3 Hidden Gem Healthcare Stocks

In this episode of Industry Focus: Wildcard, Jason Moser and Motley Fool contributor Brian Feroldi give a breakdown of three great small caps you probably didn't know about. They range from a service provider to a surgical company and finally a research and consultancy firm. Find out what makes them so attractive for investors, their operations and products, and much more.

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This video was recorded on April 1, 2020.

Jason Moser: It's Wednesday, April 1^st. I'm your host Jason Moser, and on today's Wildcard Wednesday show, we've got another Healthcare theme for you this week, folks. Fool analyst and Industry Focus contributor, Brian Feroldi is going to be bringing us three, yes, three, healthcare hidden gems for you this week. These are names in the small cap companies that possibly you've heard of one or two or maybe even all three, possibly haven't heard any of them, but Brian is going to join us here to shed some light on why he likes these three companies and how we need to be thinking of them as investors, and in today's trying times particularly. So, Brian, welcome to the show this week.

Brian Feroldi: Jason, happy April Fool's day to you my friend. It is a very special day today, and although Fool.com did not have its signature prank, I think everyone should check out what David and Tom did on Fool.com today, I know it certainly warmed my heart to see what's happening at The Fool today.

Moser: Yeah, and I think you're talking about the donation to the New York City relief efforts in regard to their fight against the coronavirus and COVID-19, right?

Feroldi: Yes, exactly. The Fool donated $1 million to the effort in New York City, which is just awesome. And, both David and Tom said, "We love pranks, now is not the time, but we will probably celebrate April Fool's day later on this year once we get through this together." But either way, Happy April Fool's day to you, Jason.

Moser: Yeah, and right back at you. Man, I'd tell you it's the first in my ten year here with the company, we haven't really dipped into the April Fool's prank bag there, but I think that's the right call. And you mentioned a word there "together," you know we're getting through this together and whether it's New York or California or every state in between. I mean, this is something that is affecting us, not only as a country, but obviously, as a global community and certainly we're all in this together. So, hopefully brighter days to come, sooner rather than later.

But for now, let's talk stocks. We want to jump into the three healthcare hidden gems that you've got for us today. And I want to open up this conversation with Healthcare Services Group (HCSG -0.09%). And I got to say, Brian, you know I was really interested to see this name on your list. And the main reason why, was because Healthcare Services Group, it's a company that's been around for a while and the name sounded familiar.

And it was interesting to see, I did a little bit of digging, I went back into my computer to check out some of the old research that I've done. And I actually looked at this business a while back for a 10-K challenge, it's just something we do on the analyst team here from time-to-time, just a good way to go through the 10-K and get an idea of a business in about an hour to see if it's something you want to learn more about or if it's something that maybe is a little bit beyond your scope of understanding. And so, I still had that Healthcare Services Group 10-K challenge that I did. And I remember walking away from it thinking, you know what, I thought this was a really cool business, I liked it a lot, so to see this on your list, I got to say, I was a little excited. So, take it away, tell us about Healthcare Services Group and why you like it?

Feroldi: Well, I'm glad to hear you say that, and the funny thing, Jason, is all three companies we're going to talk today have been on the public markets for more than 10 years at least, and maybe even 20 years all three of them. And yet, I would wager that they are names that most people have never heard of. And the company, Healthcare Services Group, is the biggest of the three we're going to talk about today.

This is about a $1.8 billion company. They are focused on providing housekeeping, laundry and food services to healthcare facilities. Doesn't sound like an exciting business, but I think listeners will be excited to learn that this stock is up 7,540% since its IPO in the eighties, and is a monster dividend payer to boot. So, when I see enormous outperformance over an extended period of time, as well as a company that is still small in the grand scheme of things, that's something that captures my attention.

Moser: Yeah. Small in the grand scheme of things. And by that, you know $1.7 billion, $1.8 billion market cap. I think, maybe when I looked at it was around $1 billion, so. Yeah, you know, [laughs] it's not maybe the sexiest business in the world, but boy-oh-boy they really provide essential services. I mean, this is a company that healthcare providers, they can't do without this.

