The Borlaug Report #2: Avantor

Teenage Thermo Needs Activist Parents

Thesis Introduction

Since going public, Avantor’s (NYSE:AVTR) share price has been a rollercoaster. However, its fundamentals really haven’t, at least relative to the average company with private equity levels of leverage. The company trades more in-line with its chemicals roots today than its current role in the life science tools industry might otherwise reflect if not for its history.

Avantor has been able to grow its revenues >6% organically since 2018, expanding its gross margin 360 basis points from 31% to 34.6%. Combined with cost control, this has led to EBITDA margin expansion from 16% to 20.9%. This is an impressive start, but you wouldn’t know that by looking at the stock price. 

The explanation for this is largely around expectations and ROIC - Avantor’s management initially struggled to properly manage investor expectations, both on a quarterly and annual basis, for the first couple of years. As things started to smooth over, hard comparisons from 2021 made 2022 a difficult year for Avantor once again, with the company under-estimating its COVID exposure and having to reset expectations around organic growth. To make things worse, Avantor chased the bioprocessing trend and paid a hefty sum for Masterflex, which has negatively impacted ROIC with no signs of real synergy on the horizon.

That said, there could be a long-term opportunity for investors who can see beyond the post-COVID noise. On one hand, the company trades at a massive discount to peers despite similar exposure to biopharma, the most attractive of tools end-markets given its lack of cyclicality. On the other, management needs to prove that it can execute on M&A integration and that it has the same quality of moat that other life science tools companies do. The bear thesis against Avantor today rests on the latter.   

Until recently, I have been on the sidelines with Avantor. With its M&A missteps and the COVID hangover to its bioprocessing unit, as well as an apparent lack of cohesive strategy, I was worried that the company is more likely to be a value trap than a solid value investment. 

However, we are now in the late innings of the bioprocessing COVID/stocking hangover, and Avantor’s valuation is making it difficult to ignore - as surrounding industry M&A announcements and rumors pick up, I think it is only a matter of time before Avantor is approached by either a strategic buyer looking to realize the value of its channel or an activist investor looking to ensure the company gets its act together by working to improve ROIC. Either of these, or a simple improvement in communication and performance from the company over a couple of quarters could trigger a re-rating of the stock. As such, I think owning a small position in Avantor makes a lot of sense.

Company Background

Avantor was effectively 2 companies until 2017 - a chemicals company originally called J.T. Baker and VWR, an aggregator of first- and third-party lab supplies (known as a “channel”). 

J.T. Baker was founded in 1904 and operated as a run-of-the-mill chemicals company until 1995, when it was acquired by Mallinckrodt. The same year, it was acquired from Mallinckrodt by Tyco International and renamed Covidien. In 2010, private equity firm New Mountain bought it from Covidien and named it Avantor Performance Materials. Under New Mountain, the company started rolling up other chemical products companies, such as RFCL, POCH s.a., and NuSil Technology. Finally, Avantor acquired VWR International in 2017 for $6.4B, arguably the most transformative deal in the company’s history. In 2019, the company went public via a handful of blue-chip investment banks. 

After IPO, Avantor spent a short while de-leveraging but continued to be aggressive on the M&A front in 2021, with the acquisitions of bioprocessing companies RIM Bio (amount undisclosed), and Masterflex ($2.9B) as well as Ritter, a liquid handling consumable company for robotics workflows ($1.1B). 

Below are two ways of looking at Avantor’s revenue mix in 2022 (from the 10-k): 

However, I think there is a third way of looking at how the revenue mix for the company has progressed since IPO that is important enough to mention. Below is a build from 2018 that separates out contribution from VWR’s channel: 

Today, 70% of Avantor’s transactions are done via its digital sales channels. This will be important information for later. First, a review of the end markets Avantor is exposed to:  

Traditional Biopharma Segment (~32% of revenue, growing low- to mid-single digits) 

The biopharma end market grows 5-7% per year on average, but within the broader market there is a share-taking story from larger molecules (“dubbed bioprocessing”) where relevant, which is predominantly in manufacturing. To be clear, manufacturing and R&D are not mutually exclusive - lots of R&D dollars go into making a drug as manufacturable as possible. 

That said, traditional biopharma R&D isn’t going anywhere, and growth is driven by R&D budgets from the entire industry, which is driven by venture funding, NIH and grant funding, and large biopharma spending, which still makes up the majority of total R&D dollars today.     

