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3 Health Care Stocks for the Next Decade

By: David Sterman
Posted: 9/14/2010 4:06:00 PM
Referenced Stocks: EPS;ERES;LMNX;MDT;NUVA

A clear trend has emerged in the health care sector. Large companies are having an awfully hard time finding ways to grow. As an example, I recently took a look at the dimming outlook for industry giant Medtronic ( MDT ) . [ Read more. ]

In that column, I added that, "it's been a great era to invest in smaller medical device companies." These firms (which should be widened to include the companies in the field of health care diagnostics) seem better equipped to move nimbly in new markets, and some have proven to be attractive buyout candidates. Well, I've been tracking three companies that I think make great investments -- with or without a buyout. All three are expected to boost sales around +20% to +30% both this year and next, and all three are well off of their highs seen a few years ago.

eResearch Technology (Nasdaq: ERES)
I first took a deep look at this company, which helps test the cardiac side effects on new, un-tested drugs, back in May after it had made a smart acquisition in the respiratory monitoring space.
[See: Big Pharma's Best Friend is about to Get Bigger ]

Shares have been flat since then, but quarterly results have surely been impressive. The company surged past forecasts in the June quarter, thanks in part to the newly-acquired respiratory division. As a result, earnings estimates have been raised for both 2010 and 2011. Most importantly, I think analysts are still underestimating all of the benefits of this deal, and I expect 2011 profit forecasts to rise higher in coming months.

The key to that bullish outlook is a swelling backlog . Both of eResearch's divisions are bringing in new business at a fast pace, and the company's recent book-to-bill ratio was 1.5, which means that for every dollar in sales the company had in the June quarter, it secured $1.50 in new contracts. Backlog now stands at $300 million, which implies that the company should have little trouble matching estimates through 2011. And as new contracts come in, the 2012 slate is filling up as well.

Demand is so strong because of changes at the Food & Drug Administration (FDA). An increasing number of drugs have been rejected for insufficient analysis of side effects, known as toxicity. By using eResearch's software and hardware in the testing process, drug companies can provide a much deeper set of data for regulators to analyze.

I expect shares to move toward the $11 mark during the next year, which translates into 20 times next year's likely profits. That represents a solid +40% upside from current levels.                   

NuVasive (Nasdaq: NUVA)
When a stock on my watch list sells off, I look at the reasons why. If events have led me to change my long-term view of a company, then I take it off of my watch list. But if the factors behind a stock drop are part of my investment thesis, then shares can be considered even more appealing. That's the story behind NuVasive, which has lost about a third of its value since March due to expectations of slowing growth.

On Tuesday, NuVasive cautioned that sales are only likely to grow +15% to +20% this year, which is in sync with what some more bearish investors had expected. Even as the company laid out that new slightly lower growth target, shares barely budged as investors now view forecasts to be more realistic.

Nuvasive sells a set of products to make back surgery a far less onerous experience. And the medical community has quickly warmed to the company's devices. Even as the overall spinal surgery market has been growing at a slow pace, NuVasive's sales have risen at least +48% in each of the past eight years.

Nuvasive's gear, which provides surgeons with more than 50 tools to operate more delicately and quickly, allows doctors to make a less invasive incision in the side of the body. The company's visualization systems avoid nerve damage, reduce trauma and cut operating times by half. In addition, patient recovery times are faster, hospital stays are shorter and the body suffers less blood loss and trauma.

As noted earlier, sales growth is starting to cool, but I still expect NuVasive to grow at a +15% to +20% pace in the coming years, thanks to a program that continually trains more doctors on the company's platform. (Only 10% of all back surgeons have been trained on the platform thus far).

NuVasive recently made a pair of acquisitions to bolster its position in bone graft regeneration and in the field of cervical disc replacement. The company is also rolling out new products targeting specific back ailments like deformity and scoliosis. Lastly, the company is just getting underway in the untapped international market. International sales accounted for just 3% of revenue in 2009, but with new offices opened across Europe, that figure should rise to 10% to 15% within a few years.

Thanks to this summer's sell-off, shares now trade for less than 20 times next year's profits -- the lowest forward multiple in the company's history. I think earnings per share ( EPS ) can reach $3 by 2013 thanks to steady sales growth and better leverage off of the company's fixed overhead . Shares trade for around 10 times that view. As investors come to expect moderating growth that can be sustained in the long-term, shares should re-visit the 52-week high of $46, which is roughly +50% above current levels.

Luminex (Nasdaq: LMNX)
As is the case with NuVasive, this company has also adjusted to a world of slower, albeit respectable, growth. Sales rose +40% in 2007 and 2008, and are now growing closer to +20%. That's fine with me, especially since there is a clear case to be made that this level of growth can be sustained for quite some time to come.

Luminex makes diagnostic tools for genetic analysis, drug discovery, clinical diagnostics and biomedical research, and offers exposure to a wide range of medical technology trends. The strength of Luminex's technology lies in its ability to rapidly analyze massive amounts of genomic and biologic data. Previous machines were quite fast, but not fully accurate. Luminex's xMap system ends that trade-off by offering highly-accurate and speedy results.

Luminex sells its gear to research labs, which also end up buying a host of consumables used in the testing process. The company also sells its software to other industry players, which incorporate the xMap engine into their hardware. That technology is protected by more than 50 patents, with an additional 100 patents pending. 
 
Why do I think growth can be sustained? The company has more than $100 million in cash, which has led to a strong jump in the development of new products. For example, a 3-D mapping system has been a recent hit with customers

This is not a cheap stock, trading at nearly 40 times projected 2011 profits. But as sales continue to grow at a steady pace, profits should grow even faster in subsequent years. The company has just emerged from a period of heavy investments that will dampen 2010 profit growth, but set the stage for very robust profit growth starting next year.

It's hard to place a target price on this kind of business model , as the real value lies in the core technology and the ability to grow market share , and not simply near-term profit trends. As Luminex continues to grow at a solid pace in coming quarters, shares should break out of their year-long mid-teens trading range and move up toward the $20 mark. 

Action To Take --> All three of these stocks make for good portfolio candidates. These companies are building wide moats around their business by investing heavily in R&D or growth-inducing acquisitions. They may no longer be growing at extreme rates, but they appear to be settling into solid long-term growth in the +15% to +20% range. Shares may trade erratically, thanks to the occasional quarterly miss, but should power higher into 2011 -- and beyond.


-- David Sterman

David Sterman started his career in equity research at Smith Barney, culminating in a position as Senior Analyst covering European banks. David has also served as Director of Research at Individual Investor and a Managing Editor at TheStreet.com. Read More...

Disclosure: Neither David Sterman nor StreetAuthority, LLC hold positions in any securities mentioned in this article.

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