Avantor: Shrink to keep fundamentals pending price convergence (NYSE: AVTR)
Following a rapid change in price action and the recent earnings downgrade, I moved my position to Avantor, Inc (New York stock market :AVTR) hold. At present, I argue against allocating additional/upfront capital despite the appeal of its trading at 23x P/E and 17.5x FCF – well below historical averages.
I want to be clear: we are still bullish on AVTR in the long term. I just advocate refraining from allocating at this time. Selective opportunities loom on the horizon in this name. However, market experts have a lot to do. AVTR was punished heavily during Exercise 22 on the back of the SPX delta, alongside tightened leadership guidance for Exercise 22.
Right now, I’m watching price action in AVTR to understand where to go with risk and sizing, having already pulled the position back around 70% this year amid the steep decline. Nevertheless, there will once again be an opportunity in the name for those who are patient, in my opinion.
AVTR guidance for the full year has tightened on the bottom line
AVTR’s earnings forecast is crucial to the investment debate. Tight management Range of GAAP and non-GAAP EPS for fiscal year 22 during the earnings call. He now expects EPS growth of 250 to 300 basis points or $1.38 to $1.40 from $1.43 to $1.49.
Several headwinds explain the forecast. The first is an impact of around 200 basis points / $0.30 per share from its M&A outlook, with another 200 basis point drop in organic growth factored into the guidance.
More headwinds noted as “risk in the European macro-environment, as well as excess inventory in certain categories of laboratory consumables” should also be dilutive for EPS. Chief among them is the withdrawal of revenue related to Covid-19, a former driver of medium-term growth. Another 330 basis point effect on EPS from forex headwinds is also expected. Forex headwinds are also expected to reduce revenue growth by 200-300 basis points in FY22.
The question is, what impact does this have on the long-term outlook? In my opinion, not much. Looking at the FY23-FY24 quarterly numbers, it’s not unreasonable to expect double-digit GAAP earnings growth, with acquisition benefits and revenue increases. Reconciliation with non-GAAP estimates yields similar medium-term results.
Therefore, it really comes down to whether the market has overshot its run on AVTR, or if there is still more to discount in the stock price. Alas, despite these projections, based on the price action discussed below, there is likely to be more downside ahead before AVTR finds its bottom.
Figure 1. Forward estimates still suggest strong quarterly profit growth from FY23 [GAAP & non-GAAP]
AVTR price action drifts to new lows
Ceteris paribus, long AVTRs have suffered a substantial loss on yields achieved throughout the pandemic era [FY20-FY21 total]. As shown in the chart below, AVTR suffered a strong rally after the March FY20 selloff. It was one of the best performers in our stock budget throughout the year. Stocks have since corrected from that point and fell sharply amid a more than 50% decline.
Simply, the high beta trade completely unfolded in FY22. Investors unloaded AVTR stocks this year in parallel with this trend. Additionally, the AVTR stock beta premium once received has declined since the middle of FY21, as shown below. Thus, the June rebound in broader equities was not felt by AVTR shareholders.
With this downtrend, AVTR continued to sell off as the SPX formed a fairly stiff base from the past 3 months of trading. Alas, despite the many fundamental insulators that I have identified in previous analyzes on AVTR [See: here, also here, additionally here, and here]market mechanics exceeded the order book, which led to a sharp decline in FY22.
Exhibit 2. SPX AVTR bifurcation as covariance structure moves lower as investors continue to unwind high beta plays
Exhibit 2 shows weekly AVTR bars from March FY21 to date. The first indication of a sell for me came when the stock showed significant upside volume with a dark red bar in September FY21.
In the weeks that followed, shares consolidated at the 50DMA, and the subsequent downward trend in volumes [shown below] came with a narrow and flat base in the price distribution. Stocks have tested 50DMA for a total of 10 weeks at this point, while weekly volume has declined significantly. Important: Low volume with sideways price action, when testing this 50DMA, is an indication of strong resistance in my experience. This led us to reduce the position size by 50%.
Looking for current price action [November], it remains bearish in my estimate. The price action continues to unfold towards pre-pandemic levels, with the distribution moving further away from the 50DMA and the resistance line shown below. As weekly volume increases, the downward gradient in price also increases, suggesting there is more strength and momentum in the move, as well as greater penetration on the short side of the order book. .
