Another Disappointing Quarter Still Doesn't Make Cepheid Cheap


So far, this has been a tough quarter for some of the growth darlings of the medical technology sector. It's still somewhat early in the reporting cycle, but Intuitive Surgical (ISRG) and MAKO Surgical (MAKO) have both disappointed, and Cepheid (CPHD) joins that unfortunate list for the second time in as many quarters. While the sort of operational disturbances that Cepheid is seeing are not at all uncommon with small, young companies, the cripplingly high expectations built into the stock give it little room to breathe.

For The Most Part, Operationally Okay In Q2

Like many companies this quarter (both in and outside of med-tech), the post-release action in the stock wasn't so much about the actual quarter as the guidance for the next.

Cepheid reported 21% revenue growth this quarter, with system revenue up 5% and reagent revenue up 26%. Commercial system placements increased nicely on a sequential basis (9%), but were down almost 10% from last year, and management did cite a tougher hospital spending environment.

Commercial reagent sales were up 22% and management claimed annual and sequential growth across all nine tests currently on sale. I do wonder if it's worth watching the utilization number, though. Management does not provide this figure, but taking the reagent revenue and dividing it by the number of systems installed at the end of each quarter (which increased 50%, by the way) shows a 16% year-on-year decline. I'm tempted to think a lot of this has to do with the company's HBDC business (a program to make the systems and cartridges available to emerging markets), but it's worth noting.

Cepheid also delivered a one and a half point improvement in gross margin on product sales, and 3% operating income growth.

HBDC Causes More Operating And Guidance Headaches

While I do believe that Cepheid's participation in this HBDC plan could be very good for the company's long-term business plan, it comes with real costs in the here and now. Namely, this business has proven to be exceptionally volatile on both a system placement and cartridge revenue basis.

It's also impacting the company's guidance, as it looks as though numbers are heading lower for the next quarter on the basis of under-absorbed overhead for a facility in Sweden targeted mostly at filling European and HBDC orders) and lower overall HBDC sales. In addition, the company is seeing lower-than-expected margins on the new Infinity systems and I wouldn't rule out some sluggishness in the basic diagnostics end-user market in Europe.

Perhaps it's worth asking if all of this trouble is worth it. I say yes, as Abbott (ABT) and Roche (OTCQX:RHHBY) have both seen pretty good growth in their OUS diagnostics businesses over the years. Likewise, others in the diagnostics space like Becton Dickinson (BDX) and Siemens (SI) are trying to increase their exposure to rising per-capita healthcare spending in markets like China and India, so Cepheid's desire to establish a foothold overseas makes sense.

More Tests, And More Leverage, Are On The Way

While Cepheid gets plenty of love from the Street, I'm not sure investors appreciate just how much leverage potential is in the business. Right now there are Cepheid "boxes" in about 20-25% of North American hospitals, and that's just with nine tests available (and far and away the most popular tests are for hospital-acquired infections like MRSA and C.diff and drug-resistant TB).

Cepheid has a deep pipeline of tests in the queue including CT/NG (chlamydia and gonorrhea), vaginitis, HCV, flu (CLIA-waived), and breast, bladder, and colon cancer monitoring. Not only will these tests make the GeneXpert system more compelling, but they should lead to higher utilization, higher revenue per installed unit, and higher profits as Cepheid leverages the higher-margin consummables sales stream.

Now, the bad news. Hologic (HOLX) (which is acquiring Gen-Probe (GRPO)), Danaher (DHR) (which bought Beckman Coulter), Siemens, Abbott, and Becton Dickinson all have more or less the same plans in mind, and established bases of business and reputations from which to build. Still, Cepheid has an elegant system and a reasonably good history of getting tests from the bench to the hospital shelf, so I am by no means counting them out.

The Bottom Line

All of that said, a little perspective is in order regarding the share price. Even if Cepheid can produce excellent free cash flow margins, say on the order of Gen-Probe's 25% (and much better than Beckman Coulter ever managed before selling out to Danaher), Cepheid will need to be as big as Becton Dickinson's diagnostics business is today in ten years (excluding the preanalytical business) to merit a stock price in the low to mid $30's. By the same token, if Cepheid can become the "next Abbott" by that time, today's price is practically a bargain.

To a certain extent, arguing about "the next Gen-Probe/BD/Abbott" is a little pointless, as I fully expect Cepheid to get bought before then. While I do appreciate the out-sized potential of this company and do love a good growth story based on superior tech, I'd really like to see the shares pull back under $30 before jumping in with my own money.

Disclosure: I am long OTCQX:RHHBY.