Ron Baron on Community Health, Covance Inc., IDEXX Labs, Lamar Advertising, Mettler Toledo and Mohawk Industries
Community Health (CYH)
Community Health is a $1.4 billion equity market cap operator of nonurban and midsized market for-profit hospitals with 118 facilities in 29 states. Community’s business model has been to acquire three or four poorly performing, undercapitalized not-for-profit hospitals annually. It then improves those hospitals by adding physicians, upgrading infrastructure and addressing higher acuity patient care; reversing patient outmigration; and growing admissions. Due to disciplined cost and capital spending controls, Community has a strong track record of revenue and margin growth at its facilities. Given its size, and the 2007 acquisition of 51 hospitals, Triad could be considered a break with this model. We believe Community is on track to be just as successful on this larger canvas.
Community’s stock has been under pressure as investors worry that even healthcare demand, once considered inelastic, will be pressured by unemployment and the rising number of uninsured. While we are watching admissions, bad debt and payor mix trends carefully, we believe the company, sole provider in 65% of its markets, is uniquely positioned to weather the storm. Community, in our view, has the opportunity to increase its 50% share of the $28 billion healthcare spend in its markets through ER upgrades and physician recruiting. In 2008 alone, the centralized, bonused recruitment team signed close to 1,500 new doctors, representing around a net 6-7% addition to the company’s physician base. Once established, we think these doctors, along with service and facilities investments could help support 1 – 2% admissions growth. Community’s recruiting focus, in our view, was likely responsible for its bucking dismal third quarter industry trends, reporting same store admissions and revenues +2.3% and +5.7% respectively, while guiding to 20% 2009 EPS growth. Recruitment for the class of 2009 looks encouraging.
Community’s $8.9 billion debt has also been a focus of investors despite what we believe is its strong cash flow, comfortable covenant cushion, adequate access to capital, and no material debt maturities until 2014. Management demonstrated its acumen after its 1996 leveraged buyout and we expect them to repeat that performance by growing operating cash flow and reducing Triad’s capital expenditures.
We believe over the next several years Community can more than double its earnings through a combination of modest top line growth, margin expansion at maturing facilities and deleveraging. With a normalized multiple, we believe we have an opportunity for significant gains. (Susan Robbins)
Covance Inc. (CVD)
Covance is a leading contract research organization (CRO) that we have long admired. When its share price dipped below our $2.5 billion market cap limit, we bought shares. Covance is one of the only CRO’s that provides the complete spectrum of outsourced drug development services to the pharmaceutical and biotech industries, from preclinical animal model studies to the management of global Phase IV drug trials with thousands of patients. This year Covance announced a groundbreaking ten year $1.5 billion strategic outsourcing deal with Eli Lilly. The agreement, which included dedicated space agreements, guaranteed contract minimums and the permanent transfer of both staff and infrastructure to Covance confirmed to us that unsustainable cost structures and looming patent expirations are forcing pharmaceutical companies to make fundamental changes in the way they develop drugs. We think Covance’s business should benefit as it is increasingly seen as a trusted and capable partner able to bring compounds to the market quicker and at lower cost. Research and development is the lifeblood of the pharmaceutical industry, reaching an estimated $80 billion in 2008; it has grown around 10% a year for the last three decades. Around 27% of this spend is now outsourced, a penetration rate we believe will grow. As one of just a few CRO’s with the global presence and scale to handle increasingly large, complex and multi–continent trials, Covance, with $2 billion in annual sales, and about $4.2 billion in backlog — 36% in take or pay dedicated contracts — is positioned, in our view, to benefit and gain share as pharma continues to narrow its preferred vendors. Covance’s balance sheet is strong with over $200 million in cash and no debt.
Despite the challenge presented by near term currency headwinds, a slowdown in early stage research as clients focus on getting late stage products to the marketplace, and a difficult environment for biotech funding, we see the long term picture for Covance as bright. (Susan Robbins)
IDEXX Labs (IDXX)
IDEXX Labs is the market leader for animal health diagnostics, and is the only company offering an integrated portfolio of in-clinic diagnostic equipment, rapid assays, outsourced reference laboratories and practice management tools. Despite headwinds from the economy, we continue to believe that the veterinary health market is in the early stages of a fundamental shift in the way that people care for their pets. Owners “humanize” their animals, and are consequently now demanding veterinary care at similar levels to human health care with only moderate regard to cost. Veterinarians have responded by offering an expanded array of animal health care services with an increased emphasis on preventative medicine. Favorable demographics including demand, in our view, from empty nest baby boomers and an increasing tendency for young professionals to defer children and instead purchase animals, should also help to accelerate the trend.
We believe that IDEXX is well positioned to capitalize on these strong secular trends. The company has roughly 65% market share of the in-clinic diagnostic instrument installed base, over 80% of the rapid assay market, and about 30% of the outsourced reference lab market. We expect IDEXX to gain share in in-clinic diagnostics with the launch of its nextgeneration blood chemistry platform, branded the CatalystDx. Catalyst, launched in late 2008, has three times the throughput of the current generation of machines, allowing vets to test more samples, practice better medicine, and run their practices more efficiently. Since IDEXX’s in-clinic diagnostic platform is a “razor/razorblade” business, we expect new Catalyst placements will also drive more sales of IDEXX’s high margin consumable slides. Similarly, we believe that Idexx’s robust R&D capabilities and focus on innovation will help it add new, differentiated tests to its suite of SNAP rapid assays and reference lab tests, helping it to grow its business at double digit rates over the long term. (Neal Rosenberg)
Lamar Advertising (LAMR)
Lamar Advertising is the third largest outdoor advertising business in the United States, with more than 150,000 billboard displays. Lamar focuses on smaller markets (top 50-250 markets), where it has aggregated market shares as high as 80-90%, offering pricing power. Zoning for new displays is difficult, providing high barriers to entry.
