Avantor (AVTR): ROIC Without Goodwill And Intangibles (2/2)

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I covered the basic return on invested capital calculation for Avantor in the prior post, and will now get into calculating ROIC without goodwill, then ROIC without goodwill and acquired intangibles. Excluding acquired intangibles massively boosts AVTR’s ROIC, so the approach to the math and the reasoning behind it are worthy of some consideration.

Looking At ROIC With Goodwill Removed

As we know, accounting goodwill is created by acquisitions, and AVTR and its life sciences competitors do lots of them. Why? The rationale is, they can buy smaller businesses with single or limited product offerings and a nice list of customers who make recurring purchases (many of the products are consumables), tack them onto their existing distribution networks, and take out a lot of the redundant fixed overhead and get some cross-selling opportunities (the infamous “revenue synergy” concept). And the small targets are generally available at much lower multiples than the buyers trade for. I am of the commonly held view that most M&A destroys value, but in the case of these businesses, I am open to the idea that they can be accretive if done with discipline. This is an important consideration because a reliable stream of successful acquisitions here can really drive incremental ROIC for some of these firms and support stock appreciation. For example, acquisitions are often cited as part of the bull thesis for TMO – as mentioned in the Borlaug post, they have integrated dozens of them over the last decade.

AVTR has also been active on the M&A front. Its most recent deals were these 3 acquisitions in 2021, which are all summarized in the Avantor 2021 10-K:

TargetDate ClosedAnnounced Value ($mil)Announcement Press Release
Masterflex Bioprocessing11/1/20212,700Masterflex 
Ritter GmbH6/10/20211,061Ritter 
Changzhou Rim Bio Co Ltd6/1/2021Not materialRIM Bio 
AVTR had a TEV of about $22B at the end of 2020 and $16B at the end of 2019 (pre-COVID run-up), so these were large and consequential deals (aside from RIM) for this company. AVTR actually issued more than $750mm in stock at $42 for its all-cash purchase of Masterflex. Equity is expensive capital and this acquisition is generally viewed as a failure and partly responsible for a current stock price that is less than half of $42. The Borlaug stock pitch cites the Masterflex transaction as the basis for what is essentially a soft activist opportunity at AVTR: the need for a more disciplined approach to M&A and more finely tuned management stock comp incentives related to acquisitions. I will devote a post specifically to some of the details of this transaction later.

Back to breaking down AVTR’s ROIC – without goodwill. The higher the percentage of a company’s asset base that is represented by goodwill (i.e., the more acquisitions it does), the greater the disparity between ROIC calculated with and without goodwill, of course. Here are AVTR’s ROIC levels both with and without goodwill:

You can see invested capital increasing substantially in the first chart which includes the goodwill created by the acquisitions. Since what was being acquired in 2021 was mostly goodwill (both accounting and economic), excluding it means invested capital was basically flat in 2018 – 2022 while at the same time, AVTR picked up the incremental income. This caused ROIC to improve substantially. Looking at ROIC through this lens, which is the correct one for people (like me) who are focused mostly on the underlying economics of the business, AVTR seems to be a pretty good, high-returning business. What are some common sense guesses for why that is?

Well, they seem to have an underlying customer base that relies on AVTR’s products and reorders them, and AVTR doesn’t seem to have to invest too much money in maintaining or improving these products to maintain and grow sales and continue to reap solid gross margins (though AVTR’s seem low in comparison to some of its competitors). Per AVTR’s 2022 10K, 40% of customers have been customers for > 15 years, and no customer comprises > 5% of sales. Since these customers are often non-profits, or the scientific research arms of for-profits, there doesn’t seem to be too much price consciousness or comparison shopping among buyers. They value the familiarity they have with the products they have been using for a long time and are focused on research results, not trimming what is essentially a tiny expense item from their lab budgets.

In fact, all of the companies in AVTR’s comp set also seem to generate solid economic profits when we take out goodwill: ROIC excluding goodwill for LTM ranges from 13% t 31% (see Excel sheet at bottom for details).

Looking At ROIC With Goodwill And Acquisition Intangibles Removed

Remember that  McKinsey Valuation 7th Edition included acquired intangibles as part of goodwill and therefore excluded these assets when calculating invested capital for ROIC. In the numbers above we have not done this, and doing so would be very consequential for AVTR’s ROIC because of the large intangible asset amount on its balance sheet from the Avantor 2022 10-K:

Other intangible assets are about $4.1B, which is about 80% of the goodwill amount and about 31% of total assets at YE 2022. Invested capital goes to about $2.1B from $6.3B (with just goodwill removed) for 2022 if we take it out, and ROIC (using tax effected EBITA rather than EBIT, so that we take out the amortization related to the intangibles we have excluded in the denominator) ROIC surges to about 54% from about 13%. So the decision to include/exclude intangibles here is very meaningful in thinking about capital productivity. taking out intangibles also bumps ROIC for most of the comps – Danaher is particularly notable, reaching 65%. All of this can be seen in the attached Excel below.

What exactly is in the Other intangible assets line item? See below:

It’s mostly customer relationships. When AVTR acquired businesses, these customer lists were deemed identifiable assets and valued as such. AVTR does have to constantly replenish these assets as if it would have to maintain a factory with maintenance cap ex, for example. It has got them, period. Any maintenance or growth “investment” in these relationships is already picked up through sales and marketing expense in the income statement. It seems reasonable to exclude the entire line item for ROIC purposes.

One interesting wrinkle for AVTR’s intangible asset line item is that, per the balance sheet above, it went down substantially from 2021 to 2022 – from about $5B to $4B. All other things equal, this would instantly improve AVTR’s ROIC for 2022 (via a lower invested capital base or denominator) for anyone looking quickly and not backing out intangibles, i.e., Bloomberg. I poked around to try to understand how this happened, and from what I can tell the company changed valuation assumptions – you can see that the gross value simply went down, the net value was not decreased because of amortization, and non-goodwill intangible assets are not tested for impairment (I also didn’t see anything run through the income statement related to this reduction). I wonder if this was done by management to boost ROIC. Another thing to consider is that, when accounting for an acquisition, management has some discretion as to whether to attribute purchase price to identifiable assets or have that value fall into the goodwill bucket, and this choice could be guided by management’s view as to which bucket results in the highest ROIC. For example, if the view is that investors back out only goodwill and not other intangibles, then of course the bias would be to push that value into goodwill. That route would also mean less amortization expense running through the income statement.

What’s the bottom line? AVTR and its public competitors seem to have businesses with strong underlying economics as reflected by high ROIC – after the adjustments described above. If we are considering AVTR as an investment candidate we need to study exactly why this is the case (asset intensity vs. margins, competitive dynamics, etc.), how sustainable it is, and think about what valuations do and don’t make sense for acquisitions, because all of these companies love to do them. It’s also worth noting that looking at the ROIC that Bloomberg and other data services spit out, one would think that capital productivity here is fairly ho-hum, when in fact these core businesses are very attractive, at least from what we learned from our first cut at breaking down ROIC on a company-by-company basis.

The Full Life Sciences Tools ROIC Comps Spreadsheet

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