Organic revenue growth of 5% is nothing to get too excited about, but increasing margins made for a nice bottom-line improvement at Natus Medical (NASDAQ:BABY). Non-GAAP net income increased 16.5% year over year in the third quarter to $10.6 million.
Gross margins came in at 63% on a non-GAAP basis, up from 61% in the year-ago quarter. Sales in the U.S., where Natus doesn't have to give distributors a cut, and sales of higher-margin products helped increase gross margins. Depending on the mix of products, the high-water mark might be hard to hit again in the fourth quarter, but at least investors know what's possible.
Gross margins should improve more as Peloton, the company's newborn hearing testing service, gets off the ground. At this point, Natus is incurring start-up costs for the service without much revenue coming in. Natus Medical signed up 17 hospitals for the outsourcing service in the third quarter, bringing the total number of hospitals under contract to 39 at the end of the third quarter.
Peloton is a win-win both for hospitals and Natus Medical. Hospitals won't have to spend capital on the company's Algo hearing screener, but can still bill insurance companies for the testing service Natus performs. And Natus Medical increases the revenue per baby from $10 for the disposables if hospitals use their own machine to $100 or more for performing the test for the hospital.
There are around 3,000 birthing hospitals in the U.S. that are large enough to justify outsourcing the testing service to Natus Medical, so there's potential for substantial growth. For now, management is sticking with its conservative goal of signing up five to 10 hospitals per quarter, but mentioned that it does have a pipeline of quotes out to hospitals. With revenue around $150,000 per hospital per year, the new service could upsize Natus Medicals' revenue -- expected to come in around $355 million this year -- fairly quickly.
And it comes with higher margins to boot.
The new service should help Natus Medical reach its non-GAAP operating margin goal of 20% in 2016. Third-quarter non-GAAP operating margin came in at 18.9%, so it's close to getting there. The non-GAAP operating margin is a good number to watch because it closely matches cash flow since amortization expenses are not included in the number.
Natus backed off of its growth through acquisitions model to focus on organic growth. The company has launched a couple of new products this year including its Vista Ultrasound System, which adds ultrasound capability to Natus' EDX and UltraPro S100 EMG workstations to help doctors locate nerves. Look for four to eight new products over the next 18 months.
But with all that new cash that Natus Medical is generating -- and having paid off $37.5 million in long-term debt over the last year -- it seems likely that it will go back on the hunt for external growth through acquisitions.
As long as the acquisitions don't bring down margins, investors should welcome the growth however it comes.
Brian Orelli has no position in any stocks mentioned. The Motley Fool recommends Natus Medical. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.