Hologic's Wholly Illogical Merger
j.a. is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.
Hologic (NASDAQ: HOLX) specializes in women’s health and operates in four business segments:
- Breast Health 31%
- Diagnostics 32%
- GYN Surgical 17%
- Skeletal Health 3%
The company was a pioneer in digital mammography taking on the big conglomerates like GE and Siemens AG who had much larger and better-established radiology divisions. Hologic’s early growth was astronomic.
Part of that growth was through business mergers and acquisitions. They made six between 2006-2007 and their returns on capital were reasonable for a growth stock making serial acquisitions in high single-digits to low double-digits through 2008. In 2009, revenue growth began to slow and in 2011, it was only 6.5%.
Unhealthy merger with Cytyc
Hologic made their biggest acquisition when they merged with Cytyc Corporation in late 2007—a specialist in ThinPrep technology for pap smears and testing for human papilloma virus(HPV)—a leading cause of cervical cancer. It was a complementary addition to women’s health, with a $6.2 billion price tag that came with $3.8 billion in goodwill.
The high price diluted shareholders with 132 million shares issued to Cytyc and $1.5 billion in convertible debt that still resides on the balance sheet along with the dilution hangover.
A useful ratio for valuing an acquisition is price/ EBITDA – lower is better. The rule of thumb says a fair price is price/EBITDA of 8X to 10X – just a lazy man’s rough estimate. Hologic paid 23X EBITDA and 9X revenue. My discounted cash flow pegged the company worth $2 billion. For Cytyc to be worth $6 billion, its compounded annual growth for a decade had to be 25% with $675 million in revenue turning in to $6 billion at year 10 -— completely unrealistic.
As a result of overpaying, Hologic was forced to write off $2.3 billion of the $3.8 billion in goodwill just two years later. The stock lost nearly 25% its share value over the next few days after the write down.
If we can learn from history, then the current offer for Gen-Probe (NASDAQ: GPRO)should make investors slightly nervous.
Déjà vu all over again
HOLX is paying 20X EBITDA and 6X revenue for Gen-Probe. The news sent GPRO up 20% but HOLX dropped 10%. Part of the decline may have been driven by the company's fiscal Q2 report that was slightly disappointing, but most of the slide was due to news of the Gen-Probe deal.
Presumably, shareholders with long memories are recalling the misguided and unfortunate premium Hologic paid for Cytyc. Hologic is once again paying a generous premium at $82.75 a share in cash--a 20.4% premium. Gen-Probe shares will be cancelled and converted into $82.75 in cash paid to shareholders. The cost will be $3.7 billion and funded through available cash, term loans, a revolving credit facility and additional loans and/or notes. The transaction is expected to be completed in the second half of calendar 2012 and be 20¢ accretive in the first year.
Gen-Probe
GPRO is small with a $3.7 billion market cap. They operate in three segments -- clinical molecular diagnostics, blood screening and research. The clinical molecular diagnostics segment with its strong women’s health portfolio will be complementary to the Cytyc and add sexually transmitted disease diagnostics including high-end HPV testing.
There is a lot competition in molecular diagnostics including competitor Qiagen (NASDAQ: QGEN) that also does big business in HPV testing with medical diagnostics making up 46% of its business. Gen-Probe is probably more attractive to HOLX for its blood screening business, the fastest growing segment.
Gen-Probe Q1 2012
Total revenue growth in Q1 is only 7% --in line with the past three years. The best performing segment is blood screening.
Gen-Probe’s growth over the past three years has slowed markedly from the high teens to 6% in 2011 and margins have contracted from a 5-year high of 30% in 2008 down to 22% in 2011. With these recent numbers and accelerating competition in molecular diagnostics, we have to ask if Hologic is once again overpaying for potential growth that may not be worth 20X EBITDA and 6X revenue. Part of this premium can be blamed on Roche and it’s relentless pursuit of Illumina that started in January at a bid of $44.50 per share. After Illumina said no, Roche raised the ante to $51 in March -— a $6.7 billion offer and a price/EBITDA of 21X. Most of the molecular genetics diagnostics segment benefited from the Roche offer and saw rising share prices. Before the bidding for Illumina started, Gen-Probe was trading in the mid-$50’s with an enterprise value/EBITDA of 15X. Hologic’s timing could not have been worse.
Value of Gen-Probe
In order to get Gen-Probe to the $82.50 per share price, growth for ten years is 18% and revenue in year ten is $3.4 billion – an unlikely five-fold+ increase in revenue. We don’t have the details of the merger or the value of goodwill yet and that will be the critical component since it is tested for impairment yearly. Cytyc failed cash flow tests and created a massive write off.
Using a growth rate of 7%(close to the last three-year average) the equity value is $1.7 billion and $36 per share, implying $2.2 billion in goodwill or 60% of the price. That’s about the percentage of goodwill they paid for Cytyc. If that’s how the numbers work out in upcoming filings for the merger, investors should be thinking about the potential of non-cash impairment charges that will drop Hologic’s share price -— if history is any guide.
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