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Ron Baron on Varian Medical (VAR), Ecolab (ECL), Edwards Lifesciences (EW), CheckFree (CKFR), Whole Foods (WFMI), Helmerich & Payne (HP) and CarMax (CMX)

Ron Baron on Varian Medical (VAR), Ecolab (ECL), Edwards Lifesciences (EW), CheckFree (CKFR), Whole Foods (WFMI), Helmerich & Payne (HP) and CarMax (CMX)

Ron Baron invests in small and mid-size growth companies. He likes companies with open-ended growth opportunities and defensible niches. He applies a bottom-up company research, invests for long term, and tries to purchase companies at what he believes are attractive prices.

Baron has been heavily investing in health care stocks. He said, "The most important theme, one of our megatrends, in which we invested was a beneficiary of our aging population; the theme, of course, was efficient providers of quality healthcare services and products".

These are his commentaries on healthcare stocks Varian Medical (VAR), Ecolab (ECL), Edwards Lifesciences (EW), and some of his opportunitic purchases such as Whole Foods (WFMI), Helmerich & Payne (HP) and CarMax (CMX).

Varian Medical (VAR) (Market cap $6.1 billion)

Varian Medical is on the cutting edge of cancer radiation therapy (RT) and the dominant player in the global RT equipment market. With placements at 78% of the top fifty U.S. cancer centers, Varian technology gives physicians the ability to precisely target tumors with intense, previously toxic, amounts of radiation while sparing surrounding healthy tissue. This reduces side effects, shortens treatment duration, improves patients’ quality of life, and allows treatment of cancers once deemed inoperable. RT, often in combination with other treatments, is already being used to treat 50% of diagnosed cancers and is contributing to improving five year survival rates; we believe this percentage could reach 70%-80% over time. Unfortunately, due to our aging population, cancer is a growth industry with new cases projected to increase by 50% to 15 million annually by 2020.

Varian has a history of innovation. In 1993, it pioneered the most significant change in RT since radiation was first used to kill cancer cells 100 years ago. IMRT (Intensity Modulated Radiation Treatment) lets physicians modulate an x-ray beam’s intensity, sculpting it to conform to an actual tumor. It is now considered the standard of care. In 2004, Varian followed up with IGRT (Image Guided Radiation Therapy) which allowed monitoring of tumor size and positioning by incorporating imaging modalities directly into treatment.

Varian’s newest product is Trilogy, a radio surgery machine that targets tumors so precisely and intensely that treatment can be administered safely in a single session. We believe radiosurgery, with its particular applications in head, neck, spine, lung and prostate cancers will ultimately take share from traditional surgery, reducing overall healthcare costs, and improving outcomes. Varian’s recent $30 million acquisition of privately held ACCEL places it in the forefront of what many believe is the next significant innovation— proton therapy. Varian’s equipment innovations have been accompanied by similar advances in software development; it is the only fully integrated provider in the marketplace. Complex treatment plans, which once took specially trained nuclear physicists days to prepare, can now be completed in a matter of hours. Innovation begets pricing power—a customer buying a $3.0 million Trilogy is paying two and a half times Varian’s average transaction price in 2001.

We believe further penetration of existing markets driven by equipment replacement and upgrades on its 4,750 machine base, increases in cancer incidence, and demand from emerging markets will allow Varian to grow revenues in the mid-teens for at least the next several years, supported by its $1.4 billion backlog. IMRT uptake came about three years after its introduction, and now has around a 60% global share, and represents 98% of new orders. IGRT experienced a three times faster ramp with 325 installations at year end and a 20% increase in U.S. sales in the December quarter. We believe international IGRT adoption, in typical pattern, will lag the U.S. by two to three years, and could ultimately achieve similar penetration to IMRT. Of the 15% of Varian’s $1.6 billion fiscal 2006 revenues from nononcology sources, it has a small, but, we think, fast growing x-ray tube and flat panel digital image detector manufacturing business; investors also have a homeland security option in Varian’s Security and Inspection division, where its powerful scanning technology is capable of rapid screening cargo for explosives or other dangerous materials.

Varian has $300 million net cash. Since 1999, Varian has repurchased nearly $1 billion of its stock, a practice we expect will continue, spending $271 million in fiscal 2006 alone, against $202 million in cash flow from operations. We believe Varian has the potential to double its revenues and earnings over the next four to five years. (Susan Robbins)

Ecolab (ECL) (Market cap $10.8 billion)

Ecolab sells cleaning products and services to restaurants, hotels, food and beverage producers, healthcare facilities and other businesses. We believe Ecolab’s business model has attractive financial characteristics: consistent growth, predictable results, high returns on capital and strong free cash flow generation. Ecolab’s business has these characteristics because its end markets are stable and growing; because its products need constant replenishment and are delivered through proprietary dispensing devices, thereby driving recurring revenue; and because Ecolab has built a sustainable competitive advantage through its high level of customer service. Ecolab has more than 13,000 territory managers around the world who visit customer sites on a regular basis. These territory managers ensure systems are working correctly, make emergency service calls, and sell additional products and services. Customers are typically high-volume businesses where cleanliness is critical and failures in core processes like warewashing can be disastrous. The cost of cleaning products is a small part of the customer’s total budget, and we have found that customers are willing to pay Ecolab’s premium price to obtain peace of mind.

