Description

Alere is a point-of-care diagnostics and health management firm specializing in diagnostics and monitoring for cardiology, infectious disease, drugs of abuse testing, women’s health and diabetes. Alere’s goal is to merge the diagnosis and monitoring of chronic disease with health management leading to more focus on home healthcare with the result of lower overall healthcare costs through reduced hospitalizations. The main growth drivers for Alere are:

• Alere is in the process of launching monitors for congestive heart failure, blood gas and electrolyte, and HIV viral load that have a combine estimated TAM of $2 billion in 2015. In the case of CHF and HIV viral load monitoring they are first to market and with blood gas and electrolyte monitoring they are second to market.
• In the past, Alere’s management has built two innovative blood glucose monitoring companies with one sold to Abbott and the other to JNJ. After a 10 year non-compete with JNJ Alere can re-enter the $9 billion blood glucose monitoring business as of November 2011. 
• While it is almost completely ignored by the street, Alere will start converting its point-of-care infectious disease platform (about $440 million in 2011 revenues) from immunoassay to a new molecular platform by late Q3 2012. Current ASPs and reimbursement for molecular infectious disease tests are 3-3.5 times immunoassay tests.

Alere is currently trading at just over 7 times conservative 2012 cash EPS guidance of a minimum of $2.50. I believe this is a very attractive valuation for a company that achieved almost eight percent organic growth in its core diagnostics business in the TTM and has a very clear, and significant, growth runway for the next 3-5 years. The reasons for the low multiple are evident but I believe increasingly in the past.

At the recent JPM Healthcare conference Ron Zwanziger, CEO, gave guidance that was about 10 percent below analyst’s estimates. This is the third time in the last 18 months that this has happened and investors are understandably frustrated. Also, Alere recently was the subject of an FDA product recall for certain cardiology products related to their Triage platform with financial impact to margins on about $50 million in quarterly revenue. Importantly, Alere continues to ship product to their customers of these products and hopes to have the issue resolved by September of this year. Even with the recall the company did not revise guidance. While there have been many frustrating issues with the company, Alere is going through the launch and ramp of six new products with an aggregate market opportunity of over $3 billion and along with launch costs, and acquisition integration, has had to work out manufacturing inefficiencies and fund clinical trials. These issues will sunset over the next 18 months and should lead to significant operating leverage.

The company’s net Debt/ EBITDA (post the acquisition of Axis Shield) is over 5 times so an equity investment requires the belief that Alere will not be significantly impacted by global macro issues. While this is clearly not for the faint of heart, Alere’s business is quite stable and extremely cash generative under almost all economic conditions (the core diagnostic business was flat during the great recession) and alleviates most concern. Zwanziger has hinted that he could sell Alere’s drugs of abuse franchise for $1 billion (when it was much smaller and based on implied multiples would be more like $1.5 billion today and this value is confirmed by the recent acquisition of Medtox by Labcorp) leading to a more palatable 3.2 times Debt/EBITDA and, in the event of an acquisition, any potential acquirer would have an easy “synergy” through refinancing Alere’s debt leading to pre-tax savings of at least $50 million in interest cost.  I would note that Zwanziger has said in the past that he is “quite comfortable” with Debt/EBITDA at 4-5 times so expectations of debt reduction should be managed.

Finally, the cause of the debt is a significant number of acquisitions made over the last five years and investors generally perceive Alere as roll-up with associated concerns about its true growth rate. Over the next 18 months Alere will be launching six new products, with an aggregate market opportunity of more than $3 billion (not including blood glucose monitoring, a $9 billion market), that are the result of these acquisitions and will provide significant organic growth for the company over the next 3-5 years. While the company is likely to continue to make small acquisitions over the next few years (especially in diabetes/blood glucose monitoring) they now have a very comprehensive product offering for the future and are focused on delivering on their forward strategy of in-home chronic disease monitoring and shifting their traditional diagnostics business toward a much higher value molecular platform (CPHD would be a comp for this part of the business and trades at 8x sales). As launch and clinical trial costs come down and new product revenues ramp over the next 12-18 months I believe investors will switch their focus to the significant opportunities ahead as opposed to the stumbles of the past.

