HOLX facing serious headwinds Disclosure: I have no positions in any stocks mentioned, but may initiate a short position in HOLX, over the next 72 hours. (More...)
The current state of Hologic (HOLX) is summed up well by Amit Hazan of SunTrust Banks in an article on Firstwordmedtech.com. Mr. Hazan stated "I just don't see a pathway forward that could happen without the equity really getting hurt." This article will explain how Hologic has destroyed shareholder value in the past at an extreme level. We will also explain how this may be occurring again right now. At this point, if an investor is still long Hologic, they need to consider whether there are better investments available to them then Hologic and whether the risk, which is obviously high, outweighs any significant potential return on investment, which is not likely to be seen until at least 2015. Morgan Stanley analyst David Lewis published an article on January 6, 2014, supporting our view that Morgan Stanley's "SOTP analysis suggests portfolio optimization may not be the quick fix some investors expect and we see a longer road to value creation."
Hologic is a repeat offender of the worst kind. Hologic has routinely used shareholder's assets, namely cash or Hologic's enterprise value, in failed or failing attempts to spur higher growth and enter new markets that are supposedly compatible. However, diagnostics businesses such as Gen-Probe and Cytyc and mammography imaging businesses such as Hologic's Selenia Dimensions 3-D system ("Dimensions") product do not necessarily combine to form a powerful dominant organization with limitless opportunity to cross-sell each service or product within women's health. This was debated by a variety of analysts when Hologic acquired Cytyc. Jacob Goldstein, a Wall Street Journal blogger, stated "the tie-up of a manufacturer of capital equipment and a maker of high-end lab tests (none of which run on Hologic's machines) would be unusual." We attribute a 73% decline in Hologic's market capitalization between 2007 and 2009 as being primarily due to the failed Cytyc deal. It appears Hologic didn't learn its lesson. Once the Cytyc acquisition failed, Hologic then went on to acquire Gen-Probe in 2012. Now that Gen-Probe appears to be a failing acquisition, it appears shareholders should consider whether similar losses, upwards of 70%, are possible yet again.
The Failed Cytyc Acquisition
Hologic has been a well-known leader in women's health technology since at least the time of its acquisition of Cytyc in October 2007. Cytyc was a provider of high-end diagnostic lab tests. Hologic's purchase price for Cytyc was $6.2 billion. Post-acquisition, the combined operations of Hologic and Cytyc were valued by the market in excess of $10 billion. Cytyc was a failed acquisition that diluted shareholders by over 50% at the time of the acquisition. Hologic trades around $6 billion today. Management contended that the dilution was worthwhile as the combined company would eventually become a healthcare behemoth. It is now 6 years later. We believe it is safe to say that those plans failed miserably.
The Failing Dimensions Product
In February 2011, Hologic's Dimensions became the first three-dimensional breast imagining technology to be approved by the U.S. Food and Drug Administration ("FDA"). However, as noted in an article by radiologytoday.net, the FDA approved Dimensions as an "adjunct" to existing two-dimensional ("2D") systems and not as a replacement to 2D. Dimensions offers both 3D and 2D technology and competes with other 2D technology providers in the U.S. and internationally with both 3D and 2D providers.
Management contends that Dimensions has not generated the growth Hologic anticipated as a result of the increased cost associated with exams using both 3D and 2D screening. Management also refers to the limitations placed on any product, including Dimensions, in the medical field that does not have its own Medicare and Medicaid insurance code or has low reimbursement rates in general.
However, its worth nothing that even if and when Dimensions obtains a insurance code, the costs to patients to use 3D in addition to 2D is and may remain significant. This is because insurance reimbursement rates for mammography have historically been low, as confirmed by a National Institutes of Health study and discussed by a physician here, and show no signs of increasing. Additionally, the medical community may still be analyzing the additional data provided by Dimensions to determine how useful its 3D technology really is.
