The global healthcare market is about $8 trillion in 2018, or roughly 10% of global GDP. The diagnostics industry drives much of this spending and also the opportunity to reduce the costs. Developments in an array of diagnostics technologies provide new picks and shovels to the companies pursuing lifesaving treatments, and offer numerous areas for strong long-term investments. The In-Vitro Diagnostics (IVD) industry is $80 billion in total and incorporates instruments, reagents, systems, and techniques used in vitro—generally in test tubes or culture dishes—for the examination and research of specimens such as blood, urine, or tissue with the goal of detecting disease, infection, or other anomalies. The IVD market has long been considered the silent champion of healthcare, influencing over 60 % of clinical decision-making, while accounting for only about 2% of total healthcare spending. The developed markets of the U.S. ($30B), Europe ($22B), and Japan ($7B) account for nearly 75% of current industry sales. There is great opportunity for the leading companies to grow into the emerging markets, like China and India, as rising living standards lead to the opportunity to utilize diagnostics and improve healthcare. Three major factors are driving global demand for IVD products:
- The aging population—the number of people aged 65 and older is projected to grow from 524 million in 2020 to 1.5 billion by 2050, and as the world’s population ages, there will be greater pressure on the healthcare system for inexpensive and accurate diagnostics;
- Growth in chronic and infectious disease—the American Heart Association recently reported that the number of Americans with diabetes is projected to increase from 30 million in 2016 to 46 million by 2030—an annual 3% growth rate, while cancer incidence is rising as fast as 4% annually;
- Technology advancement—in the past, functions performed by in-vitro diagnostics were exclusively performed in labs or clinics. As technology has developed, these functions have been made accessible in smaller, easier, cheaper, and more portable versions—the simplest examples being take-home pregnancy tests and blood glucose testing devices.
The IVD market has gradually been consolidating. We expect this trend to continue. Smaller players tend to be highly specialized, whereas the largest companies compete in multiple verticals. The fastest growing segment of the IVD industry is molecular diagnostics, which at over $7 billion in size is projected to grow as much as 12% a year through 2024. Molecular diagnostics uses techniques such as DNA (deoxyribonucleic acid) microarray analysis, mass spectrometry, and nucleic acid amplification to make rapid diagnoses, and, importantly, detect genomic variants. This is the key to the future of improved healthcare treatment through precision medicine, where a drug is tailored specifically to one’s genetic makeup. Next-generation sequencing instruments and genome-wide association studies provide invaluable insights into the mechanisms of disease. Genomic biomarkers allow physicians not only to assess disease predisposition, but also to design and implement accurate diagnostic methods and to individualize therapeutic treatment.
With that as a background, we now look at some specific diagnostic businesses within your portfolio.
Perkin Elmer has total revenues of $2.7 billion with its diagnostics segment over $1.1 billion in revenues. The diagnostics business is the global leader in maternal and fetal health testing and its newborn screening tests are the standard of care in more than 100 countries. Hospitals, medical laboratories, clinicians, and medical researchers use their products to improve the health of families. Perkin’s product set spans the consumable reagents used in the tests, the instruments that analyze the results, and the software that manages the workflow and interpret results. The reproductive health screening products are designed to provide early and accurate insights into the health of babies—both before and after birth. These tests screen for dozens of disorders ranging from cystic fibrosis to sickle cell disease, and enable faster care and intervention—even before any principal symptoms are apparent. For example, their AutoDELFIA immunoassay system is the screening solution of choice for laboratories around the world and has provided over 300 million screenings. The company estimates that its newborn screening tests find and allow treatment of 50 babies every day that would otherwise have developed severe diseases. Without the screening, many of the 50 would have died in infancy.
The picture shows two children, both positive for congenital hypothyroidism. The 7-year old girl on the right was successfully treated after newborn screening highlighted the disease. The 14-year old boy was not screened, and the lack of timely treatment resulted in developmental disorders. One of Perkin Elmer’s many tests enables early detection of this condition. Management at Perkin Elmer is acutely focused on the diagnostics opportunity. They recently expanded their diagnostics business through the $1.3 billion acquisition of EUROIMMUN, a global leader in autoimmune testing with expanding expertise in infectious disease and allergy testing. EUROIMMUN has over $300 million in revenues with over $150 million in China, which is growing rapidly. The acquisition will increase Perkin Elmer’s overall organic growth rate and drive faster earnings growth. Our original investment goes back nearly ten years. We like the opportunity at this specific point and time, and thus Perkin Elmer is now the partnership’s largest position at over 4% of total assets.
