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With Heightened Demand And Solid Growth Prospects, Life Science Tool Providers Are On Stronger Footing Than Before The Pandemic

Capital Markets View - September 2022

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With Heightened Demand And Solid Growth Prospects, Life Science Tool Providers Are On Stronger Footing Than Before The Pandemic

Our outlook on the life sciences tool industry is positive  The outlook primarily reflects our expectation that the subsector should have solid long-term growth prospects, relatively good earnings visibility given the highly recurring nature of their offerings, and limited pricing pressures compared to those of other health care subsectors. M&A continues to be a ratings overhang for the industry, but given the financial capacity created by COVID-19-related tailwinds and strong long-term growth prospects, positive rating actions could exceed negative ones in 2022 despite ongoing M&A.

In March 2021, we assigned positive outlooks to the two largest life science tool providers we rate: Danaher Corp. and Thermo Fisher Scientific Inc. Both companies announced large acquisitions in 2021, but like the broader industry, they've also well exceeded our projections for organic growth, profitability, and operating cash flow generation. This outperformance stemmed partially from increased demand due to the COVID-19 pandemic. While we anticipate the COVID-19 pandemic tailwind will eventually subside, we still expect most companies we rate within the industry to generate annual organic revenue growth (excluding COVID-19 tailwinds) in the mid- to high-single-digit percent area over the next several years while maintaining adjusted EBITDA margins higher than pre-pandemic levels.

Table 1

Life Sciences Tool Provider Ratings
Business risk profile Financial risk profile Active modifier Issuer credit rating

Thermo Fisher Scientific Inc.

Strong Intermediate CRA* (-1 notch) BBB+/Positive/A-2

Danaher Corp.

Strong Intermediate CRA* (-1 notch) BBB+/Positive/A-2

Agilent Technologies Inc.

Satisfactory Minimal CRA* (-1 notch) BBB+/Stable/A-2

Illumina Inc.

Fair Minimal -- BBB/Stable/--

Bio-Rad Laboratories Inc.

Fair Minimal -- BBB/Stable/--

PerkinElmer Inc.

Satisfactory Intermediate -- BBB/Negative/--

Ortho Clinical Diagnostics Holdings PLC

Weak Highly Leveraged -- B/Watch Pos/--
*CRA--Comparable rating analysis.

Demand for life science tools should remain strong well beyond the pandemic.  We expect most life science tools companies we rate to generate annual organic revenue growth (excluding COVID-19 tailwinds) in the mid- to high-single-digit percent area over the next several years. This incorporates our view that growth in the biopharma end market should be at the higher end of that range, with academic/government end markets growing at the lower end.

Growth in the biopharma sector has accelerated over the past few years due to research and development spending within the pharmaceutical industry, new breakthroughs and technologies (including gene therapy, CRISPR genome editing, and mRNA), and increased venture capital funding for emerging biotech firms. We also anticipate that number of large molecule drugs--such as biologics--will increase more quickly than smaller molecule drugs. This would be a continuation of recent trends (see Chart 1) and indicate more complexity in the research, development, and manufacturing of new drugs, which should bolster demand for more products and services offered by life science tool providers. In our view, Thermo Fisher is the most favorably exposed to the biopharma market based on our estimate that following its acquisition of PPD Inc. (which closed on Dec. 8, 2021), just over half of its revenue will be generated from that market. As such, we believe the company's organic revenue growth will likely be closer to the high-single-digit percent area over the next several years.

Academic/government research labs are the second-largest end market for most of the life sciences tool providers we rate. We expect annual demand growth in this market to be in the mid-single-digit percent area over the next few years, which is roughly in line with the historical growth rate in National Institutes of Health (NIH) funding. The NIH is the largest biomedical research agency in the world, and it deploys most of its budget for medical research conducted at universities, medical schools, and other institutions across the U.S. Because these institutions use many of the instruments and consumables offered by the industry (including microscopes, centrifuges, and flow cytometers), demand should generally increase with NIH funding. Over the past 25 years, NIH funding has grown at an average annual rate in the mid-single-digit percent area (see Chart 2). We expect growth to follow that trend over the next few years, particularly given that the pandemic has highlighted the importance of medical research to better understand and combat public health threats.

