Of turbine blades and sandwiches...

Mark Sargeant investigates the growth and globalization of the UK laboratory market

Followers of Bodycote, the LSE listed metallurgical services company that helps Rolls Royce manufacture turbine blades for jet engines, may have noticed that the company recently acquired Law Laboratories, a Birmingham-based laboratory that tests sandwiches and ready meals for the major supermarket retailers. 

This deal followed on the heels of Candover’s late 2004 acquisition of Alcontrol, the Anglo-Dutch food and environmental testing laboratories group. The private equity firm was rumored to have paid £240 million, or around 19 times reported EBIT, to win the deal following a competitive auction process.   Bear in mind that Alcontrol was no turnaround story, generating margins of 15% and having already spent three years under the ownership of fellow private equity firm Bridgepoint.

Similarly, in April 2004, Legal & General Ventures completed the acquisition of a majority stake in LGC, the bioanalytical and diagnostic laboratory services provider, valuing the company at approximately £70 million or 15.8 times reported EBIT for the year ended 31 March 2003.  

Established laboratory testing players like Intertek, Eurofins Scientific, and Bureau Veritas have also been active, each making bolt-on acquisitions in the UK laboratory testing market over the last 24 months. 

As if to underscore interest in the sector, in April 2005, Inspicio, a company with little more than a business plan and a board of lab industry veterans, raised £3 million through a flotation on AIM to pursue acquisitions in the lab testing and inspection sector. 

So why the sudden interest in the historically sleepy world of laboratory testing?

Attractive top line growth rates
Undoubtedly, both trade and private equity players have been drawn to the sector by the prospect of attractive top line growth rates. 

Across all markets, increased safety awareness and a growing web of health, safety and environmental legislation are driving demand for expert laboratory testing services to provide regulatory and brand protection assurance. As the recent scare involving the banned food colourant Sudan 1 demonstrates, the costs of getting it wrong can be considerable. 

The globalisation of supply chains is also driving market growth. Multinational businesses increasingly source ingredients, components and finished products from lower cost economies. They are turning to laboratory testing companies to ensure they meet the demanding regulatory and quality requirements of end-user western markets. 

The acceptance of outsourcing as a business tool, even in previously core functions such as quality assurance, has given added momentum to market growth. Intertek has been particularly successful in this field, securing long term contracts to provide outsourced laboratory testing and analytical services for companies such as BP, Ericsson and Unilever. 

Strong pressure for industry consolidation
The current structure of the UK laboratory testing sector and changes in the competitive environment also provide strong pressure for industry consolidation. 

Historically, the UK laboratory testing market has been fragmented, with numerous small regional players each serving a local customer base. However, as the UK’s manufacturing base has declined, certain traditional customers have disappeared. Lacking global reach, smaller players have found it hard to win new business from multinational customers often requiring support across numerous geographies.

At the same time, all industry participants are finding they need to invest in expensive IT systems and laboratory automation equipment to improve customer service (reduced sample turnaround times, real time sample tracking and online access to results) and improve profitability (by reducing intervention by expensive technicians and scientists).  For smaller companies the cost of such investment can be prohibitive.  

Furthermore, in an increasingly litigious and brand conscious environment, the perceived security and comfort offered by larger, better capitalised laboratory testing providers militates against smaller players, particularly in competing for larger, more lucrative outsourced testing contracts.    

Taken together, these factors are combining to make the competitive environment increasingly challenging for smaller laboratory testing companies. 

By contrast, the competitive environment for the larger, international testing companies has been generally positive in recent years, driven by the macro trends of growth in international trade and increasing regulation. However, to capitalise on these trends, the larger trade players are now seeking to enhance both their geographic reach and portfolio of services with the aim of providing multinational customers with an effective global one-stop-shop capability. 

Wave of industry consolidation
The result has been a wave of industry consolidation, as a supply of available bolt-on acquisition targets coincides with the growth ambitions of the larger, international testing companies. The substantial synergies available from combining laboratory infrastructures and leveraging international marketing and distribution networks provide additional support for industry consolidation.

Against this backdrop, the interest of private equity players in the laboratory testing sector is unsurprising.  A combination of strong growth prospects, sustained industry consolidation and the relative paucity of publicly quoted laboratory testing players suggests potentially lucrative exit opportunities via either trade sale or initial public offering. With the added attraction of recurring revenues to support leveraged acquisition structures it becomes easier to understand the multiples paid by Candover and Legal & General Ventures in recent deals. 

