The Long Case for Natus Medical

| About: Natus Medical (BABY)

David Nierenberg Newsletter Value Investor Insight carried an interview July 28th with D3 Family Funds manager David Nierenberg (pictured left), whose $500 million fund focuses on small and microcap stocks and has generated an average net return of 16.8% per year since its launch in 1996, versus a 9.3% for the Russell 2000, according to Value Investor Insight. Here's the segment of the interview in which Mr Nierenberg discusses his position in Natus Medical (NASDAQ:BABY), which was trading at $11.17 at the time of the interview (chart here):

Tell us about your largest healthcare holding, Natus Medical (BABY).

DN: I have a long history with this company, originally investing in it as a venture capitalist in 1989 and serving on the board through June of 2004. One of the last things I was involved in on the board was to recruit a new CEO, Jim Hawkins, who is a very capable and driven manager.

Some 95% of newborns in the U.S. are screened – electronically and non-invasively – for any hearing deficit before they’re discharged from the hospital. Five or six out of every 1,000 babies have a hearing deficit and identifying problems early increases the chance of avoiding permanent damage. Natus’ core business is selling the equipment that does that screening, where its U.S. market share is now around 80% after closing on the purchase of its primary competitor, Bio-logic Systems, in January. That market share, and the relationships Natus has with scientists and clinicians around the world, makes me feel pretty good about the durability of the growth and margins of the core business. Most of the company’s revenue is recurring, from the sale of consumables used with each baby tested.

We really see this as a tremendous growth story trading at a value price. The stock got hit after the company reported first-quarter earnings, because the auditors discovered that certain net operating losses the company thought were valid for reducing future taxes, in fact, weren’t. Fortunately, the company was going to burn through its NOL by the middle of 2007 anyway, so the negative unexpected tax impact will total only $5 million versus where the company had given guidance. Because of that sin, though, for which current management had no responsibility, the company lost $200 million in market cap. That’s a pretty extreme overreaction, 40-to-1.

What’s the growth story?

DN: There are several sources of substantial growth. One is to drive similar penetration for their newborn-screening equipment in developed countries outside the U.S. Roughly one in four newborns are now tested in the same way outside the U.S. and we believe that penetration will rise very quickly – as it did in the U.S. after it hit the 20% level and medical legal standards started to change across the country. We think this international business can quadruple in the next four years.

The company also has new products that have great potential. They recently formed a partnership with Welch Allyn, a leading distributor of diagnostic equipment, to sell new pediatric hearing screeners for older children into pediatrician’s offices. That business ultimately could be as large as the newborn-screening business in hospitals. Sales are rising sharply for their product for the treatment of jaundice, called neoBLUE, which uses blue light rather than the typical white light in competing products. Natus also picked up two additional diagnostic product lines, in neurology and sleep markets, when it bought Bio-logic and I expect them to invigorate the growth of both.

My expectation is that Natus will make an acquisition each year to add products that can be sold by its sales force to the perinatology section of hospitals. There are many companies out there that are technology-rich but distribution-poor. Natus has no net debt and already generates free cash flow of $4 million per quarter, so they have the capacity to make additional fold-in acquisitions. So on top of organic top-line growth of 20% annually we expect over the next three to four years, we believe acquisitions can take the company from the current revenue run rate of $80 million per year to as much as triple that. Jim Hawkins has been very strong in controlling costs, so we expect even faster bottom-line growth.

With the shares currently around $11.20, half the 52-week high, how are you thinking about valuation?

DN: Medical-device companies, because of the value of their FDA and patent “moats,” usually trade at an enterprise value of 3-5x forward revenues. Less than a year ago, in fact, Natus traded at 3x forward revenues. Now they’re trading at 2.2x, after making an accretive acquisition that took about a 15%-share competitor from the market. Just getting back to that 3x multiple, the shares would be worth $16 per share today.

If the company can reach $250 million in revenues in three to four years, I would expect the collective exit scenario to be its sale to a big medical-device company at up to 5x revenues. Even with some dilution from a secondary offering to fund acquisitions, that would result in an exit at probably four times today’s share price.