Becton, Dickinson Finds ‘Sweet Spot’ Pharmas Have Missed

• Predictability of revenue and earnings along with a likely dividend increase make BDX an appealing investment.

It is hard not to be impressed with Becton, Dickinson (BDX) and its management. The company is producing consistent organic growth in both the top line and bottom line through innovation. It has invented a safety needle category. It dominates most of the segments where it competes. Due to the one-time use nature of most of its products, a very large portion of its revenue is recurring, resulting in steady, predictable growth in revenue. It is consistently increasing its R&D spending which will further ensure continuation of product innovation.

Impressive margin improvements this year and projected improvements in 2005 stem not just from increased efficiencies, but also from constantly evolving and shifting product mix from conventional products to higher-margin, more innovative products. Also, migration from the first generation’s already high-margin products to the second generation’s even higher-margin products is a decided plus.

Yesterday, the company reported it had exceeded earnings expectations of 68 cents per share, delivering 70 cents per share. The performance was good company-wide. Sales were strong across all segments. Even after adjusting for FX, constant dollar sales were up about 5%, all of which was organic growth. BDX net margin increased 1.1% despite increase of 30 basis points in R&D expense, which has helped to fuel 14.2% operating income growth.

Sweet Spot
BDX, like many other device makers, is in a very sweet spot. It enjoys the benefits of very favorable demographic trends that create an incredible backwind. However, it doesn’t face a slate of problems that are hovering over its pharmaceutical comrades.

• An absence of political risks. BDX products are fairly inexpensive, especially relative to branded pharmaceuticals. Products (i.e., syringes, needles, etc.) have very tangible characteristics, whereas pharmaceuticals have tangible results (which is often taken for granted by consumer). Also, pharmaceutical products appear to have little intangible value, since most of the value in a pill is not in the manufacturing but in the R&D that went into the pill’s creation. This makes pharmaceutical companies an easy political target. I don’t remember politicians complaining about syringe prices.
• BDX’s products are not usually purchased directly by the consumer. The end users are usually nurses in hospitals and doctors’ offices, though the company is bringing more consumer products to the market. The product price is usually embedded in a medical bill, which is not seen by the consumer and usually represents a very small fraction of the total medical bill.
• All aforementioned factors reduce political risks substantially. The chances of price controls and syringe/needle/surgical instruments reimportation from Canada or other countries with socialized healthcare are very unlikely.
• A very diverse product line. The company’s success is not driven by several blockbuster products that account for a large chunk of its revenue, which is a very common problem in the pharmaceutical industry.
• Patent expiration not as significant an issue as with big pharma. Intellectual rights are very important, but by the time a patent has expired, the company has already created several new generations of products that make the original protected products obsolete.

Outlook
Risk/reward characteristics in the BDX core business are very favorable. Though there is not much upside in the P/E expansion, the downside is very limited as well. I expect revenue growth in the 6%-8% range, and earnings growth in the 9%-10% range due to constantly improving product mix and increasing operating efficiencies (the company’s guidance was in the 10-12% range).

Management indicated a likely dividend increase, which is the right thing to do considering the strong capital structure and very strong free cash flows. Sustainability and predictability of revenue and earnings make this company a very appealing investment.

Vitaliy N. Katsenelson, CFA

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