Feroldi: Yeah, exactly. So, their main customers are nursing homes, rehabilitation centers, hospitals located throughout the U.S. And their revenue is split between two main businesses: So, housekeeping and laundry is one; and food services in the other. And this company has a long history of going into facilities and convincing them to outsource those core but basic services to Healthcare Services Group, which has the scale and the buying power to do essentially what the hospital could do for itself, but cost effectively. And hospitals aren't really in the business of selling food or doing laundry, so it does make sense to me that they have consistently said yes to Healthcare Services Group and outsourced their work to it.

Now, the nice thing about boring businesses is they are essential. One thing that I really like about Healthcare Services Group is it has a +90% customer renewal rate. And last I checked, everybody at healthcare facilities kind of likes clean sheets and food. So, this is not something that is cyclical in any means, it's just a boring steady-Eddie producer of services. And I understand why it has been such a stellar performer over the long-term.

Now, in 2018, this company unfortunately became a lot more exciting. A couple of their biggest customers ran into financial trouble and basically couldn't pay their bills on time. So, Healthcare Services Group was kind of forced to scramble a little bit and renegotiate its customer contracts. And they actually renegotiated their deal, so that rather than Healthcare Services Group buying products and then charging the company for them, they basically said, "Nope, you're just paying us for the service now. You're buying the services directly." So that had the effect of actually dampening down this company's revenue growth. So, if the only metric you looked at was revenue over the last couple of years, you'd be disappointed with where it's heading.

But profits haven't been hit as hard, they have been hit by a lot of one-time costs to kind of go through this change-out, but the good news to me is that the growth drivers of this company, the long-term growth drivers, are still very much in play. And if you look at the company's financial statements, there's a lot of reasons for optimism, I believe.

Very clean balance sheet, I see a $170 million in cash, no debt. It does have a few long-term liabilities to be aware of, but a very solid position. As I mentioned, revenue is very sticky, so some margins are typically very sticky.

And how is this for a stat, Jason, this company has increased its dividend 66 quarters in a row. So, every quarter it increases its dividend, and that is back till 2003. So, that includes throughout the Great Recession. You're currently getting a 3.6% dividend yield, because the stock has been smacked around. So, to me, given the long-term trends in America, I mean, Americans are getting older, I think the demand for long-term care facilities is going to continue to grow. As the leading provider of these services in the industry, I think Healthcare Services Group has a long growth runway ahead of it. And I think it can continue to increase the dividend quarter-in and quarter-out for essentially the foreseeable future.

Moser: So, yeah, it's pretty fascinating actually, when you think about it, 66 quarters in a row.

Feroldi: Quarters, not years, quarters.

Moser: Not years, quarters. And that is still, though, when you think about that, this is a company that actually is knocking on the door of becoming a dividend aristocrat, if they keep this behavior up. And I don't know the data on this. I mean, we could certainly research it and find it out. I don't even know if there are any small cap companies that are dividend aristocrats at this point. I mean, you could see where this business is actually set up to be able to achieve that. And I would imagine at this point in the game, they really don't want to look back, because as we know, a dividend aristocrat is not about every quarter, it's just raising that dividend at least once annually for 25 consecutive years. And then once you get that membership status, I mean, it's kind of like the American Express card and then membership has its privileges, and maybe sometimes those privileges aren't as explicit or obvious, but companies that get that dividend aristocrat status want to keep it for the most part, and they'll do what they can to do so. I wonder if that's something that this management team has in mind?

Feroldi: I'm sure they do. I mean, you don't grow your dividend that long without having ambitions to become a dividend aristocrat eventually. And again, just to put some numbers, the company did post some numbers on its long-term potential. So, revenue last year was about $1.8 billion. The company believes that its market opportunity in the U.S. is $32 billion. So, although this company is the largest player at what it does and there could be opportunities for it to steadily acquire little businesses here and there to kind of get his foot in the door with markets that it hasn't penetrated yet, substantial, still, room for growth, I believe.

So, not the most exciting business, definitely not going to produce eye popping topline growth anytime soon, but if you like boring and dividends, Healthcare Services Group might be for you.

Moser: Yes, slow and steady wins the race a lot of times. Man, we'll keep that in mind. Well, let's take a look at this next one you have on the list. It's not a company that I am familiar with at all, but as soon as I saw the name and looked at what they did, it made me think of another company that I've started digging into a little bit for our Augmented Reality service, which, obviously, you are a part of as well, and that is STAAR Surgical (STAA 0.61%). Tell us a little bit about STAAR Surgical and what they do?