Exhibit 3. Poor volume with pullback at 50DMA originally reported as selling point. An additional volume spike in September FY22 with a strong resistance drift signals further size reduction.
Price action does not appear to be supported by its current levels and long-term trend indicators [on-balance volume (“OBV”), momentum] suggest further cuts may be warranted. OBV in particular remains in a continuous downtrend, which is important information. While broader equities rallied sharply during the June market rebound, AVTR’s OBV trended south deviating from the market trend. Naturally, the selling pressure continues from then until the date as shown below.
Exhibit 4. During the June rally in broad stocks, AVTR’s OBV drifted lower deviating directly from the market trend
Third Quarter Results Indicative of FY23 Trends
AVTR third quarter figures were mixed and illustrate potential headwinds for the future. Revenue of $1.85 billion (“Billion”) increased approximately 100 bps year-over-year, decompressing gross margin by 150 bps year-over-year to 35%. The increase in gross margin appears to come from favorable acquisitions, by management. Thus, quarterly operating profit of $275.8 million increased 16.2% year-on-year. This led to a marginal 416 basis point year-over-year EPS growth to $0.25. Notably, AVTR’s weighted average number of shares outstanding also increased by 85.6mm to 674.1mm year-on-year.
Based on the review, third quarter operating trends remained in line with longer-term averages, as shown in Appendix 4. Quarterly free cash flow margin remained in range at approximately 12% in revenue, while operating profit and gross profit also increased year-on-year, despite falling highs in sequential declines from the first quarter of FY22. Nevertheless, investors can now allocate to AVTR at a yield of 5.7% FCF – which ranks in its 99th percentile of its historical ranges since its introduction in FY19.
Exhibit 5. Although quarterly operating trends have retreated from highs in the first quarter of FY22, FCF margin [revenue] remains in double digits, with annual growth in operating income
FCF conversion and return on invested capital (“ROIC”) trends also remain within range, as shown in the chart below. Free cash conversion continues to remain in a cyclical upward trend for AVTR and TTM’s ROIC was 8.2% last quarter, in line with the 2-year average of 8.9%. The number is significant as quarterly CapEx widened to $39 million [vs. 2-year average $27.4mm] and invested capital decreased by approximately 15.5% year-on-year to $5.8 billion.
This coupling between free cash and ROIC tells me that the company is still getting a decent return on its investments – but it needs to improve here to clear the 9.3% WACC hurdle. Currently, it suffers an economic loss at this ROIC/WACC gap of $23.22 million.
Exhibit 6. Return on capital and FCF trends continue to merge, showing good performance in this capital budgeting cycle
Evaluation and conclusion
In evaluating AVTR as I did, I noticed that there was a disconnect between fundamental and technical price targets. Price targets obtained from the dot and number charts below suggest a downside target at $16.25, a 17.2% decline from the current market price.
Our EPS estimates [shown in Exhibit 1] imply FY22 EPS of $1.39, implying the stock should trade at a fair forward P/E of 20.9x, well above the consensus 14x forward earnings [Exhibit 8]. At this multiple, AVTR is valued at $29. The premium implies a rise in EPS which is above consensus estimates and therefore represents an alpha opportunity.
The problem is the discrepancy between the two ratings [$16.25-$29], a total of $12.75, placing less confidence on the upper boundary. The arithmetic mean of the 2 targets is $22.62, a familiar range at AVTR over the past 2-3 months.
With that in mind, my upside target is $29, downside at $16.25 and a range of $22.25. In either case, a near-term upside for AVTR seems unlikely, and that means I advocate keeping the additional/initial capital allocation to AVTR stocks.
Exhibit 7. Targets down to $16.25 after simply withdrawing $19.25
Exhibit 8. Upside target to $29 based on net income fundamentals, forward estimates
Net-net, the long-term buy thesis remains unchanged for AVTR based on continued fundamental momentum and rising EPS. This is demonstrated by its metrics on ROIC, FCF growth, and earnings forecasts. What is not favorable is the technical data of the market which suggests that a further decline in the AVTR is likely, before any return to the upside. I think the stock is fairly priced at 20.9x earnings, a push above market consensus earnings of 14x, and just below its current P/E of 23.1x. Alas, while I continue to consider this a buy, at this time I advise against attribution to Avantor, Inc., so I stand by.