As a result, after a full 21 months subsequent to approval by the FDA, the adoption of Dimensions by medical facilities has been anything but smooth and growth has not panned out as management projected. It is also important to note that in the most recent earnings call, management confirmed that competitive 3D technology exists outside the U.S. Hologic's competitors have focused on international markets possibly because most other markets are less regulated than the U.S. and reimbursement cost issues are not as apparent. During the recent Fiscal 2013 earnings call, management, specifically David Harding, agreed that other competitive technology is coming to the U.S. when he stated, "We are anticipating that GE will launch in the United States at some point. We are not exactly sure when but we do anticipate it being within this fiscal year, probably sooner rather than later." Hologic may have lost its chance to dominate the 3D market with Dimensions. Its "first mover advantage" has not been much of an advantage at all. Now, larger players, who have much larger marketing budgets, are likely to command a larger portion of the market on a going forward basis. In the most recent earnings call, Jack Cummings, the former CEO, responded to analysts by inferring that these marketing dollars will increase awareness and actually help Hologic sell more Dimensions units. This is a highly questionable statement in our opinion, and is unlikely to be supported with any factual data. Mr. Cummings is no longer CEO. Physicians know about 3D systems. Marketing is not the issue. Providing discounts, attractive financing options, or incentives for sales, which larger players can do more easily than Hologic, could become a differentiating strategy that GE or other large players in the mammography space could adopt. Hologic can't afford to do any of this at a level that would allow them to compete from a marketing standpoint. That is in no way good news for Hologic.
The Failing Gen-Probe Acquisition
Gen-Probe was acquired by Hologic on August 1, 2012 for approximately $4.0 billion. Gen-Probe was in the diagnostics business as well. Hologic intended to combine its existing diagnostics business (formerly Cytyc) with Gen-Probe's operations. Similarly to the Cytyc acquisition, investors were yet again diluted over 50% immediately upon the acquisition. To clarify, it is true that this acquisition was paid for in cash. We refer to this as a dilutive event however, as the $3.8 billion in long-term debt that was issued in order to complete the transaction, should be offset against Hologic's enterprise value to arrive at an estimated measure of the value of Hologic's outstanding common stock/market capitalization. At the time of the acquisition, simple math results in a significant decrease in the estimated value of Hologic's market capitalization. The following are a few notes from the press release announcing the Gen-Probe acquisition.
- Gen-Probe was expected to add $0.20 to Hologic's non-GAAP earnings per share for the fiscal year ending September 28, 2013 ('Fiscal 2013").
- The impact of Gen-Probe would also be "significantly more accretive on a non-GAAP basis thereafter."
- The transaction was expected to accelerate Hologic's growth rates.
- Hologic would see strong free cash flows
It is now a full 16 months after the Gen-Probe acquisition. Hologic recently filed its annual report for Fiscal 2013. It is now clear. None of management's expectations have come true.
A History of Failure
Current Hologic longs will suggest that the Cytyc, Dimensions and Gen-Probe failures and pending failures thus far have all been a result of prior management ineptness. Investors may believe current management can magically solve all of Hologic's issues. However, we will suggest that even the best management is unlikely to succeed when they are attempting a turnaround in an environment where competition is about to increase, perhaps significantly and from multiple entrenched industry players, and perceived technology superiority alone is not producing large marketshare gains. This is what lies ahead for the current management team at Hologic.
Impairment losses associated with Hologic's diagnostics businesses, which we relate to the Cytyc and Gen-Probe acquisitions, are outlined in the table below.
The failing Gen-Probe acquisition is eerily reminiscent of the failed Cytyc acquisition. We are defining a failed or failing acquisition as any acquisition that generates impairment losses in excess of 25% of the purchase price of the acquisition. Both Cytyc and Gen-Probe qualify under this definition.
The following is a quick summary of where Hologic is at this point.
- The Dimensions product is not dominating the mammography market as management had hoped once it received FDA approval in 2011.
- Hologic booked a $1.1 billion write-down on its diagnostics business during Fiscal 2013. This write-down represents approximately 28% of the Gen-Probe purchase price and 18% of Hologic's current market capitalization. There is no way to twist this news. To date, the Gen-Probe acquisition is a failure. Additionally, this is Hologic's second attempt to build a dominant diagnostics business. At this stage, it is reasonable to wonder if Hologic will fail in both attempts to develop a dominant diagnostics business.