Zwanziger is also not very “street friendly” and can often come off as abrasive with sell-side analysts and this is obviously not favourable to sell-side valuation expectations/ recommendations.

Analysis of professional diagnostics segment:

I have provided segmentation of this business by the existing business and then provided details for each new product being launched over the next two years.

I have the existing professional diagnostics business (tests for infectious disease, cardiology, drugs of abuse) growing at five percent annually and maintaining its 14.5 percent EBIT margin. Many analysts have point-of-care diagnostics growing at high single to low double digit rates as more testing is being done in hospital labs and average physician office size has grown from about 5 to greater than 20 providing the scale to do in practice testing. While both these things are true, I have decided to be conservative looking forward. Also, the medical device tax of 2.3 percent will be implemented in 2013 and could affect margins on the slightly less than 50 percent of the business that is done in the U.S. if the company doesn’t manage opex accordingly. Any margin aggression in my estimates should be offset by revenue conservatism.

Within the professional diagnostics segment the company has a business for home monitoring of patient’s Warfarin levels that has been growing at greater than 30 percent and is currently annualizing at about $105 million even though home monitoring was only approved three years ago. The growth rate will slow as new branded competitive products to Warfarin are introduced that don’t require monitoring (although this still a question mark) but even at 15 percent this product would provide almost 20 percent of the total growth for this segment. Again, I think my revenue growth estimates are reasonably conservative.

Axis-Shield

Alere acquired Axis-Shield in Q4 2011. Axis-Shield is a UK/ Norway based provider of point-of-care instruments (they have a small but decent lab business as well) and diagnostics. I am a former shareholder of Axis-Shield and believe Alere got a decent deal in their hostile takeover of Axis-Shield. Axis-Shield provided Alere with a re-entry in to the diabetes market with a decent franchise (about $35 million in revenue) in the testing for hbA1c, a $300 million global market. Testing for hbA1c is typically only done a couple times of year versus often daily testing for blood glucose but the market could expand well over time if projected growth in the diabetic population comes true.

In the developed world Axis-Shield’s primary point-of-care instrument platform is Afinion and the company has placed 12,000 of these instruments in only three years. The primary test is for hbA1c what the test menu continues to grow and this will provide high margin growth going forward.

Axis-Shield was also defensive in that the company is about to launch an Afinion based lipid panel for cholesterol testing that presented a threat to Alere’s greater than $100 million LDX/ Cholostech business. Importantly, Axis-Shield’s lipid panel was the first test they had developed that allowed for multiple tests with a single sample and will allow Alere to develop other panels (multiple tests from a single sample) for other chronic diseases. It should be a good contributor to growth when approved by the FDA.

Finally, and probably most importantly, but completely ignored in all the coverage of the transaction is that Axis-Shield has placed 43,000 Nycocard instruments mostly in emerging market countries. Nycocard is a low cost, semi-automated instrument that is largely used for hbA1c testing. This will provide Alere access to large and growing diabetes markets (India has the largest diabetic population in the world) and will also give Alere greater distribution access to sell their other large menu of products for infectious disease and cardiology. Growth could also come as Afinion replaces Nycocard at higher ASPs.

Alere is in the process of consolidating its European (and some Global) operations in Galway, Ireland and Axis-Shield will be incorporated in to this process and location that was already operational in Q3 2011. Both companies also have R & D facilities in Stirling, Scotland that will allow for easy integration. With top level management removed and operations consolidated to scale, Axis-Shield’s margins should improve well over the investment horizon and probably more quickly than my estimates.

New Products

For each of the new products listed below, Alere gave guidance at their analyst day in November 2011. The low-end of this guidance was for $350 million in revenue in 2013 but given the fact that these are new products and involve regulatory approvals I have estimated revenue at $310 million.

HIV Viral Load Monitoring

HIV viral load monitoring is used both to diagnose HIV and to manage therapy. As a diagnostic tool it can diagnose infection a few days after infection versus an antibody test that requires the patient to have been infected for 2-6 months prior to the test. For managing the therapy it is recommended that tests be done every quarter to ensure antiretroviral drugs are managing the level of infection.

