Description

CryoLife (CRY) is a mature Medtech company (operating in mature-to-declining markets); and yet, it's trading like a high-flying growth company. Currently at nosebleed multiples (~50x NTM P/E; ~16x EV/NTM EBITDA), CRY’s stock price both ignores competitive risks to its newly-acquired mechanical valves, or On-X, business and overstates the potential growth drivers behind its surgical adhesive product lines.

INTRODUCTION

Medical Device companies in the U.S. are facing some of their toughest prospects in years. The go-go six years that began when Obamacare was signed into law in March 2010 have encountered some serious speed bumps; and yet, valuations do not reflect this fact. Decelerating and more limited top-line growth (U.S. Medical Device ETF “IHI” members LTM y/y sales growth, for example, decelerated 80 bps to 8% from its ~8.8% CAGR over the previous 4 years), cost pressures throughout the healthcare system, fewer opportunities to raise prices due to increased regulatory scrutiny that could potentially lead to legislative action, volume growth at more mature levels in developed markets – this is the new norm. And yet, Med tech multiples are standing at multi-year highs.  For example, take the U.S. Medical Devices ETF (Ticker: ITI), which is currently trading at a record high. Its 47 members are trading for a median EV/NTM EBITDA multiple of 14x (which compares to 9x five years ago).

Exhibit 1: IHI Equity (U.S. Medical Devices ETF)

Exhibit 2: CRY is capturing significant premium multiple to its U.S. medical device peers, despite its inferior margins and lower sales growth over last 5 years.  

As a result, over the next five years U.S. Medtech companies broadly are likely to experience lower revenue growth, less R&D efficiency, and more gross margin pressures than they have over the previous five. According to a recent Morgan Stanley research report, and we agree, these realities will place more of an onus on these companies to leverage their distribution to offset pricing pressures, use M&A, and look to emerging markets for growth.

Against this gloomy backdrop, it is jarring to see a ~$380mm medical device company that has been around for more than 30-years, and that operates in the mature tissue and mechanical heart valve markets, is devoid of any real innovation, and instead has turned to M&A for growth, trading for ~50x NTM earnings!

The bullish hype underpinning this stratospheric valuation for the Medtech company, CryoLife (CRY), is the belief that with its recent acquisition of On-X (maker of mechanical heart valves) – and the benefits of improved labeling that this company’s primary product now enjoys – CRY will be able to gain market share against its more well-entrenched, bigger competitors in this space, companies like St. Jude (STJ), The Sorin Group, and Medtronic (MDT).

But in its ebullience, the market is overestimating CRY’s potential for not only market share gains in the mechanical valve market, but also the size/market growth rate for the mechanical valve market itself.

The first has to do with the fact that cardiologist are a conservative bunch – and gaining share with this customer base requires changes in behavior that are extremely hard to come by.

The latter point has to do with the rise of a new technology (Transcatheter Aortic Valve Replacement, or TAVR), which is a less invasive procedure for treating valve heart problems than is the open heart surgery needed to implant mechanical heart valves. Originally, it was believed TAVR would be limited to a small demographic slice of “high risk” (i.e. very old) patients, who simply could not receive open heart surgery. But recent findings suggest the market for TAVR procedures is far larger than previously believed, and could include low and intermediate risk patients as well.

If so, this means TAVR surgeries could ultimately begin to cannibalize the market for mechanical valves – which would mean the kinds of market growth and market share gain expectations buoying CRY’s current stock price will prove overhyped.

Important to note, TAVR has become a huge growth area for well-capitalized behemoths like STJ and EW. Also, all the growth in this technology that these companies have achieved has occurred despite a very unfavorable reimbursement regime for TAVR (i.e. the hospitals lose money on this procedure, but do it anyway because it is often the right thing to do for their patients). But this reimbursement regime could improve, providing yet another gust of wind in the sail of a technology that has the potential to take significant share from one of CRY’s core products, and from the product that is absolutely essential to its growth prospects. The growth of TAVR also makes it tough for CRY to gain market share on the likes of STJ in the mechanical valve market, since STJ often provides volume discounts across the bundle of its product offerings. Consequently, a hospital will be far less likely to switch their mechanical valve maker (especially for a labeling claim that has yet to withstand 6+ year follow-up data test), especially if it meant jeopardizing both the price and expediency with which they could access the more promising TAVR technology from the likes of a STJ.

With the niche tissue valve business in a mature state, and the prospects of CRY’s surgical adhesive product BioGlue not enough to support the current stock price, the only chance at all for CRY’s stock to maintain current valuations is from the realization of vast amounts of revenue synergies (i.e. market share gains) from the recently acquired On-X product, specifically through a more efficient leveraging of CRY’s combined pro-forma salesforce. Any synergies to be wrestled out of the integration of On-X, however, are unlikely to ever justify the frothy 4x EV/Sales (and ~14x EV/LTM EBITDA by our estimate) CRY paid for this company. Further, the double-digit top-line CAGR they are targeting for On-X will come up against a slow-moving, conservative cardiac surgeon population and the increasing popularity and broadening targeted patient demographic for the newer and less-invasive TAVR method. Therefore, we think that CRY taking their net leverage up to over ~1x (in addition to diluting equity shareholders by ~13%) to dramatically overpay for On-X will ultimately destroy shareholder value. We think CRY could be worth as little as $6.75-$7.25 per share by 2020, for a 14% IRR (applying a very generous 1.5x EV/Sales and 20x NTM P/E to our 2020E).