- The question now is if any of the remaining $2.8 billion of the acquisition cost will need to be written off in the near future. An additional $2.8 billion write-off would equate to 46% of Hologic's current market capitalization. A writeoff that large may not be likely but a writeoff of any substantial % of the purchase price would be yet another massive loss for investors to stomach.
- Non-GAAP earnings per share for Fiscal 2013 were actually down 1,557%
- Gen-Probe has been a failing acquisition. It has not been accretive to EPS.
- On a pro forma basis, assuming the combination of Hologic and Gen-Probe actually occurred on the first day of the September 24, 2011 year end, the top line (revenues) of Hologic and Gen-Probe have decelerated from just 9% in the fiscal year ending September 29, 2012 to -1% growth in Fiscal 2013.
- Hologic generated just $494 million in cashflows from operations in Fiscal 2013. This represents a 10% increase over the averaged cashflows generated by Hologic for the two previous fiscal years. In our opinion, that is not "strong free cashflow."
- Hologic's failing acquisition has not significantly helped either the top or bottom line.
- Hologic is now left with $4.8 billion in debt as of the end of Fiscal 2013 and has no guarantee that the Gen-Probe acquisition will become accretive at some point and produce the cashflows needed to pay down the full $4.8 billion in debt.
Management's Ugly Forecast for 2014
Hologic has recently released projections for the fiscal year ending on September 27, 2014 ("Fiscal 2014") summarized as follows:
- Fiscal 2014 Revenues Will be Down 1-3%
- Fiscal 2014 non-GAAP gross margins are decreasing
- Fiscal 2014 non-GAAP operating expenses are increasing
- Fiscal 2014 non-GAAP EPS will decrease 8-12%
A New CEO
Stephan MacMillan's prior success at Stryker Corporation (SYK) is well documented. He is known as being strong at cutting costs and driving growth in the medical devices segment. An article on Bloomberg.com stated, "The challenge for MacMillan will be stiff. Demand is declining for the company's pap test, blood screening and NovaSure products, while Hologic is waiting for a permanent insurance code from the U.S. Centers for Medicare & Medicaid Services for its 3D tomosynthesis breast cancer detection system."
MacMillan takes over a company that seems to be unable to do anything right. Jonathan Groberg, a New York-based analyst at Macquarie Group Ltd., stated, "The company has destroyed value, their core business is declining. It's massively underperformed the market."
Carl Icahn
Investors may believe Carl Icahn if he says his interests are aligned with all shareholders of Hologic. However, Icahn is the CEO and 93% owner of Icahn Enterprises LP (IEP). Icahn has fiduciary duty to protect the shareholders of IEP and no duty to protect shareholders of HOLX. There are numerous instances where Icahn could potentially be faced with a decision that would benefit the shareholders of IEP but hurt the shareholders of HOLX. One example that is purely speculation by us, but is possible, is Icahn funding Hologic directly and exchanging his Hologic common stock ownership for the issuance of Hologic preferred stock or convertible debt. We believe the structure of that type of financing would be highly favorable to Icahn or any other investor looking to fund Hologic, which in turn means the common stock shareholders of Hologic would be hurt, and potentially hurt badly.
Jeremy Feffer, a New York-based analyst at Cantor Fitzgerald LP stated, "Some investors may be disappointed if they thought a sale of the company was imminent, MacMillan is known for his operational abilities. I don't think you bring in MacMillan to sell the company. At least in the short term, you bring in someone like him to turn it around. It's going to be an uphill climb. They may give him a year or 18 months to see what he can do, then Icahn will step in to cement the deal."
We do not believe Hologic is worth waiting for and we do not believe Icahn will always have the best interests of Hologic shareholders in mind when he works with Hologic's management in 2014.
