Company Review

Arista Networks, Inc. (ANET; $290.57)

Arista Networks, Inc. provides cloud networking solutions and its ethernet switching and routing platforms serve as a foundation for enabling digital transfer of information. With over $2.3 billion in revenues, Arista grew revenues at a 33% compound annual growth rate from 2014 to 2019.  Earnings and free cash flow increased at over a 50% annual rate during this time period. Due to both the pandemic and a delay in purchasing from its two largest customers—Facebook and Microsoft—revenues declined during 2020. This led to a stock decline of about 30% from the high and we initiated a small position at the lower levels. Arista has the number one share in the ethernet switch data center market and has been taking share from the major competitor, Cisco, for years. Arista’s technology is most geared toward the high end, and high-speed switches, used in data centers. We believe more and more network traffic will be centralized through the large cloud providers over time: Amazon, Microsoft, Google, Facebook, and a handful of others. With an annual investment of about 20% of revenues in research and development, Arista’s core expertise is networking hardware and software innovation.  The balance sheet is very strong and the company has no debt and over $2.8 billion in cash. We expect the company to utilize this cash to acquire additional technologies. Management recently purchased Awake Security, a network detection and response (NDR) software company that combines artificial intelligence with human expertise to hunt and respond autonomously to cybersecurity threats. Cybersecurity is a growing theme in the portfolio and the investment in Arista is a portion of our developing exposure to this concept. We will review the group of companies comprising this cybersecurity investment in our first quarter letter.

Becton, Dickinson & Company (BDX; $250.22)

Becton Dickinson is an innovative medical technology business, currently accounts for 3.5% of Stone Run’s total assets, and is a top-ten holding. Becton possesses high return on invested capital, dominant market share, strong financials, pricing power, a talented management team, and catalysts to drive revenue and earnings growth over time. We expect Becton to preserve portfolio assets in difficult market climates and to generate a long-term winning performance.

Becton had over $17 billion in revenues in 2020 and is comprised of three global business segments: BD Medical (52% of revenues), BD Life Sciences (25%), and BD Interventional (23%). BD Medical manufactures various types of catheters, ultrasonic imaging for surgical access, prefilled syringes, IV connectors and extensions, needles, and sharps disposal devices. The BD Life Sciences segment provides products for the safe collection and transport of diagnostic specimens, instruments and reagent systems to detect a broad range of infectious diseases (including COVID-19), and healthcare-associated infections and cancers. The BD Interventional segment provides primarily single-use products for vascular, urology, oncology, and surgical specialty procedures. The company is arguably the most efficient global manufacturer of these consumables, which are manufactured in lots of hundreds of million units. The company produced forty billion medical devices last year, including six billion syringes. A typical consumable product costs less than $500, which is a small part of most surgical procedures, and therefore less likely to be subject to pricing pressure.

Becton’s recurring revenues account for 60%-70% of total company sales; historically the company has been considered relatively recession-proof. However, the COVID-19 pandemic has created elaborate challenges that disrupt the normal flow of patients to hospitals and other medical sites. The recall of Becton’s Alaris infusion pumps—highly profitable in the U.S. and international markets—was an additional stressor. These issues were exacerbated by investor concerns that the company overpaid for C.R. Bard, burdening the enterprise with debt. The stock languished for most of 2020, while other growth stocks in the medical technology area made new all-time highs. Going forward, we expect a lift to operations. The company’s positive financial results for the first quarter of fiscal year 2021 add to our confidence.

Becton introduces hundreds of new or improved medical products and supplies annually. It spends about 6% of annual revenues on research and development, helping drive technological advances and new product initiatives. In fiscal year 2020, these outlays amounted to $1.0 billion. Following the acquisition of CareFusion in 2015 and C.R. Bard in 2017—the largest acquisitions in the company’s 122-year history—Becton has a product pipeline with the potential to expand the available market and position itself as a full-suite product and solutions vendor to hospitals, group medical purchasing organizations, physicians, and related healthcare entities worldwide. CareFusion derives much of its revenues from products in which it is the market leader: intravenous infusion pumps, medication dispensers, respirators, ventilators, and infection control products. The Bard deal added a highly trained and successful marketing organization; a reputation for quality products such as catheters, PICCS, syringes, and other consumables; and strong R&D capability. The combined companies offer products ranked first or second in their markets and provide one-stop shopping and bundled deals. In 2020, Becton developed and deployed multiple diagnostic assays for COVID-19, leveraging its existing BD MAX and BD Veritor diagnostic platforms to help expand access to testing around the world.

We believe Becton is superior to the average S&P 500 enterprise and increased the position size several times during 2020. There were a number of negative impacts to the business: disappointing results from its drug-coated balloon (DCB) product; the recall of Alaris, its diabetes pump; COVID-19 disruptions to elective surgery procedures; and pricing pressure on general healthcare consumables in its China business. Looking forward, these issues should give way to a number of levers for new earnings momentum. A revamped Alaris pump is expected back on the market in 2022. Becton’s recent investment of $1.2 billion in the pre-fillable cartridge and syringe business—arguably its strongest business with 8% annual gains for the past three years—will drive profits. Becton recently became one of few manufacturers of a rapid COVID-19 screening kit. Finally, Becton’s core medical surgical business should recover significantly as the pandemic abates and patients return to elective surgeries. The balance sheet is also gaining strength. Total debt to EBITDA reached a high 4.5-times in 2018 following the C.R. Bard acquisition, is now under 3-times, and we expect it to get closer to 2-times in the next two years, reflecting Becton’s strong free cash flow. Adding to the revenue opportunities, new corporate leadership is reorganizing senior talent and aspects of the operational structure, which, we believe, will help improve profit margins. Overall, the opportunity for sales and earnings growth in the next five years is on the order of 5% and 10%, respectively.

