reagents.
Within the LST&D industry, we like Thermo Fisher Scientific, Inc. (TMO), considered “the DeWalt of health care tools” because it provides a variety of high-quality tools. TMO has a strong competitive position with a number of differentiated products and significant international scale, which creates a large competitive moat. The company is taking share both through innovative new product launches and industry consolidation. TMO is also exposed to the previously mentioned secular trends. In genomics, the company has focused on the clinical market and has created instrumentation that makes it easy for less-technical staff to do a genetic analysis and interpret the results. TMO is exposed to emerging market growth drivers and is a leader in products to test air, water, and food quality. The company is also a leader in the production of biologics, providing sterile, single-use consumables and analytics for bioprocessing. TMO has a strong and experienced management team that has shown the ability to consistently improve the company’s growth and margin profile. And importantly, we see upside to the current stock price relative to our estimate of intrinsic value.
In conclusion, the tools industry offers a unique and oft-overlooked investment opportunity in an otherwise challenging health care sector. The companies in this space are innovation leaders with a number of secular growth drivers, giving us optimism about TMO over the long term.
As of June 30, 2017, Diamond Hill owned shares of TMO.
Originally published on July 20, 2017.
The views expressed are those of the research analyst as of July 2017, are subject to change, and may differ from the views of other research analysts, portfolio managers or the firm as a whole. These opinions are not intended to be a forecast of future events, a guarantee of future results, or investment advice.