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A Winner in the Breast-Cancer Fight

By Robert Gold Standard & Poor's Equity Research believes that Hologic (HOLX

; recent price, $56.67) has emerged as one of the stronger competitors in the global digital mammography market, a dynamic slice of the medical-equipment industry that we think offers sustainable growth north of 20% through 2010. From our perspective, the company's principal growth engine will be its Selenia Full Field Digital Mammography System, a second-generation product that's designed to generate digital mammographic images used to screen and diagnose breast cancer.

According to the American Cancer Society, about 214,000 new cases of invasive breast cancer occurred in the U.S. during 2004. Breast cancer ranks as the second leading cause of cancer-related deaths among women, taking an estimated 41,000 lives in 2004. As with all other invasive cancers, lowering morbidity and mortality can be directly related to the stage at which the disease is detected, and digital mammography is believed to offer enhanced detection for many women.

We think the recent release of favorable clinical trial data showing a notable improvement in breast-cancer diagnosis using digital vs. analog mammography will spur a meaningful acceleration in clinician and patient demand, along with improved insurance-reimbursement trends. Digital mammography also offers an associated long-term cost benefit to the health-care system by eliminating recurring film and processing costs, lowering image storage costs, and boosting patient throughput.

CORE LINES. We believe Hologic is a strong small-cap growth vehicle in the medical-device industry. By our analysis, the stock continues to offer compelling valuation based on relative metrics. We have a 5 STARS (strong buy) recommendation on the shares.

Hologic develops, manufactures, and supplies diagnostic and medical-imaging systems that primarily serve the women's health-care markets. The core lines of business are analog and direct-to-digital mammography equipment, bone densitometers, and digital detectors that are sold to original equipment manufacturers (OEMs).

For fiscal 2005, Standard & Poor's expects that the mammography segment will account for 58% of Hologic's total sales, followed by osteoporosis assessment at 25%, and digital detectors at 9%, with other products and services comprising the remaining 8% of revenues. Looking into fiscal 2006, we expect Selenia's further penetration into the mammography-equipment market will help increase mammography revenues to 62% of sales, while osteoporosis accounts for a projected 22%, digital detectors 10%, and service and other 6%.

SELECTIVE PURCHASE. Over the past decade, Hologic has sold non-core assets while making acquisitions as it sharpens the focus on analog and digital mammography, osteoporosis-assessment, and breast-ultrasound lines of business.

Most recently, in June, 2005, the company agreed to purchase the intellectual property of Fischer Imaging Corp. related to its mammography business and products, including the rights to Fischer's SenoScan digital mammography and MammoTest stereotactic breast-biopsy systems, subject to necessary approvals. In addition, Hologic will acquire Fischer's customer list, and intends to provide these customers with the opportunity to upgrade to the Selenia platform. The company believes Fischer has an installed base of about 100 SenoScan digital systems.

Hologic sold its first FDA-approved digital mammography system in the U.S. in January, 2003, competing with General Electric (GE

; $33; Hold), which launched its initial digital system about two years earlier. Since then, we believe that Hologic has installed nearly 350 Selenia Systems worldwide, representing an estimated 23% share of the 1,500 digital systems that we believe are installed globally.

WAVE OF CONVERSIONS. We estimate, however, that digital mammography comprises only about 8% of the installed base within the global mammography market. We think the total mammography market is generating growth in the number of procedures performed of about 15%, and expect that the digital category can expand more than 20% as the market continues to convert to this new platform. In fiscal 2005, we anticipate that 237 Selenias will be shipped and booked as revenue, up from 143 in fiscal 2004, with 320 to 340 systems likely to be shipped in fiscal 2006. Selenia has an average selling price of about $340,000, according to our estimates.

We think the company's prospects were significantly enhanced by the September, 2005, release of clinical data that compared digital mammography with film (analog) mammography. Conducted by the American College of Radiology Imaging network and published in The New England Journal of Medicine, the results of the trial showed that digital mammography detected up to 28% more cancers than screen-film mammography in women 50 and younger, premenopausal women, and women with dense breast tissue.

Indeed, the groups of women who may benefit from digital technology are those in which standard mammography has been less effective, a finding that we believe will drive significant market conversion and an expansion in private insurance-reimbursement coverage. Systems manufactured by GE Healthcare, Fuji Medical Systems, Fischer Imaging, and Hologic were all tested in the trial.

KEY GROWTH CATALYST. In the analog mammography market, we estimate that Hologic has a market share of 55% domestically and 38% overseas. Although we think the analog market will decline by about 4% to 6% annually through 2008, that this segment remains a significant part of the company's revenue base, and we believe the lower ends of the mammography-equipment market will continue to favor analog equipment, due to its more favorable initial cost profile. In addition, Hologic's analog systems can be upgraded to Selenia systems.

The company's other product lines include bone densitometers used to evaluate osteoporosis, digital detectors that are sold to original equipment manufacturers in both the digital and analog mammography and general radiography industries, and a mini C-arm product that's used to provide high resolution X-ray images at low radiation levels and lower cost than conventional X-ray and fluoroscopic equipment, primarily for orthopedic purposes.

By early 2007, we may see the emergence of a key growth catalyst that would provide Hologic with an important new source of revenue and earnings. Referred to as digital tomosynthesis, we think this possible new platform has the potential to further enhance the clinical efficacy of digital mammography and drive both expanded market conversion and higher selling prices.

