Riddle: When is "20 minutes and a glass of water" the best news you've heard all day?
Answer: When you've found out that your endoscopic exam will use Given Imaging's (NASDAQ:GIVN) PillCam rather than a tube endoscope.
For those fortunate enough not to know firsthand, endoscopy is a non-surgical procedure to examine a person's digestive tract. The endoscope, a flexible tube containing a light and camera, enters the throat or the rectum and passes through the digestive tract. Endoscopy is a common diagnostic procedure prescribed for a wide variety of gastroentorologic conditions, ranging from unexplained stomach pain to gastritis, ulcers, chronic constipation, diarrhea, and colon polyps. The number of small intestine examinations using current diagnostic methods, including endoscopic and radiological imaging, is estimated between 1 million to 2 million in the United States every year.
Given Imaging's solution is to place the camera (two of them, actually) in a pill, which the patient swallows. The PillCam generates 14 images every second, which are transmitted to a belt recording unit worn by the patient. Whereas tube endoscopy sometimes requires light sedation or even general anaesthesia, especially for pediatric examinations, Given Imaging's PillCam requires none. Compared to tube endoscopy, how could the PillCam be considered anything but patient-friendly?
Until now, Given Imaging's lucrative, exclusive niche as the camera-in-a-pill solution provider was, well, a "given." That changed somewhat last week, when Japanese camera giant Olympus, the leading maker of tube endoscopes, announced that it will market its own capsule endoscope in two years. Olympus has stated that it will begin clinical trials in the coming months.
Niche domination
Given Imaging was incorporated in Israel in 1998 and had its Nasdaq IPO in October 2001. The third quarter of 2001 was also when the company recorded the first sales of its systems.
Given Imaging is presently the only provider of capsule endoscopy. While the vast majority of endoscopic exams still use the tube method, Given Imaging's growth in sales figures indicates that capsule endoscopy has a vast potential to become a widely chosen alternative, if not a new and preferred standard. The big question is whether the company's management and marketing folks can use a two-year lead time to establish the brand among medical professionals and savvy patients. Olympus' established presence as the leader in tube endoscopy might give it advantages in medical equipment procurement channels.
Insurance reimbursement, a crucial metric for the success of almost any health-care innovation, is looking up for Given Imaging. In 2002, reimbursement for PillCam examination was established only for indication of suspected bleeding from the small intestine. During 2003, PillCam reimbursement expanded to cover more applications, including the diagnosis of Crohn's Disease and small bowel tumors. During that year, Medicare and Medicaid increased average physician payment for in-clinic capsule endoscopy by more than 20% and professional fee payment for in-hospital capsule endoscopy by 70%. Overall, in 2003, the number of U.S. patients with reimbursement coverage for capsule endoscopy grew by 141%, from 62 million to 151 million. While the insurance reimbursement story is good for Given Imaging, it's also good for Olympus, whose product, once past FDA approval, will have relatively few barriers to insurance coverage.
Given Imaging is also expanding the application of its core technology. It just received FDA approval for its new capsule endoscope for examination of the esophagus, the PillCam ESO. This will be a useful, patient-friendly, and cost-effective tool for screening and diagnosing patients with esophatitis and Barrett's Esophagus, conditions affecting many of the 40 million Americans who suffer from chronic reflux symptoms.
Marketing matters... and soon
In Johnson & Johnson (NYSE:JNJ), Given Imaging has an effective marketing partner for its PillCam and accompanying software and workstations. For J&J, this provides another horizontal presence in the diagnostics supply market. Whatever premiums Given Imaging will give up to J&J must be weighed against the impending clash with the titan of Olympus. The faster Given Imaging establishes its brand and technology as an endoscopic standard, the better.
Mastering the fundamentals
Given Imaging's fundamentals are good for the tummy of a growing company. Revenues and margins have risen impressively. In 2003, revenues increased to $40.5 million, representing a 40.3% increase over 2002. Its revenues for the first nine months of 2004 handily topped its total for 2003, and management guidance sees the company topping $60 million in revenues for the year.
While gross margins took minor dips in Q2 and Q3 2003 as well as Q3 2004, due partly to seasonal drops of non-vital medical diagnoses during the summer, TTM (trailing 12 month) gross margins have risen steadily every quarter, from 51.8% in Q2 2002 to 63% in Q3 2003 to 76% in Q3 2004. Annual gross margins reached 66.6% of revenues in 2003, compared to 58.8% in 2002. As of Q3 2004, gross margins for the past 12 months have topped 73%. With the 2004 summer market doldrums behind us, it is hard to imagine Given Imaging reporting disappointing gross margins for fiscal year 2004.
