Healthcare has been the market’s best-performing sector during the past five years, with many stocks rising 200% or more. However, investors shouldn’t assume that the sector has been fully exploited. While many healthcare stocks have probably topped out for now, others still have room to run. 

For outsized gain potential in the coming years, consider a relatively small, but innovative, medical device company called Natus Medical, Inc. (Nasdaq: BABY).

Shares of Natus have been on fire, thanks to success in the firm’s two main markets, neurology and newborn care. Yet the promise of more growth, with the help of several encouraging new ventures, should propel Natus well beyond its current market value of $1.2 billion.

Founded in 1989, Natus first made its mark in neurology by providing tests for the detection and  monitoring of epilepsy, Alzheimer’s disease and many other neurological disorders. The firm offers multiple varieties of (and adjuncts to) three such tests: electroencephalography (EEG), electromyography (EMG) and polysomnography (PSG).

In a key competitive advantage, these devices typically run on proprietary software or algorithms, which confer unique features, such as a seizure detection program that enables faster, more accurate EEG interpretation. Accuracy is further boosted by a proprietary signal amplifier. Another Natus innovation: a state-of-the-art cortical stimulator that facilitates brain mapping so surgeons can better protect especially delicate areas of the brain during neurosurgery.

Neurology devices, supplies and services account for nearly two-thirds of Natus’ current yearly revenue of about $360 million.

#-ad_banner-#The rest of the company’s revenue comes from newborn care-related products, which also incorporate proprietary technologies. Among these are audio stimulators for the diagnosis of hearing impairment, incubators for premature infants, blankets that emit phototherapy for jaundice (a common condition in newborns) and cerebral function monitors that continually record brain activity in newborns with suspected brain injury.

Going forward, Natus might only generate low- to mid-single-digit revenue gains out of existing offerings. However, the new ventures noted above should help boost sales growth over the long term.

Currently, Natus is in the process of integrating Global Neuro-Diagnostics (GND), a pioneer in mobile EEGs, which was acquired in January 2015. Traditionally, the test is done at a hospital. But GND developed smaller, more portable systems that permit testing in the home or at a doctor’s office.

Prior to the acquisition, Natus had around $7 million in annual revenue and operated primarily in Texas. However, Natus sees the potential to greatly increase sales through a nationwide expansion.

The total market opportunity is quite large. An estimated 10-to-25 million EEGs are performed in the U.S. each year, and insurers may leap at the chance to move many of these tests to more cost-effective healthcare settings.

Peloton, a hearing test service for newborns that Natus launched late last year, also has nationwide possibilities. The service is gradually gaining acceptance by hospitals, which often prefer outsourcing newborn hearing tests, rather than buy the associated diagnostic equipment and perform the tests themselves.

As it gains momentum, Peloton should provide a major top-line boost by increasing revenue per infant to $100. That’s up from the $10 that Natus typically gets for selling disposable earpieces to hospitals that do their own testing. Program operating costs and the loss of one-time diagnostic equipment sales constitute some of the difference. But profits should still be markedly greater than what Natus realizes from the sale of disposables, analysts say.

Last year, 58 hospitals signed up for Peloton and Natus says 100 should be enrolled by the end of the year, with projected revenue of $150,000 per hospital. Management estimates a nationwide market of 3,000 hospitals, the number with enough annual births to warrant outsourced hearing tests.

On the new product front, Natus recently launched Vista EMG, the first ultrasound machine that can be used with an EMG workstation. The product has been getting a good response from neurologists, who appreciate the device’s ability to locate nerves in real time. This permits more accurate positioning of EMG electrodes and, in turn, better quality nerve function studies.

Yet another promising venture is Nicview, a streaming video technology that Natus acquired several months ago. The technology enables parents with an infant in the neonatal intensive care unit (NICU) to monitor their baby on a computer or mobile device when they can’t be at the hospital.

A recent win in the public sector: During the first quarter, Natus was awarded a five-year, $32.5-million contract to coordinate hearing test screenings for the state of California.

The firm’s balance sheet is in excellent shape, with no debt and decade-high cash reserves of $67 million. Free cash flow is also robust and on the rise. The Q1 operating margin of 17% is up from last year’s 16%. Operating margins appear to be on track to hit, or at least approach, management’s 2016 target of 20%.

Risks To Consider: As a medical device provider, Natus depends to a large extent on third-party reimbursements for revenue. Thus, it’s vulnerable to any future healthcare reforms that result in lower payments. Also, annualized earnings growth in excess of 25% over the past five years may be a tough act to follow.

Action To Take –> While earnings growth may slow, this firm is still blossoming. Projected revenue and margin expansion should keep profits rising at more than a 20% pace in coming years. I estimate roughly 100% upside potential for Natus’s stock over the next five years. Though there are no buyout rumors that I’m aware of, the firm would seem to be an appealing and affordable acquisition target for one of the big medical device makers.

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