Questionable and Risky Cash Management Practices
Hologic's management have been playing a risky game. We will give the new CEO a pass on this as he was not involved in this decision, but the CFO was. He supported the former CEO's plans to pay down debt. On a very basic level this is not something a struggling company will normally do. At September 30, 2013, Hologic had $822 million in cash and cash equivalents. Subsequent to the year end, in the past three months, Hologic's management have determined to pay down $100 million of 3.75% debt, of which $175 million was due between Fiscal 2014 and September 2018. In the most recent earnings call, management stated their intention to now pay down an additional $405 million of convertible debts, as scheduled, in December 2013. We assume these payments have been made. The convertible debts carry interest at 2%. Yes, that is right, a total of $505 million in debts, including $100 million that was not due yet, with a weighted average interest rate of 2.35%, was paid down by management. On the most basic level, this means that management does not believe it can create value for shareholders in excess of 2.35% during the next four fiscal years. The Board of Directors, with management's presumed blessing, also approved a $250 million stock repurchase program just recently. This is a highly questionable use of cash at this time as well. We are unsure of any rational reason for approving a stock repurchase of any significant amount. We bring this up because of the following facts and commentary.
- Hologic is not flush with cash
- Hologic's creditors have previously secured all of its assets. A floundering company with no additional assets to secure will have difficulty issuing additional debts in the event the business continues to deteriorate beyond management's projected 1-3% negative growth range
- A debt-swap or an extension of payment terms on the convertible notes would have made a lot more sense than paying those notes off. However, it is unclear if management has attempted to restructure these debts or has no choice but to pay them off, given Hologic's current financial position and its obvious failing Gen-Probe acquisition.
Weakening Liquidity and Solvency Ratios
Hologic's key financial ratios are not strong and have been weakening since the September 29, 2012 fiscal year end. The ratio calculations below suggest significant liquidity and solvency issues. These ratios clearly indicate a struggling business. It is not the time for Hologic to be pre-paying debts and buying back stock. Hologic management and the Board of Directors need to reconsider these issues immediately.
Volatile, Perhaps Unpredictable Cashflows
Hologic's quarterly operating cashflows have been extremely volatile over the past two fiscal years. The volatility does not appear to be representative of normal business cycles. This is yet another reason to restructure debts, if possible, rather than pay them, and cancel the stock buyback.
Hologic's ability to raise capital at a reasonable cost of capital is in question at this point, negative growth is anticipated in Fiscal 2014, its financial ratios are indicating significant liquidity and solvency issues. These issues, including the volatility of cashflows, are reasons management should be more cautious with its available cash. We anticipate pressure from both Hologic's new CEO and Mr. Icahn to actually cancel the stock buyback plan. Shareholders have already suffered through the failed acquisition of Cytyc, the snail's pace growth of the Dimensions product since FDA approval, and the failing Gen-Probe acquisition. Additional bad news, such as a cashflow crunch, would be disastrous. The cancellation of the stock buyback is the only reasonable course forward in that regard.
A History Lesson
When the market realized the Cytyc acquisition was going to be a failure, the stock crashed from a high of $35.64 on December 26, 2007 to a low of $9.62 on March 5, 2009. That represented a 73% loss for investors. Cytyc was a diagnostics business. Gen-Probe was a diagnostics business. Hologic has a storied history of impairment losses resulting from failed or failing acquisitions. An investor who is long Hologic needs to ask themselves if they are sure that Gen-Probe will not be a failed acquisition.
Declining Secondary Business Segments Will be Difficult to Sell
Hologic's core profitable operations involve its Gen-Probe diagnostics business and its Dimensions breast health business. Investors and analysts have suggested that Hologic sell off its non-core operations in order to raise capital and improve Hologic's financial health. The likelihood of this occurring appears slim as Hologic's GYN Surgical and Skeletal Health business segments are both not showing signs of growth. They declined 2% and 6%, respectively, in Fiscal 2013 and together only generated approximately $27 million in operating income in Fiscal 2013. Although Hologic would certainly like to dispose of its two smaller business segments, there are not many buyers in the market that are looking for acquisitions of small, declining businesses. Morgan Stanley released statements on January 6, 2014 that agree with our assessment. Below is a snapshot from Hologic's Fiscal 2013 10-K showing the declining businesses discussed here.
