ChemoMetec - Bringing process and quality control to Life Sciences

ChemoMetec has an incredible growth track record, high profit margins and incredibly low customer churn. Find out why this company has >50% EBITDA margins, ROIC >50% and >30% organic growth!

ChemoMetec (ticker: CHEMM) is a Danish Life Sciences company that produces measuring equipment, mainly cell counters, for companies in Life Sciences. The company was founded in 1997 and has grown significantly over the last few years on the backdrop of advances in cell-based therapy. The company is still relatively small, counting only around 150 employees.

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Why is ChemoMetec interesting?

CHEMM is a company that has probably come on your radar if you have done screens for well-performing stocks over the past decade. The shares have compounded at an incredible 89% and 71% a year over the last 10 years and last 5 years respectively. These are incredible numbers, but what has made this possible?
On further inspection, it is quite clear why investors would love this business as it combines many characteristics that make for a compounder. With some tailwinds from margin expansion, the ingredients are there for major business outperformance.
The Life Sciences industry is an industry where investors can find attractive businesses that enjoy above-average growth, profitability, and a large end-market to grow into for the years to come. I have already profiled such companies on Global Quality Investing (Surgical Science Sweden, CellaVision, and ArcticZymes). CHEMM possesses many similar characteristics and combines aspects from the aforementioned companies that I can use to explain why I think CHEMM is an interesting company to study.

Business

As mentioned earlier, CHEMM supplies Life Sciences company with high-end measuring equipment and consumables to use this equipment. Put simply, CHEMM sells automated cell counters and consumables to use them. You might remember cell counters from my post on CellaVision. In that context, the cell counters were used to get an initial reading on a blood sample. CHEMM does not service the hematology sector (blood-testing) but rather the R&D and manufacturing of drugs.

For process- and quality control purposes, every step of the process needs measuring - this is where CHEMM's products come into play. Whenever a certain step in the workflow is completed, CHEMM's cell counters are used to measure if the step has been successfully completed by identifying living and dead cells within a sample. For example, if a company wants to be sure unwanted DNA has been successfully removed from a sample (like a company would do after using AZT's enzymes) or to know how many desired cells are left after a certain step, the sample is examined using CHEMM's products before it is passed on to the next step in the workflow. This process- and quality control is essential to make sure the desired result can be consistently achieved and such control measures are very much required by the FDA and other regulators. In fact, the cell counters and workflows associated with it are part of the FDA file that gets approved at every phase. Switching cell counters would need reworking that entire file/application, something customers simply do not do.

CHEMM has gained a lot of market share over the last few years and estimates its market share to be 15-20% as of 2021 vs less than 10% just 5 years ago.

Now let's look at CHEMM's products.

Products

CHEMM primarily sells automated cell counters under the NucleoCounter brand/series and consumables associated with its use. You can find an overview of the product releases by year below.

Source: Company website

Source: Company Annual Report

As you can see, CHEMM releases new products on a regular basis. Its newest product, the XcytoMatic, is not yet featured on this picture, more on this later.

The most common way cell counters work is using what is called flow cytometry. Cytometry is the measurement and quantification of cells. Flow cytometry essentially streams a fluid to create a "flow" of cells who are then measured using light reflection. I have added a helpful video that explains it below.

CHEMM's NucleoCounter, however, uses image cytometry. By adding the imaging element to cytometry, the NucleoCounter makes visual inspection of the individual cells possible. Comparison studies have indicated that the NucleoCounter is at least as accurate as flow cytometry equipment and the NucleoCounter NC-202 is touted as the most precise measuring device on the market.

In addition to these measuring instruments, CHEMM sells disposable cassettes that contain reagents and fluorescent dye. These cassettes provide a consistent way to count cells with minimal human handling, and, by extension, human error. Here is how the cassettes work:

CHEMM sells to 3 submarkets, LCB (life science research, cell therapy and bioprocessing). These submarkets are fast-growing and CHEMM has a strong position in two of the three, life science research and cell therapy. CHEMM intends to target the bioprocessing market with an automated cell counter that can handle larger volumes, the XcytoMatic.

The new Xcytomatic product, which was scheduled to be released in 2021, will finally be released within the next few months after delays due to COVID-19 and a shortage of raw materials. The XcytoMatic cell counter leverages the leading cell counting technology CHEMM has developed over the years and has been designed specifically for bioprocessing (the creation of products using complete living cells or their components) to handle a larger volume of samples in an even more automated way than the NC-202 and older generations. The XcytoMatic does not use disposable cassettes but instead uses disposable test tubes and reagents. The XcytoMatic will require service contracts for customers to stay GMP (Good Manufacturing Practices) compliant. This will be a great source of recurring, high-margin revenue for a number of years.
With many companies setting up their production facilities and workflows to support the growth in next-generation therapies (read Cell- and gene therapies), the XcytoMatic can help CHEMM be a key part of the processes that will produce drugs for clinical trials and eventually, commercialization. Customers are well aware of CHEMM and their products. The bioprocessing does not target different customers, just different parts of the workflow/value-chain. Given CHEMM's current reputation in the marketplace, I expect XcytoMatic to be an easier sell.

