Description
Alere develops, manufactures, and sells rapid diagnostic products that serve cardiovascular disease, drugs of abuse, infectious disease and women's health in the hospital, physician, and home markets. The company's strategy is to use the profitability of core diagnostic products to fund R&D or acquisitions for additional diagnostic products that can be (a) sold through their global distribution channels to hospitals, physicians, and home markets and (b) combined with a health management strategy to help save money for healthcare systems.
Alere stock presents an attractive risk/reward. A reasonable case should yield a stock price of over $60, with a more optimistic case resulting in almost $80. A very pessimistic case could result in $16.50.
Why does the opportunity exist?
- It's confusing: Since 2007, Alere has done deals totaling over $4.5b around the world and in seemingly disparate subsegments of diagnostic testing (dengue fever to pregnancy to drugs of abuse). All of their acquisitions create ongoing adjustments to EBITDA and earnings.
- It's relatively underfollowed: There are 12 analysts, but the biggest banks that cover it are UBS and Jefferies. Alere falls in the intersection between life sciences tools (like BEC, TMO, and WAT), healthcare devices (like QDEL, RMD, LNCR) and healthcare services (like HWAY). Because there's not a great overlap with analysts' logical industry segmentations, many just overlook it.
- Management recently committed the sin of lowering earnings guidance fairly dramatically and without warning: On June 8, at the Jefferies healthcare conference, Alere's CEO lowered 2010 guidance by 10% and the stock sold off 23% in the next couple of days. I will address the reasons for the guidance reduction below, but the disproportionate sell-off, I believe, was due to the poor way that management conveyed the information. Rather than issuing a press-release and an 8-K, the CEO simply lowered the guidance in the last 5 minutes of the presentation and then proceeded to be out of touch with any investor who did not happen to be at the conference. Furthermore, the company had been reiterating their guidance in private meetings with investors just the prior week - which made them come across as duplicitous at worst and stupid at best.
- The upcoming flu season will be very weak: Alere's largest segment, Professional Diagnostics, had about $100m in revenues from North American flu tests in 2009 mostly due to H1N1, but the current flu season is very weak. In fact, as part of their guidance update on June 8, Alere lowered their expected North American flu revenues for the rest of 2010 to zero. With 75% contribution margins, that resulted in half the guidance cut (15 cents)
- It's levered: Alere has used multiple layers of debt and preferred stock aggressively to do deals, and since LTM EBITDA numbers are not always adjusted on a pro-forma basis in many analyst reports, the debt can higher than it really is. Now, for example, Net Debt/LTM EBITDA is 3.4x, with no maturities until 2013.
Investment Thesis:
Alere has a solid base business that is a combination of highly defensive healthcare diagnostic tests (though subject to the vagaries of various infectious diseases), pro-cyclical drugs of abuse testing (used mostly in employee screening), and an emerging health management business.
- Professional Diagnostics (67% of revenues) is a high-margin business (35% EBITDA margins) with solid market positions, growing organically at 7-8% per year (though lower this year due to the lack of flu around the world). Alere has the largest dedicated US sales force in the diagnostics business and has acquired direct sales capabilities in 14 of the 20 world's major geographies. In addition, Alere has built up its presence of low-cost manufacturing in China.
Most of the Professional Diagnostics business benefits from (a) the expansion of access to healthcare around the world by growing middle classes in emerging markets, as well as (b) demographics in developed countries, where the aging of populations lead to greater use of healthcare. Recently, the Professional Diagnostics business has slowed down as a result of a very low level of flu around the world, coming off a record flu year related to H1N1 testing in 2009.
The Professional Diagnostics business also includes professional lab testing for drugs of abuse. Alere's drugs of abuse business now account for 14% of total company revenues. When the economy and employment picks up, this line of business will increase in a highly-profitable fashion as well.
| Professional Diagnostics |
Q109 |
Q209 |
Q309 |
Q409 |
Q110 |
Q210 |
| Total Revenues ($m) |
$261 |
$280 |
$334 |
$362 |
$336 |
$344 |
| N. American Flu-Adjusted Organic Growth* |
7.9% |
6.2% |
9.2% |
7.2% |
6.2% |
6.5% |
| Gross Margin |
63.4% |
61.9% |
62.5% |
63.7% |
62.0% |
59.4% |
* As an example of Alere's attempts at disclosure, this is a metric they mention on their quarterly conference calls. The biggest flu impacts were in Q3-Q4 2009.