International Flavors and Fragrances, Inc. (IFF; $108.84)

When we discussed IFF in our Q2 2019 letter, we noted that, despite the high quality of IFF’s historical businesses and markets, challenges in the company’s acquisition of the natural ingredient purveyor Frutarom would likely prolong share-price volatility. In fact, volatility persisted after IFF announced in December 2019 that it would merge its own lines ($5.1 billion in revenue) with DuPont’s Nutrition and Biosciences (N&B) business ($6 billion in revenue), more than doubling the size of the company.

The announcement of a new and larger deal so soon after IFF’s still incomplete merger with Frutarom was a surprise. DuPont N&B has market-leading positions in three attractive markets: enzymes (growing at 2-3%), probiotics (growing at 4-5%), and alternative proteins (growing at 9-10%)—all part of the secular trend of leveraging nature and biological processes to create healthy and environmentally friendly products. Natural enzymes grown in laboratories improve the stain-fighting qualities of laundry detergent at lower water temperatures. Probiotics—or “good” bacteria—improve digestive health. Plant protein—as in the “Beyond Meat” and “Impossible Meat” brands—matches the taste and texture of animal products. As IFF integrates N&B’s product lines over the next several months, IFF will become the largest and most diversified one-stop shop for food manufacturers and packaged food companies in the world (Figure V). Customers will not only be able to contract flavor and taste from IFF, but also raw materials and ingredients associated with the texture, efficacy, and health benefits of some of the food sector’s fastest-growing products. We believe this deal changes the competitive dynamics of the flavors and fragrances industry.

The complex Reverse-Morris-Trust transaction, involving share exchanges and a payment of $7.1 billion in cash to DuPont, adds uncertainty to IFF. Nonetheless, once the integration is complete, the new IFF should produce growing profits and free cash flow through cost and revenue synergies from the combined businesses, as well as fast-growing trends in natural ingredients, clean labels, independent brands, and alternatives to meat. Based on our study of DuPont N&B’s and Frutarom’s historical growth rates and profitability, we model annual revenue improvement of 4-5% beginning in 2021, with EBITDA margins of 25% in 2023. After a careful analysis of IFF’s mergers with both Frutarom and Dupont, and of the future prospects of the combined businesses, we plan to maintain and opportunistically grow the investment.

IHS Market Ltd. (INFO; $89.83)

Our investment in the information and analytics business, IHS Markit, dates to the inception of the partnership. In 2016, the company merged with Markit, a financial information business, in a transformative transaction that created a broader information powerhouse. This deal proved successful with the combined company outperforming the S&P 500 by about 50% in the past five years. The company is a top five position in the portfolio. Late in 2020, IHS Markit announced an even larger merger. The company intends to join with S&P Global, which is the world leader in credit ratings and index benchmarks, analytics, and data for the worldwide capital and commodity markets. Among many products, S&P Global manages the constitution of the Dow Jones Indices, the leading global investment benchmarks. Together, the two companies will be one of the world’s largest and most profitable information businesses. While the deal was announced as a merger, in essence S&P Global is acquiring IHS Markit and the partnership will be receiving shares of S&P Global (SPGI) in a tax-free transaction. Current S&P Global management will lead the new company. The deal will require shareholder approval of both companies and will occur in the second half of 2021. We will support the transaction and expect to continue to invest in the new entity. We have work to do to assess fully this new, much larger company with over $12 billion in revenues.

S&P Global and IHS Markit bring complementary data assets with cutting-edge software analytics and technology capability to corporate clients across the spectrum of industry. This will enable customers to make decisions with conviction; the integrated assets will inform workflows across the majority of the world’s leading companies. IHS Markit has $4.3 billion in revenues from 50,000 customers in 140 countries in four divisions: Financial Services (40% of revenues) aggregates market trading and pricing data across capital markets; Transportation (27%) provides automotive production and sales data; Resources (22%) is the global leader in energy information; and Consolidated Markets and Solutions (11%) integrates economic, technology, and product information. The company is highly profitable; free cash flow averages over 20% of revenues for the past five years. S&P Global has $7.3 billion in revenues from 30,000 customers in 150 countries. Its four divisions are: Ratings (47% of revenues) provides independent credit ratings, research, and analytics to investors and issuers; Market Intelligence (28%) has a portfolio of products that enable investors, government agencies, corporations, and universities to understand competitive and industry dynamics, and assess investment performance; Platts (12%) is the leading independent provider of information and benchmark prices for commodity and energy markets; and Indices (13%) develops and maintains transparent benchmarks enabling investors to monitor world markets. The combined businesses will comprise a vast array of complementary, in-depth, information services essential to the functioning of the investment world.

The revenue composition of the new company as presented by management during the conference call on the merger announcement. The product sets are quite complementary and there is an obvious logic in how to integrate the above eight divisions into five business segments. We see that just over 70% of the business is related to financial information. The companies also share the trait of predictability, with 75% of revenues now coming from recurring subscriptions. Further supporting this is the fact that both businesses were resilient during the economic shutdown periods of 2020. Leadership has targeted revenue growth at 7% annually for the next three years.