Why did operating income and margins decline in 2006 even though revenue grew 44%?

The decline stems mainly from merger accounting. The company recorded $125 million of one-time merger-related charges, including $73 million for selling acquired inventory revalued at fair value, $37 million of accelerated stock compensation, and $15 million of purchased in-process R&D. Amortization of acquisition intangibles also rose by $93 million. Excluding these items, the company says profitability at existing businesses improved on higher revenue, productivity gains, and pricing.

How much of the 2006 growth came from the Fisher merger versus the existing business?

Of the $1.16 billion increase in sales, about $978 million came from acquisitions net of divestitures, principally Fisher, and $18 million came from favorable currency translation. Organic growth, excluding acquisitions and currency, was about $163 million, or 6%, driven by higher demand and modest price increases. Growth was strongest in Asia and Europe and moderate in North America.

How leveraged is Thermo Fisher after the merger, and is there liquidity risk?

Debt is about $2.7 billion, and the company's financial covenant caps its consolidated leverage ratio at 3.0x EBITDA. Liquidity is adequate: the company held $691 million of cash and short-term investments at year-end and had $635 million available under its $1 billion revolver, which expires in 2011. Management says these resources are sufficient for at least the next 24 months. Most debt matures in 2009 or later, and much of it is convertible, so the company faces relatively limited near-term refinancing pressure.

What are the main legal and regulatory risks disclosed?

The most significant is a patent infringement suit filed in 2004 by Applera, MDS, and Applied Biosystems/MDS Scientific Instruments, which alleges that certain triple quadrupole and ion trap mass spectrometers infringe a patent. Plaintiffs seek treble damages and injunctive relief, and management says an unfavorable outcome could have a material adverse effect. Thermo Fisher has filed counter-suits. Separately, the UK Competition Commission is reviewing the GV Instruments acquisition, and the company faces possible divestiture or impairment charges if the review requires it. The company also cites product liability exposure from Fisher, with a reserve range of roughly $128–252 million on an undiscounted basis.

What should investors expect for 2007 earnings and margins?

The filing does not provide formal earnings guidance. Still, several factors will weigh on reported results in 2007: roughly $470 million of annual amortization from Fisher intangibles, which is well above 2006's level; ongoing integration and restructuring costs that management expects to finalize within a year of the merger; and the lower tax rate seen in 2006 being unlikely to repeat. Offsetting factors include expected cost synergies, a full year of Fisher contribution, and management's view that demand and pricing remain supportive. Investors should focus on adjusted operating margin trends and the pace of synergy capture.

TMO 10-K FY2006 Annual Report — Revenue, Net Income, EPS

01—Abstract

Summary

Summary of the 10-K filed March 1, 2007. Cited figures are marked; the original filing is the authoritative source.

Thermo Fisher Scientific (TMO) closed its transformational merger with Fisher Scientific International on November 9, 2006, which reshaped the company's scale and balance sheet.

Revenue rose 44% to $3.79 billion^a in 2006 (about 32 points from the merger), and organic growth was roughly 6%, driven by demand in mass spectrometry and spectroscopy and by stronger pricing. Reported operating income fell to $242 million from $263 million, with the margin dropping to 6.4% from 10.0%. The decline reflects $125 million of merger-related charges (including inventory step-up, accelerated stock compensation, and in-process R&D) and $93 million of higher acquisition-related amortization.

Net income fell to $169 million^b from $223 million, and diluted EPS was $0.84 versus $1.36. The effective tax rate fell to 20.6% from 30.6%, which partly cushioned the decline in earnings. The balance sheet changed dramatically.

Total assets grew to $21.3 billion^c from $4.3 billion, goodwill rose to $8.5 billion, and acquisition-related intangibles reached $7.5 billion. Total debt is about $2.7 billion, of which roughly 77% matures in 2009 or later, and the company has $691 million in cash and short-term investments plus $635 million of available revolver capacity. Operating cash flow was $406 million, up from $271 million, though it was held down by $157 million of merger-related outflows.

Management expects roughly $470 million^d of annual amortization from the Fisher intangibles, which will keep reported margins under pressure in 2007 and beyond. Management also guided capital expenditures of $240–260 million for 2007 and authorized a new $300 million share repurchase program. Investors should weigh the strategic logic of a combined portfolio spanning analytical instruments, reagents, consumables, and lab supplies against the integration risk, the heavier leverage, and the continuing litigation over mass spectrometer patents.