Feroldi: Yeah, I only found out about this company recently. I've heard of them before. But The Fool has several live Zoom chats going. We have a livestream going that we've had going for the last couple of weeks and we actually did a deep dive on this company to show somebody how to research a stock from scratch. So, I never heard of it before and this is a great example of that. I never heard of this company, but it came up.

And how's this again, Jason, IPO in the late-90s, I see up 940% since then. So, another market beater. And yet, $1.4 billion market cap. So, small cap, long-term market beater.

And this company is focused on the medical device, or sort of medical device market. So, add those together and you got my attention. So, the ticker here is STAA, STAAR Surgical. And they are focused on correcting vision problems. Their primary, their flagship product is called the STAAR ICL. ICL stands for Implantable Collamer Lens. And this device is used to correct a number of common vision problems. So, this would be a product that can be surgically installed into the eyes in a 20- to 30-minute outpatient procedure. And it's really, they're stealing market share essentially from LASIK, you know LASIK is the laser that goes in your eyes. This is actually an implantable device.

And it has several advantages over LASIK surgery. First off, it's removable. So, to my knowledge, once you get LASIK, that's not reversible, at least from what I understand, I might be wrong about that. But the STAAR's system, once it's put in, is actually removable, if need be. Second, there's no dry eye syndrome associated with it. It goes into the body very well and prevents the eye from drying out, which can be a problem for some people. It's upgradeable, right, so once it's in there, after a couple of years or if a newer version comes out, you could take it out and put a new one in to upgrade it. And it offers UV protection and better night vision than, kind of, LASIK can perform.

And how's this for a stat, 99.4% of patients who had this say they'd get it again.

Moser: Wow! Well, I mean, so that's interesting, because there are a lot of things that are coming in my mind here. I'm thinking this is like the Bionic Man all over again, right. I mean, you're getting bionic eyes. And then I wonder if it's upgradeable or changeable. I mean, I wonder at what point they make these devices remotely upgradeable, so that you're actually able to change or upgrade your vision at the click of a button or the opening of an app on your phone. But that 99.4% of patients would have the surgery again. I mean, that's really the testament.

Everybody I've spoken to that has gotten LASIK, for the most part, I think, everybody has been really positive about it. I mean it has made their vision better and that's the promise of the surgery. And I know that with LASIK there are certain folks that can't get it, because I believe it's because their cornea is too thin or something to that effect, and that's a bummer. I mean, if you don't have any options beyond LASIK. It sounds like this could be another option out there, which is certainly encouraging.

Feroldi: And on the investor website, they do have quotes there from surgeons that basically say, once I learned about this system, I stopped doing LASIKs at my practice because they were such believers in it. Whether that's a widespread belief or not, is up for debate, obviously. But the interesting thing about this company is it's located in California; so, that's where its headquarter is. However, the vast majority of its sales are actually overseas. So, this company really got a name for itself in overseas markets, specifically China and Japan were two of its bigger markets. And the U.S. is a newer market for it.

I don't have the number in front of me; I believe something like 95% of this company's revenue is international and it's now making a big push into the U.S. So, kind of a backwards story, given that this is a U.S. located company there. But to put some numbers on it, if we could check out the financials. So, in 2016, this company's revenue was $82 million. Last year that jumped to $151 million. So, you're talking about almost a doubling in revenue over a three-year period; that's a pretty good growth rate. And what excites me is, over that same period, gross margin went from 68% to almost 75%. So, you're seeing strong top-line growth in addition to gross margin expansion.

And STAAR is also big enough and has enough gross profit to become free cash flow positive, its earnings are positive. And again, just like Healthcare Services Group, I see $112 million in cash, zero debt. so.

Moser: Yeah. Strong capital position, it's just such a nice thing to see in this day and age. And the other thing, I mean, just the profitability factor. I mean, just looking on the surface, before even looking at the income statement, I would have bet, you know what, this is probably one of these businesses that holds all the promise in the world and probably even profitable, yet probably another one of those things is not going to be profitable. Their financials are really solid. I mean, they're profitable, they've got impressive revenue growth there. I think the market is certainly there.

