Thermo Electron (BUY)
THE NEW THERMO - INITIATE COVERAGE WITH BUY RATING
We are intiating coverage of Thermo Electron with a Buy rating and a $38 price target. We believe the stock offers an attractive combination of earnings growth, valuation, technology and defensive end-market exposure. A new management team has moved quickly to address structural problems at the company, and the results are being born out in improved results already. Thermo Electron’s newly focused operating strategy should allow it to translate its strong technology platform into faster revenue and profit growth for many years to come. Thermo has undergone a dramatic shift in strategy during the past year – from a holding company to an operating company, ending a unique chapter in the history of financial engineering. We believe there are substantial cost and revenue synergies available to the company that only now have begun to be recognized. In addition, we have high regard for the new management team and its ability to make strides in improving operations. We arrive at our price target based on a hybrid sum-of the-parts and comparable valuation methodologies. The valuation analysis requires a few additional steps because of some wrinkles in the portfolio and restructuring that remains to be done. We put a value on pieces that are noncore of approximately $8 per share, and then use comparables analysis to derive a value for Thermo’s remaining core businesses.
A combination of solid internal growth, wider margins, and the restructuring should result in a powerful earnings growth story for the next several years. We estimate 2001 diluted EPS growth at more than 25%, and we believe EPS growth will average 20% for the next four years. Earnings growth is being driven by expectations for a respectable 8% internal revenue growth rate and plenty of opportunity for margin expansion. Given the early stage of Thermo's recovery, there should be many years of healthy margin expansion - 400 bp over the next four years seems achievable (though we have not modeled this aggressively in our estimates). We think there is a reasonable amount of management conservatism in company guidance, given its desire to reestablish credibility, which suggests that upside is a possibility. Core revenue growth should amount to 7% this year, up from initial expectations for 5%. A leading position in mass spectrometry instrumentation should benefit the Life Sciences segment through deeper penetration of the high-growth proteomics industry. Further demand for telecom and semiconductor products should drive the top line at Optical Technologies. And a rebound in process industry capital spending, owing to higher commodity prices, should lead to solid gains at Measurement and Control in 2001. Good secular growth trends in most of the company’s end markets should provide some insulation from cyclical swings in the economy.
Given the strong earnings growth outlook, technology value and the early inning of Thermo’s recovery, we think the stock is attractively valued. Extracting the public value of its Spectra-Physics Lasers (SPLI) subsidiary and our valuation expectations for potential spin-offs, TMO currently trades at only 10.2 times estimated 2001 EBITDA and at 20.4 times our 2001 cash EPS forecast. Multiples for comparable companies are considerably higher, and suggest potential upside is not limited to our $38 price target. If nothing else, Thermo is, in our judgment, an inexpensive way to play the strong growth prospects for life science research equipment, especially mass spectroscopy.
Thermo has a strong technology base forged by its longstanding R&D investment in instrument technology. It has long been at the forefront of the analytical instrument business and has leading technology in high-growth markets such as proteomics research, optical technology, and semiconductor equipment. Many of these markets’ strong secular growth dimension moderates the cyclical risk as well. In our judgment, Thermo’s new organizational structure will help it apply its technology base to achieve greater market success than it has enjoyed in the past.
Proteomics Play
Thermo is one of the leading manufacturers of analytical instruments that enable proteomics research – the next big thing in life sciences. Thermo’s broad line of mass spectroscopy products is the overall market leader in this high-growth market. Bruker Daltronics, a pure-play mass spectroscopy competitor (with a number-four market position) garners a market capitalization of more than $1.5 billion on $60 million of sales and $2 million of operating income. In comparison, Thermo’s mass spec revenues make it nearly three times the size of Bruker.
Optical Exposure
Thermo owns 79% of publicly traded Spectra Physics (SPLI), we look for this unit to leverage its strong position in semiconductor-based laser and optical technologies to penetrate the telecom market – a market that it previously ignored. SPLI recently developed two new product lines – multi-mode pump lasers and Raman fiber lasers – for the telecommunications industry. The company also is a prominent manufacturer of echelle gratings. The need for greater speed in processing, smaller chips, shorter wavelengths, and emergence of excimer lasers is currently driving strong demand for echelle gratings.
An Attractive Portfolio With Limited Cyclicality
Management has targeted a business mix of 35% Life Sciences, 25% Optical, and 40% Measurement and Control, versus 34%, 23% and 43%, respectively, as the current revenue breakout. Thermo is accelerating its internal top-line and operating margins by shifting more business into higher growth life sciences and telecommunications markets. This mix has the additional advantage of having limited cyclicality.
Risks Seem Manageable
The successful completion of the reorganization and integration of acquired businesses are critical for Thermo’s future success. While the reorganization is almost complete, the final steps remain time consuming and a drain on management attention, creating the risk of management losing sight of current operations. We think this risk is manageable because most of these issues are largely confined to the executive level. The addition of a new, operationally focused COO further mitigates the risk. We estimate that Thermo has roughly $8 per share of value that could be realized through potential divestitures, spin-offs and publicly traded subsidiaries. Predicting the value of a potential spin-off can certainly be tricky, especially if it is a small-cap company like Thermo Fibertek, and limited liquidity can weigh on valuation in the near term. The proposed transactions might not realize the value we expect, or they could be delayed as management holds out for higher value. In any case, this potential value is quite small relative to our price target. Perhaps the greater risk is that management would delay the actions. However, based on our impressions, this is unlikely.
(J.P. Morgan is acting as financial advisor to Thermo Electron (TMO) in connection with the proposed reorganization plan of the company announced on January 31, 2000. The proposed reorganization is subject to shareholder and regulatory approval. This research report (first call) and the information herein is not intended to provide voting advice, serve as an endorsement of the proposed transaction or result in procurement, withholding or revocation of a proxy or any other action by a security holder.) |