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We expect revenue related to COVID-19 testing to decline meaningfully, but demand from R&D of vaccines and therapeutics should be more durable.  The life science tools industry is among the few health care subsectors that had a surge in demand for its products since the COVID-19 pandemic started. At onset of the pandemic, the industry experienced modest earnings pressure due to temporary academic research lab closures and supply-chain challenges that delayed the installation and servicing of certain instruments. Since vaccines have become available, these adverse effects have largely receded with the relaxing of many travel restrictions around the world. As such, most academic labs reopened in the second half of 2020 and are currently operating near pre-pandemic capacity levels. Furthermore, end-market diversity helped mitigate these effects because the revenue exposure to academic and government labs was generally less than 25% for the life science tool providers we rate.

The more significant impact from COVID-19 on the life science tools industry was the strong demand for instruments and consumables used in the development and manufacture of COVID-19 vaccines and therapeutics and for COVID-19 testing solutions. Revenue and incremental margins from these COVID-19 tailwinds began in 2020, further expanded in 2021, and should begin to taper off this year. The organic revenue growth of PerkinElmer, Thermo Fisher, and Danaher was most tied to this demand due to their testing capabilities and--in the cases of the latter two--their involvement in most COVID-19 vaccines and therapeutic projects. The strong incremental margins associated with these tailwinds also contributed to an increase in adjusted EBITDA margins. In our view, COVID-19-related revenue for the industry peaked in 2021 and should gradually decline over the next few years. We assume testing revenue will drop off quickly over the next couple of years because vaccination rates have increased to more than 60% in most developed countries, and so COVID-19 testing is likely to play less of a role in public health measures. However, we believe demand for instruments and consumables tied to COVID-19 vaccines and therapeutics will be more durable over the next few years. This reflects our view that the threat from emerging variants and demand for vaccines will likely persist. Only about half of the global population has been vaccinated, and many countries are now recommending booster shots due to waning protection offered by vaccines after a few months. Moreover, many countries have authorized the use of a lower dose of the COVID-19 vaccine for children ages five to 11 in recent months, which should further bolster demand for vaccines. From a non-COVID-19 perspective, the placement of instruments for use during the pandemic will likely yield a stream of post-pandemic sales for companies as well.

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Profitability is expected to moderate over the next couple of years but generally remain above pre-pandemic levels.  The very strong organic revenue growth in the life science tools industry since last year--combined with the effects of operating leverage--has expanded EBITDA margins well above historical levels, which we believe peaked in 2021. As mentioned earlier, we anticipate much of the COVID-19 tailwinds will taper off over the next couple of years, which should result in a modest compression in EBITDA margins for companies with earnings that benefited most from COVID-19 (see Chart 5).

It's worth noting that some of the downward pressure we assume on margins is associated with the acquisition of lower-margin businesses, such as Thermo Fisher's acquisition of PPD Inc., Danaher's acquisition of Aldevron, and Illumina's acquisition of GRAIL. If we were to normalize for the effect of these acquisitions, we believe that forecast EBITDA margins beyond 2021 would be more clearly above pre-pandemic (2019) levels. Our base-case assumption is that organic revenue growth for instruments and consumables not related to COVID-19 should be in the mid- to high-single-digit percent area over the next few years. We believe this will generally contribute to modest EBITDA margin expansion of less than 50 basis points per year on average (excluding the decline of COVID-19-related revenue).

The life science tools industry, like many others, is facing challenges associated with global supply-chain disruptions and inflation. These include higher prices for electronic components and materials, higher freight costs, shipment delays, and labor shortages. Key mitigating factors for most of the companies we rate within the industry include leading market positions within their respective categories or niches and significant scale advantages. In our view, these characteristics provide for stronger negotiating power with suppliers and customers when compared to weaker incumbents. As a result, these companies are generally more able to pass through higher input costs to customers and better manage shortages in raw materials or labor, thereby limiting the impact on profitability. We also believe that their ability to manage these disruptions better than the competition could contribute to modest market-share gains in certain areas.

