Even in this year's strong equity market, there is still the opportunity to find good companies selling at reasonable prices. We believe Hologic (HOLX) fits this mold; it's a strong business trading at a reasonable valuation and has an engaged management.
The company operates in the medical-device and diagnostics area, with a specific emphasis on women's health. It develops and manufactures devices and tests to screen for breast cancer, cervical cancer and osteoporosis; surgical products for gynecologic procedures; and screening and diagnostic tests for blood supplies and illnesses such as HIV and HPV.
HOLX historically has been the dominant leader in mammography, and has a clear first-mover advantage in digital 3-D mammography, or tomosynthesis, which more accurately detects suspicious breast lesions but with increased patient comfort and a lower recall rate. This enhances physician economics. An imminent decision on reimbursement by Medicare/Medicaid will accelerate its rollout.
The company is also the dominant player in Pap smears; revenue pressure from extending the exam interval in the U.S. is mostly offset by growth in international markets and bundling of additional tests from the same sample.
Last year, the company bought Gen-Probe for $3.8 billion in cash to build out its franchise in molecular diagnostics. Although the price was rich, the deal was immediately accretive and cost savings have been greater than projected. While HOLX took on a sizeable debt load to finance the acquisition, the strong cash flow generated from the high-margin businesses is quickly repaying the principal. The company's leverage ratio (net debt/EBIDTA) should be back to pre-deal levels within two years. This constraint will prevent management from being distracted by additional deals.
Over the summer, the board replaced the CEO, perhaps because of the company's recent record of repeatedly over-promising and under-delivering. Jack Cumming is now in his second tour as CEO, and has quickly made a number of other senior management changes designed to streamline and improve the organizational structure. More significantly, he initiated a major strategic review of the company, focusing on capital allocation and shareholder returns. This may also result in divestitures of some non-strategic business to accelerate the debt pay-down.
As with all health care companies, HOLX will be affected by the Affordable Care Act, but it will probably be a small net winner. Surely, the increase in people covered will help, and the combination with Gen-Probe will allow HOLX to offer a bundled array of diagnostic tests that should be more economical to the system than those from competitors with narrower product lines. A recent major contract with Quest Diagnostics (DGX) along these lines endorses this approach.
Prior to the Gen-Probe acquisition, HOLX was generally valued as a growth health care company with an efficient balance sheet in the range of 15x-18x forward earnings. The stock has lagged the market and the health care sector dramatically this year because of the debt taken on, an earnings miss and lowered guidance. It now trades at 13.4x fiscal 2014 earnings.
We believe the intrinsic value for the stock is in the upper-$20s, making the current price near $22 an attractive entry point. Management will present a major business update, in conjunction with its year-end earnings call on Nov. 11, which we believe will have positive long-term implications for the stock. While we expect the company to give 2014 earnings-per-share guidance below Street consensus, we look for that to be more than offset by the benefits associated with the strategic planning update.
HOLX has a number of high-quality businesses with good fundamentals and growth characteristics, and management is addressing the lagging and non-strategic operations. The acquisition of Gen-Probe was a good strategic fit with earnings accretion, but was fully priced. The large upside from 3-D mammography is still to come, but HOLX seems highly likely to achieve it.
The company's balance-sheet leverage is temporarily elevated, but the company is using its strong free cash flow to rapidly reduce the acquisition debt. Profitability is high due to its strong market positions and high recurring revenue, as demonstrated by HOLX's 32% corporate operating margin. And the company's international business potential is yet to be fully exploited.
Bottom line: HOLX's valuation is attractive, and shareholder returns now seem to be foremost in management's thinking. We believe HOLX is a good story for the current market, and we expect its superior business franchises to sustain and to grow value, despite ACA confusion and a fairly valued equity market.
At the time of publication, Katz was long HOLX.