Thermo Fisher Scientific, the largest provider of life science research instruments and consumables in the world, has a specialty diagnostics segment with sales of $3.7 billion across an array of diagnostic test kits, reagents, and instruments. Their products are used to increase the speed and accuracy of diagnoses in areas like cancer, transplant diagnostics, cardiovascular and pulmonary diseases, and autoimmune diseases. Two examples from Thermo’s thousands of products illustrate the reason for our investment. Personalized precision medicine is a new paradigm in oncology treatment, with advances in genotyping and genomic profiling now enabling clinicians to gather therapy-relevant molecular information. The Oncomine Dx Target Test is the first FDA-approved test that can detect multiple gene mutations for non-small cell lung cancer (NSCLC) in a single test from a single tissue sample, simultaneously delivering multiple biomarker results from one sample within four days. The test panel gauges alterations in 23 genes in total, and indicates whether the patient has alterations in specific genes. This determines which of four biologic drugs currently on the market will best be used to treat the patient. This is called “companion” diagnostics, and this personalized use of drug technology increasingly changes how we treat disease. A second example is Thermo’s comprehensive set of products for human leukocyte antigen (HLA) typing, which is used to match patients and donors for bone marrow, or cord blood transplants. HLA are proteins located on the surface of the white blood cells and other tissues in the body. Our immune systems use these proteins, or biomarkers, to recognize which cells belong in our body and which do not. HLA matching is complex with three major groups and a total of about 300 specific HLA proteins. Thermo products create a unified workflow to produce diagnostic HLA results that improve accuracy, save lives, and reduce cost. Thermo Fisher continues to innovate and we will be at the center of new diagnostic technologies in the years ahead. Thermo Fisher is a relatively small position in your partnership, and we will look to triple the size of the investment at an opportune time.
During the quarter, we significantly increased the partnership’s position in Danaher, which is focused on a number of our investment themes: life sciences research, water and environmental analysis, dental, and diagnostics. The company has been consolidating the diagnostics industry and has built a $6 billion diagnostics segment that consists of five major brands, with the largest being Beckman Coulter, best known for its leading position in flow cytometers, which analyze the physical and chemical characteristics of individual cells. At the end of 2016, Danaher acquired Cepheid for nearly $4 billion. Cepheid manufactures molecular diagnostic tests and instruments, and has an array of assays. The company is rapidly gaining market share in a number of areas including flu diagnosis. Its Xpert Xpress Flu test delivers accurate results—more accurate than the traditional tests—on the type of flu within 20 minutes and negative results in 30 minutes in settings ranging from a hospital to a physician office to a specialty clinic. The speed and accuracy improves human health, speeds time to treatment, and reduces overall healthcare cost. This business grew at a 40% rate in the first quarter of 2018, taking significant market share from competitors. Cepheid’s Chief Medical and Technology Officer says: "For too long, clinicians have been asked to treat suspected cases of influenza empirically, since gold-standard RT-PCR based tests took too long to process in the critical first 24 hours of symptom onset. With the arrival of fast molecular tests like Xpert Xpress Flu/RSV, patients and their healthcare providers can now expect an accurate diagnosis, and access to targeted therapies substantially more quickly. Unnecessary treatment with antimicrobial agents can also be avoided. This supports clinical efforts to improve the patient experience, and further streamlines workflow in the laboratory, which can be particularly challenging in the midst of a busy respiratory virus season." Cepheid continues to innovate and recently launched the first new test for rapid diagnosis of tuberculosis since the 1940s. The World Health Organization subsequently backed the new test and stated that commercialization will have an immediate impact for children. Danaher is a high achieving company with double-digit free cash flow returns on capital, and we expect it to consolidate further the diagnostics industry and build its leading platform. We expect overall Danaher results to be strong this year, and found the quarter’s correction offered an attractive entry for increasing the investment.
Perkin Elmer, Thermo Fisher, and Danaher along with a handful of other healthcare-related companies comprise about 20% of Stone Run Capital Partners and make up the core of your portfolio.
Software – Making the World
Ongoing innovation in design, engineering, manufacturing, and construction software is revolutionizing the creative process and how people and companies make the world we see around us. There are four key aspects to our investment thesis on Software – Making the World:
- Automation and robotics: The use of software in automating production is accelerating around the world. At manufacturing companies, there are now over 75 robot units per 10,000 employees versus 66 in 2015. Robot density in the United States increased significantly to over 190 robots in 2017, which lagged well behind Korea at 635, and ahead of China at about 75. The International Federation of Robotics expects robot sales in the U.S. will continue to increase between 2017 and 2020 by at least 15% on average per year.