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Superior quality and local manufacturing capacity in China are key competitive advantages for life science tool providers.  The industry companies we rate typically generate 10%-20% of revenue from China, where we believe growth prospects are stronger than in many of the other regions they operate in, including the U.S. and Europe. With the "Made in China 2025" initiative launched in 2015, the Chinese Communist Party aims to substantially increase the market share of domestic firms in China in a range of core materials and products. We believe this policy puts foreign suppliers-- including many of the life science tool providers we rate--at a competitive disadvantage. However, most of these providers have a local manufacturing presence in China, and we expect they will continue to invest in the region to expand capacity as demand grows. Another significant mitigating factor is our view that many of the instruments and consumables offered by these U.S.-based companies are of much higher quality than those produced by local firms in China, at least for the time being. For these reasons, we expect the market share in China of the life science tool providers we rate to be relatively stable over the next few years, with revenue growing roughly in line with demand.

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M&A offers an opportunity for life science tool providers to strengthen their competitive positions but can present near-term execution and financial risks.  Over the past couple of years, there have been several sizable acquisitions announced (see Table 2). A common theme among most is that they primarily serve the biopharma end market--whether the targets focused on bioprocessing, DNA sequencing, contract research and development, or other areas. As mentioned earlier, we anticipate growth in demand within the biopharma end market to generally outpace others. Consequently, we believe that some life science tool providers' strategy is to expand into complementary products and services that better meet the needs of these customers. We believe this trend will continue, due in part to the competitive advantages and scale gained from these acquisitions. The industry remains relatively fragmented, and we believe there are potential revenue synergies given that customers, including the major pharmaceutical and biotech companies, continue to simplify their vendor relationships. That said, we think companies that announced large platform acquisitions recently are more likely to focus on smaller tuck-ins, at least in the near-term. In aggregate, we estimate that of the capital deployed for acquisitions, capital expenditures (capex), dividends, and share repurchases between 2021 and 2023 from the life science tool providers we rate, about 70% would go to fund acquisitions, with 2021 being the most active year. Assuming acquisitions and capex deployed improves a company's long-term competitive position, we consider it a more favorable use of capital--from a credit risk perspective--than dividends and share repurchase.

Most of the life science tool providers we rate have considerable room for further acquisitions within the respective ratings. This stems from the meaningful free operating cash flow generation, strong organic growth prospects, and leverage that is comfortably below our downside triggers in many cases. For example, we expect pro forma leverage at Danaher and Thermo Fisher to be well below our 3x upside trigger at the end of 2021, despite them having completed very large acquisitions since 2020, including PPD, Cytiva (General Electric's Bioprocessing business), and Aldevron. We assigned positive outlooks to Danaher and Thermo Fisher in March 2021, which continue to reflect our expectation for leverage to remain below 3x over the next few years. While we see some financial and execution risk from recent and potential acquisitions, we believe those risks are abating due to stronger-than-previously anticipated operating results through 2021, organic growth prospects, and a solid track record of integrating large acquisitions. In our view, these factors make an upgrade increasingly likely for these two companies within the next 12 months provided we gain more confidence in their willingness to generally maintain adjusted debt to EBIDTA below 3x over the longer term. While we recognize that the scale and timing of further M&A could lead to periods when leverage is above 3x, a higher rating could still be appropriate for Danaher and Thermo Fisher if we believe these periods will be temporary and supported by strong deleveraging prospects, robust free operating cash flow generation, and financial policies.

On the other hand, PerkinElmer doesn't have much capacity within the rating for further acquisitions based on our expectation for adjusted debt to EBITDA to be at or above our 3x downside trigger in 2022. This stems from its acquisition of BioLegend, the largest in its history. As a result, we assigned a negative outlook to PerkinElmer in July 2021. This reflects our view that we could downgrade the company if leverage remains above 3x through 2023, potentially due to additional acquisitions, increased share repurchases, a more severe decline in pandemic-related revenues, or unexpected missteps in integrating BioLegend.

Peer Comparison

Thermo Fisher and Danaher are the two highest-rated life science companies, reflecting both life science tool providers' leading size and scale, breadth of product offerings, customer bases, and geographic diversity. Both have leading positions in several markets, serve primarily the health care and pharmaceutical research markets, have been acquisitive, and have a solid track records of integrating acquisitions, as reflected in both companies' business risk profile assessments of strong, the only two in our rated life science universe. They also have strong discretionary cash flow generation that provides them with significant flexibility to fund future acquisitions and quickly reduce leverage following large transactions. We view Thermo Fisher as the slightly more aggressive of the two in terms of financial policy, as it's been more willing to temporarily let leverage increase further for an acquisition and pursue areas that are outside of its core focus areas, such as with its foray into the contract research organization (PPD) and contract manufacturing (Patheon) segments. However, management does have a lengthy and successful track record of entering new markets and integrating acquisitions. Danaher has traditionally been more financially conservative, though it has been more acquisitive of late. For both companies, we expect adjusted debt to EBITDA below 3x over the next few of years on a pro forma basis.