And it goes back to a company that I've been researching lately for our Augmented Reality service, one that I'm digging more into, really, trying to learn a little bit more about, it plays in the same sandbox, is a company called Alcon (ALC -2.01%). The company Alcon, its ticker is ALC. And it's a much bigger company, $25 billion market cap, I believe, but playing in that same sandbox, sort of speak, focused on eye health, ocular health, and products for folks with vision problems. So, yeah, I always wonder, when you see big companies like that, when they look at something like a STAAR, or if they feel, like, "Hey, maybe that would be a nice little bolt-on acquisition," or something like that, given the size of the business and the health, no pun intended, of the business. It'd be interesting to see. I don't know what your feelings on that are. Do you feel like STAAR is a special enough company or someone would be really interested in trying to snap that thing up?

Feroldi: Oh, completely, it definitely could be, but I don't know about you, I hate it when companies that I like get bought. I just hate it. If I find a company that I like everything, I just want that thing to run, I just want it to run for years and compound my wealth for me. I don't want it to be robbed away from me because some big company also agrees with my assessment. I could see this company being an acquisition target, but that would be reason 19 to own it as opposed to anywhere at the top.

But the nice thing is, even though this company has come a long way, it's already performed well for shareholders, it actually still sees a big opportunity ahead. So, 4 million refractive procedures are done today, that's the market this company competes in, that's a $6 billion market. Again, this company's revenue last year was $151 million. So, still small.

And as you can imagine, vision problem, big, big problem. It's like +2 billion people have some sort of vision problems. And STAAR estimates that for its myopia, which is distance vision and nearsightedness, they estimate 35 million potential customers. And for presbyopia, and I'm probably butchering that, but that's OK, near vision select -- and that's when you need, near vision problems are reading glasses, 55 million patient potential for STAAR.

So, this is a management team that's out there saying, we believe revenue growth is going to grow 25% annually between now and 2022 on a compound annual growth rate. And they're still targeting margin expansion. So, they think they can get their gross margin above 80%. As a reminder, it's about 75%. So, this management team does not think the growth is done yet and they're still calling for margin expansion. So, margin expansion plus high growth equals profit growth to me.

Moser: Yeah, I mean you're telling us a great story here. And the healthcare market opportunity is a tremendous one, but certainly when it comes to vision, I mean, that's something we all rely on. And no doubt, the opportunities out there with a lot of folks that do have vision problems, whether that's vision problems from the day you're born or vision problems that just occur with old age as someone like me. I mean, I'm starting to realize those vision problems now, Brian. So, it's distinctly possible I might be looking into STAAR Surgical, well, not just as an investment.

Feroldi: Alright, you might be one of those 99.4% satisfied customers, Jason. [laughs]

Moser: [laughs] It is not out of the realm of possibility.

Well, before we continue, I do want to remind all of our listeners out there, who are looking for more stock ideas, because we know that's what you're looking for. That's why we're doing these shows for you, because you're looking for more stock ideas. And now is a great time to check out our Stock Advisor service, where you'll get stock recommendations from David and Tom Gardner every month, Best Buys Now and a whole lot more. And why is it a great time? Well, if you just go to IF.Fool.com, you can take advantage of a special 50% discount for our wonderful Industry Focus listeners. So, make sure to check that out, IF.Fool.com.

Okay, Brian, let's wrap this up with your third healthcare hidden gem here. And this is another company I am not familiar with, but really neat-looking, once I started checking it out, Simulation Plus (SLP -0.74%). Tell our listeners a little bit about why you like Simulation Plus.

Feroldi: Does this sound familiar? A company that IPO'd in the 1990s and is up 2,400% since then, and yet market cap is still small. I mean, it's remarkable to me that you can have such amazing outperformance and Simulation Plus's market cap under $600 million. So, it's still tiny. So, when it came public, I mean it must have been like a $30 million business or something along the lines.

