Two Rising Small-Cap Stars

02/27/2008 12:00 am EST

Focus: STOCKS

Stephen Biggar

Director, Product Strategy, Argus Research Corporation

Stephen Biggar, global director of equity research at Standard & Poor’s, cites two small-cap stocks that are priced attractively and earn S&P’s top five-star rating.

Covance (NYSE: CVD) is a contract research organization (CRO) that should continue to grow over the next several years. That’s because pharmaceutical firms are using more outsourcing to save on costs, and global CROs are able to expedite drug development by conducting simultaneous global clinical trials.

We believe Covance has a well-balanced mix of early-stage (50% of revenue) and late-stage (50%) development services. We see net sales rising 14% in 2008 to $1.8 billion on continued [double-digit] growth in early- and late-stage development.

We expect the rebound in central lab operations (roughly two-thirds of revenues) to continue following weakness in the first half of 2007. We also expect Covance to increase its concentration on Phase II and Phase III testing, which has not historically been a focus. But additional Phase II and III testing may increase sales but [hurt] margins, as it is more labor intensive [than] lab operations.

We estimate 2008 earnings at $3.21 a share, a 21% increase from 2007. Risks include the potential for increased project cancellations, a reduction in pharmaceutical and biotech research & development spending, and a slowdown in drug-development outsourcing. Our 12-month target price of $98 assumes a three-year earnings growth rate of 20% and a [P/E-to-earnings-growth] (PEG) ratio of 1.5x, in line with peers, applied to our 2008 earnings estimate. (So, 1.5x 20 x $3.21 equals $96—Editor.)

The shares lost 4.1% through February 14, outperforming the 7.1% decline in the Standard & Poor’s MidCap 400. (They have rebounded a bit to close Tuesday above $86—Editor.)

Shares of Hologic (NASDAQ: HOLX), which makes high-end diagnostic and medical imaging equipment focused on women’s health care, lost 9.3% through February 14th. (It closed near that price, at $61.50 Tuesday—Editor.)

Despite this, we believe the company’s fundamentals have never been stronger, and we continue to recommend purchase. In our opinion, the acquisition of Cytyc in late 2007 created one of the most diversified “pure plays” in women’s health care, with a reach extending to digital-mammography equipment, bone-density measurement, cervical cancer screening, treatment of excessive menstrual bleeding, and radiation therapy.

Sales of the company’s Selenia full-field, digital mammography equipment drove most of the company’s growth in recent years, and we expect this trend to continue since the market remains only about 20% penetrated. In addition, we think the company’s new tomosynthesis technology, which is used for breast-cancer detection, will help boost market share and support higher selling prices globally.

Standard & Poor’s sees fiscal 2008 (ending September) revenues of $1.8 billion and earnings of $2.30 a share. We project that Hologic will grow earnings at a compound annual rate of 27% over the coming three years, which should far surpass that of its peers.

Based on forward price-to-sales and price-to-earnings valuations in line with the company’s small-cap peers, our 12-month target price is $75. Risks include changes to Medicare and/or private insurer reimbursements and reduced clinical usage of digital mammography.

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