Much like ArcticZymes, CHEMM's primary market is the fast-growing cell-based therapies market. The cell counting market as a whole is projected to grow at a healthy mid- to high single digit percentage rate, but the cell-based therapies market is projected to grow even faster. CHEMM is currently viewed by most as the third largest player in the still relatively small automated cell counter market (<$300m according to Bank of America estimates) behind Thermo Fisher and Danaher's Beckman Coulter.

Business model

With some background on the products, how they work etc., some investors might already have a decent idea what makes CHEMM's products so sticky. Put simply, once a customers chooses CHEMM as a supplier for cell counters and implements it in their workflow, they never leave nor change their measurement method. Customers choose the CHEMM cell counters during the research and clinical trials stages and eventually purchase more of them once the therapy is commercialized because of the higher production needs. Customers thus are still buying cell counters released by CHEMM years ago simply because they are unwilling to switch, even to newer products.

After selling the initial instruments, CHEMM has a multi-year, sometimes even decade long revenue stream from the sale of cassettes and service contracts. These revenue streams are incredibly high-margin and, as long as the cell counter is used, the customers needs to purchase CHEMM's consumables and service the equipment. With this razor/razorblade business model, CHEMM essentially stacks almost guaranteed, high-margin revenue streams with every new instrument sale. This has resulted in an incredibly profitable business and high-growth as CHEMM has managed to win more business with each new product releases. The performance of the NC-202 seems to indicate this is far from over as, according to the CEO, the NC-202 has already sold more than older products and the sales in 2021 doubled from 2020 levels.

Source: Company Annual Report

Source: Bank of America Global Research

Instruments comprise about half of the revenues, consumables about 35-40% and service contracts make up the remaining 10%. Half of CHEMM's revenues are thus not from new business won, but from existing customers using the cell counters on a regular basis. This is a very powerful business model and, should the new XcytoMatic do well and the NC-202 keep having success, CHEMM's business will do well.

Competitive advantage

Switching costs: Customers incur significant switching costs. Although the direct costs themselves are relatively modest (around 500K USD and a ~9 months process to change the equipment in FDA filing), customers overwhelmingly choose to not change their cell counters within a certain workflow. The costs to redesign the workflows and the time it takes to recertify them with the FDA are especially prohibitive in addition to the direct costs. The benefits from upgrading to a new cell counter pale in comparison compared to the time, effort, and, to some extent, money it costs to make that happen. This is highlighted by the very low customer churn CHEMM has mentioned (low single-digit %).

Intellectual property: CHEMM's technology is protected by patents and the true differentiator is its proprietary cassette and the use of a specific dye that makes more accurate and reproducible results possible. Although management seems confident in their ability to stay ahead of the competition in terms of technology, I tend to find IP alone to be a weak source of moat by itself. Fortunately, customers tend to value relationships and track record over price and are very aware of the high costs of failure subpar equipment could bring.

Management & Ownership

CHEMM's management team has plenty of experience in the industry and both the CEO and COO have had a large role in the company's success to date. The CFO recently left and I expect the company to announce the appointment of a new CFO soon.

Steen Søndergaard, CEO - Søndergaard was the company's COO in 2012 and 2013 and took the CEO role for a year in 2014. He returned to the company in January 2020 after a few years at smaller technology/life sciences companies. His experience is primarily in commercial leadership roles in lesser-known companies.

Martin Glensbjerg, COO - Glensbjerg is one of the founders of the company and has been at the company since 1997. He was the CEO until 2013. He also holds the role of Vice Chairman of the Board. Glensbjerg holds approximately 3.0-3.5% of the outstanding shares.

The Board of Directors is quite tightly held, with the Chairman of the Board, Niels Thesrup being a partner/owner at the law firm that advises the company. Martin Glensbjerg is on the Board as Vice Chairman and three independent directors complete this small, five-person Board.

There is no particularly large shareholder involved in CHEMM. Only Martin Glensbjerg seems to have significant influence and a relatively large economic interest in the company, although just <3.5% of the share capital. This is an area where I would like to see more economic alignment between management, the Board, and shareholders.

Financials & Valuation

There is no doubt that CHEMM has had stellar financial performance over the past 5-10 years. Considering where the company, its customers and its end-markets are, it is likely that this stellar performance keeps going. The key question is: how stellar will that performance be? The business will perform well, but will the stock too? This is what I will try to answer.

First, let's take a look at the financials of the past 5 years. Note that this excludes the performance of the last 9 months as CHEMM's fiscal year ends in June.

