Avantor (AVTR): Breaking Down ROIC (1/2)

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Here is a recent Avantor stock pitch AVTR 24.93 -0.06 -0.24% from a substack account called Borlaug. I found it because I had been working on AVTR and checked out the company’s cash tag on twitter and, after scrolling through a lot of daytrader spam tweets, voila. The pitch is good and definitely worth reading. It includes a brief discussion of AVTR’s ROIC and ROIC for its competitors.

In this post, I thought I would go deeper into AVTR’s ROIC because…that’s what this blog is about, and AVTR is a good case study for some of the things that I have been discussing regarding calculating and thinking about capital productivity.

Here are the topics I am going to hit:

Here is a great (albeit a bit long) quote from  McKinsey Valuation 7th Edition (page 249 soft cover version) that will frame my comments on each of these topics:

“The reason to compute ROIC with and without goodwill is that each ratio analyzes different things.

ROIC with goodwill measures whether the company has earned adequate returns for shareholders, factoring in the price paid for acquisitions.

ROIC excluding goodwill measures the underlying operating performance of the company.

It is not affected by the price premiums paid for acquisitions. ROIC without goodwill is also more relevant for projecting future cash flows…A company does not need to spend more on acquisitions to grow organically, so ROIC without goodwill is a more relevant baseline for forecasting cash flows…companies that have a high ROIC without goodwill will likely create more value from growth, while companies that have low ROIC without goodwill will likely create more value by improving ROIC

In our analysis, we treat goodwill identically to acquired intangibles. Therefore we will often shorten the expression “goodwill and acquired intangibles” to goodwill.”

AVTR’s ROIC

Below is a screen grab from the ROIC comp template I use, applied to AVTR and some of its competitors. I took the comp list from the Borlaug post – the author described them as Closest ROIC Comps. The companies are: Thermo Fisher TMO 594.01 -1.29 -0.22%, Danaher DHR 267.19 +0.64 +0.24%, Agilent A 152.87 -0.80 -0.52%, Bruker BRKR 78.29 +1.89 +2.47%, and Bio-techne TECH 80.79 +0.38 +0.47%. The numbers are a bit clearer if you expand the image by clicking on it.

You can see that the ROICs generally range from 5% to a high of about 17% over time – Agilent and Bruker put up the best numbers, largely because of the lack of goodwill on their balance sheets (see next post). But looking at just these numbers, one could say that most of these companies often don’t cover their cost of capital, or at least that the existence of a reliable economic profit spread is questionable. AVTR for example has bonds trading with a yield of close to 6% which puts its cost of capital well above that level. TMO is particularly interesting because, despite its similarly low ROIC to AVTR (measured this way, at least) it commands a much higher P/E.

It’s also important to break down the drivers of ROIC whenever looking at comps like this. By that I mean, examining margins (ROIC numerator) vs. capital productivity (ROIC denominator). I won’t do that here because there is a lot of other ground I want to cover, but as can be seen in the Excel sheet in the next post, one thing that jumps out quickly is that AVTR has substantially lower gross margins than its comps in Life Sciences Tools. This is likely because AVTR distributes brands other than its own and products that are perhaps more commodity-like than the companies. AVTR has discussed its initiatives to improve mix over time toward its own products to help on the margin front.

Here is an Avantor investor presentation from March 2023 that shows a breakdown of the company’s customers, products, and end markets and provides some good top-level information on what the business does.

Also note that in my RIOC comps, I apply an effective tax rate of 25% to operating income across the board. As discussed here, one can use actual effective tax rates, or apply a fixed number such as 25%. This is an important choice for these companies because they have effective tax rates for the past few years of as low as 8% (e.g., TMO) to mid-teens. So my assumption of 25% is hammering the ROICs. This is why Bloomberg and Borlaug show ROICs closer to 10% for the comps: higher NOPAT because of lower tax assumptions.

Next post: Measuring ROIC without goodwill and then without goodwill and acquired intangibles. The numbers really improve, and that combined with what looks to be solid secular growth potential makes this industry (and the companies in it with lower valuation multiples – AVTR being the lowest) worthy of some study as investment candidates.

Please email me with questions/comments/errors related to this post!