In A Growth-Starved Sector, Becton Dickinson Rules

By Stephen D. Simpson, CFA | May 03, 2013 AAA

It's a curious thing that investors' desire for short-term growth will often lead them to pay what looks like much too high a price for a company's long-term stream of cash flows. Although I wouldn't necessarily say that Becton Dickinson's (NYSE:BDX) current price is “much too high”, I do believe the stock is trading above its long-term fair value due to the fact that it's one of the few top-line growth stories in a very growth-challenged healthcare sector.

A Small Beat And Good Organic Growth
At a time when many large healthcare companies are showing minimal organic growth in their device and diagnostics businesses, Becton Dickinson's fiscal second quarter results end up looking pretty strong.

Revenue rose nearly 4% as reported, or about 3% on an organic basis. This was basically in line with expectations, though the sluggish U.S. performance (barely up) and strong international results (up nearly 7%) were both a little different than average sell-side guesses.

Results were pretty decent in the Medical (up 4%) and Diagnostics (up 5%) businesses, while the Biosciences business was weaker (up 2%) but still positive. Significantly, the diabetes business continues to grow – up 7%.

Margins looked a little different than forecast, but still came out okay. Gross margin declined slightly from last year (coming in half a point shy of estimates), largely due to acquisitions, pricing pressure, and currency. Operating income fell 1%, and operating margin dropped 80bp, but this was actually slightly better than analysts had expected, allowing the company to post an operating beat of a few pennies.

SEE: Understanding The Income Statement

Diabetes Still A Cornerstone Franchise
At a time when many companies on the device side of diabetes are seeing softer conditions (including Johnson & Johnson (NYSE:JNJ), Roche (OTC:RHHBY), and Medtronic (NYSE:MDT)), Becton Dickinson continues to roll along.

In my view, this is due to where the company sits in the therapy ecosystem – the company's needles, pens, and syringes allow it to leverage the growing number of diabetics (and the growing number of diabetics who need/use injected therapies like insulin and GLP-1 analogs), without taking on the same amount of reimbursement exposure or competition risk.

Leveraging Expertise Into New Markets
Becton Dickinson is also showing investors that it is more than willing to look for new ways to leverage established expertise and manufacturing capabilities. Relatively recently, the company announced that it was entering the pharmaceuticals business via the sale of pre-filled generic injectables.

Under the BD Simplist brand, BDX will initially target about 20 to 30 drugs that it can sell into ICUs and critical care units. BDX's pre-filled syringes should improve efficiency and reduce error rates – both of which are critical factors in the aforementioned units. What's more, this is a good use of existing facilities and know how on the part of the company. While I certainly wouldn't call this a wholesale charge on market leaders like Hospira (NYSE:HSP), Fresenius (NYSE:FMS), and Pfizer (NYSE:PFE), I wouldn't be surprised if the initial launches go well and encourage the company to expand this business.

The Bottom Line
Even with lower utilization (fewer office visits) and longer intervals between tests hurting the women's health portion of diagnostics, Becton Dickinson is delivering solid results relative to its peers across pretty much all of its business lines. With so many of its rivals struggling to deliver similar growth, it's not a big surprise that investors have bid up these shares and that the stock has doubled the performance of the S&P 500 over the past year.

That said, this is still Becton Dickinson that we're talking about. While the company's efforts to grow its diagnostics business and its global (particularly emerging market) operations should offset the slower growth potential of most of its Medical division, investors need to be careful not to get carried away.

SEE: 5 Must-Have Metrics For Value Investors

I expect Becton Dickinson to continue growing its free cash flow at a rate around 5% (against a 7% growth rate over the past decade). At that level of growth, and using a discount rate that balances the company's strong position in areas like diabetes against intense competition in diagnostics and risk of commoditization in other businesses, fair value appears to be in the high $80s or low $90s. With the stock already near $100, I think investors are overpaying for this better near-term growth profile and I think better investment options are available today.

At the time of writing, Stephen D. Simpson owned shares of Roche.

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