Investment Decision:  BUY.  I bought 1,000 shares at 15.529 on 10/18/06.

Investment Hypothesis
I view this investment as low risk, modest return opportunity.  EZEM is a small but growing medical product company.  The company has had solid by not stellar income and earnings growth, has a modest market capitalization of 170m and modest valuation measures (P/E ttm 19.87; PEG of 0.86).  The company is not widely followed (four analysts have published opinions), suggesting the company, if it were under-valued, could be small enough to escape notice by many investors.  Further, the company has virtually no debt and almost $40m in cash and short-term investments, suggesting that the company is well protected against any short to intermediate term liquidity crises.

The open question for this company is determine how strong are the prospects for its specific niche in the medical products industry and how well positioned is this company to continue to thrive within this particular niche.  In other words, are the solid revenue and income gains that it has shown in recent years likely to continue and potentially improve?  If the answer to this question is “yes”, this looks like a very attractive investment.

I am still learning about this company, and specifics of this industry are still not completely intuitive to me, but my expectations are that this company will continue to grow both revenue and income at recent historical trends.  If, during my research, I do discover something that is material to the perception I have of this company, I will re-evaluate my investment decision.  I am making the calculated bet that even if there is a material problem that is yet to be discovered, that the company’s valuation is conservative enough that a sudden drop in stock price is unlikely.

Summary of Business

Industry
The bulk of EZEM’s products are used in the radiological examination of the GI tract (via either CT scan (growing) or X-ray fluoroscopy (more mature).  Diseases of the GI tract are a major competent of human mortality and morbidity.  Their annual includes the following summary:

Diseases of the GI tract are considered to be the second most prevalent after cardiac diseases. According to the National Institute of Diabetes and Digestive and Kidney Diseases, 60 to 70 million people each year are affected by digestive disease, leading to more than 234,000 deaths (including deaths resulting from cancer), 14 million hospitalizations (equal to 13 percent of all hospitalizations), 6 million diagnostic and therapeutic procedures (equal to 14 percent of all procedures), 45 million physician office visits, 1.9 million people with disabilities, and costs of $107 billion, including $85.5 billion in direct medical costs and $20 billion in indirect costs (e.g., disability and mortality). According to the American Cancer Society, colorectal cancer is America’s third most common cancer in both men and women, and is expected to account for nearly 55,170 deaths and 148,610 newly diagnosed cases in 2006.

As the US population ages, one can reasonably expect that GI radiological exams will increase.  EZEM’s products are markers in GI radiological exams, both in CT and X-Ray fluoroscopy.  In further analysis I hope to better understand their competitors, technological change in the field and impact of governmental and insurance re-imbursement on their procedures.  At this depth of analysis it would appear that the industry niche is due to grow steadily.

Medical Process Involving CT Scans/X-Ray Fluoroscopy
Based on conversations with medical professionals, I have developed a limited understanding of the medical process that involves barium contrast agent that EZEM sells.  CT and X-Ray fluoroscopy are very similar processes, with CT being better but somewhat more expensive.  Both of these basically allow the doctors to get a broad view of the GI to help with a general diagnosis.  For example, if a patient something wrong in their GI but the physician is uncertain what it is, they will often perform a CT to get a broad view of what the GI tract looks like.  The more specific the illness or diagnosis, the more likely the physician will use a colonoscopy (inserting a camera into the GI tract).  The colonoscopy has the advantage of being able to get a much better picture of particular areas and also allows additional medical procedures, such as biopsies and cauterizing.  In fact, for the purposes of screening (patients that are at risk for GI disease but without symptoms), colonoscopies are generally preferred because they provide a much more detailed view of the GI tract, potentially finding things that would be missed by the CT scan.  Or, as one physician put it, if you do a CT scan or a virtual colonoscopy (basically a better CT scan), and the physician finds something, they are going to do have follow up with a colonoscopy anyway, so they often recommend skipping the initial CT scan.

This business is rather steady, should gradually expand and there does not sound like there is anything imminent that would replace barium contrast agents as an integral part of CT imaging and X-Ray fluoroscopy. 

Virtual Colonoscopy
A virtual colonoscopy is basically a better CT scan, but it is accompanied by sophisticated software to give a more detailed, reliable view of the GI tract than a CT scan.  As the name suggests, its goal is provide as accurate a view of GI tract as a traditional colonoscopy.  The advantage of the virtual colonoscopy are cost and ease of administration.  The virtual colonoscopy does not require a specialist to be present, any sedation of the patient and the subsequent observation of the patient.  Both of these make a virtual colonoscopy roughly ½ to 1/3 the cost of a traditional colonoscopy, and that gap ought to widen as virtual colonoscopies gain operational scale.