- Health Management (27% of revenues) is a services business (22% EBITDA margins) that consists of the "convergence" offerings described in more detail below as well as other services businesses. Alere's health management programs run the gamut from undifferentiated to highly differentiated, which is critical to understanding the recent performance of the business.
- Undifferentiated programs are corporate wellness programs that are paid a relatively low rate. Health management companies attempt to get corporate employees to enroll in programs that may or may not make a long-term difference in patients' health. The business is largely characterized by low margins and low barriers to entry.
- Highly differentiated programs are highly targeted programs that attempt to control the highest cost areas of healthcare. For example, in addition to the CHF and anticoagulant programs described below, Alere also has programs for high-risk pregnancies, which can result in either very expensive deliveries or time in a NICU. When possible, Alere attempts to tie in their health management services with diagnostic technology.
- Somewhere in between highly differentiated and undifferentiated lie other components of Alere's health management business: smoking cessation programs, genetics testing and counseling, and a partnership with CVS for services at their MinuteClinics.
Since 2008, health plans and other payors have cut back on undifferentiated offerings or attempted to take them in-house. When Alere acquired Matria in 2008, they acquired approximately $150m of this revenue type, which has shrunk over the past couple of years. However, the decline in this business has slowed recently, and based upon the visibility in the business due to the sales cycle, 2011 should return to growth as a result of the growth of the differentiated offerings.
| Health Management |
Q109 |
Q209 |
Q309 |
Q409 |
Q110 |
Q210 |
| Total Revenues ($m) |
$122 |
$123 |
$131 |
$146 |
$149 |
$150 |
| Organic Growth* |
NA |
0% |
1% |
-3% |
-11% |
-5% |
| Gross Margin |
56.3% |
55.5% |
55.1% |
53.3% |
50.0% |
52.4% |
- Consumer Diagnostic (6% of revenues) is a JV with P&G that provides pregnancy and other women's health tests for sale into the retail channel (Clearblue, Accu-Clear). P&G paid $325m for their 50% of the JV in May 2007 (implies ~15-18x EBITDA at the time). P&G has a put right for 2011 at fair market value, which is an undisclosed formula. Alere's management has expressed that they doubt that P&G would put it back to them at the pre-determined price.
Alere is showing evidence of bending the cost curve in healthcare: I believe that too few healthcare companies do enough to truly "bend the curve," but Alere has shown an ability to do so. Their strategy consists of taking diagnostic products from the lab setting into the physician setting (also known as "point of care") and then finally into the home setting, allowing individuals to manage their own chronic conditions better. Alere refers to this marrying of diagnostics, home-based devices, and health services as "convergence." Alere already has two thriving convergence programs in existence.
The Alere Home CHF program is for people with moderate to severe congestive heart failure (CHF). Alere's program consists of a special scale and digital device that are linked to Alere's nurses. Patients step on the scale and then answer a bunch of yes/no questions using the device. The results are transmitted to Alere's central systems, which determine whether or not a nurse intervention should be required. If so, an Alere nurse calls the patient and talks the patient through whatever issue he or she might be having (prescription adherence, exercise program, diet, etc.). If the situation is serious enough, the nurse will engage the patient's physician. Currently, Alere has over 100,000 patients enrolled in CHF programs across approximately twenty clients (the health plans or other payors). For context, 4.7 million people in the U.S. suffer from CHF, and approximately two million are hospitalized each year at a rate of $5,500 per episode. Alere has been able to reduce hospital admissions by 29.5% and overall costs (net of Alere's fees) by 9.5%. Due to the cumulative impact of behavioral changes and oversight by the Alere programs, Alere has a near-100% retention rate for their CHF program. Alere has about $100m in annualized revenues from their CHF program.
Alere Home Anticoagulation Monitoring is for patients who are taking warfarin, a blood thinning drug. The challenge for doctors prescribing warfarin is to get the dosage right, since certain foods and other drugs change its anticoagulation properties. If the drug loses its effectiveness, the patient's blood will start clotting and the patient will likely end up in the emergency room. The situation was serious enough that Medicare agreed to pay for home anticoagulation monitoring for heart transplant patients starting in 2002. Based on its effectiveness, in 2008, Medicare agreed to pay for weekly monitoring for patients taking warfarin for atrial fibrillation and deep vein thrombosis, which affects about 4 million Americans (mostly of Medicare age). Alere's anticoagulation business was created by combining two 2007 acquisitions: Hemosense, which had the easy-to-use tests, and QAS, which provided the monitoring services. For Alere, this business now represents $80m of annualized revenues.