INVESTMENT HIGHLIGHTS SUMMARY:

CRY Overpaid for On-x; growth prospects for combined company are dramatically overstated: We are skeptical of the baked-in expectation that On-X can take market share from bigger, more formidable competitors in a mature (and arguably declining) mechanical valve market, where customers (cardiac surgeons) are extremely conservative, and reticent to make equipment vendor changes.

On-X labeling as of now are not enough to spark significant change in behaviors: We believe CRY’s 375-person, ~3.8 year average follow-up RCT data (in 2014) is unlikely to drive any meaningful change in cardiac surgeon buying behavior, which it needs to do for CRY to achieve the degree of market share gains currently embedded in consensus expectations.

TAVR will likely cannibalize On-X share of market: The growth of TAVR procedures, and their ability to cannibalize the “intermediate risk” patient market (the broadest patient demo for any kind of valve replacement procedure – especially mechanical) also makes the $130mm that CRY paid for On-X seem far too aggressive.

Other products – and their growth potential in Asia and Europe do not justify multiple: We believe the potential for these businesses are much more limited than popularly believed. In many cases CRY is just a distributor of the product (PerClot). Also, the potential approvals in new geographic territories for these products is fraught with delays and risks. Thirdly, we believe recent elevated levels of inventory for CRY are perhaps suggestive that these products are not turning to the degree management expected they would (see “Earnings Quality” section below). Finally, the surgical sealant products (vs. tissue and mechanical valves) compete with much larger and more formidable companies: J&J, Pfizer, and Baxter (vs. Medtronic, St. Jude, and The Sorin Group on the mechanical valve side).

Poor earnings quality/Insider sales: Both CRY’s Days Sales Inventory "DSI" and Days Sales Outstanding "DSO" have been on the rise (with their elevated inventories more troublingly dedicated to their supposed growth – i.e. non-tissue – markets). Poor working capital management has translated to deteriorating cash conversion, and generally paltry FCF generation, over the years. Also, CRY has been a regular equity issuer due to the lack of cash flow that their business generates, resulting in significant dilution to equity holders. Finally, the founder of CRY has been an active seller of his holdings in recent years.

COMPANY OVERVIEW

CRY has been around since 1984 – and so, they’re no spring chicken. CRY is a medical device company, who has historically focused primarily on the tissue preservation of cardiac and vascular tissue (human and bovine) used in open heart and other types of surgery.

Exhibit 3: Revenue by Product (with On-X)

When a patient needs a heart valve transplant, they would get one of two type of valves: a tissue or mechanical valve. The former is human tissue (some of CRY’s products are derived from bovine tissue). The latter is a mechanical contraption implanted in the heart. Whether a heart patient gets a tissue valve or mechanical valve usually depends on the age of the patient (and therefore expected life and what stage of their heart’s growth cycle they are in), the patient’s lifestyle (i.e. those with a more active lifestyle are more at risk being on warfarin, which is part and parcel with getting a mechanical valve), and a weighing of the risks of potentially having to undergo a second surgery (i.e. to replace a tissue valve at the end of its expected life).

A general rule of thumb regarding what kind of valve a patient gets is as follows: a pediatric patient and a very old patient are most likely to get a tissue valve. A pediatric patient cannot get a mechanical valve, because their heart is still growing. An elderly patient is not likely to outlive a tissue valve, and also being on warfarin can increase the risk of stroke for an elderly patient. A middle-aged patient is more likely to get a mechanical valve, because they would likely outlive a tissue valve – and therefore would have to subject themselves to the risk of re-surgery.

Talk to CRY, and they would tell you anyone ages 40-65 that needs a valve replacement is going to get a mechanical valve. The development of a new procedure (TAVR – more on this later) will present a different option for many patients in this age group over time in our view – one that does not require open heart surgery. While the above intervention algorithm is over-simplified, we believe it is an illustrative framework for the discussion ahead.

Tissue business

CRY’s tissue preservation business is unique in that by law companies cannot buy and sell human tissue. So instead of “buying” tissue and calling it “inventory”, CRY “preserves” tissue and records it as “deferred preservation costs” (i.e. the capitalized value of the tissue they will ultimately transfer back to a recipient hospital in return for a “preservation service fee”). So effectively they are taking in human tissue that is being held and preserved to ultimately be used in the surgery of another human, but by quirk of law and statutes, the language CRY uses to describe this activity is not as straight forward.

Also, one more note about the tissue preservation business – it’s as you might imagine fraught with potential liability. Because human tissues under the care of CRY have the potential to become contaminated, they are heavily monitored by the FDA. If a contaminated tissue found its way into a recipient, the consequences could obviously be grave. In 2013, CRY received a FDA warning letter related to its tissue business, hampering this segment’s operations. The warning letter concerned their handling of the tissues under their care – and was not resolved until Q115. Tissue sales perhaps not coincidentally peaked in 2013, and have not yet returned to that peak:

Exhibit 4: Tissue Sales by year  

Tissue sales grew at a 3.3% CAGR from 2009-13.  Tissue sales declined at a 1% CAGR from 2013-15, presumably due to lingering impacts from the FDA warning letter.

There is certainly always the risk of further such FDA action, or of CRY mishandling tissues, and subsequent lawsuits. Also, this business is working capital intensive. And finally, it’s a niche, mature market with no real growth opportunities.