- Additive Manufacturing: Additive manufacturing or 3D printing and software systems are driving a revolution in how companies make products. Additive manufacturing is making it possible to manufacture products more quickly and cost-effectively, in smaller and smaller batches. Digital technologies are narrowing the distance between manufacturer and consumer, allowing manufacturers to bypass traditional intermediaries.
- Construction information technology: The global construction industry is approaching $10 trillion annually, and yet is decades behind in integrating software and information systems into the building process to improve efficiencies and reduce costs. A wave of disruption is now spreading through the commercial construction industry. There has been $1.6 billion in venture capital funding of construction technology startups since 2016 and a handful of leaders are emerging.
- Internet of things (IoT) and precise positioning: Technological advances enabling modularity and connectivity are transforming products from inert objects into “smart” devices, while the ability to know exactly where an object is will revolutionize all industries.
Autodesk has $2.5 billion in revenues and is the dominant global leader in architectural design software—computer-aided design (CAD)—and continues to develop its strong positions in other design areas including manufacturing and robotics. We have invested in Autodesk for over fifteen years and adjust the size of the investment based on our outlook for the business and its valuation. At present, Autodesk is going through a business model transition to a subscription-based cloud revenue model, which should drive a significant increase in free cash flow over the next five years. Along with this, the company is at the forefront of software used to create designs for additive manufacturing and has an array of end market specific robotics applications.
While it is currently a small component of revenues, Autodesk® PowerMill Robot provides powerful, flexible, and easy-to-use tools for off-line programming of robots, simplifying the optimization of robotic paths and simulating virtual mock-ups of complete manufacturing cells and systems. This area is growing rapidly. Garner Holt, the world's largest manufacturer of animatronics and special effects for the theme park industry, previously sculpted by hand, but now uses PowerMill Robot to machine and cut foam faster, and with greater precision—imagine if Michelangelo had had this tool. PowerMill further allows higher quality polished surfaces through grinding and belt sanding applications. A major aircraft engine manufacturer used Autodesk PowerMill Robot to polish high value fan blades with a Fanuc robot.
Autodesk provides software for creating and printing three-dimensional objects through additive manufacturing. Additive manufacturing is a family of processes that produces objects by adding material in layers that correspond to successive cross-sections of a 3D model. Plastics and metal alloys are the most commonly used materials for 3D printing. Autodesk’s Fusion 360 set of applications enable both the professional corporate user and the hobbyist to work in the additive manufacturing world. Athletic apparel manufacturer Under Armour is shaping the future of footwear technology with their first 3D-printed performance shoe. Using Autodesk’s Fusion 360 software, Under Armour developed a sneaker stable enough for weightlifting, yet lightweight and flexible enough for cross-training. 3D printing is the only way to fabricate the intricately-structured midsole (pictured here).
Autodesk Within Medical is the company’s 3D printing and orthopedic implant design software that enables companies to create medical implants that are porous and optimized. Novax DMA is an Autodesk customer and specializes in the research, development, production, and marketing of innovative medical technologies. Novax primarily makes medical implants for orthopedics and cranial surgery—the skull image shows an example of an actual implant produced using Autodesk Within Medical. Founder and CEO Daniel Fiz discusses the integration of medical technology and manufacturing enabled by Autodesk software: “Biologically, bone cells deposit different material and mineral densities in different parts depending on the structural needs of the body. What this software allows us to do is clearly design the porosity of bone implants, and essentially create any complex structure that you want. In the past, with traditional coating methods, it was very difficult to have control of the porosity and it was a challenge to create interconnections between the pores. Now we can create porous interconnections, regulate the dimensions of each pore, and regulate the density of the pores in different parts of the implant, meaning we can create an implant which is much closer to the real thing.” Utilizing Autodesk and the most cutting edge 3D printers, Novax can now print directly in titanium, a major breakthrough as previously they relied on either polymer filled molds or the use of conventional subtractive methods.
With continued growth, we believe Autodesk can earn in excess of $10 per share in free cash flow by 2021, and trade at 20x this for a share price 50% higher than today.
Trimble is an integrated technology and software provider enabling professionals and field mobile workers to improve and transform their work processes. With over 1,200 patents, $350 million a year in research and development, and millions of customers in over 100 countries, Trimble has $3 billion in revenues through the integration of real-time positioning technologies, wireless communications, software, and information technologies. Through sub-meter positioning solutions in products such as R2 Integrated GNSS (global navigation satellite systems), Trimble offers continuous mobile positioning and high-accuracy orientation for applications such as navigation, guidance, and control of unmanned vehicles and unmanned aerial vehicles (UAVs). Trimble integrates a wide range of positioning technologies including GPS and inertial technologies with wireless communications and industry specific application software. For example, through software such as Connected Farm and Farm Works, Trimble provides farmers with precision control over their agricultural equipment, while also managing seed locations, fertilizer rates, and harvest data.