(click to enlarge)
(click to enlarge)
Valuation
Hologic did not have earnings for Fiscal 2013. As a result, a price to earnings multiple is not useful for determining a valuation of Hologic's shares. We also believe Hologic's large debt balances, which represent almost 80% of its current market capitalization, need to be factored into any valuation discussion. As a result, we have focused on enterprise value, which is defined as the market capitalization of a company added to its net debt. Net debt is the company's debt less its cash and investments. This is in effect the amount which an acquirer would pay to acquire Hologic. We then considered several multiples to compare Hologic's enterprise value to a list of 10 companies that are fully reporting to the SEC and are either competitors or are comparable companies to Hologic. Enterprise value is referenced in the chart below as "EV." The other references are multiples of EV:
- EV/B = enterprise value/book value
- EV/S = enterprise value/sales
- EV/C = enterprise value/cashflows from operations
Notes: Market capitalization is as of January 3, 2014. Other figures used in the analysis are from the most recently available twelve months reporting sourced from SEC filings, Yahoo Finance and Bloomberg respectively. Amounts are in $ billions. Figures for Koninklijke Philips adjusted for currency differences to $ billions using the monthly averages for the Euro vs. the USD for October 2012 through September 30, 2013 for revenues and cashflow figures and the September 30, 2013 Euro vs. USD rate for the book value figure.
This analysis suggests Hologic shares are over-valued by between 30% and 81%. We believe the enterprise value to cashflow multiple, which suggests Hologic is overvalued by 30%, is most meaningful as that multiple represents real cashflow from operations over the market's value with an adjustment for debt and cash/investments held by Hologic. Cashflows are ultimately perhaps the most important metric to measure any business, in our opinion.
Conclusion
The thesis behind this article is summarized by a few statements below.
- Hologic has a history of failure that it seems unable to escape. The Cytyc acquisition was a failure, Gen-Probe is a failing acquisition, and Hologic's cornerstone Dimensions breast imaging product is failing. History may repeat itself. Hologic's stock was down 73% the last time a large acquisition (Cytyc) failed. Our valuation work and related interpretation suggests Hologic's stock is over-valued by 30%.
- Management stated in the Fiscal 2013 earnings call that Hologic's 3D breast imaging competition, including General Electric (GE), seems set to enter the U.S. market in 2014 and that overall top line and non-GAAP bottom line would decline in 2014. GE and several other firms have been selling 3D systems overseas for years now. These competitors will utilize their capital to build their marketshare, to Hologic's detriment.
- Hologic's core profitable operations involve its Gen-Probe diagnostics business and its Dimensions breast health business. Investors and analysts have suggested that Hologic sell off its non-core operations in order to raise capital and improve Hologic's financial health. The likelihood of this occurring appears slim as Hologic's GYN Surgical and Skeletal Health business segments are both not showing signs of growth. Morgan Stanley agrees with our assessment. These business segments declined 2% and 6%, respectively, in Fiscal 2013 and together only generated approximately $27 million in operating income in Fiscal 2013. There are likely not many buyers in the market that are looking for acquisitions of small, declining businesses.
- Hologic's $4.8 billion in debt obligations as of the end of Fiscal 2013 are fully secured by all of Hologic's assets. Hologic's financial condition is very poor. Hologic's chances of raising additional debt or equity at reasonable rates are low. A capital raise or restructuring of Hologic's debts that involves a large dilution of Hologic's current shareholders appears much more likely.
- Hologic's liquidity and solvency ratios declined dramatically in Fiscal 2013 as compared to the prior year. Cashflows in the last two years have been extremely volatile. Management has stated its intentions to be aggressive in paying down its debts and can repurchase shares at will, up to $250 million. This is a struggling company. The last thing Hologic management should be doing is focusing on aggressively paying down debts and buying back stock.
- A new CEO has been hired. Stephen MacMillan is a quality manager and may be given a year or more to turn the company around before an outright sale of Hologic would be considered. Hologic is a real challenge for him. We are highly pessimistic that a simple restructuring or other conservative strategies will allow Hologic to complete a successful turnaround.
- Carl Icahn has invested in Hologic and is taking an active role. Hologic has allowed him to appoint two of his representatives to the Board of Directors. Mr. Icahn's impact could be minimal in the next year or so as the new CEO is given a small window to complete a turnaround.