Products

Over the years, CRY diversified into the sale of certain surgical adhesives and products that complemented their core tissue product. The idea being that since CRY’s medical sales reps made calls on heads of cardiac surgical departments, they could also easily drop one more tool in their tool box (and hopefully add a few items on to each given order with their cardiac surgeon/hospital buying group customers). In some cases, the product that CRY is selling is one they own (BioGlue and PhotoFix), and in other cases they are merely a licensed distributor (PerClot). While these products have bigger addressable markets in some instances than tissue valves, CRY is up against even more formidable competition for these products (Pfizer, J&J, and Baxter) than they are in their other product lines.

Expanding further beyond the core

Two years ago, a new CEO took the reins at CRY – Pat Mackin. 49-year old Mackin joined from Medtronic (MDT), where was Senior VP & President in their Cardiac Rhythm business. Sell-side’s reception of Mackin has generally been favorable; but this is his first time in the skipper role. One of his boldest strokes as head of CRY to-date was to acquire his way into a market that historically CRY had chosen not to play in: mechanical valves. Mackin did this through acquiring a mechanical valve company called On-X in January 2016. CRY purchased On-X from a strategic, Paul Capital. Paul Capital took a combo of cash and CRY stock (but per 6/21 13G/A filing, they’ve been selling CRY stock. Their lock-up expired in April).

The governing thesis of this acquisition is that On-X has the potential for significant growth, despite the fact the mechanical valve market is mature (we would argue declining – see TAVR section below). The reason Mackin believes On-X can gain market share vs. its bigger competitors (Sorin Group, MDT, STJ) is because On-X will now have the benefit of increased labeling claimed thanks to results from a recent RCT trial that they funded. Also, Mackin believes there are revenue synergies to be had from the fact that On-X products will now have access to a bigger, dedicated, and integrated global direct sales force under the CRY umbrella.

The below sales bridge aims to represent the consensus sales view for CRY by product line – and shows how important On-X market share gains/growth is to the prevailing view.

Exhibit 5: Bridging to consensus sales – it’s all about On-X.

We believe, however, that consensus is vastly overstating the potential growth opportunities in front of CRY. Also, in no way do we think the prospects for On-X justify the hefty ~4x EV/Sales (And 14x EV/LTM EBITDA by our estimate) that Mackin paid for On-X. And so, the On-X move seems more an act of desperation by a first-time CEO, who is eager to find new sources of growth (no matter the price) in the face of mature core markets, than it does a stroke of savvy capital allocation.

INVESTMENT HIGHLIGHTS DETAILED

CRY Overpaid for On-x; growth prospects for combined company are dramatically overstated

CRY’s acquisition of On-x, which closed in January 2016, for $91mm in cash and $39mm in CRY common stock, amounted to a ~4x EV/Sales multiple. On-X grew double-digits in recent years, and CRY management believes the company, under their watch, can continue this above-market growth rate. Sell-side is equally optimistic on the deal. Piper, for example (who advised on the deal mind you), argues, “We believe the acquisition provides CRY a platform for improved revenue growth and margin expansion with our model projecting double-digit revenue growth for On-X products through 2020.”

We believe this is far too optimistic. We will outline why in detail below. The above assertion rests primarily on the idea that On-X can take market share from bigger, more formidable competitors, and that the total addressable market for mechanical valves is not shrinking. We think mechanical valve customers (cardiac surgeons) are extremely conservative, and reticent to make equipment vendor changes. Further, we believe the market for mechanical valves will decline MSD. And we believe it unwise to extrapolate any of On-X's share gains realized to-date.

STJ has made comments that they will be de-prioritizing their mechanical valves business going forward in favor of more promising, higher-growth markets, which is perhaps underpinning the expectations expressed in the below Exhibit 6. STJ said this, however, because they think mechanical valves are a "mature product" in a declining market, mainly because more patients are opting for tissues valves in place of mechanical valves. On-X is not immune to these trends - and the share gains expected of them are even more pronounced when you consider the end-market they operate in is declining.

Exhibit 6: Canaccord expects CRY’s share gains to come at the expense mainly of STJ in the U.S. and LivaNova and STJ internationally.

Also, On-X is believed to operate with superior Gross Margins than CRY’s legacy business (~70% worldwide; 90% in U.S.). Important to note, though, CRY will be selling On-X through combining the two salesforces (17 CRY sales reps in US plus 33 On-X sales reps in US plus 23 CRY sales reps abroad with plans to add up to 7 more in those markets by 2018, and getting up to a possible 91-100 direct sales reps worldwide over time. On-X uses distributors exclusively abroad as of now). They have talked about revenue synergies from each member of the sales force “cross-selling” the products of the other company to their clients. They have not quantified any specific cost synergies.

According to Canaccord, “Second, the acquisition should elicit operating margin expansion going forward – On-X gross margin currently running at ~70% worldwide (over 90% in the US), which compares favorably to CRY’s corporate average in the low-60s.”

This is based on management guidance of:

The On-X products carry very attractive gross margins. In the U.S., we expect gross margins to be close to 90%. Internationally, we expect to drive margins higher as we transition from a distributor model to a direct sales model in select geographies over the next few years. We expect the acquisition to immediately benefit revenue mix and our growth trajectory which should, in turn, drive gross margin expansion and double-digit compounded growth and adjusted non-GAAP earnings from 2016 to 2020.

