Description
INTRODUCTION
Analogic designs, manufactures and sells advanced medical and security imaging equipment and subsystems. These are systems used to convert analog signals (like pressure, temperature) into digital format for processing by computers. In addition, most of ALOG’s products perform complex high-speed calculations on the data to enable analysis of the same. ALOG is a world leader in this field. Approximately three quarters of the data acquisition systems used in Computerized Tomography and almost half the systems used in Magnetic Resonance Imaging have been designed by ALOG. ALOG is trading at 6.4x trailing EBITDA and 12x earnings (excluding cash).
PRODUCTS/SUBSIDIARIES
The company gets a majority of its revenues from selling the following products: -
Medical Instrumentation Technology Products - consisting primarily of electronic systems and subsystems for medical imaging equipment, accounted for approximately 79% of product and engineering revenue in fiscal 2002. This includes products for Computed Tomography (CT), Digital Radiography (DR), Ultrasound, and Magnetic Resonance Imaging (MRI).
Security Imaging Technology Products, consisting of advanced explosive detection systems, accounted for 12% of fiscal 2002 product and engineering revenues. Analogic designs and manufactures the Explosive Assessment Computed Tomography (“EXACT”) scanner.
Signal Processing Technology Products, consisting of A/D converters and supporting modules, high-speed digital signal processors such as Array Processors, and image processing equipment, accounted for approximately 9% of fiscal 2002 product and engineering revenue.
Rather than go into great detail about how these products work, please refer to the company’s website www.analogic.com and publicly filed documents for additional technical information.
Though primarily an OEM supplier, Analogic also sells complete medical systems. Most of these are sold under other labels though it sells some under its own brand name as well. In addition, the company also sells patient monitoring systems. Analogic has the following subsidiaries –
Camtronics - a 100% owned subsidiary, is the world’s largest supplier of multi-modality image and information management systems for cardiology. The management of cardiac data is complex because the data can be collected from various places including hospitals, clinics and homes and using a variety of equipment like CT, MRI or ultrasound.
Anrad - holds patents for the process of coating the amorphous Selenium detector plates used by Hologic in its mammography system.
Sound Technology, Inc., a 100% owned subsidiary, produces linear and tightly curved array ultrasound transducers and probes for a broad range of clinical applications that are supplied to medical equipment companies.
SKY Computers, a 100% owned subsidiary, designs and manufactures high performance multi computing platforms used in advanced medical, military, and industrial imaging applications. The Company’s SKYpack ™ multiprocessors provide the image processing power for Analogic’s advanced CT scanners. In addition, it is an integral component in the EXACT Explosives Detection System (EDS) being sold by Analogic.
Cedara Software - In September 2001, the Company acquired 19% interest in Cedara Software Corporation of Mississauga, Ontario, Canada, in return for an equity investment of $7.5 million. Cedara is a premier independent provider of imaging software technology and custom imaging software development to leading Original Equipment Manufactures (OEMs) in the healthcare industry.
BUSINESS
The worldwide market growth for medical supplies and devices is growing at 12%. Medical imaging is the medical device industry’s most profitable sector. The important trends that will drive the economics of this sector in the future are – demographics – an aging population that increasingly requires healthcare products and a focus on healthcare cost containment by managed care entities.
The industry is characterized by significant barriers to entry, namely regulatory (lengthy tests and voluminous documentation required by the FDA. Also the manufacturing site must be FDA cleared), economic (high R&D budget and big sales force and marketing network to distribute the product) and legal. Hence it is difficult for smaller manufacturers to go up against larger ones who have more scale. Also, switching costs are high for the end user who demands to work with higher quality suppliers. Note that Analogic sells to OEMs like L-3, Philips Toshiba and GE which themselves have the capability to manufacture imaging subsystems. Despite this, ALOG’s components find their way into 75% of all CT systems. For companies in this sector, new products – i.e. those introduced within the last 2 years typically account for 30% of sales. Product obsolescence is the greatest risk. Hence companies are constantly on the prowl for new markets. New growth is driven by products targeted towards previously overlooked niches. For example, in the past few years, multi slice scanners have rejuvenated the market for CT scanners (more slices increases the amount of data that can be captured and increases the data processing ability of the device). The product life cycle is long taking years of R&D, clinical trials and regulatory clearance. In addition companies compete using product quality and longstanding relationships with OEMs and customers.
