Time For Hologic To Translate Technology Into Results

By Stephen D. Simpson, CFA | November 12, 2012 AAA

How does an investor profit if a company has the best technology in the world, but can't deliver market-beating returns? That's probably a harsh intro for Hologic (Nasdaq:HOLX) today, but the fact remains that the company has to demonstrate that it can drive tomosynthesis adoption and solid growth in diagnostics for this stock to really work over the coming years. That puts the shares in a challenging place for investors; bulls can likely see a lot of value here, while bears will point to the high debt and oncoming competition and likely conclude that the shares are best avoided for now.

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A Decent Close to the Year
Due to an extra week in the quarter, a purchase accounting adjustment and the impact of the Gen-Probe acquisition, this was a messy quarter for Hologic investors. The good news is that, on balance, this a solid quarter with most of the key items ahead of expectations. Institutional and individual investors can effectively use earnings to gain a good hold on a company.

Revenue rose about 29%, including the purchase adjustment. On an organic basis, revenue rose about 7 to 8% (depending upon whether you factor in the extra week), with breast health revenue up about 6%, legacy diagnostics up 10% and gyn/surgery up 17% (ex-Adiana) on strong MyoSure performance. These results were all modestly better than expected, though it looks like Gen-Probe's growth was a little less impressive than previously forecast.

On the profit side, Hologic likewise did pretty well. Gross margin (adjusted) was up about a half-point from last year, but a little shy of most sell-side estimates. Operating income (also adjusted) rose about 28%, with a slightly better-than-expected operating margin.

Tomo Tomorrow?
Hologic continues to see customers its new(ish) tomosynthesis platform in the breast health business, but the pace continues to be slower than the original pre-launch hopes of most analysts. The issue is not that the system has disappointed clinicians or administrators, nor that General Electric (NYSE:GE), Siemens (NYSE:SI) or Philips (NYSE:PHG) are capturing share. Rather, the issue is that reimbursement has been slow to come and hospital administrators have to rational budget dollars across other options like Intuitive Surgical's (Nasdaq:ISRG) robots and Varian's (NYSE:VAR) radiation oncology systems, both of which have better-established reimbursement today.

In time, this situation should improve. The long-awaited Oslo dataset should be published next year, and that should open the door to better reimbursement. That said, the ongoing sluggishness and budget consciousness in Europe shouldn't be ignored, particularly as it may well shrink Hologic's time-to-market advantage over its rivals.

Navigating the Crosswinds in Diagnostics
Hologic's large diagnostics business is likewise facing some challenging crosswinds. On the negative side, the core ThinPrep business is being challenged by recommendations for larger intervals between tests. At the same time, companies like Cepheid (Nasdaq:CPHD), Qiagen (Nasdaq:QGEN) and Becton Dickinson (NYSE:BDX) are all trying to build their own diagnostics businesses and there are only so many dollars and patients to go around.

On the positive side, Cervista is growing well and HPV testing is still under-penetrated (and Qiagen should be a beatable opponent). Likewise, while core ThinPrep testing volume may be under pressure in the developed world, emerging market demand, while risky, should help offset this to some extent. Last and not least, Gen-Probe should improve Hologic's overall diagnostics platform, particularly enhancing efforts like molecular diagnostics and automated platforms.

The Bottom Line
Hologic had to use a lot more high-cost financing to do the Gen-Probe deal than originally hoped, and that carries a real cost. On the flip side, we're still talking about a business that has long generated good free cash flow, and that should add a deleveraging kicker to the Hologic bull thesis.

As I said in the intro, the fair value calculation on Hologic is a little more complicated than usual right now. Investors who believe that tomosynthesis adoption is a "when, not if" proposition and that Hologic will be the leading platform, as well as those who believe that Gen-Probe will strengthen Hologic's hand in diagnostics, will see these shares as offering pretty good long-term returns from these levels. I'm inclined to fly the flag for the bull camp when it comes to Hologic, but competition and leverage up the risks here and this is definitely not a stock for those looking for a conservative health care investment.

At the time of writing, Stephen D. Simpson did not own any shares in any company mentioned in this article.

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