Bioprocessing-Facing Biopharma (~20% of revenue, growing low-double-digits)

Bioprocessing is today’s most coveted long-term exposure to have as a tools company. The drugs of old were effectively just chemicals, and performing research on them looked equally as much like chemistry as it did biology. Next-generation drugs, however, are more biologically complex, which makes them exponentially more expensive to play with as well as manufacture. As such, this industry is poised to benefit both from share gains in R&D (as expressed by both dollars and number of programs) and number of commercial drugs (both in volumes and dollars) over time. The combination of volume share gains and complexity easily supports 12%+ growth in bioprocessing for the next 5+ years. In the future, I plan to write specifically about this megatrend.

Avantor sells liquid handling and single-use tubing into this industry, among other things. Once defined in an FDA filing, even things as simple as tubing can become nearly impossible to switch - making products like these extremely defensible. The same can not be said for things like liquid handling consumables, which are mostly used in R&D - this has been a primary knock on Avantor’s competitive moat. However, things as small as liquid handling consumables also aren’t expensive enough to incentivize a user to switch frequently. 

Advanced Materials (26% of revenue, growing high-single digits) 

Avantor’s Advanced Materials segment serves electronics, space, aerospace, and defense customers as well as the food & beverage industry. This exposure is unlike that of any other chemicals company - the quality standards on the products made for these customers is incredibly high (measured in parts per billion - higher than medical-grade), making it a source of proprietary chemicals and coatings that are hard to get elsewhere - and switching costs can be high for many of these the industrial-facing products (especially government-regulated ones like A&D). A lot of what is driving growth, however, is quality control reagents. Avantor has been growing this segment low-double digits over the past couple of years on the back of its liquid chromatography-mass spectrometry reagents, a popular way to quality control food, chemicals, batteries, and much more. 

Fun fact: Avantor sells the coating that goes on the stealth bomber!  

Education & Government (12% of revenue, growing low- to mid-single digits)

This segment is straightforward - Avantor sells basic lab chemicals, equipment, and consumables to academic and government customers for R&D purposes. Growth for this end market is largely levered to academic budgets.

Healthcare (10% of revenue, growing mid-single digits)  

This segment is largely of Avantor’s Nusil acquisition from before its IPO. The segment largely consists of medical-grade silicone which is used in aesthetics (breast implants) and other medical devices, such as contact lenses, vertebral implants, and pacemakers. Growth in this segment is largely tied to medical procedure volumes. 

Combined Growth Algorithm - What Should Normalized Organic Growth Look Like?  

In a world where share gains and losses don’t exist, industry growth would be an excellent way of understanding how a company like Avantor should grow in the average year before considering M&A, currency, etc. While we obviously don’t live in this world, it is an excellent starting point. Given its segment exposure, below is a short table of what that rate would look like (Weighted-average-market-growth or WAMGR): 

For reference, here is WAMGR that instead uses low-end estimates of each market’s growth: 

So in a vacuum, Avantor should conservatively be able to grow its business roughly 5-7% without gaining share or acquiring businesses, even leaving a little room for share losses. This is largely in line with what it has done since 2018 (~6%). Right between midpoint and low point of organic growth as measured by end markets.   

Industry Background - Peer Group(s), Competitive Discussion, and Relative Valuation 

Life Science Tools is a competitive industry - Several large companies all compete for the same R&D and COGS dollars from biopharma, academia, and government - but it is not THAT competitive. These companies all compete for those dollars with different equipment and consumables, and have little ability to drive the incremental adoption of those technologies given that most of these markets are fully saturated/operating near 100% utilization. For example, Thermo Fisher (TMO) and a handful of others make high-resolution mass spectrometry equipment for academia, but Danaher tends to ignore the academic segment of the market and focuses on quality control via the assets it acquired via SCIEX. When boiled down, many of these end markets are effectively mini-oligopolies assembled in different combinations across an array of parent companies. 

Below is a comp sheet that best reflects the tools peers that Avantor could best be compared to:

Taken together, one can see that these larger peers all have higher margins, higher normalized forward growth, and enjoy these as a benefit to their valuations. One could argue that Avantor could enjoy those valuations too if it convinces investors it is a business of equal quality. 

Why Does Opportunity Exist Here? 

Two of the biggest drivers of valuation, especially for life science tools companies, are normalized growth expectations and ROIC. Another hit to valuation tends to be leverage above 3x - which is why most tools companies don’t stay above those levels for long after an acquisition. Right now, the market thinks that Avantor will grow its revenue and EBITDA more slowly than its peers, with EPS growth being higher due to normalization of leverage. From a buyside perspective, trust in management is also extremely low. 

On a more short-term basis, management is guiding to effectively no growth this year, as intense COVID headwinds and the compounding stocking of supplies from COVID are unwinding. This makes Avantor unattractive to investors given there are plenty of other places to own quality growth in tools. 