The implicit guidance here is that the 90% targeted gross margin in U.S. will come merely from higher revenue growth, not from any reduction in redundant costs. The salesforce reduction that CRY initiated after the merger (about 9 people in U.S.) was more pent-up deferred attrition at CRY, than it was reduction of redundant workers. During the salesforce realignment strategy transition, we believe CRY merely deferred the decision to make changes to their work force, knowing their salesforce would be realigned as part of the integration.

Note: On-X sales are currently ~50/50 US/International. US mechanical valve market is $80mm (i.e. On-X 21% share), and International is $140mm (i.e. 12% share), or ~15% share of the worldwide market.

We do not know precisely how this GM% guidance for On-X business (70% worldwide; 90% in U.S., with 50/50 sales split) will flow through to EBITDA, but we would guess that On-X has higher operating expenses-to-sales, given it is slightly lower ASP than tissue valves, and because it requires more sales reps per one dollar of sales than legacy CRY. For example, On-X has 33 sales reps on $33mm in sales. CRY has 40 sales reps and excluding On-X does $145mm in sales, which is more than 3x the sales-per-rep as On-X. And importantly, management has not indicated any opportunity to shed less productive or redundant sales reps as a result of this acquisition.

But we will give CRY the benefit of the doubt, and assume with cross-sell synergies, that they do in fact maintain gross margins in U.S. of 90%, and it all flows through to EBITDA margins (so 48% EBITDA margins in U.S. and only 8% international, given the 50% GM% implied over there, keeping sales mix constant), that would translate to 28% EBITDA margins for On-X, and a ~14x EV/EBITDA multiple before any benefit of going direct outside of the U.S. (“OUS”). If we give On-X credit for 70% GM% overtime OUS, this would amount to 38% EBITDA margins for On-X worldwide, and a ~11x acquisition multiple after the revenue synergies derived from going to a direct sales model abroad.  

Exhibit 7: CRY Pre and post-rev synergy acquisition multiple estimates

Consensus is modeling a $34mm increase in sales in 2016. This is ~$30mm from On-X (i.e. not quite full year of rev). They divested of HeroGraft – so that is ~$7mm in lost sales. That means legacy business is expected to grow $11mm. Historical incremental gross margins are ~65%. So 65% of $4mm for legacy business. If we assume 90% gross margins in U.S. and 70% international (50/50 split) for On-X, that amounts to $27mm in incremental gross.

Consensus gross for 2016 is $114mm vs. $90mm in 2015. So $24mm higher. So consensus seems to be giving them credit for 50% GM% abroad and 90% in U.S., and not any credit yet for improving international GM% it appears. We believe GM% estimates could prove optimistic.

The synergies that CRY has talked about with the On-X deal (and not quantified) are primarily “cross-selling” revenue synergies. CRY salesforce is already calling on cardiac surgeons for tissue valves, which is a more technical and complicated sale (and therefore, if anything, these tissue sales reps have a better relationship with the surgeon than a mechanical valve sales rep). Since these two products compete in different patient markets, the idea is that their combination under one salesforce has the potential to be synergistic. Also, since CRY, is eliminating the use of distributors in small portion of its international markets to expand its direct salesforce internationally, the act of putting a complementary product into its salespeople’s toolboxes could have even greater benefit, given this consolidation of the salesforce and move in international markets entirely to the direct model. The implicit assumption here is that the cardiac surgeon or hospital buyer derives some value in getting their mechanical and tissue valve from the same sales rep, which based on our fieldwork this does not seem to be the case. Also, even the potential for this type of synergistic dynamic requires a lot of salesforce expansion, integration, and training, which will all come at a cost (and one that we believe will not necessarily result in an attractive ROIC).  

So we are skeptical of one of the acquisition’s central premises – its “cross-sell” synergy potential. We are also skeptical about whether CRY necessarily has the scale to get an attractive IRR on an international expansion of their direct salesforce.

Finally, we think that CRY paying a pre-synergy multiple of ~14x for On-X (assuming 90% U.S. gross margins; 70% worldwide), one that is in-line with the median multiple for their bigger peers (MDT, STJ, BAX, and EW), makes little sense, especially given some of the fast-growing end markets (i.e. TAVR) that members of the peer group are in vs. CRY, which exclusively sells into the mature-to-declining market for mechanical and tissue valves.

Exhibit 8: Peer median multiples.

On-X labeling as of now are not enough to spark change in behaviors

One of the chief assertions underpinning the bull case for CRY is that increased labeling claims for On-X have greatly increased the product’s addressable market. The labeling claims in question are a recent Randomized Control Trial (RCT) that looked at the ways in which On-X’s mechanical valve reduced a patient’s need for warfarin (based on a 3.82 year follow up period, as of April 2014, which is important, as most surgeons based on our fieldwork will look for confirmation of the efficacy of a given intervention past a 6-year follow-up point, before reconsidering the valve in question. This is because most valves that show efficacy at a 4 year point ultimately present complications at a 6-year follow up). Warfarin is a blood thinner that recipients of mechanical valves need to be on after their procedure to limit the potential of blood clots forming around the valve, which if occurs can result in major complications. Being on warfarin, however, is not without its own risks, and is a major downside to having a mechanical vs. a tissue valve, because the medicine makes a patient’s blood overall thinner, and can increase the risk of bleeding to death and of having a stroke. So a mechanical valve that also comes with a lower need of warfarin would indeed be an attractive mousetrap, as it would reduce a major barrier between a patient and their decision to get a mechanical valve in the first place.

