Small-cap companies are supposed to release bad news when fewer investors are around: late on Friday afternoon or in the December/January holiday season. Not excellent trading updates when most investors are still on holidays and less likely to read the news!

That was not entirely the case when impressive medical-stgice distributor LifeHealthcare Group issued a bullish trading update on January 12. Although LifeHealthcare spiked 30 per cent on the news, the gains may not be over in the medium term as the market better understands its performance and reappraises its prospects.

I wrote about the well-run LifeHealthcare Group for The Bull in May 2014 at $2.25 a share, in “Stocks to cash in on an ageing population” and mentioned it again in July in an IPO story for The Bull. LifeHealthcare is now $2.58, having rallied as high as $2.79 after the trading update.  

I wrote in May: “… LifeHealthcare looks a solid long-term investment for portfolio investors who want exposure to medical-stgice companies, without the higher risk of backing emerging lifescience companies. LifeHealthcare offers the best value of recent healthcare IPOs.”

Frustratingly, the other main stock mentioned in that article, Japara Healthcare, has fallen from $2.60 in May to $2.01.

Chart 1: LifeHealthcare Group

Source: ASX

To recap, LifeHealthcare raised $76.6 million through an IPO in December 2013 at $2 a share. Founded in 2006 through six acquisitions of medical-stgice companies, it distributes high-end medical stgices in Australia and New Zealand and works closely with surgeons, hospitals, nurses and other medical specialists.

Unlike a Cochlear or a ResMed Inc, it does not research, design or build stgices. It mostly distributes high-end medical products made by others, meaning it does not have the same upside as a successful medical-stgice maker, or the higher risk that comes with that sector.

Its sustainable competitive advantage is strong relationships with surgeons who use the stgices it distributes, and its position in a global network of medical-stgice suppliers, hospitals, surgeons, private health-insurance providers and patients.

LifeHealthcare’s trading update in January reinforces its potential as one of the market’s more interesting micro-cap healthcare stocks. Management expects unaudited underlying earnings of $8.4 million in first-half FY15, and after-tax net profit of $4.3 million – substantially higher than at the same time in FY14 well up on prospectus forecasts.

Strong growth in its implant business and capital equipment led to higher profit margins, and strategies to mitigate the weaker Australia dollar (relative to the US) have worked.  As trading updates go, it was a beauty, given difficult general trading conditions in a sluggish economy.

One line in the update stood out: “Growth in implantable-stgices revenue has been achieved through an increase in the number of surgeons using LifeHealthcare’s implants and increasing penetration of its products among new and existing surgeons. This has been supported by a number of new product introductions and recruitment of further experienced sales staff.”

Growth in its surgical customer base is a critical metric to assess LifeHealthcare. Surgeons are the key customers for its distributed stgices and have great influence over what stgice is used for patients, usually more than the hospital.

LifeHealthcare defines “active surgeons” as those generating more than $50,000 in annual revenue and its FY14 earnings presentation showed 89 active surgeons, up from 83 a year earlier.

The trading update did not elaborate on the current number of active surgeons using LifeHealthcare products (more will be known when the half-year FY15 result is released in late February). But such strong growth in performance, and its general commentary, implies good market penetration and/or growth in surgeons who are below the $50,000 threshold.

The recruitment of experienced sales staff also bodes well. These are highly trained individuals, often with specialised medical backgrounds, who sell to surgeons, specialists and hospitals, and also provide support services. LifeHealthcare’s investment in human resources in existing and new growth segments, noted in its last full-year commentary, is paying off.

One can envisage faster growth as LifeHealthcare increases its customer base of “active surgeons” and distributes more implantable stgices, such as orthopaedic and prosthetic products, amid an ageing population. The result should be higher margins and profits, a higher intrinsic value, and over time a higher share price, although some share-price pullback is likely after such strong recent gains. LifeHealthcare looks fully valued, at least in the short term.

Long term, it’s a great business when it works. As LifeHealthcare grows, it can offer a wider range of medical stgices to surgeons, and its independence means it is not bound to any particular stgice. Its size also means more support services for surgeons and more touchpoints within the medical community. This provides greater opportunities to cross-sell stgices.

These relationships, once stgeloped, tend to be “sticky” as surgeons stick with stgices and distributors they know, and over time use more products through the same distributor. The upshot is a business that although in an area with seemingly low barriers to entry, given it distributes products made by others, has built a formidable, sustainable advantage on the strength of its people and relationships with surgeons.

As a $108 million company, with just over a year of history as a listed entity, LifeHealthcare suits investors who are comfortable with micro-cap stocks. But there are worse ways to play demand for medical stgices in an ageing population.

Tony Featherstone is a former managing editor of BRW and Shares magazines. This column does not imply stock recommendations. Readers should do further research of their own or talk to their adviser before acting on themes in this article. All prices and analysis at January 21, 2015.