The company also faces a UK Competition Commission review of its GV Instruments acquisition. Integration is still in progress, and the company says cost synergies and restructuring actions are expected to be finalized within a year of the merger.

02—Key points

Key Highlights

Revenue grew 44% to $3.79 billion in 2006, with about 32 points from the Fisher merger and about 6% organic growth; the company now reports two segments, Analytical Technologies (64% of revenue) and Laboratory Products and Services (37%).
Operating income fell 8% to $242 million (6.4% margin, vs. 10.0%), mainly from $125 million of merger-related charges and $93 million of higher amortization; diluted EPS was $0.84, down from $1.36.
Total assets nearly quintupled to $21.3 billion, with goodwill of $8.5 billion and acquisition-related intangibles of $7.5 billion; the company expects about $470 million per year of amortization from Fisher intangibles.
Total debt is about $2.7 billion (77% due 2009 or later), and liquidity is solid at $691 million in cash and short-term investments plus $635 million of undrawn revolver capacity under a new $1 billion facility.
Operating cash flow rose to $406 million from $271 million, despite $157 million of merger-related cash outflows; capital expenditures are guided to $240–260 million for 2007.
Shareholders' equity more than quintupled to $13.9 billion because Thermo shareholders received about 39% of the combined company and Fisher holders about 61%, in a stock-for-stock deal valued at about $10.3 billion in equity.
Board authorized a new $300 million share repurchase program in February 2007, and the company has never paid cash dividends.

03—Questions

Frequently Asked Questions

Why did operating income and margins decline in 2006 even though revenue grew 44%?
The decline stems mainly from merger accounting. The company recorded $125 million of one-time merger-related charges, including $73 million for selling acquired inventory revalued at fair value, $37 million of accelerated stock compensation, and $15 million of purchased in-process R&D. Amortization of acquisition intangibles also rose by $93 million. Excluding these items, the company says profitability at existing businesses improved on higher revenue, productivity gains, and pricing.
How much of the 2006 growth came from the Fisher merger versus the existing business?
Of the $1.16 billion increase in sales, about $978 million came from acquisitions net of divestitures, principally Fisher, and $18 million came from favorable currency translation. Organic growth, excluding acquisitions and currency, was about $163 million, or 6%, driven by higher demand and modest price increases. Growth was strongest in Asia and Europe and moderate in North America.
How leveraged is Thermo Fisher after the merger, and is there liquidity risk?
Debt is about $2.7 billion, and the company's financial covenant caps its consolidated leverage ratio at 3.0x EBITDA. Liquidity is adequate: the company held $691 million of cash and short-term investments at year-end and had $635 million available under its $1 billion revolver, which expires in 2011. Management says these resources are sufficient for at least the next 24 months. Most debt matures in 2009 or later, and much of it is convertible, so the company faces relatively limited near-term refinancing pressure.
What are the main legal and regulatory risks disclosed?
The most significant is a patent infringement suit filed in 2004 by Applera, MDS, and Applied Biosystems/MDS Scientific Instruments, which alleges that certain triple quadrupole and ion trap mass spectrometers infringe a patent. Plaintiffs seek treble damages and injunctive relief, and management says an unfavorable outcome could have a material adverse effect. Thermo Fisher has filed counter-suits. Separately, the UK Competition Commission is reviewing the GV Instruments acquisition, and the company faces possible divestiture or impairment charges if the review requires it. The company also cites product liability exposure from Fisher, with a reserve range of roughly $128–252 million on an undiscounted basis.
What should investors expect for 2007 earnings and margins?
The filing does not provide formal earnings guidance. Still, several factors will weigh on reported results in 2007: roughly $470 million of annual amortization from Fisher intangibles, which is well above 2006's level; ongoing integration and restructuring costs that management expects to finalize within a year of the merger; and the lower tax rate seen in 2006 being unlikely to repeat. Offsetting factors include expected cost synergies, a full year of Fisher contribution, and management's view that demand and pricing remain supportive. Investors should focus on adjusted operating margin trends and the pace of synergy capture.

04—Continue

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