Some further background is probably in order here as well. The reason a patient even gets a mechanical valve vs. a tissue valve typically has to do with age. A middle aged person in need of a valve replacement is more likely to get a mechanical valve, because if they were to get a tissue valve, they would be more likely to outlive their valve (and therefore would need to do a second replacement surgery at the end of the tissue valve’s expected life). This second surgery comes with a lot of risk. So if someone is of the age that they are likely to outlive the expected life of a tissue valve, they are more likely to be given a mechanical valve. Now, the TAVR procedure is changing this (but more on that later).

Here is what CRY management had to say about the increased labeling claims of On-X:

We became excited about the prospect of acquiring On-X after commissioning significant customer and clinical evaluation of their technology. As you will hear today, the performance of the On-X valve is supported by robust clinical data… Supporting our long-term view of the On-X opportunity is the recent labeling On-X received on their aortic valve. On-X has the only FDA approved mechanical aortic valve that is approved and labeled for an INR range of only 1.5 to 2.0 INR, which is determined by a blood test that measures the length of time required for a patient's blood to clot, and is regulated by taking blood thinning anticoagulant medication such as warfarin.

And sell-side is equally excited about the prospects for this labeling claim. This is from Canaccord’s April 2016 Initiation report:

While the mechanical heart valve market (which we estimate to be $220M worldwide) is a mature one, CRY anticipates the On-X portfolio to grow at a double-digit CAGR over the next five years, owing to 1) On-X’s proprietary low-dose anticoagulation FDA label, and 2) much larger distribution muscle of CRY’s 50+ direct domestic sales force, not to mention a larger OUS sales effort comprised of both distributors and expanding number of direct reps. For these reasons, we think On-X will be a strong growth catalyst for the company as a whole.

For context, on a platform with much narrower sales distribution and fewer resources from 2010-2014, On-X delivered an average growth rate of 13%, contrasted against CRY’s ~5% growth rate over the same timeframe.

But again, after checking with cardiac surgeons in the field we discovered a different view. One cardiac surgeon we spoke to suggested he would never make a buying decision change based on findings that centered on only a ~4 year follow-up as the On-X study did. Rather, a mousetrap different than the one he currently uses would have to demonstrate efficacy beyond a 6 year follow-up point before he considered changing. This is because most valves begin to show their limitations as you get out beyond this point. So without any knowledge of what complications may arise with the On-X studies valve, he must take the Proact trial results with a grain of salt.

Also, there were numerous mechanical valves in the past, this surgeon suggested, that demonstrated efficacy at the same point that On-X’s valve has, but the majority of those began to show any number of issues in the 6-year+ follow up.

Finally, he also suggested the 375 person sample size was a little on the light side of what he would prefer.

If these views are representative of a larger surgeon population, than it would be appropriate to approach the potential for On-X’s new labeling claims with a far greater degree of caution. We believe CRY’s self-commissioned, 375-person, ~3.8 year average follow-up RCT data is unlikely to drive any meaningful change in cardiac surgeon buying behavior, which it needs to do for CRY to achieve the degree of market share gains embedded in sell-side expectations. Therefore, we find it imprudent to extrapolate the recent growth rates On-X has enjoyed (working off a low base).

TAVR will likely cannibalize On-X share of market

Another impediment to CRY’s potential to grow their mechanical valve business is the rise of a new procedure, Transcatheter Aortic Valve Replacement (or TAVR, and sometimes referred to as TAVI).

Here is a very helpful visual representation of what the TAVR procedure looks like – and how it is less invasive than full out surgery:

https://www.youtube.com/watch?v=csxJYTLXNJY

Look no further than recent sell-side commentary and sales numbers from the likes of Edwards Lifesciences (EW) for a sense of the promise that TAVR offers.

This from April 18, 2016 EW sell-side report from Morgan Stanley summarizing the key points that came out of a series of panel discussions they hosted for several high volume TAVR and Surgical Aortic Valve Replacement (or “SAVR”, i.e. mechanical and tissue valve) practitioners to discuss the state of the TAVR market and the implications of the recent PARTNER II data.:

Surgeon enthusiasm around TAVR was noticeable and even outpaced the interventionalist on the panel as many objections to TAVR melt away under the heat of new data, suggesting SAVR cannibalization could be much higher than we thought. One surgical panel member noted that based on predicates such as AAA, TAVR penetration could go as high 90%. Already, some surgical centers reported seeing double digit declines in SAVR volumes. Relative to our base case, which assumes only 40% penetration in low risk patients, these dynamics could spell significant potential upside.

Note that SAVR encompasses both Tissue and Mechanical valve replacement surgeries, which together form 55% of CRY’s 2016E proforma sales.

The above note came after the TAVR procedure received broader labeling of its own – labeling which opened it up to serving intermediate as well as high-risk patients (and which raised the idea that it would one day also be approved for low risk patients). This is a new development – as the Partner II data referenced above was released after CRY’s purchase of On-X. What Dr. Roxana Mehran (Icahn School of Medicine, Mt Sinai, NY) told heartwire from Medscape sums it up well, "This is a very positive day for transcatheter aortic valve and for patients…[and now there are data that] show definitely in a great comparative study like this that you are no different if you had surgery or TAVR."