In short, the market is giving a large discount to Avantor because of 1) low short-term growth, 2) low confidence in guidance, 3) leverage, 4) concerns around relative quality of assets, and 5) ROIC. 

The Short-Term Opportunities - Re-Rating Via Earnings or M&A as Catalysts 

Earnings: In the near term, specifically over the next 6 months, Avantor could re-rate as it simply hits the low expectations it and investors have set for itself. A large, liquid, and stable tools company growing 5% organically with optically safe levels of leverage could easily trade at 16x forward EBITDA or 22x EPS - after all, Waters (NYSE:WAT) does, and does it with even lower growth expectations in front of it. The oversimplified forward picture for Avantor will look a lot better as we exit 2023, and the stock could trade up to reflect it by pure virtue of lack of negative newsflow. Furthermore, there is always a world where Avantor uses more of its pricing power than the market expects, which would have positive consequences across PnL and ROIC metrics. 

The takeout thesis: I also believe that Avantor is a no-brainer acquisition target for the likes of the academically-focused tools companies not named Thermo Fisher or Merck KgA. This is because of the VWR channel asset that Avantor owns, which only the two aforementioned companies have (via Fisher and Sigma). If a Waters or Bruker or Mettler-Toledo wants to reach the next level as an R&D dollar consolidator, it would most likely want to own one of these assets, and they have exactly one choice - Avantor. If they don’t, Avantor could become the consolidator instead over time. 

The Long-Term Opportunity - A Growth Algorithm Proven by Peers, Enforceable by Activism 

The long-term consolidation play: To understand how Avantor could become a truly massive business, one need only to look at how Thermo Fisher reached its current size. 

Thermo and Fisher Scientific combined in 2006. It was NOT initially received well by the market. Thereafter, however, it embarked on a path to become one of just a handful of healthcare & life science companies to reach its current scale.The strategy was simple - sell more existing Thermo tools on the Fisher channel, and offer services there to support them, repeating the process with future M&A as well. By buying something and running it through the Fisher channel, revenue synergies were easy to find and had a magnitude that is hard to fully understand. 

The recipe? Between 2006 and 2019, Thermo bought the following:

• 50 Acquisitions, 10 >$500M

  • Total revenue acquired: $9.4B (~$190M/deal)  

• 10 Divestitures, 5 >$500M  

  • Total revenue divested: $1.3B (~$130M/deal)

• Invested $6B in Research and Development

• Invested heavily in China

• Brough services as a % of sales from ~15% to ~25% (less relevant for a consumables-heavy business) 

During the same time, revenue grew from $9.7B in 2007 to $24B, meaning ~$5B was added via organic growth, allowing the company to grow 3.5% organically (largely as an industrial company) from the top of the market through the great recession. This would have been impossible without significant revenue synergies. For reference, Thermo has been growing organically in the high-single digits for the past several years.   

Avantor is potentially at the beginning of a similar trajectory. Given its relative size, it can acquire smaller companies and realize more meaningful results than Thermo or Merck KgA. If the company executes, the profile looks eerily similar from a starting point of ~$7.5B in revenue (with better end market exposure to biopharma to boot - Thermo’s revenue mix was far more industrial-heavy at the beginning of its run). However, it has to get this strategy right. 

What would an activist investor fix? 

In my a opinion, there a couple things an activist investor could fix: 

M&A Strategy: Right now, Avantor’s M&A strategy has only made a little bit of sense to me. While bioprocessing is an interesting market to play in, Avantor’s biggest upside would present in the form of tuck-in legacy tools companies because they are more synergistic with the channel. Selling into the bioprocessing market is completely different - the sales process is a lot more intimate, less equipment is ordered online, and the selling company usually has an on-site sales rep a high percentage of the time. To acquire here would be wasteful, both in price paid for deals and synergies with the core business. There is a reason why Thermo’s bioprocessing exposure is only ~10%. You can’t be half Danaher (acquiring for end market growth and not integrating) and half Thermo - you have to pick a lane if you’re Avantor. An activist investor should find a way to enforce this. 

Fix Management Incentives: Below is the breakdown of management’s compensation per last month’s proxy filing. 

While the overall plan looks sufficiently long-term in nature, it misses the mark for an acquisitive company. By prioritizing sales growth, Adjusted EBITDA growth, and getting lucky in the medium-term by chasing end market momentum, management can theoretically earn its entire incentive plan. It is also concerning that Avantor’s stated compensation comparable group for includes a group of the least acquisitive tools companies and several medical device, dental, and CRO/CDMO businesses while excluding Thermo Fisher and Danaher, some of its best comparables (there are also smaller companies that would fit this profile as well). 