A shareholder of Hologic should consider their investment to be at best dead capital for the next year. Hologic management essentially asked shareholders for a pass on 2014 when they recently stated during the Fiscal 2013 earnings call that Fiscal 2014 will be a year of transition and growth will be negative. The upside in this stock, if there is any, is highly questionable at this point. The downside is indisputable and may end up being comparable to the 73% loss shareholders took as a result of the failed Cytyc acquisition. At the very least, our work to determine the true enterprise value of Hologic suggests a downside in Hologic's stock of at least 30%.
Sources: Data included in this article was sourced from sec.gov, Bloomberg, Yahoo Finance and other sources as indicated within the article. References to market capitalization and stock prices included in this article are as of January 3, 2014. SkyTides contacted Hologic's investor relations representative, Ms. Deborah Gordon, on December 19, 2013 to request clarification and thoughts on the key topics covered in this article. Ms. Gordon has not responded to SkyTides. Competitors or comparable companies used in our valuation work and the data related to each company was selected using the following criteria:
- Fully reporting U.S. publicly-traded companies identified by Hologic as competitors in its Fiscal 2013 Form 10-K
- Fully reporting U.S. publicly-traded companies identified on Yahoo Finance as competitors to Hologic or any of the other previously selected companies
- Fully reporting U.S. publicly-traded companies with market capitalizations over $100 million that are listed within the following classifications at www.bloomberg.com
- Companies such as GE, Fujifilm, Siemens and Toshiba were not included in our valuation work as their operations are significantly diversified outside of the Healthcare sector. We therefore do not believe they are useful to compare or contrast to Hologic in our valuation work.
1) Healthcare products - breast cancer detection
2) Healthcare products - diagnostic equipment
3) Healthcare products - medical imaging systems
4) Healthcare products - x-ray equipment
Disclaimer: Statements within this article include our opinions and our estimates of the valuation of Hologic shares of common stock as of January 3, 2014. We make no representation that our opinions or the valuation methodology, selection of competitors or comparable companies or results of the valuation work we performed are accurate. A valuation is inherently an estimate. It is not an absolute. Our estimate of the valuation of Hologic shares could differ from another estimate produced by another analyst, bank or individual, as an example. Those analysts, banks or individuals, may choose to use a different methodology, or different inputs into their valuation model, which may also vary from ours, to arrive at an estimate of valuation that is different than ours. This article contains statements that are not historical facts and are considered forward-looking within the meaning of Section 27A of the Securities Act and Section 21E of the Exchange Act. These forward-looking statements contain projections of a company's future results of operations or its financial position or state other forward-looking information. There are events in the future that we are not able to accurately predict or control and that will cause a company's actual results to differ from the expectations we describe in our forward-looking statements. Investors are cautioned not to unduly rely on forward-looking statements because they involve risks and uncertainties, and actual results will differ from those discussed as a result of various factors. These forward-looking statements speak only as of the date on which the statements were made, which is January 3, 2014, and are not guarantees of future performance. We do not undertake or intend to update any forward-looking statements after January 3, 2014.
About SkyTides
SkyTides searches for deep value investing opportunities and is always interested in finding and exploiting opportunities involving mispriced securities. We attempt to gather as much information from public sources and management or other sources as possible. We then attempt to value a security at a fair price using the information we have on hand at the time and utilize the most reasonable valuation methodologies available. Ultimately, subsequent to completing its research, SkyTides looks to capitalize on mispriced securities with either a long or short position.
All SkyTides articles are written by our founder, who is supported by a small team of research analysts. He has written on financial subjects, with a specific interest in technology, oil & gas and biotech stocks, since 2005, served as an executive of a variety of publicly-traded companies in the U.S., led several going public transactions, and is a former auditor at one of the Big 4 professional services firms. He has significant operating experience in the U.S. and Asia.
Stocks covered by SkyTides are generally risky investments. An investor in these stocks should always be willing to lose their entire investment in the stock. No publication by SkyTides should be seen as an offer or suggestion to buy or sell any stocks covered by SkyTides. An investor should always review the stock's SEC filings at sec.gov and all other publicly-available information about the stock before investing. SkyTides is under no obligation to update its research at any time.
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