"Roll-up" characteristics should start to roll-off over the next 12 months, and cash flows should improve: Alere's big push for acquisitions took place in a 10-month period from April 2007 to February 2008, when they spent almost $4 billion in cash and stock for 13 acquisitions. For Alere, these acquisitions were key assets for their long-term vision of convergence, but all the acquisitions left the company levered and confusing just in time for a global financial crisis, which sent the stock down to as low as $14. I will admit that Alere is still confusing, and relies on many adjustments to get you to a "Cash EPS" number that is less than ideal for those who love high-quality earnings. However, management has stated publicly and privately that they are going to be laying off acquisitions (other than small tuck-in acquisitions, largely of diagnostics distributors in missing geographies) as they focus on operations and the launch of a strong pipeline.
Alere has a strong pipeline of products for their base business:
- Alere's most promising upcoming product is the Alere Heart Check, which uses a drop of blood for BNP testing (a CHF biomarker) for the physician's office and home markets. This has already been approved for physicians' offices in Europe (launching Q310) and in certain Asia Pacific countries (launching Q410). Clinical trials for home use are underway. If all goes well, Alere should have home use approval in Europe in 2011 and U.S. in 2012.
- Alere is already selling its CD4 Analyzer (HIV biomarker marker) in sub-Saharan Africa. They had some manufacturing issues early in the launch, but those have been worked through at this point. Academic studies have confirmed the comparability of this portable rapid turnaround device with centralized laboratory tests.
- Alere is making progress on a number of other devices. I would suggest reviewing their latest quarterly conference call, as the CEO normally reviews their pipeline every quarter. The financial potential from these devices is difficult to estimate, but there is additional upside there.
Health reform helps Alere's business in the near, medium and long term: While it's difficult to quantify exactly, a review of the recently-passed health reform bill should bring benefits to Alere through more funds for prevention, screening, and health management programs. For example:
- Prevention: Alere runs the most successful smoking cessation program, called Free & Clear. Earlier this year the American Cancer Society ceased running its own smoking cessation program and outsourced it all to Free & Clear. In 2010, the health reform law provides for a Prevention and Public Health Fund for prevention, wellness, and public health activities including smoking cessation. The fund will have $7 billion in total funding for FY 2010 to 2015.
- Screening: Alere makes screening products for cholesterol levels, heart failure, deep vein thrombosis, bladder cancer, colorectal cancer, osteoporosis, pregnancy, and a number of other conditions and infectious diseases. The health reform law is already expanding coverage for uninsured individuals, adult children under age 26, and will expand coverage even further in 2014, when the number of uninsured will drop from 50 million to 31 million.
- Health Management: Alere's health management programs are tailor-made for the health reform law's grant programs for rural areas and small employers to establish wellness programs and strengthen prevention activities, and reduce chronic disease rates (funding to begin in 2010), as well as incentives to Medicare and Medicaid beneficiaries to complete behavior modification programs (funding to begin in 2011).
Alere's management team has done this before, is highly aligned with outside shareholders, and will likely sell the business within the next three years: The CEO, Ron Zwanziger, built Medisense into a highly profitable blood glucose monitor business that was sold to Abbott for over 20x EBITDA in 1996. The same team then went to build Inverness Medical Technology, a manufacturer of diagnostic products for diabetes, women's health, and infectious disease markets, which was sold to JNJ in 2001 for 52x EBITDA and 7.2x Revenues. From that transaction, Zwanziger and his team kept the women's health business, which was the cash cow that originally funded Alere's acquisition strategy.
Zwanziger (or his family) owns 6.7% of the Alere, and he purchased an additional $1m at $36.16 in June 2008 and November 2008 at $15.50. Overall, management and directors own almost 8%. Notably, Zwanziger and two other founding members of Alere were granted stock in July 2008 at a price of $61.49 (the price of their secondary offering) despite the fact that the stock was trading at $31.17 at the time. Compared to other $2 billion businesses, the management team is not highly paid in cash. For example, in 2009, Zwanziger only made $900,000 in salary and $250,000 in bonuses.
If successful, Alere would become an attractive acquisition target as healthcare systems become more consolidated. Potential acquirors would include diagnostic competitors (JNJ, Roche, ABT); companies faced with slowing growth but wanting to expand more broadly into healthcare services (CVS, WAG, PG); or perhaps even the PBMs (MHS, ESRX).