This matters and explains a lot, in my opinion. Here are Thermo Fisher’s measures. Both the quantitative and qualitative ones make much more sense than Avantor’s do. 

As you can see, Thermo Fisher management is rewarded for a cocktail of organic revenue growth, bottom-line EPS, and actual free cash flow as financial metrics, and still requires long-term planning in performance, including improving customer allegiance scores (CAS), maintaining the benefits of its PPI business system, and demonstrating a successful integration of its PPD acquisition. Avantor has none of those on the qualitative front. 

The worst part? While the plan encourages risk-taking, management didn’t see the benefits of those risks either in 2022. 

So everybody lost last year at Avantor, and it’s highly probable that if the company had the right incentive plan in place, it may not have bought Masterflex for 12-13 times FORWARD SALES and a lot of the pain experienced last year could have been avoided. Ritter seems more pragmatic to Avantor’s business model, for what it’s worth. At such a cheap valuation, value-destructive M&A is usually part of a bear case for a cash-flowing businesses and it’s clear that this is the case here as well. 

Without even replacing board members, an activist investor could push for these changes and help Avantor focus on the actual long term, not the rolling 3-year periods defined in its proxy. 

Deal ROIC is a low-hanging fruit here - goodwill is a major drag on company ROIC today. See below for more discussion. 

Get board members with more relevant  experience: Below are the board members listed on Avantor’s website with a summarized version of their company history backgrounds: 

Jonathan Peacock (Chairman): Biopharma CFO (Amgen, Novartis) 

Michael Stubblefield: CEO, Consulting Background Pre-Avantor (McKinsey) 

Juan Andres: Various at Moderna, Novartis 

John Carethers: Academic

Lan Kang: Private Equity, Consumer

Joseph Massaro: CFO at Aptiv, a car parts company

Mala Murthy: CFO of Teladoc, a telehealth company

Michael Severino: CEO of Tessera Therapeutics

Christi Shaw: CEO of Kite Pharma

Greg Summe: Hedge Fund

Not a single ex-tools conglomerate board member. Needs more Danaher. Needs more Thermo. I find this concerning. The picture does improve a little when you look at the exec team. However, the Americas head, Jim Bramwell, has spent his whole career at VWR, which likely makes him reliant on the CEO for strategic guidance, and the CEO lacks a tools background. One bright spot is that Kitty Sahin, the head of corporate development (M&A) that joined 10 months ago, comes from Thermo Fisher and Novanta with a decade of M&A experience across industrials and diagnostics. There is a good chance she fully understands the power of Avantor’s channel and will do right by the business over the long run. 

To be clear, I am not suggesting management changes -  incentives need to change first to see how much they influenced decision making. However, the board composition seems lacking. An activist investor could definitely get involved here. 

Financials - Leverage, ROIC, and Margins

While the above commentary on compensation, management, and what went wrong in 2022 paints a somewhat negative picture of Avantor, the company still looks pretty strong from a financial perspective (at least, in a vacuum). Margins have headed in the right direction, but it’s clear that more can be done. I see this as an opportunity, especially if using Thermo Fisher as the analog for where margins could go. Below is a comparison of what the two did in 2022: 

The company is still scaling away from its mix of “lower margin” products, so one can expect annual gross margin improvement on that alone, with some operating margin expansion if costs continue to be properly controlled. 

One of the most exciting opportunities for the short-term Avantor story, in my view, is the extent to which EPS is depressed by both interest and taxes. Avantor pays a much higher tax rate than peers for several reasons, not the least of which is like the excessive interest being paid going beyond the writeoff limit. This means that as the company grows and interest is paid, interest comes down but taxes stay flat on higher operating income, boosted further by any improvements in tax optimization. 

To frame this, Avantor is guiding to $1.40 for 2023 at the current guidance midpoint. This includes $270M-$295M of interest expense, and a 21.5% tax rate. This implies that without interest costs Avantor 43c per share in 2023. Said differently, EPS would be 31% higher without interest. As debt is paid down, that tailwind will be realized over the next few years alongside growth and (hopefully) margin expansion.   

ROIC: Avantor had a 13% ROIC ex-goodwill in 2022. This by itself is actually impressive - however it could be even more so given the levers Avantor has to pull over the coming years. Low ROIC is optically what keeps a lot of long-only investors away, and goodwill muddies the picture for Avantor. Goodwill impacted ROIC by about 6%, putting it in the 6-7% range. This is not enough to get investors excited. 

