Save Blood, Make Money

A few weeks back, I took a short jaunt 10 years into the future to explore which of today's fads might evolve into tomorrow's trends -- and more importantly, which might generate fantastic returns for investors.

I highlighted several such trends at the time -- robotics, VoIP telephony, and laser-eye surgery, to name just a few. Today, I want to explore one "fad" that I find particularly investment-worthy: parents paying to have the umbilical-cord blood of their newborns stored for future use in treating disease. It's a bit of a pie-in-the-sky concept, because no one is yet certain how useful stem cells will be in curing disease.

On the other hand, as an investment, it has terrific potential to become a high-margin "toll booth" business of the type lauded by investing master Warren Buffett. The cord blood collectors charge a high processing fee to accept a cord blood deposit. Then they charge low monthly fees, essentially for eternity, to preserve those deposits in cold storage for later use.

Companies like Sirius (NASDAQ:SIRI) and XM Satellite (NASDAQ:XMSR) use the same model -- charging $100 or so for the equipment needed to start service, then low monthly fees to keep the music coming. But the cord blood collectors have two advantages over the music players. First, the cord blood collectors sell health care rather than entertainment (read, a "necessity" rather than an "option"). Second, they lock their customers in much tighter than Sirius or XM do. Once someone has paid $1,000 or more for processing, the chance that they'll throw that investment away in order to save $10 a month is small. The result: low "churn" among customers, and a continuous and stable revenue stream. Forever.

It's not often that you find potential Rule-Breaking investments possessing both solid growth potential and a reasonable valuation. More often, you find profitless wonders trading at triple-digit P/Es, whether or not they have any chance of ever making money for their investors.

Meet the players
Not so with little Cryo-Cell and ViaCell (NASDAQ:VIAC). Each of these companies sports an entirely reasonable price today, and the potential to make today's price look downright cheap tomorrow. Both companies operate in a -- pardon the pun -- newborn industry. They collect stem cell-rich blood from newborn babies' umbilical cords. Then they store it (for a fee) against the day that medical science can use those stem cells to cure disease.

Now, before we go any further, I need to highlight three points:

• The collections here are entirely voluntary. No one is requisitioning blood without the owners' permission. On the contrary, parents pay steep upfront fees, plus monthly maintenance fees, for the companies' services.
• These companies avoid the ethical morass in which companies like Geron (NASDAQ:GERN) and StemCells (NASDAQ:STEM) wade. Unlike the latter two companies, Cryo-Cell and ViaCell do not engage in the harvesting or cultivation of fetal stem cells.
• Last but most importantly, you should view each of these companies, regardless of how cheap it is, as "speculative." In addition to the usual risks of being out-competed by rivals, failing to execute business plans, and so on, they are subject to regulatory risks if government grows displeased with stem-cell research, similar public opinion risks, and scientific risks if stem cells prove medically useless.

With those caveats in mind, let's proceed to first take a Foolish first look at a few numbers for ViaCell and Cryo-Cell, as well as one of these firms' competitors in this sphere.

At first glance, the advantage here clearly goes to Cryo-Cell. Why invest in a company that isn't making money? At a P/E of 44, Cryo-Cell may look pricey. But when you realize that its true cash profitability is 80% higher than its GAAP earnings, its price-to-free cash flow ratio comes out to just 24. So the company doesn't look so unreasonably priced, considering that it (a) has a high rate of growth; (b) was the first company in the pack to turn profitable; and (c) is the only company that can currently sustain itself from its own free cash flow.

Let's dig deeper
However, of the two leading public companies, I actually prefer ViaCell over Cryo-Cell. Here's why. At first glance, ViaCell's numbers look simply awful. The company lost $15.9 million in the past 12 months; with $60 million in the bank, it should be bankrupt in four years at that rate.

But ViaCell is actually two businesses: a profitable storage division and a cash-burning R&D shop. Take a look at how each division performed over the nine-month period ended September 2005. Then compare the gross margin of ViaCell's storage unit to that of storage-only Cryo-Cell:

As you can see, once you crack ViaCell open and see how its two businesses are operating, it's apparent that the storage business -- the part that competes with Cryo-Cell -- is three times larger than Cryo-Cell by revenues and 3.5 times larger by gross profits, with better margins to boot.

Splitting the -Cells
Take Cryo-Cell as the standard for what a stand-alone cord blood storage company should be worth. If we value ViaCell according to a multiple of its gross profits, ViaCell's storage division should be worth 3.5 times Cryo-Cell's market cap, or approximately $154 million. Add to that ViaCell's $52.1 million -- the net cash advantage it has over Cryo-Cell -- and ViaCell's storage business alone is worth more than the entire company's valuation today.

In other words, buy ViaCell's storage division -- get its research division for free. And how much is this freebie worth? To me: nothing. I'm not a big fan of money-losing businesses, be they stand-alone or consolidated. But I suspect that the market would value ViaCell's research division at roughly $200 million if it were a separate company.

Aastrom Biosciences (NASDAQ:ASTM) makes for a good doppelganger for ViaCell's research division. Like ViaCell's research division, it's unprofitable. It also booked roughly the same revenues as did ViaCell's research division over the past nine months: $0.5 million. For that, the market values Aastrom at almost $200 million.

Long story short, were ViaCell two companies -- one a near-profitable storage business and the other an unprofitable research shop -- I expect it would fetch nearly twice its current $400 million market cap.

Fools don't rush in
I'm not the only Fool to consider ViaCell a potential Rule-Breaking investment. It's one of more than 200 up-and-comers that make up the Rule Breaker Universe -- stocks on our radar at the Fool's ultimate growth stock newsletter, Motley Fool Rule Breakers. These stocks aren't for the faint of heart, however, and I must point out that ViaCell has not been recommended by Rule Breakers (yet.)

Want to know who we have recommended? The companies that are helping our portfolio beat the S&P 500 31% to 8%? Be our guest. You need to click here and accept a free trial of the service to see the picks, but if you're not absolutely thrilled with the service, you can cancel at any time, no questions asked. You have our word on it.

Fool contributor Rich Smith does not own shares of any company named above, but XM Satellite Radio is a recommendation of Motley Fool Rule Breakers. Why am I telling you this? The Motley Fool's disclosure policy commands, and I obey.