Becton Dickinson (BDX)

February 10, 2012 — Leave a comment

A hat tip to Matt Mandel of the Mandel Capital Blog for sharing his thoughts on Becton, Dickinson & Co. (BDX). It’s an excellent piece of high-level analysis steeped in a fundamental premise with which I could hardly agree more: when you find good companies priced fairly by the market, buy them!

My own analysis has BDX trading around 14.5x its previous year owner earnings and that it has compounded those earnings at an annual rate of 14.1 percent since 2004. It did this while maintaining a healthy balance sheet (i.e., debt it can easily manage based on its cash flows) and returns on equity hovering around 20 percent. Not bad at all.

We can make conservative estimates of its future by cutting that earnings growth rate in half (seven percent), projecting an earning multiple on par with the general market (15x), dividends growing slightly below its historical rate, and using excess cash to buy back shares on the market to the tune of 24 million over the next five years. These assumptions would give us a business worth about $142 per share in 2016. That’s about 13 percent compounded growth. Again, not too bad.

The financial analysis looks pretty good. Add to that some basic facts about BDX’s products: they tend to be non-discretionary purchases primarily from hospitals, with some elements of the razor-and-blades revenue model,  changing suppliers seems to be hard to do, and the price points of various needles and syringes (the primary business) don’t make it worth the headache of customers trying out new vendors anyway.  The thesis seems to be getting stronger by the moment.

Alas, the paranoia kicks in. Two things bother me. 1. Healthcare payers are under duress, and they are a major force behind buying decisions in the service of healthcare…something upon which BDX is highly dependent; and 2. What does something like the BD Insyte Autoguard with Blood Control do? I have no idea.

On the first point about healthcare payers, my thinking goes something like this…while I understand the demographic drivers of healthcare consumption – that human population growth is inexorable, that aging populations have a nearly insatiable need for health services, and that developing countries are a growing source of demand for western-style healthcare – I have no idea how people (or THE SYSTEM) will pay for it. I help old ladies across the street not because I’m a good Boy Scout, but because as an informed contributor to the Medicare and Social Security tax base. In other words, I know what ceramic hip replacement surgery costs if she falls down!

The point is this: healthcare demand is not driven by typical models of supply and demand. There is a powerful X-factor in the form of government and other payers. These payers are under stress. (Indeed, it’s not too difficult to argue that the government sources of payment in the U.S. and Europe are effectively insolvent already based on future obligations versus any reasonable assumption of having that funding available without bankrupting taxpayers.) When the payers become more strict with their approval of procedures and diagnostic services, it has a direct affect on the manufacturers of the products that are used in surgery or blood tests or whatever else.

It certainly puts Stryker at risk of selling fewer ceramic hip replacements when the aged population has to jump through more hoops to get approved for a $15,000 procedure. There are fewer of these surgeries. BDX faces a similar risk, albeit less pronounced. Fewer surgeries mean less demand for their catheters and needle systems and all of those other items they sell.

Non-discretionary products becomes a misnomer when the service that requires their use becomes discretionary.

All that being said, no matter how gloomy we might be about the future of healthcare reimbursement, there is no question that will continue to be tremendous demand for needles, diagnostic cell testing, and the like. The question is more about how much demand there will be and what impact that might have on BDX earnings growth.

So here’s my paranoia on point one…with the uncertainty surrounding payment methods for healthcare services, can we be very certain BDX (and its peers, for that matter) aren’t priced at a peak of market demand for their products? Part of my checklist for any investment is to ask whether the business itself is showing peak earnings for one reason or another. If so, you try to normalize those earnings to get a more realistic expectation for the future. And you certainly don’t want to pay a high multiple on top of peak earnings! Well, apply the similar logic to the question of whether the healthcare market has shown peak demand for its services based on physicians ordering excessive cover-their-rear diagnostic testing (fear the tort) and surgeons being eager to cut with the knife because they know they’ll get paid (a lot!).

What if we’ve peaked there? Despite the demographic trends suggesting increased demand for more healthcare in the future, the challenge of the payers makes me highly uncertain about how it plays out. I don’t like that level of uncertainty when investing.

Second, despite having some background in the healthcare supply chain, I have no idea what the vast majority of BDX products actually do – like the titillating BD Insyte Autoguard with Blood Control mentioned above. Nor can I make a reasonable estimate of what the market for these products might be. Moreover, if I assume I have the brain wattage to learn enough about it at all, adding it to my circle of competence would easily take months or years buried in a deep research dive.

All that being said, the company could very well go on to compound its earnings in the coming years as the issues I cite become moot. In which case, I have the regret of omission. It would not be the first, and it won’t be the last.

To sum it up, BDX has many hallmarks of a great company and a respectable investment opportunity…BUT…the flux surrounding the payment models for the industry makes me anxious about its ability to achieve even an historically conservative rate of earnings growth (seven percent versus 14 percent)…AND I tend to need to understand the products or services of the businesses I invest in (at least at a minimal threshold anyway)…AND I’m living proof that altruism (e.g., helping old ladies cross the street) is bound-up in self-interest. Call me homo economicus.

Paul Dryden

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