By some accounts, TAVR could be eligible for serving low risk patients as well starting in 2018.

Just to give you a sense of how big this is – below is chart from a recent UBS report (TAVR is now more widely perceived as an option for the much broader intermediate risk population, which is the fat of the distribution of patients):

Exhibit 9: TAVR TAM by patient type.

This table from JPM is also helpful regarding TAM for TAVR and SAVR in the U.S.:

So in the U.S., by 2018, JPM expects TAVR volumes to grow to more than 2x that of AVR-only SAVR volumes (CRY’s core market) from a 50/50 split in 2015.

SAVR volumes for AVR-only are expected to decline at a CAGR of 4% from 2015-18 in U.S. and 5.4% globally. This includes mechanical AND tissue (and it is believed that with technological advancements tissue will continue to take share from mechanical within SAVR procedures).

Cannacord is calling for only 1% declines in the mechanical valve market from 2015-18 in U.S. Note below that JPM has the SAVR market globally shrinking. So the fact that bulls have CRY growing sales for On-X means that in an environment where SAVR TAM is shrinking 4-5%, even greater share gains for CRY will be necessary to grow On-X meaningfully.

We believe it is more likely that CRY had some faulty assumptions regarding the disruptive potential for TAVR when determining the appropriate acquisition multiple for On-X. Talk to CRY, and they will tell you that they see little risk of TAVR cannibalizing the 40-65 year old mechanical valve patient demo. Their argument is that a tissue valve replacement followed by a TAVR procedure still does not get you past the patient’s expected life. This, however, is not consistent with our findings and other reports we cite in this write-up.

The growth of TAVR procedures, and their ability to cannibalize the “intermediate risk” patient market (the broadest patient demo for any kind of valve replacement procedure – especially mechanical) also makes the $130mm that CRY paid for On-X seem aggressive.

Even despite On-X's recent double-digit sales CAGR and increased labeling breadth, On-X sales will surely be under fire over coming years as both tissue valve and TAVR procedures claim greater market share from mechanical valves both in the U.S. and globally. Here are JPM estimates for the Global market:  

Further, the cannibalization dynamic noted above jives with how EW is thinking about the TAVR opportunity. The below is from an EW IR presentation (note how they expect TAVR and tissue to cannibalize the set of population currently receiving mechanical valves).

Exhibit 10: TAVR likely to cannibalize mechanical market.

Finally, to corroborate this notion, we had one industry professional suggest to us another way a middle-aged patient in need of a new valve could approach matters is by getting a tissue valve replacement, rather than a mechanical valve, and then when the tissue value reaches the end of its expected life, getting a TAVR procedure. This approach (versus getting a mechanical valve) replaces the need of being on warfarin at all, and eliminates the need for and risks associated with doing another open heart surgical procedure to put in a second, replacement tissue valve (since TAVR is less invasive).

If the AVR-only SAVR volume market declines by ~5% globally as JPM expects (vs. 1% Cannacord expects), and assuming constant ASP over that time, On-X’s global market share would have to go up to 25% from 15% globally to realize the growth rates they are targeting (vs. the ~19% market share Cannacord is calling for).

Other products – and their growth potential in Asia and Europe do not justify multiple

One other aspect of the bull case is that CRY will be able to grow their “Products” over time in Europe and Asia. We believe the potential for these businesses is much more limited than popularly believed. For one, in many cases CRY is just a distributor of the product (PerClot). Also, the potential approvals in new geographic territories for these products is fraught with delays and risks. Also, we believe recent elevated levels of inventory for CRY are perhaps suggestive that these products are not turning to the degree management expected they would (see "Earnings Quality" section below). Finally, the surgical sealant products (vs. tissue and mechanical valves) compete with much larger companies: J&J, Pfizer, and Baxter (vs. Medtronic, St. Jude, and the Sorin Group in mechanical valves).

Right now, CRY’s only product that generates a meaningful amount of sales is their surgical adhesive product BioGlue. Sell-side highlights the potential for some of these products to gain approvals in new geographic regions as an important catalyst, specifically: approval of BioGlue in China (the company anticipates trial enrollment commencing in 2017, followed by potential CFDA approval in 2018E) in mid 2018E and PerClot approval and launch in the US in H1:2019E.

Here is a brief description of each of CRY’s products:

• BioGlue and BioFoam (36% of 2016E sales): a cardiovascular surgical sealant indicated for use as an adjunct to other methods for stopping bleeding like staples and sutures. BioGlue is approved in both the U.S. and Japan. Noteworthy, BioGlue recently achieved in August 2015 an expanded indication in Japan (2nd largest market), essentially doubling the target procedure population in that market to 11k procedures from 5k procedures. This will provide $5mm in additional sales opportunity in that market. To give a sense of the potential market size in China in 2018E and beyond, should CRY achieve approvals in that market: at 40k procedures, China volumes are almost 4x bigger than those in Japan.

• CardioGenesis TMR System (5% of 2016E sales): This product came to CRY via their 2011 acquisition of CardioGenesis Corp. This product focused on the use of laser technology for the treatment of patients with severe/chronic chest pains stemming from lack of blood flow to the heart muscle. This platform is only marketed in the U.S.