Compared to these two companies, Agilent is much smaller in size and scale, and its portfolio is much more limited. These factors limit the ratings and contribute to its comparable ratings adjustment of negative one notch. However, Agilent holds several leading market positions and maintains a more conservative financial policy, which support the 'BBB+' issuer credit rating.

Illumina has a relatively narrow operating focus in genome sequencing. Despite its moderate scale, leading position, and relatively conservative financial policies, its lack of product and business diversity contributes to an issuer credit rating of 'BBB', one notch lower than the ratings on Thermo Fisher, Danaher, and Agilent.

PerkinElmer has diversified end markets (it occupies the top-three positions within most of them) and moderate exposure to some more cyclical industries. However, the company is much smaller in terms of size, scale, and market reach than Danaher and Thermo Fisher. As a result, the rating is one notch lower. Furthermore, we revised the outlook on PerkinElmer to negative in July 2021 based on our expectation that its acquisition of BioLegend will result in adjusted debt to EBITDA at or above 3x in 2022.

Bio-Rad serves several end markets and has a strong market position in many of them, but it's smaller, has lower margins, and has less exposure to faster-growing industries than PerkinElmer. That said, our issuer credit rating on Bio-Rad is 'BBB', the same as PerkinElmer, based on our view that its weaker business risk profile is offset by lower expected leverage (it currently has no debt), supported by a more conservative financial policy.

Ortho-Clinical has the lowest rating in this peer group due to its weaker competitive position and higher debt leverage. Despite the company's leading position as a provider of in vitro diagnostic (IVD) solutions for screening, diagnosing, and monitoring diseases, we believe its long-term growth prospects remain limited. This is due to our view that the IVD market is mature and that revenue will be constrained by modest pricing pressure. We put the Ortho-Clinical ratings on CreditWatch with positive implications in December 2021 following the announced acquisition of the company by Quidel Corp. (unrated), given the prospect of being part of a larger, more diverse organization with a lower leveraged financial profile.

Table 2

Recent Acquisitions
Date completed Acquirer Target Approximate transaction value (Bil. $) Type of transaction
Dec. 30, 2021 Thermo Fisher Scientific Inc. PeproTech Inc. 1.85 Developer and manufacturer of recombinant proteins
Dec. 8, 2021 Thermo Fisher Scientific Inc. PPD Inc. 20.9 Contract research organization
Sept. 17, 2021 PerkinElmer Inc. BioLegend 5.25 Developer and manufacturer of antibodies and reagents used in biomedical research
Aug. 30, 2021 Danaher Inc. Aldevron 9.6 Manufactures plasmid DNA, mRNA, proteins, and antibodies used in cell and gene therapies
Aug. 18, 2021 Illumina Inc. GRAIL 7.1 DNA sequencing
April 15, 2021 Agilent Technologies Inc. Resolution Bioscience Inc. 0.55 Next-generation sequencing-based precision oncology solutions
April 1, 2021 Bio-Rad Laboratories Inc. Celsee Inc. 0.16 Manufacturer of instruments and consumables for the isolation, detection, and analysis of single cells
Feb. 25, 2021 Thermo Fisher Scientific Inc. Mesa Biotech Inc. 0.5 Molecular diagnostic company
Jan. 15, 2021 Thermo Fisher Scientific Inc. Groupe Novasep SAS 0.8 European viral vector manufacturing business
March 31, 2020 Danaher Inc. Cytiva (biopharma business of General Electric Co.) 20.7 Leading provider of instruments, consumables, and software that support the research, discovery, process development, and manufacturing workflows of biopharmaceutical drugs

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This report does not constitute a rating action.

Primary Credit Analysts:Alessio Di Francesco, CFA, Toronto + 1 (416) 507 2573;
alessio.di.francesco@spglobal.com
Adam Dibe, Toronto + 1 (416) 507 3235;
adam.dibe@spglobal.com
Secondary Contact:Arthur C Wong, Toronto + 1 (416) 507 2561;
arthur.wong@spglobal.com

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