Investment Thesis

Hologic Inc. - currently trading at $16.73 - offers a rare opportunity to acquire a market-leading healthcare technology business with a large recurring revenue base, reliable FCF generation, a strong and improving balance sheet and a portfolio of existing products with considerable growth potential in nascent and unpenetrated markets, all at a very reasonable price with a very attractive risk / reward profile.

Shares are inexpensive both on an absolute and relative basis.  We expect shares to nearly double in the next 2 years to $30.00 driven by mid-single digit top line growth, modest gross and operating margin expansion, and a peer multiple on our $1.53 EPS estimate - equivalent to a 8% FCF yield.  In the near term we think fair value is in the low 20's; however, recent uncertainty surrounding its volume-dependent diagnostic Cytyic (ThinPrep & NovaSure ... described below) businesses and new market-building related investments could be a temporary drag on the stock as near-sighted analysts react to the headline (which we would view as an opportunity to buy more shares). 

Longer term we expect the diagnostic business to stabilize and anticipate the breast and surgical businesses to experience low double digit growth.  We expect strong cashflows to continue financing 'tuck-in' acquisitions and the deleveraging of the balance sheet (net cash position in 2012) - which will drive shares higher.

A visible catalyst for the stock is the imminent approval by the FDA of Hologic's next-generation breast imaging machine, Tomosynthesis, which recently had an extremely positive panel review in September.  This will be a hugely important product for HOLX as it likely will renew high-margin growth in the Breast Health division as hospitals and doctor offices continue the upgrade and replacement cycle which is still in its early stages.

Business and Segment Overview

Hologic Inc. is a leading developer, manufacturer and supplier of premium diagnostics, medical imaging systems and surgical products dedicated to serving the healthcare needs of women.

The business can be broken down into four broad segments:

Each segment has a long list of products.  Here is a link to the detailed product catalog: http://www.hologic.com/data/File/pdf/Hologic_PrdctCatlg.pdf

A quick overview of the product lines by segment are:

- Breast Health - Selenia Breast Cancer Screening, Sentinelle MRI Breast Coils (recent acquisition), Suros Biopsy Systems, MammoSite Radiation Therapy

- Diagnostics - ThinPrep Pap Test for Cervical Cancer Screening, Cervista HPV Tests, Rapid FFN

- GYN Surgical - NovaSure Endometrial Ablation & Adiana Permanent Contraception

- Skeletal Health - Discovery DXA, Mini C-Arm Imaging

Product Line Characteristics and Unit Economics

Of the various product lines, the major revenue drivers of the company are the Selenia / Dimension imaging systems which play a huge role in maintaining the competitive advantage and economics of the business - basically its large and growing installed base of imaging systems leads to an ongoing and recurring service-revenue stream.  ThinPrep and NovaSure are also important products that materially contribute to the firm's sales and profitability. 

In term of potential growth engines, Cervista's current market is expected to grow by 10X to $2 Billion / year, and Adiana has barely scratched the surface in terms of market penetration and market size.  NovaSure also represents a multibillion dollar market opportunity that is virtually untapped.  Most important of all, according to Robert Cascella, the CEO, "Tomo has the potential to re-create the market dynamic of technological obsolescence.  Our belief is that Tomo will do to digital what digital did to analog mammography over a three to five-year period".

The most profitable segments, measured by gross margins, are the Diagnostic and GYN Surgical segments - 71 and 77% respectively (versus 61% at the corporate level).  Together these will continue contributing to margin expansion as their sales-base continues to expand. 

Approximately 75% of company-wide revenues fall into Disposables / Service (58% disposables & 17% service) related categories with the remaining 25% classified under Capital Equipment (close to 100% of equipment sales are in the Breast Health segment).

The disposable / consumable products while sensitive to cyclical factors that impact overall healthcare utilization & patient visit volumes tend to pretty predictable and recurring in nature.  Capital Equipment sales (mostly breast imaging) are mostly higher-priced ticket items with longer sales cycles and useful lives, but they too follow a consistent and predictable sales pattern.  Current penetration into labs, hospitals and doctor offices continue to substitute analog devices with digital ones with a long runway of potential growth.

Sales & Distribution

Hologic has a direct sales and service force of over 1,500 people.  For the BH segment national account managers work in conjunction with modality account managers to target large contracts from managed care organizations as well as bottom-up cross-selling strategies oriented towards breast surgeons and radiation oncologists. Some independent dealers / distributors and sales reps are used to service hard to reach markets including international markets (Europe, Latin America and Pacific Rim) which represented 20% of sales in 2009. The Diagnostics sales force focuses on selling to clinical laboratories and OB/GYN offices, while the GYN Surgical sales force targets GYN surgeons in both hospital and office settings.

Competition

Hologic operates in an intensely competitive industry.  At a high level, the healthcare industry characterized by continual change and technology improvements.  Competitors have broad product portfolio offerings - which can be bundled and thus are attractive to big buyers.  Obsolescence risk is always present and rivals are big with deep pockets and huge sales forces - including GE, Siemens, Philips, PlanMed, Agfa, Carestream Health, Fuji, IMS Giotto, Sectra and Toshiba.  For example, the Selenia full field digital mammography system competes with GE's and Siemens' full field digital mammography systems, as well as Fuji's Computed Radiography ("CR") mammography system, a lower-priced alternative to digital mammography.

While competitive rivalry may intensify, Hologic's large installed base and market-share combined best-in-class brand recognition should serve as a differentiating factor and moat. 