An area of potential huge growth for virtual colonoscopies is with screening.  As mentioned above, CT imaging and X-Ray are used in specific situations, and that is steady, growing but not quickly expanding industry.  A potentially huge area is screening of patients for colon cancers and other diseases.  This generally first occurs with patients that 50 or older, and several times subsequent to this.  This screening is for the “average Joe/Jane” who does not have any symptoms or family history.  For those with symptoms or a family history, traditional colonoscopies will most likely remain the means of screening.  For the “average J/J”, which is the vast majority of the patient population, the current method is via colonoscopy.  This is a rather invasive procedure and it has to be administered by a GI specialist.  From the people I have spoken with, the current view is that in 5-10 years, 5 is more likely, almost all of these will be replaced by virtual colonoscopy. 

There is some controversy within the profession about virtual colonoscopy.  First, there exists some skepticism about the quality of science, many feeling that only true colonoscopy can do a proper screening.  My contacts suggest this is a reasonable position, but expect the quality of virtual colonoscopies to continue to improve.  There is a somewhat controversial medical journal study that shows that even with the current quality of virtual colonoscopies, they match colonoscopies for effectiveness in screening.  Second, these screenings are good business for GI specialists, so there is some resistance to having such a stable part of their business disappear.  Many feel these fears are misplaced; the increased screening will most likely lead to more diagnoses of GI problems, creating plenty of work for GI specialists.

In summary, virtual colonoscopy promises to be a huge area of growth.  First, there is the swapping out of traditional colonoscopies for virtual ones with the existing levels of screening.  Second, the level of screening expects to increase both because the current level of screening is under-penetrated and as baby-boomer population continues to age, the target universe will increase.

My sources did say that all virtual colonoscopies are not the same.  The software algorithms used to create the virtual view of the GI tract vary, some are good, some are bad.  It is unclear at this point how EZEM’s products stack up against the competition.  What is fairly clear, though, is the pie from which they are fighting for a slice will be growing rapidly.

Position Within Industry
In both CT Imaging and X-Ray Fluoroscopy, EZEM competes with Mallinckrodt (Tyco), GE Healthcare and Bracco.  Currently, I have neither the market share of these various firms by product type nor a good sense of how these companies compete against each other.  My default assumption is that nothing is in major flux on their position within the industries.  This will be the primary area of further research.

While I currently do not know the market shares of the contrast agents, it is my understanding that there is little product differentiation between EZEM’s contrast agents and those of its competitors.  They are all barium based and very similar.  The purchase decision is typically made by a buyer of a large health care provider where price is a major factor in the purchase decision.  More research of the buying process needs to be done to better understand the purchase decision factors.

Summary of Financial and Other Measures of EZEM

Income Statement (Latest 4 Years)
In 2004, EZEM spun off an 84% owned subsidiary (AngioDynamics, ticker:  ANGO), so the income statement shown has separated out AngioDynamics from the data.

 

Sales:
The bulk of EZEM’s sales come from X-Ray fluoroscopy (seeing “live” x-ray images) and CT scans.  CT is growing much more rapidly, eclipsing X-Ray fluoroscopy in 2005.  The particular strength of sales in 2006 was due, in part, to a product recall from Mallinckrodt (owned by Tyco) that buoyed both X-Ray fluoroscopy and CT sales.  Mallinckrodt has re-launched its competing products. Angio Dynamics (ANGO) was a business they spun off in 2004.

EZEM has been gradually improving its profitability, increasing gross profit at a faster rate than operating expenses.  The company’s guidance for 2007 shows strong revenue, but a slight drop in profitability.

Note:  net income figures without ANGO prior to 2003 could not be determined.

When one examines the same data but focuses on percentages, this highlights the improvement in profitability. Q1-2007 showed steady profit margin but a drop in net income driven by operating costs.  This drop in net income tracked the projected dip estimated by management.

Balance Sheet

The balance sheet gives me confidence that this company will not be facing any liquidity problems very soon.  Also, inventory does not seem to be expanding too rapidly.

Areas To Further Research:

• Industry drivers of both X-Ray fluoroscopy and CT for niche products
• Detailed understanding of medical process that involves their products
• Market share of their products
• Purchase decision by large
• Positioning and differentiation vs. major competitors
• Drivers of operating expense; can one expect the costs to stay relatively flat vs. revenues?
• Detailed review of executive compensation, comparing against other small cap companies