Ecolab’s only significant competitor, Johnson Diversey, announced in March 2006, that it was changing to a pure distribution model from a high-touch service model in the U.S., effectively leaving Ecolab as the only full-service provider of cleaning and sanitizing solutions in the U.S. Since then, Ecolab has been capturing market share. Management has sized the opportunity to capture share in the U.S. at approximately $150 million, with the possibility, in our view, of reaching $600 million through cross-sell initiatives. Further, we believe Ecolab can capture share outside the U.S., which we estimate represents a $1 billion opportunity.

We also believe Ecolab can triple its sales just by cross-selling additional products and services to its extensive existing customer base. In particular, we think Ecolab should be able to expand its commercial pest control business outside the U.S. and grow its commercial kitchen equipment repair business, which is currently unprofitable, at attractive profit margins.We also believe Ecolab has a large market opportunity in healthcare where Ecolab offers solutions to address the problem of hospital-borne infections, a major public health issue. In total, Ecolab’s market opportunity is $39 billion, and Ecolab has only 12% share despite being the market leader. (Neal Kaufman)

Edwards Lifesciences (EW) (Market cap $2.9 billion)

Edwards Lifesciences is the leading manufacturer of tissue heart valve products, which are used to replace or repair a patient’s diseased or defective heart valve. The heart valve market, which includes both mechanical and tissue heart valves, is a $1 billion plus market growing 5%, driven by the aging of the U.S. population. Edwards is the market leader in tissue heart valves, which offer significant quality of life advantages over mechanical valves because mechanical valves require patients to take blood thinners whereas tissue valves do not. Edwards specializes in pericardial bovine tissue valves, which have demonstrated superior performance and durability and therefore carry a premium price over both mechanical and porcine tissue valves. High barriers to entry exist in Edwards’ tissue heart valve business because cardiac surgeons select products based on performance and durability, and we think it would take a competitor many years just to bring a pericardial tissue valve to market and then many more years to demonstrate comparable performance and durability. We expect Edwards’ core tissue heart valve business to continue to grow faster than the market as the company takes share from mechanical heart valves and porcine tissue heart valves.

What really excites us about Edwards is the market opportunity in transcatheter heart valve replacement and repair. Edwards has been investing substantial resources to develop minimally invasive, catheterbased heart valve repair and replacement procedures. If successful, these new procedures would expand the treatable population to include patients considered too high risk to withstand traditional open-heart surgery and would open a new multi-billion dollar market opportunity for Edwards. Edwards has intellectual property protection in this area and we think it is well ahead of its largest competitors in its research efforts. Edwards just received FDA approval to initiate a pivotal clinical trial for its transcatheter aortic valve replacement procedure, which could reach the U.S. market in 2010 to 2011. We believe this new approach has the potential to transform the heart valve market and Edwards Lifesciences, and we areconfident that Edwards will be successful. (Neal Kaufman)

CheckFree (CKFR) (Market cap $3.2 billion)

CheckFree is the country’s leading processor of electronic bill payment and presentment (EBPP) transactions, offering products that enable consumers to receive and pay their bills online rather than using traditional paper checks. End users typically access CheckFree’s bill payment platform through their online banking website, and can also make payments via CheckFree’s network of walk-in locations, or over the phone. The EBPP industry was conceived by CheckFree founder and CEO, Pete Kight, in the early 1980s, and has exhibited almost 40% annual transaction volume growth for the past five years. Despite this rapid historical growth, we believe that electronic bill pay is still in its early phases. CheckFree, which counts nine of the eleven largest U.S. banks as its customers, processed 1.1 billion online payments in 2006, which is just 5% of the 21 billion total payments made last year. We estimate that just 20% of customers at the largest U.S. banks are currently paying at least one bill online, with the most penetrated bank (Bank of America) only seeing 30%-35% of its customers making online payments.

We see several catalysts driving the continued adoption of electronic payments over the next five to seven years. We believe that consumers will prefer the ease, convenience and cost savings of paying bills online relative to the hassle of sitting down and writing out paper checks. With most large banks offering customers free online bill payments, the average American would save almost $60 per year in stamp costs by switching to electronic payments from paper checks. Increased Internet availability should also help drive electronic payment adoption. Just 70% of the 110 million U.S. households currently have an Internet connection, and just 60%-70% of households with Internet connections have broadband, which is the largest prerequisite for online bill pay. Broadband connections are expected by industry consultants to grow 8% annually over the next several years, we think likely leading to a corresponding increase in CheckFree’s addressable market. Finally, banks have a financial incentive to convert customers to online bill pay. In general, banks find online bill payers to be 31% more profitable than off-line payers due to increased customer stickiness, higher average loan and deposit balances, and lower processing costs. Since CheckFree is paid on a per-transaction basis, we believe that the company is well positioned to convert rapid annual transaction growth to double-digit revenue growth at high incremental margins.

