FoxHollow: Scale Is Critical

In a previous column, I discussed a categorization scheme to help identify different types of companies based on the work of Bennett Stewart in his book The Quest for Value. Although the X, Y, Z scheme is not as well known as Peter Lynch's six company types (fast growers, stalwarts, slow growers, cyclicals, turnarounds, and asset plays), it can play a valuable role in understanding a company's investment story.

The X, Y, Z categorization method is especially useful as a way to ground the value of a company to its invested capital. Of the five types, the only one that doesn't add much value is the pre-Z company, because there is little operating history or few assets to weigh, and the market's voting mechanism creates lots of gut-churning volatility.

Medical-device manufacturer FoxHollow (Nasdaq: FOXH  ) is undeniably a pre-Z company. And as a pre-Z company, FoxHollow has a value is based on its potential -- a potential that at least one Fool questions.

To realize its potential, especially with medical devices, FoxHollow's management must focus on ramping up sales and creating scale, or a footprint. And scale is very important -- even at $10 billion, Smith & Nephew (Nasdaq: SNN  ) and Biomet (Nasdaq: BMET  ) both lack the scale to compete with even bigger competitors Johnson & Johnson (NYSE: JNJ  ) and Stryker (Nasdaq: SYK  ) . To gain scale, a pre-Z company must spend much more than it earns.

The worry for FoxHollow is whether it can build scale on just its SilverHawk products, which help combat peripheral artery disease (PAD). One has to look only at Boston Scientific (NYSE: BSX  ) about living off one product -- it's not pretty. Therefore, FoxHollow not only has to spend a fair amount on research and development to make sure its products have a competitive advantage, but it must also successfully develop new products, such as its MiniHawk.

At 2.8 times its invested capital or $500 million in enterprise value, investors are betting that FoxHollow's R&D spending will be a success. If FoxHollow sustains a competitive advantage in the PAD market then it would be reasonable to expect the company's revenue and invested capital to grow. The ensuing scale will help FoxHollow expand its ROIC as its spreads the development costs over more devices sold.

If FoxHollow grows its invested capital at 20% while it expands its return on invested capital to 30% over several years, then the company could be easily worth $30 per share. Considering that its invested capital is growing much faster, that could be a conservative growth estimate.

However, expect a wild ride, since pre-Z companies are a volatile bunch. Investing in companies like FoxHollow requires a strong constitution, because moves of 20% up or down in short periods of time are common.

For related Foolishness:

Here at the Fool, ourRule Breakersnewsletter service looks for promising pre-Z companies. To see what it's finding and how it's beating the market, take afree 30-day trial.

Johnson & Johnson is a Motley Fool Income Investor selection.

Fool contributor Matthew Crews welcomes your feedback -- really! He has no financial position in any of the companies mentioned. The Motley Fool has a disclosure policy.


Read/Post Comments (0) | Recommend This Article (23)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

Be the first one to comment on this article.

Sponsored Links

Leaked: Apple's Next Smart Device
(Warning, it may shock you)
The secret is out... experts are predicting 458 million of these types of devices will be sold per year. 1 hyper-growth company stands to rake in maximum profit - and it's NOT Apple. Show me Apple's new smart gizmo!

DocumentId: 519214, ~/Articles/ArticleHandler.aspx, 9/21/2014 4:20:43 AM

Report This Comment

Use this area to report a comment that you believe is in violation of the community guidelines. Our team will review the entry and take any appropriate action.

Sending report...


Advertisement