So where might all this lead?
The current pace of industry consolidation is unlikely to slow. In certain markets such as hardlines testing (toys, electrical goods, furniture etc.) consolidation is already well advanced with large multinational companies such as Bureau Veritas, SGS and Intertek increasingly powerful. Nonetheless, there remain a number of mid-sized national testing organisations, such as the German TÜVs, with significant market share often extending beyond their home markets. These represent potentially attractive consolidation targets, if complex ownership issues can be resolved.

In the food and environmental testing sectors the consolidation process is in its infancy. These markets remain characterised by numerous small players operating largely within national boundaries. However, driven by the factors outlined above, we expect that a small number of large firms operating across national boundaries will become increasingly prevalent. Alcontrol, Bodycote, Eurofins Scientific, and LGC could be companies to watch. 

For customers across all testing sectors, sustained industry consolidation should prove positive, with larger international laboratory service providers in theory able to offer more tests, across more geographies, with enhanced levels of customer service, reliability and assurance. Technology investment by larger laboratory service providers may be especially important in this regard. It has the potential to offer reduced sample turn around times, more consistent testing standards and enhanced access to results - across supply chains and irrespective of national or regulatory boundaries. 

For suppliers to the laboratory service industry, the outlook may be less positive. We expect that providers of everything from lab consumables to LIMS (Laboratory Information Management Systems) will need to react to the growing purchasing power of large, multinational testing groups. As these organisations tend toward enterprise-wide rather than local supply solutions, the result could be increased pressure on smaller suppliers leading ultimately to consolidation. 

For smaller laboratories which choose to remain independent, success will require focus on high margin, specialist testing services that cannot be readily automated and/or require sophisticated technical input.  The prospect of new UK investment in nuclear energy infrastructure (and associated demand for stringent component safety testing) provides a good example of the type of opportunity available to smaller specialist service providers over the medium term.  Nevertheless, the drivers of industry consolidation are powerful. We expect even successful niche players may wish to explore strategic partnerships and joint ventures to secure scale economies and strengthen their portfolio of services. The 2004 merger of electrical certification organisations ASTA and BEAB and the three way combination of KTL Laboratories, TRL Compliance Services and Cape Engineering evidences this trend. 

So will it be plain sailing for the large lab testing players? 
The larger trade and private equity backed laboratory testing companies would now appear poised to dominate the global testing market, benefiting from substantial scale economies reinforced by a stream of earnings enhancing, bolt-on acquisitions. 

However, as CEO’s are sometimes prone to forget, acquisition-led growth strategies are seldom as straightforward as investment bankers might have them believe. Without rigorous post acquisition integration to secure operational efficiencies, current M&A activity could easily result in reduced profitability, a loss of focus and deteriorating levels of customer service. Furthermore, given the risk of litigation inherent in providing assurance services, laboratory testing companies will need to ensure that their enthusiasm for making acquisitions is matched by their diligence in rolling out effective internal control procedures. 

So, returning to the opening theme of this article, how should we interpret Bodycote’s recent interest in the food testing sector – an astute, logical move into a high growth market segment with global potential, or a worrying step away from its core metallurgical competence? Certainly the growth prospects for food testing services appear favourable and Bodycote already has an extensive international laboratory testing infrastructure, albeit with a focus on materials testing rather than food.  Whether the company and its investors have the appetite and commitment, needed to build a global food testing capability, remains to be seen. Still, perhaps customers at least should take comfort – a company with the complex technical skills necessary to help jet engines run safely, should be well able to help the food industry keep bugs out of the humble British sandwich.

By Mark Sargeant, a partner at Strata Technology Partners LLP a London based, European technology investment bank. He has advised on a number of recent transactions in the laboratory testing sector.

References
1  Announced on 15 November 2004 that Candover Investments was close to acquiring the Alcontrol Group for £240 million (Source: Financial Times). Last reported EBIT for Alcontrol (continuing operations for the year ended 31 March 2004) was £12.814 million. (Source: Alcontrol Holdings Limited Report and Accounts for year ended 31 March 2004.

2 Prior to announcement, last reported EBIT for LGC (continuing operations for the year ended 31 March 2003) was £4.439 million. (Source: LGC (Holdings) Limited Report and Accounts for year ended 31 March 2003.


Mark will be conducting a free, 30 minute workshop covering the impact of mergers and acquisitions on the UK laboratory services sector at the Laboratory News Forum on Wednesday 18 January 2006.