Unlike most traditional media, outdoor advertising has seen little audience erosion, enabling it to gain advertising share over time. Technology has benefited outdoor, as new digital displays accommodate more advertisers rotating on the same display, allowing them to modify their messages more frequently, and more easily. The result has added demand for outdoor advertising. Returns on investment for Lamar have been quite attractive for these digital conversions.
While outdoor has continued to gain market share from other media — notably television and newspapers — it has not been immune to what has become the worst advertising environment in decades; still, Lamar’s revenue shortfalls have been far less than those of other media. This is because a large percentage of its revenues are obtained from state directional boards like “McDonald’s, next exit.” In better times, Lamar had taken on what appeared to be reasonable debt levels to make acquisitions, invest in digital conversions, and return capital to shareholders through buybacks and dividends, beyond what its organic free cash flow generation would have supported. As credit markets froze and advertising demand weakened late last year, financial leverage became a concern, and Lamar shares came under severe pressure. The stock price fell from the mid-$60s in 2007 to the mid-teens toward the end of 2008. We began purchasing shares after it had fallen sharply.
Management is the fourth generation of the Lamar family, which founded the company more than 100 years ago. While each business cycle is different, management has considerable experience managing through difficult times. Lamar has taken steps to cut costs and reduce capital expenditures, to avoid the need to renegotiate borrowing terms with its lenders. While it is not yet clear how long this economic and advertising downturn will last, free cash flow generation remains ample, and Lamar should be well positioned for an upturn. We expect its business to rebound when the economy recovers, as it has previously, and Lamar can continue to outgrow other media. Profits should grow faster than revenue, which should, in turn, drive attractive share price appreciation. (Rich Rosenstein)
Mettler Toledo (MTD)
Mettler Toledo is the world’s leading provider of weighing instruments for use in laboratory, industrial and food retailing applications. The company has a track record of generating consistent growth. Since going public in 1997, the company’s earnings have increased at a compound annual growth rate of 20 percent. The business has attractive financial characteristics, including high returns on invested capital and strong free cash flow, which the company has historically used to repurchase its own stock. Concerns about the company’s exposure to the weak economy led to a decline in the stock price from a peak of $110 in July 2008 to the $60s. In our view, the correction in the stock price provided us with an opportunity to acquire a great business at an attractive price.
We believe that Mettler’s business should be able to weather the tough economic conditions, and that once economic conditions improve, Mettler will return to its strong track record of consistent earnings growth. Mettler’s largest end markets are pharmaceutical companies, food manufacturers and food retailers, which tend to be more stable in economic downturns. Mettler also has a large installed base of 100,000 instruments which require regular servicing through annual contracts. Service revenue accounts for roughly 23% of total revenue, and disposable revenue adds another 10% to the revenue base, resulting in roughly one-third of total revenue coming from recurring sources. Mettler’s large installed base provides both a replacement and an up-sell opportunity. Mettler only services 50% of its installed base, providing an opportunity to increase its service penetration rate.
Emerging markets, which represent 25% of Mettler’s sales, have been a key growth driver for Mettler as multinational customers increase investment in China, and Chinese companies seek to benefit from the rapidly expanding export market. Another key growth driver has included the company’s market leading product inspection business, which consists of metal detectors and x-ray visioning equipment. Growth in this business has been driven by increasing food safety and consumer protection requirements. Mettler also recently introduced a new product to automate the dosing process in the laboratory. We believe this new product is an example of the company’s strategy of “hitting singles” and should enhance the growth rate and the margin profile of the company’s laboratory instruments business since the product includes a high margin, consumable stream of revenue. (Neal Kaufman)
Mohawk Industries (MHK)
Mohawk Industries is the largest supplier and distributor of flooring in the United States with a 24% market share. We believe Mohawk is an exceptionally well-run company that is poised to benefit from an eventual recovery in the housing and commercial construction markets. Mohawk has several competitive advantages. CEO, Jeff Loberbaum, and family have been in the flooring business since the 1950s and own approximately 20% of the company. Management’s experience has resulted in a highly efficient operation (mid-teens free cash flow yields) and a relatively clean balance sheet (no debt maturities until 2011 and no covenant issues). Mohawk operates in a duopolistic industry (Mohawk and number two competitor Shaw control approximately 50% of U.S. flooring) which has historically allowed for price increases. Mohawk has raised prices several times in the last five years, most recently in the third quarter of 2008.
Mohawk is a leader in all three of its business segments: (i) Mohawk (carpets/ rugs) — second at 24% market share, (ii) Dal-Tile (ceramics) — number one at 30% market share with next closest competitor at 6% market share, and (iii) Unilin (hardwood/laminate) — leading market share. We believe Mohawk has an opportunity to continue to gain market share as many of its competitors are less well-capitalized (management has been acquisitive in the past).
Management has assembled a major distribution network (300 distribution points, over 2,300 sales representatives, 900 trucks) without committing capital to buy/own retail stores. Most retailers buy the bulk of their flooring products from Mohawk in return for Mohawk providing marketing, sales training, software, etc.… We believe margins are poised to rebound with the recent correction in oil prices — 65% of the cost of carpets is petrochemical-based and carpets are approximately 50% of sales. We began acquiring shares in Mohawk following a significant decline in its stock price from a high of $103 per share to a recent price of $35 per share. We believe Mohawk should benefit from an eventual improvement in new construction, residential remodeling, and commercial activity. (Jeff Kolitch)