Over the longer term, we expect electronic bill delivery (e-bills) to become an increasingly important part of CheckFree’s business model. E-bill acceptance is currently low, with CheckFree delivering just 185 million e-bills in 2006, less than 1% of the total bills delivered nationwide over the same period. However, billers recognize almost $1 in savings for each bill delivered electronically rather than in hard copy, and we expect them to start aggressively pushing e-bills toward their customers in order to recognize this savings. Just like electronic payments, e-bills are significantly faster, more efficient, and “greener” for consumers, and we expect consumers to start to demand e-bills as they experience the benefits. In our view, the inevitable acceleration in e-bill deliveries will shift much of CheckFree’s revenue stream from its bank customers to its biller customers, thereby helping to ease the pricing pressure currently present in the company’s electronic payment business. (Neal Rosenberg)

Whole Foods (WFMI) (Market cap $6.3 billion)

During the quarter, Whole Foods announced the acquisition of its struggling competitor, Wild Oats. Though the deal is likely to weigh on earnings for a quarter or two as Whole Foods invests in remodeling and rebranding the Oats stores, we think the longer-term opportunity to turn around 110Wild Oats stores, avoiding the cost and difficulty of greenfielding, is compelling. Whole Foods currently achieves $900 in sales per square foot, produces low doubledigit comparable store sales, and records an operating margin approaching 6%. In comparison, Wild Oats does $425 per square foot, has low single-digit comps, and registers an anemic operating margin of 1.5%. Basically, Whole Foods is a much better operator across the board.

Therefore, we believe that any short-term pain is outweighed by the opportunity not only to recognize significant synergies through cost savings and greater purchasing power, but also to vastly improve the productivity of the Wild Oats stores. While Whole Foods admittedly trades at a high valuation, it remains the originator and clear leader of the organic foods business. The acquisition of Wild Oats will further strengthenWhole Foods’ competitive advantage, while reinforcing our conviction in the longterm opportunities for the company. With Whole Foods aggressive expansion plan projecting current profits and The Wild Oats acquisition creating consistency, Whole Foods’ stock price fell in the period and we increased our investment. (Alexandra Meier)

Helmerich & Payne (HP) (Market cap $3.1 billion)

Helmerich & Payne had a relatively quiet quarter from an operations standpoint, but after falling nearly 5% more last summer the shares began to rebound after we bought shares. A cold February drove natural gas heating demand and helped to ease the natural gas storage overhang that threatened drilling activity early this winter. Furthermore, late in the quarter, the threat of confrontation with Iran focused investor attention on the possibility that the supply of oil from the Middle East could be disrupted. The company’s core U.S. land drilling business held up much better during the slowdown in energy markets in the past year than that of competitors who saw weakness in demand for their older, less efficient equipment. Finally, H&P announced two more newbuild contracts during the quarter bringing the total number of rigs in its current newbuild program to seventy-five. (Geoff Jones) Iron Mountain (Market cap $5.2 billion) Iron Mountain shares declined 5% during the March quarter after the company provided 2007 cash flow guidance that disappointed investors. Although Iron Mountain has consistently reported strong revenue growth over the past six quarters, management has elected to reinvest in the business at the expense of near-term profit margins. We continue to have confidence in Iron Mountain’s management team and we continue to believe the company has robust longterm growth opportunities. In particular, we believe the company can leverage its extensive storage customer base to lead the market for digital archiving services, a market which we believe is poised to explode in light of recent amendments to the Federal Rules of Civil Procedure, which now require all businesses to produce all forms of electronic information including e-mail during civil litigation. (Neal Kaufman)

CarMax (CMX) (Market cap $5.3 billion)

Shares of used car retailer CarMax nearly doubled in 2006, as the company’s dealerships experienced accelerated sales and profit growth. The company has continued to add 15% new locations every year to its existing base of superstores. As the base has grown to over eighty stores in major metro markets, business has ramped across all classes, especially those dealerships over ten years old which are experiencing their first or second auto replacement cycle, typically every four to six years.

This suggests that the company’s market penetration continues to grow without signs of maturation. Furthermore, the company is benefiting from a mix shift to higher average selling prices, as customer demand has led CarMax into the luxury used and import segment, a category that represents 17% of sales today. CarMax is enjoying a relatively benign competitive environment from the new car dealers. This has widened the spread between new and the like-new cars that CarMax specializes in and makes the company’s no-haggle proposition to the consumer that much more relevant. The company is expanding into California, the largest auto market in the country, where it has just eight superstores today. Finally, we believe CarMax is benefiting from the leadership of a newly appointed CEO, Tom Folliard, a long tenured veteran who formerly oversaw store operations and breathes new life into this special retail concept. Over the past two quarters, CarMax posted double digit same store growth. The company’s auto finance business carries no exposure to sub prime lending since it only underwrites prime rated customers. (Matt Weiss)


Rating: 3.1/5 (17 votes)


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