A quest for value and alpha in well financed, well managed defensive names with solid visibility, reasonable growth prospects and discount valuation leads me to digital mammography and pap test leader Hologic (HOLX). The shares are off to historical trough multiples at significant discounts to what appear to be lesser peers. But with a solid quarter, reset and achievable expectations and a conference call that detailed how upside to '09 expectations is probable, I cant help but think about what can go right at this juncture.
The shares have been in a slide for the better part of a year in reaction to a major acquisition (Cytyc) which looked suboptimal and expensive initially and proved naysayers right when the sales growth of the acquired product portfolio slowed, profitability suffered and investors began to aggressively discount the expected sales and margin benefits that prompted the Cytyc deal in the first place. And then came the currency headwind. And then a sales miss. And did I mention the push out of a new sales and margin driving product?
Needless to say, the bears were vindicated and burden of proof shifted directly to management's ability to execute on improving acquired sales growth and new product commercialization which looked increasingly difficult in the face of mounting macro and industry specific headwinds. Understandably, long time longs threw in the towel, shorts pressed their positions and the share price has gotten pummeled.
What's the point you ask? To make a short story long, I think HOLX shares might now represent the kind of relative value associated with a stock with reasonable growth prospects and margin expansion opportunity in a world where few can grow or hold margins.
Sales were better than expected on strong organic unit sales growth. The company's Breast Health sales were solid, orders were strong and management was somewhat optimistic about a rebound in acquired product sales. Gross margin dollars were higher and operating expenses were lower, so operating income topped expectations. EPS was in-line.
Breast Health of sales of $221M were up 25%; guidance is for 5% in FY09', Diagnostics revenue of $133.7M was up 11% y/y; guidance is for 15-16% growth in FY09', and GYN/Surgical (which is essentially NovaSure) sales of $59.7M were up 2%; but that's an improvement from the last couple of quarters and management is looking for 17-18% growth in FY09' in that division. Management's new FY09 guidance is for 9-10% sales growth to $1.82-1.85B and non-GAAP EPS of $1.22-1.44.
All in all a solid quarter with excellent unit growth in profit driving digital mammo, steady pap test sales and a rebound in Novasure (key products acquired from Cytyc). And management lowered guidance to account for recession worsening, credit tightness, currency pressure, and slightly negative mix. Management removed any considerations for new product sales. And that only lowered numbers slightly – much less I think, than was feared. Exactly what you needed to see, in my opinion, in order to begin to exit the "show me" stock status Hologic earned.
It appears that the share price (at roughly 11 times forward earnings) discounts a substantially worse unit growth and pricing pressure in key cash flow drivers than management or most analysts do with no help from new products – i.e. what amounts to a worst case scenario. So risk (in the company specific sense) with respect to earnings and multiple appears relatively low because the unusually low multiple should hold, providing the market doesn't continue to slide hard.
One might also think that risk (in a margin of safety sense) is relatively low if valuation on cash flow, margin potential and returns of such franchises as Hologic's is low – as I believe it is. One might also conclude that a company that considers pressure on unit sales growth and margins that they are yet to realize, and omits likely incrementals in its guidance is being very conservative and thus risk to their estimates is low so that sort of risk appears to be relatively low.
Management considers the macro pressure (which they still say they haven't seen) and no new product contribution in the $1.22 guidance, when there is a high likelihood of additional revenue streams ramping by year end 2009, and 9% revenue growth that is fairly visible (strong order growth, and substantial backlog) and stable margins that can expand as sales growth accelerates.
Management seems confident that digital mammography unit sales would be up in '09 vs. '08. They admitted that average selling prices might be under slight pressure but suggested that the guidance took that into consideration. I can't help but wonder if management is more bullish than they let on about unit sales.
Another interesting thing about this situation is that cash flow appears to be somewhat resilient in the face of the aforementioned macro headwinds, while the company has a few significant growth drivers and cost save opportunities (like the new products and ramping utilization in a new low cost facility or synergy from integrating Cytyc). Thus, you might think that adds more flexibility to meet numbers.
So as the market grows (however slowly) and penetration increases, revenue growth can accelerate and margins can increase a couple of hundred basis points by year end 2010. The 1.22 can turn into 1.30 which might get a 12 multiple (~$17), and 15% growth rate in 2010 can get you to 1.50 for 2010 and could be as high as 1.60-1.70 on such faster, higher margin sales growth and a little operating leverage. And that 1.65 might garner a 14-15 time multiple (when the company is beating estimates and raising guidance) and that might get you to $23-$25 12-18 months out. If anyone knows how wrong I am, please do tell.
Disclosure: no positions