Trimble has taken a leadership role in bringing information technology to the construction industry. During the past couple of years, it has acquired a number of construction information technology companies to leverage its expertise in the building process, and to digitize the reporting practices and project management systems associated with construction. The acquisition pace picked up considerably in the last two months with Trimble investing $1.7 billion to acquire e-Builder and Viewpoint to create the industry’s most complete construction management solution. Management has taken on considerable debt to do this, which will be a drag on near-term stock performance. We will monitor progress closely and look to take advantage of stock weakness. e-Builder measures and manages every step of the capital project delivery process including planning, design, procurement, construction and operations. The software system leverages real time data to improve visibility and accountability in construction projects and connect contractor and owner. Banner Health, one of the largest nonprofit health care systems in the U.S., used e-Builder to maximize efficiency across their capital projects and saved over $90 million from their active projects, of which it then used a portion to fund a new cancer center. By incorporating design details, construction challenges, and the project schedule into one view, contractors, owners, and civil engineers can plan and manage projects more effectively. While the construction information technology business is less than 10% of Trimble’s total revenues, it is growing at a 20% rate, and can perhaps grow through an economic downturn as global construction companies increasingly adopt the platforms in order to improve economic returns.
Our third “software-making the world” company is PTC. PTC is a leader in providing computer-aided design and product lifecycle software to the world’s most sophisticated manufacturing companies. The aerospace company, Raytheon, has standardized on PTC’s software Creo since 2007. CEO Jim Heppelmann, who has worked with the company and its predecessors for decades, is a visionary. Beginning in 2013, through the acquisition of ThingWorx, he has pushed aggressively to build a software platform to enable connectivity in the Internet of Things (IoT). Along with this, he is now incorporating augmented reality (AR), which integrates the power of visualization with quantitative data—as they say, a picture is worth a thousand words.
The number of devices connected to the Internet now exceeds the total number of humans, and expectation is that there will be as many as 50 billion connected devices by 2020. The implications span all industries. PTC has a nearly $200 million IoT business, which is growing at 30% annually, and based on reports from industry research firms like Forrester and IDX Marketscape, has one of the most robust IoT offerings on the market. One customer, Embedded Energy Technology (EET), works with many of the 50,000 district and industrial steam facilities in the U.S., which represent almost 15% of U.S. annual energy usage. EET designed a sensor that monitors the steam pipes, pipe insulation, and rooms they are in to measure how much heat is being retained and to provide insight into whether or not the component is functioning as intended. Initially the company planned to build their own software development team, but they ultimately selected PTC’s ThingWorx to be the platform for their customers across a range of information. PTC’s IoT platform partners with Microsoft and has an increasing list of blue chip customers. One large PTC customer signed a contract for IoT worth over $10 million in 2017. At present, PTC looks to be a winner in this space and the growth opportunity is huge.
Augmented reality is a set of technologies that superimposes digital data and images on the physical world. Though still in its infancy, AR is poised to enter the mainstream, with spending on AR applications expected to be in the tens of billions of dollars in the next several years. PTC’s AR software connects with a 3-D digital facsimile of the object in the cloud, called a “digital twin,” which enables the user to assess the object in a far more comprehensive way than is possible in the confines of physical reality. An unusual example highlights the opportunity. PTC and Boston Children’s Hospital, the number one pediatric hospital in the U.S., are collaborating to explore the use of AR to help children with autism and related disorders learn how to communicate and engage with the world more effectively. AR bridges the physical and digital worlds by overlaying an image onto a physical environment to help children with autism better understand specific tasks despite their challenges. Typically, AR is used in the industrial setting to transform volumes of data and analytics into images or animations, but the autism example suggests how AR will merge the digital and physical worlds to change how humans learn and communicate. In a more typical example, Newport News Shipbuilding, which designs and builds U.S. Navy aircraft carriers, uses AR near the end of its manufacturing process to inspect a ship. The software marks for removal steel construction structures that are not part of the finished carrier. Historically, engineers had to constantly compare the actual ship with complex 2-D blueprints. With AR, they can see the final design superimposed on the ship, which reduces inspection time by 96%—from 36 hours to just 90 minutes. Time savings of 25% or more are typical for manufacturing tasks using AR.
Based on the current developments in the business and a long-term outlook, PTC can generate free cash flow per share above $5.00 in 2021, which along with a strong growth rate, could lead to the stock trading above $100 versus the current $80 share price. PTC is perhaps fully valued at present, and we have reduced the size of the position, but will increase it again if we get the opportunity.