But, OK, Simulation Plus sells software that aids in the drug development and discovery process. So, this is a company that is focused primarily on the pharmaceutical, biotech industries, they also do stuff with industrial chemical makers, cosmetics companies, food ingredients companies. But they have 12 different software programs that help to simulate how molecules will be absorbed in the body, distributed throughout the body, what your metabolism will be like with those drugs, how they exit your body, and what kind of toxicity they could have -- which is a big problem for drugs, one of the main reasons that drugs kind of get rejected or tossed in the bin is because of toxicities issues.

So, Simulation Plus' software is really used on the very early side and it incorporates clinical data and it has very advanced modeling to kind of allow companies that are researching new molecules to predict with accuracy how they will react once they get into an animal or into a human. So, it really aids with decision-making on the pharma and biotech company side to say, "Hey, we have this molecule, what do we think it's going to do?" And it allows them to say, "Nope, get rid of it, it's clearly, according to the simulation here, it's going to be something that just throws off toxicity." So that, to me, is a big, big value-add. If I was a drug-maker, I would want to know that kind of information right away.

And by using a software to do that, you can get that answer much quicker than you can before. Now, you still have to, of course, do clinical trials and all that kind of stuff, but this helps -- this software has been around for decades and it's been refined in numerous ways to make it more accurate.

And the other thing that it does; this is actually two businesses. They actually also do consulting services. So, if you are a company that wants to have this kind of research done on a molecule, you can actually hire Simulation Plus to come in and do this work for you and consult. And their revenue is split about 50%-50% between software and consulting.

Moser: Yeah, and you know digging in a little bit more here, I do see -- I mean, we always love to see founders with skin in the game, taking stakes in the businesses that they've built, and it certainly looks like Simulation Plus is no exception. One of the Co-Founders, Walter Woltosz, looks like Walter holds a significant stake in the business here with around close to 28% of the shares outstanding, actually. He serves as Co-Founder and Chairman of the business, still. You know, it does feel like to me, when you have someone who's bought into that vision to that level -- I'm not saying that's an automatic and that's why you go buy a stock, but, boy -- that's an encouraging sign to see.

Feroldi: Definitely. And he was the CEO himself for many, many years. He did hand the CEO off a couple of years ago. Walter is 75 years old. And I love to see it when the Founder, who's obviously 28% of the shares, I mean he's worth well over $100 million, if not closing in on $200 million, still takes time to be the Chairman. Obviously, this company means more to him than just the money, otherwise, he would hang up his spurs a long time ago. So, I love to see that and, clearly, this is a man that thinks and acts with the long-term in mind.

And when you dig in, this is a company that it's easy to get excited about, given everything we've talked about so far. And we haven't even covered the financials yet. [laughs]

Moser: [laughs] Well, let's talk a little bit about the financials, because this is a small business, right. I mean, you're talking about, I don't know, man, they're not even generating $40 million in revenue it looks like.

Feroldi: That's correct. So, over the last 12 months, this company generated $36 million in revenue. So, again, not much, but the last quarter, which is a good proxy for, kind of, growth, revenue grew 25% to $9.4 million, gross margin of 72%; and keep in mind that gross margin includes consulting and software, so I would guess that the software margin is incredibly high and the consulting margin was maybe 50%, 40%, and you wrap that together and you get that 72%.

But how does this sound, Jason? Net income, up 34% to $2.1 million. So, you're talking about $2 million in net income on less than $10 million in sales.

Moser: I like the way that sounds, I like the direction that's headed, I like the potential there. Given the size of the business, you have the nature of what they do, and given the time that we're living in right now, it really feels like this is a business, this type of business, is going to be more relevant now than ever before. And I would think also that what's going on today is going to provide at least some tailwinds for a business like this going forward. And the importance in research and testing and getting this data and modeling and understanding more about how all of these factors, all of these moving parts work together. I mean, do you feel like that -- am I close there, do you think?

Feroldi: Yeah, I would completely agree with that. I mean, right in the 10-K, the company says, and we've been talking about its business, "We believe our proprietary AI/machine learning software engine has a wide variety of potential applications." So, that tells me that they're using all of the data that they've accumulated over the last 30, or 20-something years and they've been feeding into this system to really make their software top-top, the best of what it does. Now, there are competitors out there for its programs, but it does say that the competition -- this isn't like a CRM tool or anything like that, this is very niche software, obviously -- so, the competition in the software space is very limited.

