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Prospering in Women's Health Care

By Robert Gold We at Standard & Poor's Equity Research are positive on the overall health-care sector, which is why we now recommend that investors overweight their exposure to the group. And we think that within the sector, one of the most compelling subgroups is the medical-equipment industry, with Cytyc (CYTC

; recent price, $22.60) among our top selections. The stock carries S&P's highest investment ranking of 5 STARS, or buy.

We're especially positive on Cytyc after its acquisition in March, 2004, of privately held medical-device outfit Novacept for a net price of $311 million. We think the deal is strategically important for Cytyc, as it extends its reach in the women's health-care market and provides an exciting new growth vehicle.

BETTER TESTS. Cytyc derives the majority of revenues and earnings from the sale of its ThinPrep Pap Test for cervical cancer screening, a product that received Food & Drug Administration marketing approval in 1996 as an alternative to the conventional Pap smear. Industry sources estimate that more than 110 million Pap tests are performed annually worldwide, with about 50 million in the U.S. alone. Widespread and regular use of the conventional Pap smear has been credited with helping to reduce mortality associated with cervical cancer in the U.S. by more than 70% since the late 1940s.

However, the U.S. Health & Human Services Dept. estimates that false-negative results occur in about 49% of conventional Pap tests. Based on more than 50 major clinical studies conducted since 1996 and published in peer-reviewed journals, ThinPrep consistently demonstrates statistically significant increases in the detection of high-grade cervical lesions -- the immediate precursors to cervical cancer -- while simultaneously reducing false negatives.

In June, 2003, the FDA approved Cytyc's ThinPrep Imaging System, an automated imaging and review system for use with ThinPrep slides. The system automates the process of preparing cervical specimens, thereby enhancing the quality of slide preparation and diagnostic accuracy, and boosting productivity at the lab level. During 2003, the Centers for Medicare & Medicaid Services (CMS) established a specific reimbursement code for the screening of thin-layer preparations using an automated system and set the price at $37.

MATURE BUT GROWING. The ThinPrep System also serves as a platform for additional gynecological applications, including FDA-approved tests for the sexually transmitted diseases chlamydia trachomatis and neisseria gonorrhea. Cytyc has also received FDA approval for human papillomavirus testing.

Since Jan. 1, 1998, Cytyc's lab customers have been able to request reimbursement for the ThinPrep test from health-insurance companies at about $28 per test, nearly double that for the conventional Pap smear, which has, in our opinion, helped boost market conversion to this technology. Although we believe that the ThinPrep Test is nearing maturity, with an approximate 70% share of the U.S. Pap market, we think that Cytyc can continue to generate growth in cervical cancer screening during 2004. In our opinion, this will result from modestly higher testing volumes and rising sales of the ThinPrep Imaging System.

We believe Cytyc will have more than 120 imagers placed at customer sites during 2004, and we're forecasting imager sales of $20.5 million for the year. In the U.S. alone, we're looking for ThinPrep revenue of $275 million, which assumes volume growth of 200,000 units per quarter and stable pricing at about $7.50 per slide.

BILLION-DOLLAR MARKET? Recently acquired Novacept has developed an FDA-approved device to treat menorraghia, also known as excessive menstrual bleeding. The NovaSure System incorporates a hand-held, single-use device that includes a flexible, metallized-mesh electrode used to deliver radio frequency energy to safely remove the endometrium, or lining of the uterus, which is responsible for the occurrence of excessive menstrual bleeding. In January, 2004, CMS raised the reimbursement rate for this procedure from $983 to $1,535, which we believe will help fuel market adoption of the technology.

Cytyc estimates that the global market opportunity for NovaSure is approximately $1 billion. We believe the deal will add approximately $45 million to 2004 sales and $100 million to 2005 sales. We estimate that it will dilute 2004 earnings per share by 1 cent and add 5 cents in 2005.

For 2004, we see product sales totaling $390 million, up from $303 million in 2003, which includes $45 million of NovaSure sales. We project ThinPrep Pap Test revenues of $310 million, up from about $288 million in 2003, and believe ThinPrep Imager revenues can approach $21 million. Sales of other products are seen at $7.2 million.

WIDE DIVERGENCE. In our opinion, net margins in 2004 are likely to compress, as the higher sales are accompanied by an expected spike in selling, general, and administrative spending in the second quarter in support of NovaSure, along with interest costs associated with $250 million in convertible notes issued to help fund the Novacept purchase. Share buybacks are not anticipated during the first half of the year but could resume in the second half.

After taxes at an effective rate of 39.5%, we see 2004 earnings per share of 79 cents, and project 2005 EPS to reach $1. We believe five-year earnings growth will be be approximately 20% to 23% annually.

Our S&P Core Earnings estimates are 33 cents per share for 2004 and 47 cents for 2005. The respective differences of 58% and 53% from our operating forecasts reflect Cytyc's use of stock-option compensation for employees. The divergence between the two estimates is high relative to our overall medical-device universe. However, the differential is roughly in line with similar small-cap, niche medical-device names in our research coverage. The company has no defined benefit pension plan.

BETTER MULTIPLES. In our opinion, the Novacept deal represents an important catalyst for share-price appreciation, as it offers a highly visible new growth opportunity amid a maturing ThinPrep market. We think the Novacept deal was an excellent fit from an operational standpoint, with products that can be marketed by the existing Cytyc sales force and leveraged as the company builds out its women's health-care franchise. We believe that this transaction will help drive meaningful expansion in Cytyc's p-e multiple over the coming 12 months.

The stock recently fetched 22.6 times our 2005 EPS forecast, a steep discount to the average 2005 price-earnings ratio of 27 for similar small-cap medical-device names in our coverage universe. The shares' 2004 p-e-to projected five-year EPS growth ratio of 1.3 was significantly below the peer-group average of 1.7.

As a result of the Novacept acquisition and other strategic initiatives, we believe visibility on Cytyc's forward sales and earnings is at least on par with its peers. We believe that the shares should command a similar valuation. Our 12-month target price of $27 assumes a 2005 p-e multiple of 27, in line with the peer average. Our

discounted cash-flow (DCF) analysis estimates present intrinsic value at $26 per share, and intrinsic value 12 months from now at $29.

CONTRACT RISKS. In our opinion, the principal risks to our investment opinion and the stock achieving our 12-month target price are centered around Cytyc's ability to sustain share in the cervical cancer market, to successfully integrate the operations of Novacept, and to broaden the operational reach in women's health care and other markets.

Third-party reimbursement decisions should remain a risk element, as is Cytyc's relatively high dependence on contracts with clinical laboratory operators Quest Diagnostics (DGX

; S&P Rank 5 STARS; recent price, $83) and Laboratory Corp. of America (LH

; 4 STARS, accumulate; $39).

Other potential risks include adverse outcomes in product-liability lawsuits or intellectual-property disputes, as well as a broader stock weakness in the medical-device sector. Analyst Gold follows stocks of medical-equipment companies for Standard & Poor's Equity Research

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