BIGGER TAX BITE. During digital tomosynthesis, multiple X-ray pictures of each breast are taken from many angles. The X-ray tube moves in an arc around the breast while 11 images are taken during a seven-second examination. The resulting information is sent to a computer, where it's assembled to produce clear, highly focused 3-D images throughout the breast. Initial studies have indicated that tomosynthesis has the ability to reveal 16% more cancers than conventional mammography and reduce false positives by 85%.

We view Hologic as a compelling investment opportunity in the rapidly growing digital mammography field. Consistent growth is likely for the company's osteoporosis and digital-detector products. We believe the company offers some of the more visible revenue streams in our small-cap device coverage. We look for sales growth at a compounded annual rate of about 17% to 18% over the next five years, and we believe that visibility on revenue growth remains high.

However, we project that earnings comparisons in fiscal 2006 will be hurt by two factors. Most significant is the expiration of tax-loss carryforward credits, which is expected to result in an effective tax rate of 37% in fiscal 2006, vs. a projected 17.8% rate in fiscal 2005. In addition, the company will begin formally expensing stock options in accordance with accounting standard FAS 123. We believe that Hologic will have $2.5 million in stock option costs in fiscal 2006, approximating 11 cents per share, spread evenly over four quarters.

SALES BOOST AHEAD? The outfit is presently reducing the amount of stock-option grants to management and directors, so we think this expense item will continue to decline going forward. Over the coming five years, we project that expanding gross and operating margins will help drive earnings growth well beyond sales expansion. We look for a per-share compounded annual growth rate of 23% to 25%.

We expect sales to advance 14%, to $324 million, in fiscal 2006. But our forecast doesn't yet include the benefit of Selenia sales that are likely to result from the favorable clinical trial data released in mid-September, 2005, revenues that would accrue from the pending acquisition of Fischer assets, or incremental revenues from digital tomosynthesis products.

We see the operating margin widening to 12.6% in fiscal 2006, up from the 10.9% that we estimate for fiscal 2005, and dramatically higher than the 5.5% margin recorded in fiscal 2003, reflecting both a shifting sales mix and general operating efficiencies. Per-share operating earnings comparisons in fiscal 2006, however, are likely to be hurt by a sharply higher tax rate stemming from the expiration of tax-loss carryforwards.

NO PENSION DRAIN. Because of our estimates for a higher tax rate in fiscal 2006 vs. fiscal 2005, we believe investors should focus on fully taxed earnings in both years to gauge the actual underlying earnings power of Hologic. Based on this measure and including stock-option costs in both years, we see EPS rising 45%, to $1.12, from 77 cents. For fiscal 2007, we project EPS of $1.40, representing growth of 25%, based on projected sales of about $373 million.

Over the coming five years, we see sales growing at a compounded annual rate of 17% to 18%, with an apples-to-apples operating EPS CAGR of 23% to 25%, both above our medical-device coverage universe and in line with peers.

Hologic doesn't have a defined-benefit pension plan and, as a result, there's no impact on Core Earnings stemming from projected pension-plan income or expense. In terms of stock options, the company has historically had a high level of stock-option grants relative to our device coverage, though generally in line with similar small-cap growth names.

VISIBLE STREAM. In fiscal 2005, we think stock-option expense will lower Core EPS by 15 cents. However, during fiscal 2006, the company will formally expense stock options in accordance with FAS 123. As such, we don't anticipate any divergence between earnings under generally accepted accounting principles (GAAP) and Core Earnings.

The stock was recently trading at 48 times our fiscal 2006 EPS estimate of $1.12 and approximately 3.8 times our projected fiscal 2006 revenue-per-share estimate. Assuming a five-year EPS growth rate of 24%, the stock was priced at a p-e-to-growth (PEG) ratio of 2.0 times, below the 2.5 times average for its peers.

In our view, Hologic's focus on digital mammography provides it with a highly visible stream of revenues, and we therefore believe that the stock deserves a valuation at least on par with similar small-cap medical-device names. On that basis, we have a 12-month target price of $72. At that level, the shares would command a forward price-to-sales multiple of 5 times, and a PEG of 2.7 times, levels that we believe are appropriate relative to peers and our projected growth rate for Hologic. The stock also trades at a discount to our calculation of a $66.90 intrinsic value, as measured by our discounted free cash flow analysis.

WHERE RISKS REMAIN. The company's corporate-governance policies are generally in line with those of other small-cap medical-device companies, in our view. We would look favorably on a decision to separate the chairman and CEO titles but note that the business does have a board-approved CEO succession plan in place and the full board of directors is elected annually, with a committee that has oversight on corporate-governance issues.

Historically, Hologic had granted stock options to officers and directors at a level we deemed to be high relative to peers, but the compensation committee approved several changes in mid-September, 2005, that included a reduction in stock-option grants to independent directors in exchange for higher annual cash-retainer fees.

Risks to our recommendation and target price include the failure to successfully commercialize products in the R&D pipeline, increased competitive pricing pressures within the company's core markets, a slower-than-expected market conversion to digital mammography, an inability to obtain raw materials from suppliers that could disrupt sales growth, and the loss of any significant customer contracts.

Analyst Gold follows shares of health-care-equipment companies for Standard & Poor's Equity Research Services

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