Searching for the Next Franchise in Diagnostic Testing

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Ever since the human genome was completely sequenced in 2001, investment opportunities have abounded in the diagnostic testing industry, as exciting, new technologies have been built around this important scientific discovery.  The increasingly recurring nature of the testing business, and its strong profit margins, have brought private equity firms to the sector in search of buyouts.  The latest target is Life Technologies (NASDAQ: LIFE), which recently announced that it was reviewing strategic alternatives based on communications with interested parties.

Hunter Becomes the Hunted

Founded in 1987, Life Technologies is a leading provider of systems and instruments for use in clinical diagnostic testing, cell research, and forensics.  The company has grown through the development of patents and technologies, as well as through the acquisition channel. 

Over the past four fiscal years, Life Technologies’ revenues grew 194.6%, primarily due to acquisitions that included the purchases of Invitrogen and Applied Biosciences.  While the diagnostic testing segment remains its main focus, the company is achieving better sales growth in areas that target cell research and various forensic testing markets.

In FY2012, Life Technologies has reported slow growth, with increases in revenues and operating income of 1.2% and 3.1%, respectively, versus the prior-year period.  With an operating footprint across 160 countries, the company’s revenues have been hurt by economic pressures, especially in its European markets, which generated 30% of total sales during the period.  Cost issues in the U.S. market are also a concern, as the federal government continues to implement its 2010 landmark health care law, which incorporated an excise tax on the sale of certain medical device products.

However, Life Technologies has been able to increase its operating margin this year by reducing its R&D activities and initiating cost-savings programs.  Despite the lack of sales growth, operating cash flow remains very strong, with $556.8 million in 2012, which the company has used to reduce its debt and continue its share repurchases.  Despite an acquisition price tag over $10 billion, private equity firms probably see an ability to leverage Life Technologies’ balance sheet at relatively favorable interest rates, and a chance to profit from the industry’s expected future growth.

Looking Elsewhere

Since Life Technologies is premium-priced for a buyout, investors should probably look elsewhere in the sector for an investment.  A natural alternative selection would be Quest Diagnostics (NYSE: DGX), the leading provider of clinical testing services in the U.S. Founded in 1967, the company offers diagnostic tests through a nationwide network of facilities, and it has benefited from both the outsourcing of tests and an increased use of drug testing in the hiring process.

In FY2012, Quest has also exhibited slow growth, with increases in revenues and adjusted operating income of 1.1% and 3.9%, respectively, compared to the prior-year period.  The company benefited from growth in hiring and associated drug testing, with segment transactions up 6%, but these gains were offset by weakness in other product areas. 

Quest has pursued growth outside its core testing business, including its healthcare IT solutions segment, but its non-core business only generates roughly 9% of total sales.  In the current slow-growth environment, the company is wisely using its cash flow to pay off acquisition-related debt and repurchase shares.  At a 13 P/E multiple based on recent prices, this company is pretty cheap.

A Little Adventure

More speculative investors might want to target companies that are focused on the growing, genetic testing segment.  One company with an innovative product is GenMark Diagnostics (NASDAQ: GNMK).  The company’s system allows medical practitioners to process 24 samples simultaneously, with initial results generated in roughly thirty minutes.  GenMark currently has approval for four products, which are used to identify cystic fibrosis, blood clot disorders, and respiratory viruses.

In FY2012, GenMark has reached profitability on a gross margin basis, although operating losses have persisted due to the need to build next generation products.  The company has reported a 270.6% gain in revenues this year, as it increased the number of installed systems by 81% compared to the prior-year period.  Instead of charging for hardware, the company recovers its production costs through the ongoing sale of system cartridges, with minimum purchase requirements built into its sales agreements.  While this strategy has led to operating losses, it should provide a long-term user base that will generate favorable, recurring revenue streams.

The Bottom Line

Investors should skip the drama at Life Technologies, given its premium valuation and uncertain buyout prospects.  GenMark is an interesting story with its technology, although it needs to gain size quickly to compete with the industry giants.  Quest is probably the best bet, given its nationwide network of facilities and the ability to add diagnostic testing segments to the core business.  In this business, you need size to survive, and Quest delivers it.

rghanley owns shares of GenMark Diagnostics. The Motley Fool recommends Quest Diagnostics. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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