The total market sizes (per year) for the company’s products are as under –
CT systems - $1 billion
MRI systems - $1.3 billion
Ultrasound systems - $1.4 billion
GROWTH AREAS
Explosives Detection Systems
After Sept. 11th, Congress passed the Transportation Security Act of 2001 and created the Transportation Security Administration (TSA). The TSA has given contracts to 2 companies to supply Explosives Detection Systems (EDS) – Invision and L3 Communications for about 2,000 scanners. These scanners are to be installed in domestic airports.
Analogic has used its CT technology to develop an EDS subsystem, which it calls EXACT. EXACT is basically the CT scanner subsystem used in the EDS sold by L3. Currently, the FAA approves only CT Scanning for use in bomb detection equipment. Each EXACT system sells for about $300,000.
The TSA ordered only 1000 EDS systems in 2003. However, due to budget overruns, the TSA had to postpone additional spending. Current plans are to spend an additional $150 million in 2004 for EDS systems. Though this market looks small, the overseas market is as big as the US domestic market. In addition, the systems will generate service revenues (about 10% of sales). The replacement market is estimated to be about 3-5 years long. Furthermore, the company is developing a carry-on baggage scanner called Cobra. Note that the TSA currently spends $3 billion on screeners annually and this product is targeted at this market. Analogic has recently signed a deal with Lockheed Martin to market this product and it represents a huge opportunity.
Digital Radiography
Is a new technology. Analogic (through its Anrad subsidiary) holds patents on key technologies in this field. DR systems convert radiation directly into digital data, considerably improving image quality. Analogic’s product is an end user product so the returns could be much higher. Analogic provides these systems to Hologic, which has the dominant market share in this market (35%). Analogic is well positioned to take market share once growth starts.
VALUATION
Analogic is a tough company to value. Analogic has $12.4 cash per share. In addition, the company has significant real estate assets - a hotel in Peabody, Massachusetts and 65 acres of undeveloped land. I value the real estate at $350,000 an acre or $1.7 per share. Management has stated that it has received offers to purchase the hotel for $30 million or around $2.2 per share. Add that up and it comes to about $16.
I take my estimate of FCF (using maintenance capex) of $22 million. Further assuming inflation pacing growth of 5% (medical imaging market growth is between 4-8%) and discount rate of 15% produces a DCF value of $21 for the base business (6% growth @ 12% beyond year 10). Total comes to about $37.
However, these conservative estimates give no credit to the new markets the company is targeting – namely DR and EDS systems. The company is well capitalized. It has a strong market position and history of successfuly introducing innovative products. A combination of earnings growth and multiple expansion to the 20x or greater range should lead to a good total return.
Comps –
Hologic – EV/EBITDA of 98 and P/E of 114.
Datascope – EV/EBITDA of 14 and P/E of 22
Arrow Intl. – EV/EBITDA of 12.5 and P/E of 23
OTHER FACTORS
Analogic has primarily been an engineering company and management does not seem to communicate well with its shareholders. John Wood, who has succeeded Bernard M. Gordon as CEO, has said in conference calls that he will communicate more with analysts about the company’s business.
Bernard M. Gordon has contributed 4.6 million shares to a charitable trust, which has been recently selling shares to raise cash. The Trust sold $50 million of stock in 2003. About 2 million shares are still left. This has caused the downward pressure in the stock throughout 2003.
RISK FACTORS
Obsolescence remains the primary risk for Analogic. The industry is tough and driven by innovation. Success depends largely upon being able to successfully discover new markets. However the company has successfully negotiated these treacherous waters (Analogic was founded in 1969) and built up a strong brand and relationships with its customers and OEMs.
Customers – The top 4 customers made up 63% of sales in FY 2003 and 44% of sales in 2002. Some of these customers also compete directly with Analogic.
Acquisitions – Management currently seems to have no plans for returning excess cash to shareholders (dividends) or stock repurchases and is concentrating on acquisitions to broaden the product portfolio. Though historically, management has been pretty successful in turning acquisitions into viable products, this might not happen in the future.
Catalyst
Short term – Gordon Trust completes selling its shares
Ramp up in TSA orders
Long term - New opportunities like DR and Cobra.