Valuation:
I believe that a base case for Alere in a few years will reflect over 100% upside, while an upside case could reach ~ 2.7x the current stock price. For downside, I see "only" a 45% decline in the stock. Naturally, I believe that given company and management track record and industry dynamics, the base and upside cases are much more likely than the downside, presenting an attractive risk/reward. Futhermore, if the upside case occurs, my assumption of 12x EBITDA is probably low given likely synergies with logical acquirors.
In determining valuation for Alere, I look at three scenarios for projecting 2010-2014, with a takeout multiple in 2012:
Base case: "Realistic growth and Normal Seasonal Flu"
- Total revenues grow at around 6%, as Professional Diagnostics is stable and Health Management, while not spectacular, has solid and stable growth.
- EBITDA margins increase from an estimate of 26% in 2010 (low as a result of the lack of highly profitable flu tests) to over 31% in 2012 and beyond as scalability improves.
- Takeout multiple of 10x. To frame the multiple, even in the depths of February 2009, Abbott paid 10x EBITDA for Advanced Medical Optics, which had ~25% of its revenues in capital equipment (Lasik surgery machines).
In this scenario, the stock price would be ~$61 after taking into account the conversion of the convertible notes (conversion price of ~$44) but not the preferred stock (conversion price of $69). This would be an implied P/E multiple of ~17x.
Upside case: "Normal flu, Health Management works, Alere Heart Check success"
- Total revenues grow at just over 6.5% in 2011 but increase to over 8% in 2012, as Alere Heart Check takes off.
- EBITDA margins expand to over 31% by 2012 as scalability improves.
- The potential for Alere Heart Check is huge. There are 8 million patients with CHF in the U.S. and Europe who could be eligible for such monitoring. Alere gets $150/month for their anticoagulation monitoring services, so I consider that a minimum baseline for what they might get for Heart Check. If on the back of a more effective product than their current CHF monitoring they are able to double their current population base (which would be an overall penetration rate of 2.5%), that would increase revenues by almost $150m and EBITDA by approximately $50m.
- Takeout multiple of 12x, reflecting the high growth and profit potential of the business. To frame the multiple, Novartis recently paid 20x EBITDA for an additional 52% stake in Alcon.
In this scenario, the stock price would be ~$79 after taking into account the conversion of both the convertible notes and the preferred stock. The implied P/E multiple would be 21x. If Alere Heart Check is tracking to higher than a 2.5% penetration rate, then this is probably a conservative upside case (if such a thing exists).
Downside case: "Very slow growth, Normal seasonal flu"
- Total revenues grow at only 2% beyond 2012 for any number of unforeseen reasons (competition, execution issues, etc.)
- EBITDA margins still expand to just over 27%, since highly profitable flu tests will come back somewhat.
- Takeout multiple of 6x EBITDA. This multiple would essentially reflect the value of Alere in its existing stable businesses, without giving them any credit for growth.
In this scenario, the stock price would be about $16.50, in which case the convertible note and preferred stock would both be debt. The implied P/E multiple would be just 5.8x.
- Execution risk: Alere is currently in the process of rolling out its most important products for the next wave of growth. How well they execute is uncertain.
- Intellectual property: Diagnostic tests' patent protection can go away and margins can erode. However, Alere has a wide variety of products with worldwide distribution, which mitigates the impact of any one patent/product/geography combination.
- European exposure: The European austerity measures were part of the reason for the guidance reduction in June (reduction of 7 cents). Furthermore, if the Euro drops to parity with the dollar, that will cost an additional 7-8 cents of earnings.
- Health management strategy still faces skepticism: The healthcare community generally believes that something like health management should work, but its overall effectiveness to date has not been the home run most expected it to be.
- Largely opaque financial guidance: They provide Cash EPS guidance somewhat reluctantly, but they do not spell out the components to get there.
- The world is now rid of the flu forever. Wishful thinking for global health, but unlikely.
Catalyst
- Successful launch of Alere Heart Check (professional use) in Europe with approval for home use sometime in 2011.
- Continued organic revenue growth in Professional Diagnostics business resulting in operating leverage.
- Ramp up of Health Management pipeline in 2011, reflecting revenue growth.
- Return of the flu in 2011.
- Alere management renegotiates terms of the senior notes allowing for stock repurchases.