Diagnostics - Doctor, doctor, is this a good investment?

Mention healthcare stocks and most investors will be looking at biotech for the best returns – make-or-break companies which will strike it rich if their drugs under development get through the FDA approval process. Income investors know the appeal of Astrazeneca and Glaxosmithkline, huge pharmaceutical companies with massive portfolios of relatively mature drugs.

Neither as risky as biotech tiddlers, nor as boring as the big drugmakers, the healthcare equipment stocks are stuck in the middle – and don't get a lot of attention. But they can get the same kind of growth rates as the biotechs – while several of them have the kind of earnings record that would make a big-pharma finance director nod in approval.

This week saw news that one in six NHS patients suffer misdiagnosis [ref] Daily Telegraph,21 September 2009:http://www.telegraph.co.uk/health/healthnews/6216559/One-in-six-NHS-patients-misdiagnosed.html [/ref] . While technology can't solve every health problem, diagnostic technology has become increasingly accurate – and cheap; so I thought it would be a good time to take a look at some of the diagnostics stocks. There are quite a few.

Diagnostics appears to be relatively resilient in tough economic times. Testing is increasingly seen as a way to help manage healthcare costs, by identifying diseases early and addressing them before major intervention is required.

I particularly like the fact that some of these companies are establishing good barriers to entry. That's something Warren Buffett always looks for – he calls it a 'moat' around the company – and it could help the companies sustain their competitive advantage in the long term, which isn't always possible with drugs. Once the company has its equipment in the surgery, its future revenue stream of diagnostic tests is safeguarded, as it's not economically sensible to change the system

There are also opportunities for cross-selling new products using the same equipment at the point of care. For instance, Axis-shield now has over 5,000 of its Afinion systems installed worldwide for testing for diabetes. This year, it's announced that it is going to start marketing a new test on the same platform, this time for diagnosis of patients who might benefit from being prescribed statins to prevent cardio-vascular disease (the test picks up CRP - high-sensitivity C-reactive protein).

Axis-shield was formed in 1999 by the merger of Norwegian company Axis Biochemicals and UK based Shield Diagnostics, and still has a dual listing in Oslo and London. Revenues rose 18.5% at the half way stage, with underlying pretax profit doubled to £3.6m [ref] Interim results presentation 2009: http://www.axis-shield.com/assets/2009%20Interim%20Analyst%20Presentation.pdf [/ref] . The company is forecast to more than double earnings this year – which partly explains the high valuation (the stock trades at 63x historic earnings).

The 5,000 Afinion systems installed in surgeries worldwide should grow fast – the company plans to install another 2500 this year [ref] Herald Scotland, 27 August 2009: http://www.heraldscotland.com/axis-shield-doubles-first-half-earnings-1.917342 [/ref] – giving it a great platform for developing further tests on the same platform. At the same time, Axis Shield sells its older Nycocard product into less developed markets – and this is still growing revenues at 9% [ref] 2009 interim results [/ref] .

The company is now focusing on higher value added areas, such as theranostics (identifying patients most suitable for treatment with a particular drug, rather than simply diagnosing the disease). All in all, it looks an interesting investment

Immunodiagnostic Systems Hldgs is focused on immunoassays used in the area of bone disease – for instance it tests for Vitamin D and bone formation markers. It's operating in a growth market - requests for Vitamin D tests in the US rose by up to 90% last year, and the French market has tripled in size in less than two years [ref] Growth Company Investor, 20 June 2009: http://www.growthcompany.co.uk/recommendations/1054872/immunodiagnostic-systems.thtml [/ref] . While it managed to achieve 80% growth in the US last year with its older, manual testing product, it has now developed an automated testing product, iSYS, which offers clear cost advantages for Vitamin D testing, and expects to increase that growth rate. The company claims to be dominant in its chosen niches [ref] Annual report for year to March 2009: http://www.idsplc.com/z_includes/z_assets/asset_file.php?id=9210 [/ref] , which gives it a decided market advantage in expanding to new markets.

Revenue last year rose 52%, and pretax profit 27%; the company also paid an increased dividend [ref] Annual report for year to March 2009: http://www.idsplc.com/z_includes/z_assets/asset_file.php?id=9210 [/ref] . The company did however blot its copybook a little with an emergency fund raising – management was perhaps distracted by negotiations to acquire a US diagnostics business, which proved unviable in the end. Still, that's the fourth consecutive year of growth in revenue and profits – quite a track record. At 22x historic earnings, with growth likely to rev up (50% earnings growth might well be possible) as new products start to gain traction, this could be quite an interesting company to follow.