Before 2021, when Ritter and Masterflex were acquired, this spread was about 3%. It is clear that on an underlying basis, Avantor’s returns on invested capital might look good, but it needs to focus on making the total-company level ROIC reflect that. Generally, tools companies don’t get that much credit for goodwill in ROIC because they aren’t acquiring IP or other intangible value that you can’t see in financials over the subsequent few years. 

If Avantor does a better job of growing its NOPAT organically/via synergies going forward and pays down debt, ROIC can improve to double digits with ease. For reference, the median ROIC (with goodwill) for the tools group is ~10%. Thermo and Danaher are at 8% and 9%, respectively, which, while still low, on a % change basis is much higher. If Avantor can get simple ROIC to those levels, it may be worth a look in the eyes of a wider investor base. 

Closest ROIC Comps for reference:

Key Risks 

In my view, the key risks to owning Avantor are as follows: 

Share losses: If you see a company growing at the “bottom end” of what you’d expect in market growth, it likely means share losses, especially since we have been in an inflationary environment, implying that pricing power pushes competitive businesses to the higher end of the range, not the lower. I will assume this means Avantor has lost share in a lot of its pharma-facing markets. If this continues, it breaks the entire M&A rollup thesis and exacerbates the second risk I flag. 

Value-destructive M&A: Overpaying for M&A is almost always value-destructive. Overpaying can be defined either by purely evaluating multiple paid, or via deal ROIC. Given the discussion above on ROIC, I’d say deal ROIC is the more important of the two. If management continues to overpay for growth assets that it doesn’t have a perfect channel to support, the synergies will never justify the price, making all deals value-destructive and keeping investors far away. 

Further multiple compression while in penalty box: Avantor trades lower than most tool companies have traded in the past decade, including when they were in the penalty box such as when Waters had its meltdown in 2019 - notice the chart below in which the company still never traded as low as 15x forward earnings. 

Avantor trades at 14x NTM. Therefore, I’d assert it’s clear the company is getting a partial chemicals/materials multiple, which can get down to the single-digits. If 14x is possible, why isn’t 10x possible?  

Framing Upside/Downside - Not a Lot of (Likely) Downside, But Fast Upside Unlikely Too Before ROIC Improves 

Below is a quick-and-dirty sample PnL model to a potential return profile for Avantor:

42% annualized….Looks attractive, right? The problem is that most of the return rests on multiple expansion. A little more organic growth, a little more margin expansion, etc. is dwarfed by the magnitude of potential multiple expansion. Example below. 

Holding the base case constant, each 1% in organic growth in 2024/2025 and each 50bps of tax rate improvement makes only a couple % difference in returns outcomes. On the other hand, each 50bps of margin expansion has a whopping 5% impact on the return profile in a vacuum. 

As such, the case has little to do with share gains, revenue growth, etc. - it is a margin and multiple story. You could argue that revenue growth supports margins, but the incrementals aren’t as important as pure cost control/M&A cost synergy. Below is a sensitivity of the same case across exit multiple and margin expansion. 

Ironically, these two are linked - margin expansion (ex-M&A) drives ROIC up, especially when compounded with a little revenue growth. Higher ROIC makes Avantor interesting to a larger investor base. Larger investor base drives re-rating. 

Conclusion 

The above upside framing is at the core of why I’m interested in Avantor. With no multiple expansion or contraction, one could theoretically earn high-teens to 20% returns annualized over ~18 months with un-heroic growth assumptions, moderate margin expansion, and a little debt paydown (effectively returns = EPS growth). In exchange for the risk of further multiple contraction, which could only bring returns negative approaching 10-11x earnings, you get the upside risks of activist involvement or M&A which could pull forward any re-rating one could hope to achieve over the long term. 

Furthermore, a couple of faster-than-expected margin expansion quarters over the next 6-8 earnings releases could drive multiple expansion as well. In a deflationary environment for chemical inputs, which we could be looking at as soon as this year, the benefits of price increases Avantor has been able to justify by offsetting inflation could quickly turn to gross margin expansion. 

Overall, there is a lot that can go right with Avantor, and given the sticky industry dynamics of being a tools company serving biopharma and other highly regulated industries, I’d argue we’ve seen about the worst one could see with a company like this. With an upside-downside skew at ~4x, I am planning on making space for a position in the coming months, and will probably feel regret if 1Q earnings somehow drives the re-rating investors are hoping for. I’d describe the investment case from here as owning a compounder with a re-rating call option realizable over time.

Disclosure: I do not currently own shares of Avantor. Sources for all are Capital IQ, company filings, personal estimates.