As of the end of June, Given Imaging's net earnings had gone from red to black ink, yielding a net profit (diluted) of a penny per ordinary share year to date and $0.03 for the second quarter. October's conference call revealed a Q3 net profit of $0.04 per share (diluted). Net profit for the first nine months of 2004 was $400,000, or 1.5 cents per share (diluted), compared to a net loss of $9 million ($0.35 per share) for the same period a year ago and a loss of $18.3 million ($0.73 per share) for 2002.
Overall, Given Imaging has done an admirable job of reducing accounts receivable and inventories. Accounts receivable stood at 38% of TTM revenues at Q2 2002 and have since shrunk to 18% as of Q3 2004. These figures are quite impressive considering that the company's systems are new products in an existing market and that its revenues depend on insurance reimbursement. From Q2 2002 through Q2 2003, inventory figures hovered between 34% and 39% of TTM revenues. From the following quarter to Q2 2004, inventories reduced steadily from 28% to 18% of TTM revenues. Like a sudden case of indigestion, inventories backed up to 24% of TTM revenues in Q3 2004. While this too might be due to the seasonal summer hiatus, investors and watchers should check that inventory reduction gets back on track for Q4. Even so, the overall inventory reduction is still impressive -- compare 2004's Q3 (24%) with 2003's Q3 (28%).
Valuation
Taking a cue from Given Imaging, I've used the FoolCam (also known as "due diligence") to check out the company's financial innards. I've diagnosed a healthy emerging company with a great idea enjoying great execution so far. But is its current stock price itself too large a pill for investors to swallow?
As Given Imaging is just turning profitable, its share valuation is a complicated matter. The company's market cap stands at just under $1 billion. Given Imaging trades at 10.8 times its book value and 17.8 times TTM sales. These are not unreasonable metrics for an emerging company with newly positive earnings, high margins, and impressive short-term growth prospects. Operating cash flow is steadily rising, and the rapidly growing market of insured capsule endoscopy should ensure positive and growing earnings.
The company's long-term guidance is for 50% revenue growth for 2005 and 2006. If the company hits this target, and then slows to sustain 30% annual growth after Olympus enters the market, then the current market capitalization is equivalent to revenues for the next five years. On that basis, Given Imaging might be considered fairly valued, assuming that cash flow and income trends continue. If it sustains or increases its growth rate past the next two years, then the present market cap could be undervalued. Obstacles to execution, including an early market entry by Olympus, could slow earnings growth enough to make Given Imaging's stock seem pricey. Clearly, this is a stock that carries some risk.
Analysts have stated that the stock has already got quite a bit of growth priced in, and a number of them think it is overpriced. The market won't be forgiving of unexpected glitches in execution. If such glitches cause sudden stock price drops, savvy investors may want to gauge market overreaction and reevaluate Given Imaging's situation and fundamentals for possible bargain hunting.
There is no material debt on Given Imaging's balance sheets, so revenues pass more directly to the cash-flow bottom line. The trend of share dilution, however, might make investors a little queasy. In 2003, a 4.3 million-share stock option proposal was passed, and since the end of 2003, shares outstanding increased by 7.1%. This authorizes the company to issue additional shares to the tune of 9% of current shares outstanding. While these levels are not uncommon for growing companies introducing new products, investors should monitor the dilution as the company matures.
Forty-four percent of the company's shares are held by industrials, and insiders hold 65%. At least 10 analysts from major brokerage entities are covering Given Imaging.
For now, Given Imaging seems to be hitting its global approval and insurance reimbursement targets. On December 15, 2004, the United Kingdom's National Health Service received guidance from the National Institute for Clinical Excellence for the use of the PillCam, in effect making the PillCam accessible for any of the 58 million Britons who may require small bowel diagnostics. Given Imaging is aggressively positioning its systems for authorization in Europe and Asia.
If the company continues to execute efficiently and effectively, grows revenues and keeps margins high, and limits its share dilution, it will be not only patient-friendly, but investor-friendly, too.
Fool contributor Michael Jaffe is a freelance writer who would rather let the mysteries of his colon remain unexplored. He owns stock in Given Imaging. The Motley Fool has a disclosure policy .
