I have no qualms with those who believe it is the responsibility of the management of public companies to communicate clearly and accurately with investors (and analysts) about the current state of the business and the likely near-term conditions. Likewise, I don't particularly object when the Street punishes those companies that come in short of expectations without having given suitable warning.
So I can understand some of the disappointment with Hologic (Nasdaq:HOLX) these days – the company arguably could have done a better job communicating (and adjusting expectations) in regards to the fall-off in 2D mammography, ThinPrep, and the Chinese business. At the same time, though, I see a lot of what's troubling Hologic as macro issues impacting the sector as a whole. As the company is continuing to execute reasonably well on costs and the Gen-Probe integration, today's share price may be something of an opportunity.
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Another Disappointing Quarter
With fiscal second quarter results in hand, Hologic has now delivered two straight disappointing quarters – certainly not what investors wanted to see from what is a pretty highly leveraged company and what was a pretty highly-valued stock.
Revenue rose by a reported 31% this quarter, though stripping out Gen-Probe drops the comparable revenue performance to negative 2%. Breast health squeaked out a slim gain (up 1%), while surgical was up 1% pro forma and skeletal was down about 5%. Diagnostics would have been down about 6% without Gen-Probe, as ThinPrep declined 7% and HPV testing declined about 9%. On its own Gen-Probe performed okay, growing revenue around 5% as reported.
Hologic missed across the board with revenue, but the margins came in significantly better. Gross margin improved almost one and a half points, beating the average estimate by about two points. Operating income rose 37%, and the operating margin (up about 150bp) beat estimates by more than a point.
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Women's Health Is In A Rut
Although I think Hologic arguably could have done a better job shaping Street expectations for this quarter, the actual performance isn't so bad relative to the broader sector. Looking back just a week or so ago to Becton Dickinson's (NYSE:BDX) earnings report, BDX likewise saw weakness in its cervical cancer screening business, as utilization rates decrease and intervals between tests increase. Likewise with Qiagen (Nasdaq:QGEN), which reported a year on year decrease in HPV testing revenue. While Hologic's declines seem sharper than for its peers, adjusting for the impact of a sales realignment in China brings the performance back to roughly peer levels.
It's not just routine testing that is seeing a slump. NovaSure (part of the GYN Surgical business) is going nowhere fast, due both to a tougher healthcare utilization environment and competition from the likes of Johnson & Johnson (NYSE:JNJ) and Boston Scientific (NYSE:BSX).
Mammography is also continuing to move quite slowly. Although interest in 3D mammography (tomo) is picking up, particularly since the Oslo data, the overall hospital capex environment is still pretty poor – something we've heard from Hologic rivals like General Electric (NYSE:GE) and Philips (NYSE:PHG), as well as other equipment vendors like Varian (NYSE:VAR) and Stryker (NYSE:SYK). While I do believe 3D mammography adoption is a “when, not if” scenario, I continue to have concerns that slow physician/buyer acceptance and slow reimbursement progress will blunt much of Hologic's time-to-market advantage.
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The Bottom Line
With two straight soft quarters, some of the overvaluation has been washed out of Hologic shares. That still leaves very relevant questions about the macro environment, competition, and management's ability to really leverage and maximize the expensive acquisition of Gen-Probe.
At this point, I'm still inclined towards optimism. I do believe that Hologic can grow its revenue at a mid single-digit rate for the long term, while improving margins such that free cash flow (FCF) grows at a mid-teens rate. Unfortunately, the hefty debt load takes a lot of the value out of the discounted cash flow analysis, leaving a fair value in the neighborhood of $22. That is below the current price, though, so investors do have the option of picking up the shares of a quality healthcare company (focused on women's health) below fair value.
At the time of writing, Stephen D. Simpson did not own shares in any of the companies mentioned in this article.