Lower Expectations Can Lead to Higher Shares

Steve is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

Becton Dickinson (NYSE: BDX), dominates the needle and syringe business with a 70% market share and has leveraged the competitive advantages it has built in that market to develop its diagnostics (32% of revenue) and biosciences units (17% of revenue).  The company has a trusted brand earned from decades of providing high quality products and services and inherent economies of scale from manufacturing and distribution centers located around the world which are the primary competitive advantages that allow it to produce very consistent revenue growth, superior profitability and cash flow, and expanding profit margins. 

Furthermore, the company's management has demonstrated superior capital allocation which has led to outstanding returns on invested capital averaging more than 16% since 2002 and improved to more than 18% since 2007.  The company has experienced a slight reduction in its growth rates since 2007 but I expect rates to normalize going forward as the company invests the excess cash flow from its slow growing medical system segment (needles & syringes) into the faster growing diagnostics and biosciences segments.  An improved economy and increased clarity about the federal government's legislated involvement in healthcare, which should come this summer after the Supreme Court's ruling, should also support renewed growth for Becton Dickinson.

The company's primary customers are hospitals and their spending has been cautious in the current weak economic environment where uncertainty surrounding the healthcare system complicates spending decisions.  Another weakness in Becton Dickinson's primary medical system business (51% of company revenue) is that the products it sells, needles and syringes, are commoditized which makes price the primary competitive factor and cost control becomes crucial. The flip side to this weakness is that Becton Dickinson's products are essential and require only small, recurring purchases rather than large one time expenditures that hospitals might be disposed to delay in a weak economy.  This focus on selling price competition due to commoditization of products makes the industry unable to exert much pricing power.  However, within the industry Becton Dickinson has the most pricing power due to its trusted brand.

Analysts are becoming less optimistic about the company's prospects in the coming two years and have lowered their earnings estimates.  Over the past 90 days, consensus earnings per share estimates have declined by about 2.4% and 3.0% from $5.80 and $6.39 for 2012 and 2013 respectively, to $5.66 and $6.20, respectively.  One factor in these downward revisions is that Becton Dickinson is planning to sell its Discovery Labware unit to Corning (NYSE: GLW).  This business unit represents about 18% of the biosciences segment and about $0.23 to $0.27 in earnings per share.  The expected growth rate for 2012 has been shaved from about 4.3% to about 1.8% currently, increasing the price to earnings to growth (PEG) multiple to about 7.6x currently from about 3.1x 90 days ago.  Looking out to 2013, analysts have lowered their consensus earnings per share growth rate estimate from about 10.2% to about 9.5% currently which has elevated the PEG multiple to 1.30x from about 1.18x 90 days ago.

These lowered expectations by analysts and resulting higher PEG multiples are somewhat discouraging, but I believe there is a fair chance that earnings estimates will prove too pessimistic. This is partly because Becton Dickinson has a history of delivering positive surprises in earnings.  In three of the past four quarters, the company has surprised to the upside.  Specifically, Q2 and Q3 2011 earnings were 6.2% and 5.6% above estimates, respectively, while Q1 2012 earnings were 3.4% above estimates.  Q4 2011 earnings per share exactly met estimates of $1.39 per share.  Another factor that leads me to believe that 2013 earnings estimates are beatable is that they are based on revenue growth of 3.7%, which is well below the 5.3% average since 2007 and follows weak 2012 revenue growth of only 0.7%.  I am very comfortable paying 1.3x PEG for 2013 earnings that I strongly believe will be realized, if not exceeded.

I prefer to invest in companies where the financial interests of management are aligned with me as a shareholder.  To measure this I examine how much skin they have in the game through their holding of company stock.  I then make sure that their compensation is not excessive relative to competitors.  Becton Dickinson's key insiders, which includes 10 executives and 12 independent directors, own only 0.3% of shares.  However this ratio is higher than competitors Abbott Laboratories (NYSE: ABT) and Baxter International Inc. (NYSE: BAX) where key insiders hold only 0.18% and 0.12%, respectively.  Because the key insiders at Becton Dickinson have reduced their holdings of company shares by about 1.9% over the past 12 months while insiders at Abbot Labs and Baxter have increased their holdings, I am neutral about this aspect of Becton Dickinson's management.

Becton Dickinson's management compensation has been generous compared to these two rivals and this generosity has grown since 2007.  The company paid about 0.24% of revenue as management compensation in 2007 compared to only 0.23% for Abbot Labs and only 0.21% for Baxter.  By 2011, this disparity had grown to about 0.31% for Becton Dickinson compared to about 0.12% for Abbot Labs and about 0.21% for Baxter.  By increasing compensation by about 12.3% when revenue grew by only about 5.3%, Becton Dickinson clearly is the laggard on this measure.  Baxter has increased both management compensation and revenue at about 5.4% annually while Abbot Labs has actually cut compensation by about 4.6% annually while it has increased its revenue by about 10.7% annually since 2007.  I view this as moderately negative for Becton Dickinson because the company has been able to generate average returns on invested capital of about 18.1% since 2007 compared to about 13.9% for Abbot Labs and 18.2% for Baxter.

With the prospect of an improving economy, increased clarity around the status of Federal healthcare legislation coming later this year, escalated investment in higher growth diagnostic and bioscience business segments, and lowered consensus earnings estimates with a realistic chance for upside surprises, now is a great time to buy Becton Dickinson at the recent share price of around $77.  As these factors emerge, the company will be able to leverage its sustainable competitive advantages and superior capital allocation capability to return to its impressive record of very consistent revenue and cash flow growth, strong profitability with expanding margins, and solid returns on invested capital.  And while waiting for operations to improve, the patient investor can pick up a 2.3% dividend yield to augment his or her total return.


Motley Fool newsletter services recommend Becton, Dickinson and Co., and Corning. The Motley Fool owns shares of Abbott Laboratories, and Corning. 56Steve has no positions in the stocks mentioned above. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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