Which, again, is another fact that kind of attracts me to this business. But I do believe that because of their depth and their history and their enormous dataset with predicting how molecules are going to work and then actually having data from clinical trials and then actually having data from the real world, that, to me, gives them a dataset and experience that would be extremely difficult for potential competitor to replicate.

Moser: Alright. Well, as we wrap things up this week, I am going to not throw you to the wolves here, Brian, but I'm going to make you make a decision here. If you have all three, if I say, "Brian, I'm going to let you be an owner of one of these three companies today and you got to hold on to these shares for the next ten years ... " and that's the idea behind small caps really, which we're trying to give them as long of a timeframe as possible, if you have to pick one of these three businesses today to own for the next ten years, which one is it going to be?

Feroldi: Well, I want to say, you're asking me that question, I think that's the important thing.

Moser: I am asking you this question. [laughs]

Feroldi: So, I am not a dividend investor. So, I am not a value investor, I don't focus on dividend. So, for that reason I would not pick Healthcare Services Group, not because I don't think it's a good rock-solid company that's going to grow, it's just dividends are not my focus right now, I am a growth-focused investor. So, to me, based on that, it would come down to between STAAR and Simulation Plus.

And I think there's merits to both businesses, certainly. Between the two, I would pick Simulation Plus. STAAR Surgical [sic] does have some customer concentration issues that we did not touch into the show, but a few customers account for a pretty big portion of this company's revenue. I would guess those are distributors that are in international markets, so they're probably protected by contracts. But that is something that I personally look for and knock companies down for, is when they have big customer concentration issues.

Simulation Plus has a couple of big individual customers, but they do say that their biggest customer is 8% of revenue. I think that STAAR's -- again, going from mostly memory here -- STAAR has one that's over 20% of revenue. So, based on that, that would give the edge to Simulation Plus to me. But I think that both businesses are worth at least checking out, getting to know and both have clearly been homerun investments over the long-term. So, I'm glad we could bring them all to our listeners' attention today.

How about you? Jason, now that you have had a chance to digest this, what do you think?

Moser: [laughs] Well, you know, Brian, I could totally cop out here and say, "Well, why not just take all three and make a healthcare basket." I'm not going to do that, though. [laughs] I'm not going to do that. I'm feeling a little nostalgic, though, man. I mean, I'm looking at Healthcare Services Group, in my memory of that business, I was always fond of it. And you know, I'm not really a dividend investor, but I am older than you, I probably need to be focused a little bit more on those dividends. You know, I don't know, I do remember everything about Healthcare Services Group and liking it. I think I would probably put that one at the top of the list, but STAAR really -- you know, considering the fact that I'm probably going to have to do something about my vision at some point, STAAR would be a very, very close second.

But they're all three terrific ideas and ones that I think our listeners will enjoy digging more into. I really appreciate you bringing them forward this week.

Feroldi: Sure thing. And Healthcare Services Group is definitely the value play. We did not touch upon valuation at all, but I assure you that Simulation Plus and STAAR are trading at higher valuations, deservedly so, in my opinion. But, hey, that's why investing is fun. So many factors to consider when you're making capital allocation decisions.

Moser: That's right, it never gets old. Well, listen, Brian, I know you've had a very, very busy week and it's not stopping now, but I really appreciate you taking the time out this week to join us on Wildcard Wednesday and bring three great new ideas to our listeners. Thanks so much.

Feroldi: You know I'm always up for it, Jason. Love, love, love scouting healthcare and finding stocks that nobody else is talking about.

Moser: Well, we will do it again very soon. And that's going to do it this week for us, folks. Remember, you can always reach out to us on Twitter @MFIndustryFocus, drop us an email at [email protected]. Tell us how you're managing through these tough times or just, hey, reach out let us know what stock you bought last, how about that. Let us know the last stock you bought and why. We're always interested to hear these latest and greatest ideas from all of our wonderful listeners out there.

But, as always, people on the program may have interests in the stocks they talk about, and The Motley Fool may have formal recommendations for or against, so don't buy or sell stocks based solely on what you hear.

Thanks to the man behind the Zoom, Austin Morgan, for keeping us running so smoothly in these difficult times. For Brian Feroldi, I'm Jason Moser, thanks for listening and we'll see you next week.