This is a fairly virgin monitoring market and Alere has been launching this product in sub-Saharan Africa. In the past the company has commented that there have been contracting delays and manufacturing issues. Demand is high so revenue will come once the contracting issues are resolved but the company is currently losing about $5 per test because of lower pricing in Africa (funding to purchase tests typically comes from the Clinton Foundation or the Bill and Melinda Gates Foundation) and the manufacturing issues which are expected to be resolved in Q4 through automation. Alere will be launching in the U.S. and Europe in 2012 and expect margins to be in the range of other professional diagnostics products so while this year’s zero EBIT contribution may be accurate, I believe this product will make a bigger EBIT contribution than my estimate in 2013. The FDA has been more flexible in approving products related to infectious disease so the company seems confident they will get approval by early 2013 at the latest.

The company will have a follow-on molecular instrument and test that will be going through clinical trials this year with a PMA and CE mark submission in 2013. The menu will be extended to Hepatitis C after 2013. No guidance on revenue has been given for this product.

HeartCheck

HeartCheck is a monitor for patients with congestive heart failure to regularly monitor levels of BNP.  BNP is secreted by the heart's ventricles in response to changes in pressure that occur when heart failure develops or worsens.  As the symptoms of heart failure become more severe, the level of BNP in the blood increases.

The company is currently running two clinical trials to assess the effectiveness of BNP monitoring in the home in reducing re-hospitalizations and total healthcare costs. Zwanziger is optimistic based on early results from one trial, HABIT, and expects results of both trials to be published in 2013. The other trial, HOME, is also being done in Europe and Asia and based on the trial results the company hopes to launch HeartCheck in the home in these regions as well.

The company already has large market share of BNP testing in the point-of-care (they have the only clia-waived test on the market) and lab setting (runs on Beckman’s machine) but expects that even if home testing isn’t approved that the point-of-care market will grow significantly from $40 million in 2011 to $175 million by 2014. If approved they expect the global home monitoring business opportunity to be greater than $300 million by 2015. My revenue estimates are conservative as the home monitoring market opportunity has yet to be proven.

Epoc Blood Analysis System

It is a bit misleading to say that this is a new product since the company acquired the distribution rights and contingent takeover rights from Epocal in late 2010 but revenue in 2011 was not significant. The epoc monitor is the first and only point-of-care, portable and wireless blood gas and electrolyte analyzer. The company will leverage its relationships in hospital labs to introduce epoc in to the hospital setting. The primary competitive product is Abbott’s i-Stat that was developed by the Epocal team and sold to Abbott in 2004 for $240 million or about 5 times sales. The easier competitors to displace are the portable monitors (think computer on a trolley) or lab based tests. Alere’s goal is to penetrate 25 percent of the 15,000 hospitals worldwide that perform about 8,500 tests p.a. at $7 asp by 2015. To achieve this Alere will have to continue to expand the test menu and ensure integration with the hospitals IT systems so the advantages of the epoc’s wireless, handheld being used at the patient’s bedside are fully realized. On the Q1 conference call Zwanziger said the epoc monitor was starting to gain good traction in the U.S.

Tests for Acute Kidney Injury and Pre-eclampsia

To be honest, while the company continues to highlight these two tests Alere is always entering the market with new tests. Three years ago they entered the market for c. difficile testing and rapidly gained share generating an estimated $50-60 million last year. These test are interesting because they are novel but certainly not critical to estimates.

NGAL is a novel marker to determine acute kidney injury with the expected benefit that it can detect a kidney injury earlier than the current standard creatinine test. Creatinine also has many false positives and negatives and NGAL is believed to be more effective. While the research thus far is positive (Finnish NGAL researchers are suggesting every ER patient with elevated creatinine be given an NGAL test at Helsinki hospital) the product has not been approved in the U.S. The company has said they believe NGAL could potentially be as big as their $200 million + BNP franchise.