• PerClot (2% of 2016E sales): is a powdered blood-stopping solution that is derived from a plant starch, and used after surgical procedures and after traumatic injuries. According to Canaccord, “One primary advantage of PerClot is the product comes ready to use, with no special mixing required, and does not require special storage or handling conditions.” PerClot is a product that CRY merely distributes via a partnership with Starch Medical, which they entered into in 2010. In 2014, PerClot received an expanded indication for received FDA approval for use as a topical treatment for mild bleeding wounds, and for mild bleeding associated with topical ENT surgical wounds. CRY, though, was suspended from selling this product for much of 2015 due to an injunction that came as part of a lawsuit filed by Medafor. The two companies reached a resolution in late 2015, whereby CRY agreed to keep PerClot Topical out of U.S. markets until 2019, when Medafor’s patent expires. Nonetheless, CRY is moving forward with a trial in 2H16 that seeks approval for PerClot Surgical, which will have an indication in the U.S. that extends beyond that of topical, and which will include other types of surgery: general and urology as well as cardiac.

• PhotoFix (1% of 2016E sales): a solution used in intra-cardiac repair, great vessel repair, congenital defects and pericardial closure procedures. It is a product primarily used by pediatric surgeons. CRY historically has been merely a distributor of this product, as they gained distribution rights from Genesee Biomedical in August 2014, and launched the product in Q115 (although this product was commercially available in U.S. back in 2010). CRY in 2016 exercised their right to purchase PhotoFix at a predetermined price. According to Canaccord, “CRY estimates the current market for biological patches used in overall cardiac surgical procedures exceeds $30M, growing at an 11% CAGR.” They estimate CRY’s 2016 sales to be only $1.9M; or, “(+33%), with faster growth projections stemming from CRY’s enhanced sales presence in the cardiac surgery arena following the On-X acquisition.”

While the potential exists for some of these products to meaningfully extend their addressable markets, we believe the risk associated with approvals being delayed or denied, the threat of competition, and recently elevated levels of products inventory all suggest these opportunities are overstated.

Poor earnings quality/Insider sales

Because of quirks in how CRY accounts for its tissue business, it is possible for us to assess inventory levels in the tissue business as separate from the other Products businesses. Namely, tissues that are capitalized on CRY’s balance sheet are not called “inventory” – but rather “deferred preservation costs”.

So first, in looking at just the Days sales inventory (“DSI”), or the relationship of inventory to COGS, of their non-tissue business lines, we can see that CRY’s DSI has risen meaningfully over time (particularly since Q114). There was a large spike in the MRQ, but that was from the addition of On-X inventory, which we excluded the impact from in the chart below.

Exhibit 11: Non-tissue DSI (excl. On-X) has been on the rise.

One of the suggested reasons for this rise is that years ago CRY was not able to adequately stock BioGlue. Consequently, CRY made a concerted effort to build 2-3 months of inventory in all products starting around this time.

We would note that this concerted effort to build BioGlue inventory coincided conveniently with an inflection point in BioGlue sales (i.e. right before they turned negative y/y in 2015).

Exhibit 12: CRY built inventory ahead of a turn lower in BioGlue sales.  

Also, On-X came over with a healthy amount of inventory (~$13mm in inventory, based on ~$8.3mm sales quarterly at full run rate).

In 2015, inventory management became part of the leadership team’s inventive plan.

Looking at Tissue DSI – they have actually gotten more efficient in this arena over the years – but the thing to note is just the extent of the working capital commitment this business requires – as on average tissue stays in inventory for almost half a year, even after years of efficiency improvements.

Exhibit 13: Tissue DSI has been improving, but still a working capital intensive business

Even despite the improvement in Tissue DSI in recent years, over the last 2 Q’s total DSI is up 12% and 20% y/y (including On-X in MRQ). And yet, the street is anticipating stable gross margins.

Exhibit 14: Gross Margin expectations call for stability, despite building inventories

We would argue that given the capitalization of expenses that are occurring on the balance sheet, there is a real risk to GM% expectations. Management has provided guidance for 65% GM% in 2016 (including $3.3mm in inventory step-up from On-X added back).

Days sales outstanding (“DSO”), or the relationship of receivables to sales, has also risen significantly since the beginning of 2014.

Exhibit 15: DSO also marching higher – suggesting the possibility CRY has been “stuffing the channel” with some of their international distributors.

DSO (even when excluding the impact of A/R coming over from On-X without the benefit of a full Q of sales) was 19%, 20%, 13% and 7% above 3-year averages over the last 4 Q’s.

If we assume that the rise in DSO is related to CRY stuffing the channel, then the rise in DSO in the MRQ relative to its historical average could explain as much as 40-45% of the EBIT earned in the most recent Q. Given the incremental margins on a $1 of sales, the impact from a little earnings management by CRY can have a big impact on operating profit.

Interestingly, DSO became part of management’s incentive comp plan in 2015 as well (although this has not seemed to make a difference in its trend higher). The company does use distributors in certain international markets, like France, where it is possible they have stuffed the channel to manage earnings. The deterioration in DSO and DSI has led to worsening cash conversion.

Exhibit 16: DSO and DSI trends straining cash conversion.  

Probably not surprisingly, CRY has failed to ever generate attractive ROIC or meaningful FCF.

Exhibit 17: Poor working capital management putting strain on FCF.

