Thermo's New Lab Partner

S&P thinks the proposed splice of Thermo Electron with Fisher Scientific could result in a life-sciences leader

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From Standard & Poor's Equity Research

We believe the proposed merger of Thermo Electron (TMO; recent price, $37) with Fisher Scientific would create a life-sciences powerhouse, offering the most extensive product roster to the life-sciences industry. Products and services for the proposed company would range from sample preparation and analysis to data interpretation and storage.

The combination, in our view, would also form a highly diversified company with a significant global footprint. We believe the breadth of products and services, along with an extensive and well-established global presence in over 150 countries, would be unmatched in the industry.

We think the new company, to be called Thermo Fisher Scientific, would have a significant competitive advantage, as we believe pharmaceutical firms will continue to consolidate their supplier/vendors and to re-evaluate supply chain management, putting significant pressure on smaller businesses without the new company's anticipated array of products.

TRIMMING DOWN. Although a transaction of this size should present some integration challenges, we believe the management teams of both companies are highly experienced in successfully integrating companies. We have a 5 STARS (strong buy) recommendation on Thermo Electron, and a 12-month target price of $52.

On its own, Thermo Electron is a worldwide provider of analytical instruments, scientific equipment, services and software solutions for the life sciences, drug discovery, environment and industrial laboratories end-markets. Through a major restructuring initiated in 2000 and completed in 2002, Thermo spun off or sold numerous companies, such as paper-recycling and medical-products businesses, that it didn't believe fit with its core strategic businesses. It has also been very active in growing its business internally through a robust research and development effort and, externally, through numerous strategic acquisitions.

The company, as currently constituted, now reports its business in two principal segments: Life & Laboratory Sciences, which accounts for about 75% of sales, and Measurement & Control, which accounts for the remaining 25%.

GROWING MARGIN. Life Sciences instruments and supplies are used primarily by pharmaceutical and biotechnology companies for drug discovery and development. Instruments include mass spectrometers, chromatographers, and optical spectroscopy. Measurement & Control instrumentation serves the industrial endmarkets and government agencies for process control and optimization and for environment monitoring, safety, and security.

Assuming the Thermo-Fisher merger is consummated as planned, we project sales of $9.3 billion in 2007, which would make the new entity the leader in the life-sciences industry. We see adjusted operating margins expanding 400 to 500 basis points within three years, to about 19% to 20%. Thermo's adjusted operating margin grew from 12.7% in 2004 to 14.1% in 2005, and we see further expansion to 14.9% in 2006, inclusive of stock-option costs. This improvement is a result, in our view, of new product introductions, improved productivity, cost-savings synergies from past acquisitions, and operating and sales leverage.

We think both companies have proven track records in acquiring and integrating acquisitions. Although this would be by far their largest transaction, we believe the management teams are highly experienced and capable of successfully integrating their operations and realizing savings and synergies beyond these estimates. (Note: The companies gave estimates of $150 million in cost-saving synergies and $50 in revenue synergies within three years of the merger.)

BETTER BLEND. Although life-sciences products will generate the bulk of revenue, the combined company is expected to continue to have a strong presence in the industrial and health-care endmarkets. Demand from the industrial endmarkets within Thermo's Measurement & Control unit are growing rapidly, we think, due to capacity expansion in the production of commodity materials, along with the continued build-up in worldwide power generation and stricter air-quality regulations. Health-care endmarkets should provide a stable source of sales and cash flow.

We also view favorably the revenue product mix expected from the combined company, which should consist of about 56% consumables, 28% instruments, and 16% services and software, vs. Thermo's current revenue breakdown of 8% consumables, 56% instruments, and 35% services and software. We anticipate that the increase in consumables would remove some of the cyclicality of instrument sales.

The company would also have a significant global reach, with over 7,500 sales personnel in over 150 countries, including a strong presence in rapidly growing Asian markets such as China and India. Thermo recently built large facilities in Shanghai, China and Mumbai, India.

VITAL SIGNS. Separate from the external growth created through acquisitions, Thermo has an extensive and highly successful research and development operation. The company develops numerous new products each year, which is important to revenue growth and margin expansion, since new products typically carry higher price tags and margins.

Thermo measures its R&D efforts with a metric it calls the "vitality index," which is the percentage of sales derived from products introduced in the past two years. The vitality index has improved significantly over the past few years, from 15% in 2003 to 20% in 2004, and to 23% in 2005. We believe TMO can continue to improve this key metric over the next several years, to about 30%. However, post-merger, this metric should fall significantly, as the addition of Fisher Scientific's revenue would likely dilute the percentage.

Thermo Electron adopted accounting standard SFAS 123R beginning on January 1, 2006, and expenses the value of employee stock options. We estimate 10 cents per share in stock-option expense in 2006.

TARGET PRACTICE. We believe the shares are attractively valued, trading at about 16 times our 2007 pro forma earnings per share (EPS) forecast of $2.30 (assuming consummation of the Fisher Scientific merger), inclusive of stock-option expense. Although we anticipate some integration risk with Fisher Scientific, we believe at current levels Thermo is undervalued due to superior revenue and earnings growth potential and prospects for significant margin expansion.

The stock recently traded about 29% below our 12-month target price of $52, which is based on our discounted cash flow and p-e-to-growth analyses. Our DCF model uses a weighted average cost of capital of 9.6% and a terminal growth rate of 3%. Our P/E-to-growth analysis uses a PEG ratio of 1.4 (based on our 2007 pro forma EPS estimate), slightly below peers, as we take potential integration issues into account.

We have a neutral view of Thermo's corporate-governance practices. We view positively that the board is controlled by a supermajority of independent outsiders (over 75%) and that the nominating, compensation, and audit committees are comprised solely of independent outside directors. However, the chairman is an affiliated outsider and the board is authorized to increase or decrease the size of the board without shareholder approval. Further, new directors added to the board to fill vacancies may not be up for shareholder election at the next annual meeting. The company also has a poison pill in place, with a trigger of less than 20%.

CONSOLIDATING FIELD. There are several risks to our recommendation and target price, in our opinion. The primary risk would be failure to consummate the proposed merger with Fisher Scientific. Despite management's significant experience in acquiring and integrating companies, the planned merger is by far its largest transaction. Integration of operations of this size carry significant inherent risks, including possible culture clashes.

We expect consolidation within the life-sciences industry to continue and perhaps accelerate. We wouldn't be surprised to see additional transactions involving analytical-instrument manufacturers and life-sciences consumables companies potentially forming sizable competitors to the new entity.

A significant slowdown within the life-sciences industry predicated by reduced research and development spending by pharmaceutical companies, and a continued, or further, softening in worldwide government funding of research, academic, and government institutions would affect the company.

Analyst Loo follows shares of scientific-equipment companies for Standard & Poor's Equity Research Services

All of the views expressed in this research report accurately reflect the research analyst's personal views regarding any and all of the subject securities or issuers. No part of analyst compensation was, is or will be, directly or indirectly related to the specific recommendations or views expressed in this research report.
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