A Whole New Opportunity For Hologic Inc?

Women's health specialist Hologic (NASDAQ: HOLX  ) has had a rough go of it. At a time when most companies in the medical equipment or diagnostics markets can look back on a great two-year run in their share prices, Hologic's shares have chopped around and gone nowhere fast (up just 2%). This isn't a mistake on the part of the market, as Hologic has underperformed due to slow adoption of 3D tomosynthesis, changing recommendations for cervical cytology testing, and fiercer competition in diagnostics.

In hiring former Stryker CEO Stephen MacMillan, though, the board may have put this company back on the right track. MacMillan's experience in improving sales efforts and integrating acquisitions both speak to areas where Hologic needs to improve, and there is certainly room for improvement here.

Diagnostics not getting any easier
As the company's fiscal first quarter results (released earlier this month) show, Hologic has to get its diagnostics business turned around and growing again. Revenue fell more than 10% at a time when other diagnostic companies, including Abbott Labs, Becton Dickinson (NYSE: BDX  ) , and Cepheid (NASDAQ: CPHD  ) , are doing notably better.

Cepheid highlighted its continued leadership in cervical cytology in a recent presentation to lenders, but the reality is that ThinPrep was still down 11% in the quarter as the market continues to adapt to new recommendations about screening intervals. At the same time, the company's market-leading blood screening business saw a 14% decline in revenue.

There are still valuable parts with which Hologic can work. The molecular diagnostics business was up 3% this quarter and helped by Aptima, Hologic has been gaining on Qiagen in HPV testing. What's more, the company has a large menu of tests across multiple treatment areas.

The key will be in putting this together and marketing effectively. Becton Dickinson trails Hologic in STD testing (roughly one-third share versus Hologic's one-half), but the company is really pushing to get its BD MAX platform into more labs. Elsewhere, Cepheid has recently turned its attention toward the STD testing market and Cepheid's success in hospital acquired infection (HAI) testing cannot have Hologic feeling secure about its long-term position. Hologic still does very well in high-volume labs (where hospitals/clinics send their tests), but Cepheid is threatening to offer an option that would allow many customers to take testing increasing in-house.

I believe this is an area where MacMillan can make a difference. Like Becton Dickinson, Hologic has actually has a number of attractive testing platforms and a good menu of tests. The key will be bundling, cross-selling, and marketing them more effectively. Likewise, I would argue that Hologic has really thus far failed to maximize the value of its Gen-Probe acquisition.

For tomo, it's not too late
Hologic has also disappointed investors with the pace of adoption in 3D tomosynthesis – a new technology for mammography. Clinical trials have supported the notion that 3D tomo offers better sensitivity and specificity (more accurate results), but the market has been slow to adopt as reimbursement has yet to favor this more expensive approach. With that, the company's time-to-market lead over General Electric and Siemens has looked less and less meaningful.

Breast health revenue was up less than 3% in the fiscal first quarter, and this is another high priority for MacMillan to improve. As Intuitive Surgical has ably shown, you can sell expensive capital goods to hospital even without advantageous reimbursement, but a huge part of that is creating demand in the physician and consumer populations. Hologic will be starting up a direct-to-consumer ad campaign to support its 3D tomo platform, and hopefully that will start driving better adoption.

Will a turnaround reignite growth?
During his time at Stryker, MacMillan did a good job of restructuring the sales effort (including more bundling/cross-selling), improving operating margins, and integrating acquisitions. All of those skills will be of use at Hologic. Most important in my mind, though, is really maximizing the value and potential of the diagnostics business. Whereas Cepheid has established a very strong system (the GeneXpert) and is building its value with an ever-expanding menu of tests, Hologic has been slow to lay out its own attractive roadmap of follow-on menu development. As I said, Hologic has a strong base business in cytology, STD, and molecular diagnostics, but they need to overcome the issues in cervical cytology and maximize value.

I'm looking for revenue growth of 4% to 5% right now, with slightly higher cash flow growth on better sales efficiency and operating leverage. Discounting that back, and factoring in the large debt load, I believe Hologic shares are worth about $21 per share today.

The bottom line
In addition to the DCF-based target, I use an EV/revenue approach to value these shares (EV/revenue is a popular, albeit very flawed, metric for med-tech valuation). Giving the slow-growing breast health, surgical, and skeletal businesses a 3x multiple and the presently unimpressive diagnostics business a 5x multiple, the resulting 4.0x average suggests a fair value of about $22 today. The good news here is that if Hologic can turn the diagnostics business around, the higher multiples that diagnostics businesses get today (6.0x and up in many cases) suggest real rewards to the stock.

I was a fan of MacMillan's work at Stryker, and I see Hologic as a company that could really use good executive leadership. It's not my favorite idea based on current performance, but the turnaround potential here is definitely worth monitoring.

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