A misunderstood and underappreciated metamorphosis

Hologic is misunderstood by the street.  The prevailing view seems to be that Hologic's core divisions are a collection of stagnant, no-growth businesses pursuing expensive & value-destroying acquisitions accompanied by recurrent product delays.  Furthermore, a number of sell-side analysts believe Hologic will in the future face business destroying headwinds as standards and technologies change, new entrants emerge and existent competitors with deeper pockets roll-out new products that will assail HOLX's existing franchises.

The sell-side, as usual, has also fixated on recent cyclical weakness in volume-dependent businesses / product lines and extrapolated these trends indefinitely into the future, while ignoring the bigger picture potential of these underpenetrated markets and the product innovations that will tap it.  No doubt, some concerns about recent trends are legitimate.  In particular, valid worries include a continued decline in volumes in the diagnostic division (ThinPrep & Cervista) due to recent changes in cervical cancer screening guidelines (screening interval guidelines have lengthened for pap tests impacting the demand of ThinPrep - one of the flagship diagnostic products) & weak procedural volumes due to a decline of patient visits in response to the fragile economy.  Still, there is anecdotal evidence to suggest things are stabilizing and that patients will begin to return to their physicians to get their scheduled pap and HPV tests.  And while lower overall demand for paps will likely hurt the ThinPrep business we expect Cervista growth to offset some of the weakness.

In truth, the market is not giving HOLX any credit for the overall stability and recurring-nature of its revenue; not to mention their high gross / cashflow margins.  The market is also ignoring the potential growth around the corner from a very robust pipeline of next generation razor-blade model businesses that should keep doctors as captive customers while throwing off consistent and predictable cashflows. 

Unsurprisingly, management's stated investment plans to prepare for the Tomosynthesis-rollout, combined with planned infrastructure and distribution investments for their international expansion in Asia and Latin America (international is currently only 20% of total sales) and A&P spending for its direct-to-consumer campaign for NovaSure to create more awareness (which is gaining market share at a high double digit pace), have spooked the analyst community who figure it will create "margin pressure" - thus prompting them to lower their EPS estimates and targets.  We are taking a longer-term view and believe these are all sensible and necessary investments that will have attractive ROI characteristics in the long-run. 

The bottom line is that Hologic is technological and market share leader with a #1 or #2 position in most of its markets (65%+ share in the mammography market).  Its huge installed base in the breast segment creates high switching costs and feeds its service-business.  Moreover this business line provides an organic, high-touch environment for replacement / upgrade sales.  While there might be some near-term challenges and startup costs associated with Tomo we believe it will reinvigorate and lead the company into its next growth phase.

Valuation & Growth Initiatives

Based TTM valuation metrics, on the surface - 8x EV/EBITDA, 10x P/FCF & 14x P/E - some investors believe shares of HOLX are trading near fair value (at a discount to peers).  We disagree and think shares should trade on par or even a slight premium to peers.  The cash earnings power of the existing businesses alone warrants, in our opinion, a higher multiple - this, of course, would ignore the embedded value and optionality of potential growth initiatives.  We believe the company's robust pipeline of new products will add several percentage points to the top and bottom lines without consuming significant capital. 

To analyze the true earnings power of Hologic one has to understand and appreciate its business model and the drivers behind its growth strategy.   As with most other tech and sales driven organizations, a significant part of the company's "investments" are expensed above the operating income line falling mostly in Sales / Marketing and R&D line items.   A large proportion of these ongoing expenses are maintenance related, needed to keep the businesses humming along; however, an important portion of these are investments are related to growth initiatives to grow the market & market- share of both existing and new product lines.  These figures vary from year-to-year and aren't totally transparent, but we estimate that at least 20 - 30% of these expenses are growth related.  So based on this logic, we estimate that the existing steady state, no-growth, FCF would is in the 550 - 600 MM range (versus the stated 450 - 500 MM; which would translate into a current 13% FCF yield.

Obviously, the above analysis is a hypothetical exercise used simply to understand the true cash earnings power of the business.  In reality, management has set ambitious growth goals and is actively investing to expand its existing franchises and accumulating cash to pursue 'tuck-in' acquisitions.  Which brings up an important point - historically, management has had mixed success with some of its larger acquisitions (e.g. Cytyic Acquisition) having overestimated the market potential and cross-selling opportunities.  This has resulted in some expensive, value-destroying transactions (which have been written down over the years).  On the other hand, management has also made some very smart acquisitions that have and should continue to be accretive to shareholders in the long-run.  So capital allocation is a mixed bag, but we have reason to believe management will follow a more disciplined and conservative approach going forward - the main purchase criteria being "product line extensions and new technologies complementary to our core businesses and allow us to leverage our sales and marketing infrastructure" and "synergistic product additions that have consistent call patterns, require minimal training, are easy to service and fit within our manufacturing operations".  A recent example of a sensible acquisition was Sentinelle Medical which will be immediately dilutive but will add value in a 1 to 2 year time-frame.

Assuming a reasonable yet conservative return on current investments we expect to FCF to grow to close to $600 MM in 2012 (around $750 MM before investments), which combined with cash accumulation, should drive shares to the high 20's / low 30's.

Risks to Investment Recommendation

Potential risks include:

• Higher cost of digital mammography equipment versus its analog predecessors (~$350,000 vs. $35,000-75,000) could dissuade continued conversion of digital technology
• Recent FDA reclassification of the regulatory requirements for digital mammography approval process potentially eases the path for future competition
• Aggressive use of pricing and product- bundling tactics from large, well-funded players such as GE, Siemens, and  Fuji to gain market share
• New technologies
• Poor capital Allocation, or integration issues associated with past or future mergers.