Ventana Medical Systems (NASDAQ:VMSI) reported second-quarter earnings on Thursday afternoon, but it was the future earnings prediction that made it happy day for investors.

Ventana increased year-over-year second-quarter net sales by 21%. Earnings, however, were relatively flat over the second quarter of last year, because of expenses related to determining whether the company should accept Roche's $3 billion hostile takeover bid. A slight drop in gross margins -- from 76.5% to 75.3% -- also contributed to the flat earnings. The drop was due to an increase in sales of its lower-margin reagents, relative to the instruments it sells. Margins were also dragged down by Ventana's decision to upgrade customers from its older Nexus systems to the new BenchMark machines, but that should pay off down the line since the BenchMark uses 30% more reagents.

The business
Before I get into Ventana's stellar predicted increase in earnings, it's important to understand the company's business model. Ventana designs and sells instruments and reagents that stain tissues. Any time tissue is removed from the body, it goes to the pathology lab where it is made into a slide, stained, and examined under a microscope. The primary staining determines if the tissue is normal -- 80%-85% of the time, it is. For the unlucky patients who end up being diagnosed with cancer, advanced staining is used to determine the nature of the tumor, which helps the doctor determine the best course of treatment.

Since its inception, Ventana has primarily been involved with advanced staining diagnostics, but it entered the primary staining market with the introduction of its Symphony machines last year. The machines are fully automated high-throughput, which means oodles of reagent sales. Management reports that placement of machines is "accelerating." The first clinical trials using the machines are due out in the last part of the year, which could convince pathology departments to take the leap and increase sales even further.

Essentially, the business model is to sell machines to pathology laboratories of hospitals; Ventana makes a little money off of the sale and then reaps continued sales from the customer, who orders reagents for the machine year after year. Thus, placements of machines are the key to future revenues and investors should check the placement numbers every quarter to ensure that machine sales are growing -- you'll likely need to listen to the conference call, as the number may not be reported in the press release. Currently Ventana receives an average annual annuity of about $120,000 per machine. The newer Symphony machines may raise that number, though, since they bring in reagent sales as high as $800,000 per year for larger labs.

As Ventana places more machines in hospitals, it will be able to increase sales of reagents. It plans to leverage this increase to push down margins. Ventana currently has a large sales force -- perhaps larger than it really should -- that has allowed it to increase sales over the last few years. As it increases the number of products it sells, the drag from selling general and administrative costs on net margins should decrease.

Ventana's spending on research and development over the last few years has been dragging down net margins, but the payoff appears to be near. It plans to launch 10 new diagnostic antibody tests next year. Also, it has a recently gained FDA approval for a gene test for patients who may respond to Genentech's (NYSE:DNA) Herceptin therapy.

Companinon diagnostics
Many of Ventana's advanced staining products test tumor samples for the presence or absence of proteins or genes. They are designed to test for proteins known to increase the power of chemotherapies to kill the tumor and thus give doctors a better idea of which drugs might work.

The next obvious step is to design companion diagnostics before the clinical trials begin. The value for Ventana isn't terribly immense; the market for tests in the four largest cancer markets -- prostate, lung, breast, and colon -- is about $150 million to $200 million, and other markets are considerably smaller. But the value to the drug companies is huge. By testing patients in clinical trials and only enrolling patients that will likely respond to the drug, the drug company increases its chances of having a successful trial and gaining marketing approval. Presumably the drug companies are footing the bill for the development and perhaps paying milestone payments since it's so lucrative for them, but Ventana is being silent on the details because the drug companies want to be secretive.

Ventana did say that it is working with nine pharmaceutical companies on 22 different projects. Some of the projects are in phase 3 clinical trials, and so the test and drugs could be marketed as early as 2010. This should certainly provide growth in the number of products it sells.

Great company, bad investment?
Considering the great prospects for the Ventana, it has upped its earnings estimate for the year to $1.31 and boosted its anticipated earnings for 2008 to $1.86-$1.96 per share. It also issued an initial forecast for 2009 of $2.62 to $2.76 per share, a whopping 40% growth over 2008 estimates.

Just because the company is growing at a substantial clip doesn't mean that it's a good investment -- after all, Ventana does have a P/E north of 65. The Fool Ratio is a better measure of value for fast growing stocks. Using the Fool's PEGulator, I get a Fool Ratio of 0.73-0.88 based on the 10 quarters of earnings estimates remaining. Certainly not overvalued, but not terribly undervalued either. A better time to invest was obviously last month, before Roche pointed out to everyone that Ventana was undervalued. If Ventana can keep its sales growth at 20% beyond 2009, then it's probably still a good investment, but it's awfully hard to determine growth that far in the future.

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Fool contributor Brian Orelli, Ph.D., has looked at so many cells on microscope slides that he often sees them when he closes his eyes. He doesn't own shares of any company mentioned in this article. The Fool's disclosure policy is rock solid.