Immucor Lets the Cash Flow

Its new line of blood-testing equipment will grow its steady income stream from consumables.
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This column was originally published on RealMoney on Feb. 1 at 10:07 a.m. EST. It's being republished as a bonus for TheStreet.com readers.

If operational consistency in a growing, recession-proof market is something that attracts you to an investment,

Immucor

(BLUD)

is worth consideration.

The company is the market-share leader in a specialized field of blood diagnostics. Like most diagnostics equipment companies, Immucor has a razor-and-razor-blade business model; the company generates a high percentage of its revenue from consumables. About 90% of Immucor revenue comes from reagents used on its machines in laboratories of hospitals and blood collection centers.

Immucor has separated itself from the competition by developing a highly automated, user-friendly diagnostic machine called the Galileo for use in large-volume labs. Competitors have lagged Immucor because their equipment requires more manual steps, has difficult-to-use reagents or can't be stopped during analysis. Automation is speedier and more reliable than conventional manual analysis and is at the heart of Immucor's success, because labs are short-staffed in general. The company should continue to sell Galileo units into the U.S., and there is opportunity for some growth in Europe as well.

Other opportunities for the company exist which will enable Immucor to maintain its superlative growth. Later this year, the company will begin to sell Galileos into Japan through its joint venture. In addition, Immucor expects to receive Food and Drug Administration approval for the Galileo Echo, which will serve labs in the small hospital market.

A few hiccups, including delays in validation of Galileos in the U.S., have enabled investors to buy Immucor shares at reasonable prices recently. The company seems to agree; it has been buying back stock at these levels. After Immucor gets the next few quarters under its belt, I expect the stock to reflect the company's return to exceptional performance and trade near $40 per share.

Ruling the Blood-Testing Market

Before entering the blood supply chain, each pint of donated blood undergoes a battery of tests mandated by regulatory bodies to ensure the safety of the blood supply. Immucor's testing specialty resides in three areas:

  • Blood typing, to determine whether the blood is type A, B or O.
  • Rh testing, a further blood-typing test that returns a positive or negative result.
  • Antibody screening, which tests for a variety of blood-borne diseases.

These tests are conducted multiple times, using Immucor reagents, on each pint of blood for validation.

Larger hospitals and blood analysis labs usually run these blood tests on machines that have various levels of automation and functionality, while smaller hospitals rely on lab technicians to run these tests manually. The trend toward automation has driven Immucor's success. Automation saves time and money and increases reliability and patient safety. The short supply and high comparative cost of lab technicians around the world exacerbates the need for automation.

The European blood testing market is composed of about 10 competitors that have varying degrees of automation and reagent reliability. I estimate, on the basis of the number of installed machines and a rough total of the number of units available to win, that Immucor holds 30% of the available market in Europe with its installed base.

In the U.S., Immucor splits the market with

Johnson & Johnson

(JNJ) - Get Report

. A third competitor recently was approved in the U.S. but has had very little uptake because of the outdated nature of its machinery. Immucor launched the Galileo in the U.S. in late 2004, and the Galileos have captured about 10% of the North American market at this point. The rest of Immucor's reagent market share in the U.S. is utilized on its legacy machinery or for manual reagent testing.

I expect the Galileo to continue to gain share in the U.S. market, and to hold nearly half of the market in a few years' time. Each Galileo customer will consume $100,000 to $150,000 per year in reagents supplied by Immucor at very high margins. That would make for a promising long-term view.

Immucor will launch its Galileo systems in Japan later this year. While the Japanese market is about one-half to two-thirds the size of the U.S. market, it offers the greatest opportunity for growth. So far, Immucor has served the Japanese market on only a limited basis. I expect about half of Immucor's Galileo-driven growth to come from Japan once this launch is fully under way.

Later this year, Immucor expects to launch its newest product, the Galileo Echo, in Europe and the U.S. The Echo has been engineered using the same reagents and mechanics as the Galileo, but it runs at a lower throughput rate. This lower-volume market is currently served exclusively by manual reagent testing. Even though the Echo will generate only about 25% as much revenue as the full-scale Galileo model, there are roughly six times as many potential Echo customers as there are potential Galileo customers. I expect the Echo to be the largest driver of growth in the future for Immucor.

Stock Stumbles

The U.S. launch of the Galileo started off on the wrong foot, and that contributed to weakness in Immucor's stock price. While Immucor was successful in selling Galileos to U.S. customers, including some competitive wins, the validation of these machines, required by hospitals to ensure the safety of their patients, took longer than expected and delayed the realization of high-margin reagent sales. The company believes it has addressed this problem with new contracting, which gives customers incentives to validate their machines quickly.

A strange accounting nuance has contributed to market angst as well. Because a hefty portion of the value of each machine sold resides in the reagent revenue stream, Immucor's accountants argue that the entire value of the machine resides in the reagents themselves.

As a result, the accountants invoked a recent accounting rule, EITF 00-21, Accounting for Revenue Arrangements with Multiple Deliverables. That decision requires the company to book 100% of the costs of the machine upon sale, while amortizing the machine's revenue over its five year use-life, even while Immucor receives cash for the machine sale right away. This treatment understates the true economic earnings and masks the strong cash flow of the company; this should be noted when investigating its financials.

Let the Cash Flow

Immucor's outlook is impressive. The company has become a market-share leader with its technology in the niche blood-testing market. Its installed base should continue to generate revenue, which grows at mid-single-digit rates annually. The company also has several new avenues of growth, including new Galileo placements worldwide, a new launch into Japan and a new product aimed at an underserved market. The company's ongoing share buyback is also a testament to its optimistic outlook.

As a result of Immucor's accounting treatment for equipment sales, I prefer to analyze the company using free cash flow. My estimates for fiscal 2007 and fiscal 2008, ending in May, have Immucor earning close to $1.40 and $1.65 per share in free cash flow. I believe a 25-30 multiple on that cash flow properly values this kind of earnings growth, and I expect the stock should trade near $40 per share in the not-too-distant future as a result.

At the time of publication, Ferayorni was long Immucor, although positions may change at any time.

Justin Ferayorni, CFA, is the founder and principal of Tamarack Capital Management and was an analyst and portfolio manager at Bricoleur Capital. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Ferayorni appreciates your feedback;

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