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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.

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