Hologic's Narrow Economic Moat Remains Strong Thanks to Pandemic

Senior Equity Analyst

Debbie Wang

Under CEO Stephen MacMillan's watch, Hologic has been able to focus on structural competitive advantages, improve its balance sheet, and judiciously step into complementary markets, which has smoothed out the vagaries of product cycles. 

Though the purchase of Gen-Probe was pricey, Hologic now holds a strong position in a host of molecular diagnostic tests across women’s health, infectious disease, and oncology that run solely on its proprietary instrumentation. The technology platform came in handy during the pandemic, and Hologic has skillfully leveraged the opportunity to significantly increase Panther installations, which should pay off over the longer term. Further, Hologic controls roughly 65% of the U.S. digital mammography market and leads the way in 3D mammography. While 3D adoption has slowed, Hologic's clinical data still gives it an edge over its larger competitors, and there are still opportunities to sell ancillary accessories for mammograms and biopsies. 

However, Hologic faces secular and competitive hurdles. Recommended cervical screening intervals have lengthened, reducing Pap smear volume and forcing Hologic to preserve market share against Becton Dickinson. In addition, heavyweights General Electric and Siemens compete in the 3D mammography market, which could be challenging, given GE's entrenchment in select hospitals and ability to bundle an extensive menu of capital equipment.

While material, we think Hologic has done a good job of navigating the competitive pressures. Importantly, the pandemic opened an opportunity for the company to aggressively pursue enlarging its footprint in the molecular diagnostic market. Overwhelming demand for COVID-19 PCR tests allowed Hologic to expand its installed base by roughly 50%. The related boost in cash flow from these tests also opened the door for Hologic to make strategic purchases of a wider array of molecular diagnostic tests, which could pave the way for a more robust stream of recurring revenue after the pandemic that goes beyond Hologic's historical stronghold in testing for sexually transmitted diseases.

Business Strategy & Outlook

We believe Hologic has dug a narrow economic moat based on the switching costs and intellectual property that surround its breast health and diagnostics platforms. Hologic pioneered the first Food and Drug Administration-approved 3D mammography platform in the U.S. Mammography equipment such as this is typically a big-ticket purchase for hospitals and radiology clinics at price tags of $300,000 per digital unit and up to $450,000 per 3D installation, and the time to retrain on systems and reorganize workflow means that customers have little incentive to switch platforms. Furthermore, it will be considerably less expensive for Hologic’s 2D customers to upgrade their equipment rather than switch to a competing system. With a sizable installed base, the firm also reaps the benefits of five-year service contracts that annually cost about 10%-12% of the purchase price. While optional, more than 90% of its installed base falls under contract.

Additionally, lengthy FDA approval processes and the sophistication of the technology are tall barriers that deter new market entrants, though both General Electric and Siemens have received FDA approval for 3D systems. While this adds a new level of competition and could apply some pricing pressure, we think the growing body of clinical data for Hologic's Genius system helps to establish its superiority in the minds of clinicians. 

After acquiring Gen-Probe in 2012 and Cytyc before that, Hologic’s diagnostics division also leverages the high switching costs that surround its proprietary instrumentation and the tests that run on it. Adding to ThinPrep’s leading share in the liquid-based Pap market, Gen-Probe dramatically expanded Hologic’s diagnostic capabilities in HPV, chlamydia, gonorrhea, trichomonas, and blood screening. Once labs commit to the firm’s automated equipment to streamline operations, they run the company’s tests to consolidate workflow to fewer platforms. In addition to the time required to train lab technicians and adjust work flow, steep switching costs are built around instrumentation, with the $150,000 price tag built into per-reagent costs. This molecular diagnostics platform saw a boom during the COVID-19 crisis, and Hologic benefited from demand that significantly enlarged the firm's installed base of machines.

Hologic's 2017 acquisition of Cynosure provided a sizable footprint in the aesthetics market. However, we did not think this medical aesthetics business was worthy of a moat on its own, nor did we think the business bolstered Hologic's moat, because the cosmetic laser market is vulnerable to disruptive technology and has low barriers to entry, relatively low switching costs, and little clinical data to differentiate competitive products. Manufacturers compete primarily on the basis of marketing, which isn't necessarily Hologic's forte, in our view. We've mainly been relieved that Hologic decided to jettison the business three years ago, in favor of focusing on its existing footprints in molecular diagnostics and breast health.

We think Hologic’s remaining segments, surgical and skeletal health, do not have moats. The firm’s hysteroscopic surgical product, MyoSure, has led to pockets of success with strong cash flows. However, lower-cost alternatives have put pressure on its NovaSure product and adverse macroeconomic conditions have resulted in mixed skeletal results. Nevertheless, we believe Hologic’s breast health and diagnostics segments largely outweigh these drawbacks.

From an environmental, social, and governance perspective, we think there's little risk of these factors causing permanent impairment of Hologic's competitive advantages. However, some of the more vulnerable areas of risk would include the high quality standards that diagnostics makers must follow to ensure results are accurate and valid. As we saw with the Theranos debacle, inaccurate test results can lead to inappropriate medical treatment. This risk is mitigated for Hologic, however as its tests and equipment are regulated by the FDA. 

We believe Hologic's exposure to product governance risks has actually diminished now that it has divested its medical aesthetics business. The legacy Cynosure business fell into a gray area; though cosmetic lasers are regulated by the FDA, the use of such lasers is left up to the practitioners. In practice, this means practitioners would often use use those lasers off-label, for conditions or procedures for which they were never approved. This exposure for laser manufacturers is exacerbated by the patchwork of regulation regarding who is qualified to use these lasers, which varies by state. At present, just New Jersey requires that only trained medical doctors can use the lasers. In other states, nonphysicians can also operate these lasers, which becomes risky as the medical spas where many of these treatments take place are only loosely regulated on a state-by-state basis.

By divesting its aesthetic laser business, Hologic has taken a big step away from product governance risk, in our view.

Narrow

Economic Moat

Hologic

Hologic, Inc. engages in the development, manufacture, and supply of diagnostics products, medical imaging systems, and surgical products dedicated to serve the healthcare needs of women. It operates through the following segments: Breast Health, Diagnostics, GYN Surgical, and Skeletal Health. The Breast Health segment includes a portfolio of solutions for breast cancer care for radiology, pathology, and surgery. The Diagnostics segment consists of products used to aid in the screening and diagnosis of human diseases. The GYN Surgical segment involves the NovaSure Endometrial Ablation System, the MyoSure Hysteroscopic Tissue Removal System, and the Fluent Fluid Management System. The Skeletal Health segment covers the Horizon DXA and the Fluoroscan Insight FD mini C-arm. The company was founded by S. David Ellenbogen and Jay A. Stein in 1985 and is headquartered in Marlborough, MA.

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Hologic, Inc. engages in the development, manufacture, and supply of diagnostics products, medical imaging systems, and surgical products dedicated to serve the healthcare needs of women. It operates through the following segments: Breast Health, Diagnostics, GYN Surgical, and Skeletal Health. The Breast Health segment is involved in a portfolio of solutions for breast cancer care for radiology, pathology, and surgery. The Diagnostics segment focuses on products used to aid in the screening and diagnosis of human diseases. The GYN Surgical segment offers the NovaSure Endometrial Ablation System, the MyoSure Hysteroscopic Tissue Removal System, and the Fluent Fluid Management System. The Skeletal Health segment covers the Horizon DXA and the Fluoroscan Insight FD mini C-arm. The company was founded by S. David Ellenbogen and Jay A. Stein in 1985 and is headquartered in Marlborough, MA.

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