Another diagnostic company which looks like a potential fast growth stock is Mediwatch,  a urological specialist. It was founded by CEO Philip Stimpson in 1996, and markets a prostate cancer diagnostic system, PSAWatch, for which it has now signed a global distribution agreement with US major, Inverness Medical Innovations. Its point-of-care product has real advantages against lab tests – results take 10 minutes rather than 3 days to arrive, and it's cheaper to use. That makes Mediwatch a possible beneficiary of cost cutting programmes in healthcare, rather than a likely victim.

The year to October 2008 saw Mediwatch increase its revenue by 64%, but more importantly make a profit of £408,000 against a loss of £256,000 the year before. It also saw positive cash flow – no longer burning cash as it had done the previous year [ref] Preliminary results 2008: http://www.mediwatch.com/images/pdf/PreliminaryResults2008.pdf [/ref] . Brokers' forecasts are for £620,000 pretax profit in 2009, growing to £1.2m in 2010 [ref] Growth Company Investor,8 April 2009: http://www.growthcompany.co.uk/recommendations/1016867/mediwatchs-healthy-growth-prospects.thtml [/ref] – the shares trade on 22x historic earnings, but look much more realistically valued on a prospective basis.

Genetix Group provides solutions for imaging and intelligent image analysis, serving life science as well as diagnostic markets. The company has a leading position in genetics testing, and has reinforced its operations in digital pathology with the acquisition of Slidepath in May 2009. Its Cytovision software platform is used for chromosomal investigations within the clinical diagnostics field, while its ClonePix and QPix systems are used in life sciences for screening mammalian and microbial colonies used in the production of biotherapeutics.

Interim results to June 2009 showed revenue up 14%, and underlying operating profit up 24% [ref] Interim statement 2009: http://genetix.com/en/news/pr_news/news_2009-08-06/index.html?backurl=%2Fen%2Fnews%2Fpr_news%2Findex.html [/ref] . The company has cash, and even pays a dividend. A new CEO, Charles de Rohan, joined last year from Abbott Laboratories, and intends to continue acquiring companies that can complement the group's strengths.

Genetix trades on 121.6x historic earnings, and even though earnings may dip this year, that appears to give investors relatively cheap exposure to a growth sector.

Akers Biosciences Inc is a diagnostic testing company that has some interesting technologies, but has been loss making until recently. Thomas Nicolette joined as CEO in 2007, and has brought a more commercial approach with him, commercialising the technology. Various diagnostic products include the MicroParticle catalyzed biosensor, which picks up particles in the patient's breath; disposable breathalysers sold to the US military made up most of the company's revenues last year. The company also has a low cost test for allergy to heparin, an anti-coagulant often used in surgical operations to avoid clotting. This test, PIFA, sells for about a third the price of the leading product on the market, so should be able to gain increasing share.

 The company finally made its maiden profit last year, with revenues of USD 6.5m and pretax profit of USD 2.7m. Killik & Co forecasts 78% growth in revenues and 41% growth in earnings per share next year [ref] Killik & Co research: http://www.akersbiosciences.com/investor/documents/27_March_09_Killik&Co_buy.pdf [/ref] . The stock is trading on a PER of 7.6x prospective according to these forecasts – quite cheap compared to the other diagnostics stocks, though of course Akers doesn't have the long track record of profitability enjoyed by some of the other companies in the sector.

 Diagnostics has also acquired a new company quite recently, Dundee-based 3D Diagnostic Imaging, which floated on Plus Markets earlier this year. The company is valued at just under £7m, so it's a real minnow. It acquired the CarieScan PRO technology from a company in administration; the device looks like a toothbrush, and is above to detect hidden tooth decay without using x-rays.

 Essentially this company is a punt on whether management can commercialise the device better than its previous owner. So far, it's already signed a distribution agreement with Clark Dental, which the company estimates could be worth up to £4m in revenue over the next 3 years [ref] 3D Diagnostic Imaging Press release, 16 July 2009: http://www.cariescan.com/investors/news160709.php [/ref] . Despite the deal, the shares don't appear to have moved far from their flotation price, so it's clear investors still have to be convinced.

This is an intriguing sub-sector. While you might expect it to be full of stocks trading on sky-high growth stock valuations, a lot of the valuations seem quite reasonable, and most of the companies in the area have good track records of profitability. They seem to be fairly resilient in the teeth of recession, too – while governments may be looking to cut drug costs, they're aware that cutting diagnosis spending could actually increase health costs if it leads to diseases having to be treated at a more advanced stage.

So while I'd want to do quite a lot more research on the individual stocks, this is a sector that looks worth following – and potentially worth taking a stake in.