PLGF is a test for pre-eclampsia with a low PLGF result being indicative of a pregnant woman with hypertension and often placental problems.  Pre-eclampsia affects 6-8 percent of all births worldwide so early detection can save significant healthcare costs from early pregnancy hospitalization. The company will use the test for diagnosing pre-eclampsia and, once diagnosed, patients will be monitored with the test until childbirth. Based on 6 percent of the developed world pregnancies being monitored this could be a greater than $200 million market as well.

Point-of-care Molecular Testing

The U.S. diagnostic industry is in the early stages of converting from legacy immunoassay testing to molecular testing. In the point-of-care market the first test to gain some traction was Cepheid’s test for staph infection. Cepheid currently sports a $2.3 billion market cap and is trading at 8x TTM sales and 200 times 2012 estimates. In 2010, Meridian Biosciences received approval for a c difficile test and after 18 months sales are expected to run at an annualized rate of $25 million. The most important thing about the trend toward molecular testing is that the tests are being reimbursed at a rate of $50 versus the traditional immunoassay test reimbursement rate of $15. Alere’s current immunoassay infectious disease business is about $450 million. The reimbursement for an immunoassay test is about $14 so as infectious testing converts to molecular the market will grow substantially. Molecular tests are more sensitive and specific and thus find more infected patients and require less confirmatory testing and will ultimately save the healthcare system money. Clearly there will be pricing pressure over time but Alere should still experience good growth from this conversion over the next 3-5 years (expands current infectious disease revenue opportunity from the current $450 million to at least $1 billion). The company expects to have their first test for flu by 2013 and will also be entering markets where they have not participated in the past such as MRSA. Notably, their test should be much faster than Cepheid’s and their instrument will be much cheaper.

Alere also has a health management business that provides disease management (cardiac, diabetes, cancer) and health management consulting (smoking cessation, diet consulting) on a corporate and individual patient basis. The long-term goal is to merge at home patient monitoring with professional health management and the company currently does this for prothrombin time monitoring (patients on Warfarin), diabetes (500,000 patients monitored), congestive heart failure and cancer. This business has been a huge disappointment as corporate budget cuts and industry price competition have hurt more commodity health management programs and cuts to Medicaid have hurt Women’s health programs such as pre-natal monitoring.

The company believes most of the pain has been felt in contract and more commodity service related revenue and they will continue to build their more proprietary service revenue in PT monitoring, CHF monitoring and diabetes monitoring. The company has about 1,000 nurses internally that consult with patients based on alerts provided by their internally developed patient management portal, Apollo. The objective is continue to get cardiologists to adapt to using Apollo so the monitoring programs will continue to focus on cardiology and related disease such as diabetes.

The company has also said that if they don’t begin to see improvement in their lower value added service business they are likely to sell it and have said there are "numerous" people interested in the business. Nevertheless, I believe most of the bad news has passed here and investor focus will start to shift to the growth opportunities described above.

Alere’s consumer diagnostic business is a 50/50 JV with Procter & Gamble that primarily involves OTC pregnancy and fertility diagnostic tests under the Clear Blue brand. There have been rumors that the JV will also involve home molecular diagnostic testing outside of cardiology and diabetes but there are few details at this point.

Incorporating all the segment analysis above, I believe Alere is a business that will generate slightly more than $3 a share in free cash flow next year and as growth and operating leverage kicks in from all the new product introductions, could make more than $5 per share in free cash flow in 5 years. With the current share price at $18 I believe Alere offers a compelling investment opportunity. For the free cash flow calculation it is important to note that Alere will experience $303 million in amortization charges across various income statement categories so GAAP income is not really useful. For those who are more short-term focused, I expect that current quarter numbers will have to come down as there are a couple of analysts that have not made appropriate adjustments to their EPS estimates given theTriage product recall and regular seasonality in the business (end of flu season). In my FCF per share calculation I have included all options even though they are all out of the money so I may have unfairly penalized the company by about 10%. Finally, given the high degree of financial leverage some may be more interested in either public debt (current yield about 8%) or the preferred shares that have a make whole provision in the event of a takeover.

Catalyst