Source: Company Annual Report

Here is a graph overview of the revenues, EBITDA- and EBIT margin.

Source: Company Annual Report

It is quite obvious that CHEMM's financial ratios are all excellent and indicate we deal with a high-quality company here. With half of the sales coming from consumables and service contracts that carry Gross Margins >85%, CHEMM's financials look like those of a high-quality software company. Returns on Capital are excellent and growing, EBIT margins have crossed >40% and EBIT translates very well in cash.

For this fiscal year, CHEMM expects revenues to reach 420M DKK and EBITDA to be around 220M DKK. This implies revenue growth of 49% and an EBITDA margin of >50% vs 48% last year.

These are incredible growth and profitability numbers, but surely, the market has noticed it? Well, yes. CHEMM's Enterprise Value is 13B DKK, or a 59x EV/EBITDA multiple. The stock has never been cheap on multiples (for good reason considering the performance).

CHEMM is an above-average business in an above-average industry with above-average growth prospects. There is no doubt in my mind that this warrants a premium over the market, or even above most Medtech businesses, but how much of a premium.

Let's take the expected sales for 420M DKK and assume that, given all we know about the company and its end market, we are confident in assuming a 25% CAGR in revenue until 2030. I understand this is not conservative, but this sets up a baseline of expectations from which we can adjust. Chances are CHEMM will still warrant a decent multiple in 2030 if this performance were to materialize, after all, it sits in end-markets with tailwinds that could last more than a decade and mature Medtech businesses routinely trade at 15-20x Free Cash Flow, sometimes even higher. So our baseline assumptions for 2030 are:

• 25% Revenue CAGR

• 55% EBITDA margins (implies 3% expansion over 8 years)

• 60% of EBITDA converts into Free Cash Flow

• Exit multiple of 15-20x Free Cash Flow

This gives us the following outputs:

• Revenue 2030E: 2500M (2.5 Billions) DKK

• EBITDA 2030E: 1375M (1.375 Billions) DKK

• Free Cash Flow 2030E: 825M DKK

• Entreprise value 2030E: 12.375B - 16.5B DKK

At the lower end of this scenario, CHEMM's EV does not change for the next 8 years. You might receive some dividends along the way, but this would essentially be dead money for the next decade despite an incredible decade for CHEMM.

At the higher end, the EV compounds at 3% a year for the next 8 years and you receive some dividends along the way. This scenario doesn't get me excited to put my money to work with the risk that CHEMM cannot grow 25% a year and maintain an above-average multiple.

Although I'm convinced the company CHEMM will do well and I love every part of the business, owning the stock at this valuation implies more optimism than I'm willing to have. Truthfully, considering the opportunities that are out there and my recent experiences around valuation, it will probably take a 50% decline (<350 DKK per share) for me to even get interested in taking the execution and valuation risks.

Sure, CHEMM might trade at higher multiples if those assumptions turn out somewhat right. Hell, CHEMM might even outperform these assumptions. However, the base rates for companies growing at 20%+ CAGR over a decade are not in your favor. CHEMM might be the one in a few hundred that can do it, but if they aren't, you will be sure to lose money on this investment.

Essentially, everything needs to go very right for CHEMM as a business and the price the market is willing to pay for investors to make a good return, let alone an above-average return. Not a bet I want to make.

Conclusion

ChemoMetec is the perfect example of a great business, but probably a poor investment looking forward. This reminds me of Richard Lawrence's quote in the recent Investing by the Books episode: "Sometimes, you get tomorrow's price today".
ChemoMetec is an incredible business in an attractive industry with many tailwinds at its back. It has industry-leading technology, a high-margin razor/razorblade business model with customers who simply do not churn. It is able to charge high prices for mission-critical measurement equipment and customers, once locked in, are more than willing to pay to keep using the equipment. This has resulted in a tripling of sales in just the last 5 years with extraordinarily high profit margins for such growth rates. The stock has done well as a reflection of this outperformance.
Even with my enthusiasm about the company, its end-market and the future performance I expect from the company, today's valuation is simply too high for me to justify putting capital at risk.
Despite the high valuation, I would recommend anyone who is interested in European Medtech or the developments in cell- and gene therapies to study ChemoMetec and ArcticZymes. Whenever the valuation makes sense, these are the types of companies I would love to own in size. I will also try to spend more time on these Healthcare / Medtech companies. I have already covered a few names, but the cell- and gene therapies space seems like a great opportunity to find compounders for the next decade and a half. For this, I would like to encourage any readers with insights into the industry or companies to reach out. I am actively looking for companies in this space globally, like CDMOs or other picks-and-shovels for the industry.

Disclaimer: Always do your own research. This is not investment advice and for informational purposes only. Partnership Investing is not a registered investment adviser and may or may not hold securities discussed on this blog.