The stock currently trades at 2% LTM FCF yield (and only 3% if we exclude changes in working capital). And mind you, this is not some young, hugely-promising Medtech company investing tons of R&D in some new exciting, differentiated mousetrap with the potential to take meaningful share in a huge addressable market. This is a non-market leading player in a series of niche markets that has been around since 1984 – and failed to generate meaningful FCF since – that is ultimately putting its hopes behind the promise of cross-selling technology that is adversely positioned relative to new technologies. Note, CRY is also much more ineffective converting R&D investment into profitability than is its peers (their R&D as a % of sales is 7.2% vs. 7.9% average for members of IHI; and yet, they have 15% EBITDA margins vs. 20% peer average). In fact, going back to 1997, CRY has generated $37mm in FCF total!

CRY has largely funded their growth largely through dilutive equity offerings that have more than doubled the share count since they went public.

Exhibit 18: CRY has been a serial issuer of shares.

CRY’s serial issuances of common stock through the years also provide ample motive for the kinds of earnings management we note above. The common stock shares issued in conjunction with the On-X deal were sold via private placement to eight accredited investors, the two largest of whom (PTV Sciences II, L.P. and Paul Royalty Fund, L.P) are part of Paul Capital Management, the strategic that owned On-X. CRY offered 3,703,699 shares for $34.5mm, or $9.32 per share. Paul Capital Management was subject to a 90-day lock up, which expired on April 19, 2016. They were CRY’s largest shareholder (~8%). But 6/21 13G/A filings revealed they have been selling stock – reducing their position down to ~5% of the company.

Exhibit 19: PE firm that sold On-X has been selling the CRY stock they got as part of the On-X sale.

Over the last two years, the former chairman and founder of CRY, 77-year old Steven Anderson, has been reducing his stake in the company. He now owns ~4% of the company.

Exhibit 20: Founder has been trimming his stake.  

VALUATION DETAILED

We think CRY could be worth as little as $6.75-$7.25 per share in our base case by 2020, for 14% IRR (applying a very generous 1.5x EV/Sales and 20x NTM P/E to 2020E). We assume sales company-wide will grow at only a 3% CAGR (which assumes 3% On-X growth – or modest share gains offset partially by mechanical valves share loss to TAVR. We assume 3% sales CAGR for BioGlue and Tissue valves too). We assume SG&A 47.5% of sales, R&D 7.5%. 36% tax rate. Finally, we assume 100 bps GM% degradation for Products from FY2015, due to normalization of inventory situation offsetting any product mix benefit from higher On-X gross margins. Also, because we believe On-X sales expectations are far too high; and consequently, so too are consensus incremental On-X gross margin expectations.  

In our risk case, we assume a 2020 target price of $15.50, for -7% IRR, which amounts to an attractive 2-to-1 upside-to-risk ratio. In this scenario, we apply above historical median multiples of (28x NTM P/E and 2.3x EV/Sales) to our 2020E. We assume 12% sales CAGR for On-X (significant share gains for On-X, and no share loss for mechanical valve to TAVR). 4% sales gains for BioGlue and 5% for Tissue valves. We assume SG&A 47.5% of sales, R&D 7.5%. 36% tax rate. Finally, we assume 75-80% On-X incremental gross margins.

Finally, we would note a 5-year DCF (assuming 8% discount rate, and a 5% terminal growth rate) would require 15% cash earnings growth to justify the current stock price of ~$12, highlighting the outsized growth expectations that currently underpin CRY’s stock price.

Exhibit 21: CRY’s stock price are heavily dependent on lofty growth expectations.

RISKS

• Historically, some believed CRY would make a logical acquisition target. With high gross margins, their SG&A and sales force would be largely redundant in an STJ, for example. But these companies are focusing on TAVR. We believe both because of this, and because CRY has been around since 1984 (and at much cheaper valuations in the past) without being taken out, we view this risk as small.

• CRY issues a follow-up study to their original PROACT trial, which demonstrates similar results as first study, but over a 6+ year follow-up period. This results in increased market share for their product.

• Salesforce integration/consolidation for On-X/CRY proforma comes with the promised revenue synergies, even absent more clinical data.

• BioGlue successfully expands into new markets like China

• CRY turns around Tissue business with strong vascular tissue sales growth.

• Note: Last Q, organic revenue growth was HSD, but this benefitted from an abnormally strong Q in vascular tissue due to ASP mix and BioGlue sales in France having a favorable comp due to change in distribution there. On-X was up only 7% pro-forma y/y. OUS On-X revenues were particularly weak (-6% y/y pro-forma).

   

This report (this “Report”) on Cryolife Inc. (the “Company”) has been prepared for informational purposes only. As of the date of this Report, we (collectively, the “Authors”) hold short positions tied to the securities of the Company described herein and stand to benefit from a decline in the price of the common stock of the Company. Following publication of this Report, and without further notice, the Authors may increase or reduce their short exposure to the Company’s securities or establish long positions based on changes in market price, market conditions, or the Authors’ opinions with respect to Company prospects. This Report is not designed to be applicable to the specific circumstances of any particular reader. All readers are responsible for conducting their own due diligence and making their own investment decisions with respect to the Company’s securities. Information contained herein was obtained from public sources believed to be accurate and reliable but is presented “as is,” without any warranty as to accuracy or completeness. The opinions expressed herein may change and the Authors undertake no obligation to update this Report. This Report contains certain forward-looking statements and projections which are inherently speculative and uncertain.

Catalyst

• Market begins to appreciate the new Partner II TAVR data findings, and what it means for TAVR’s potential to cannibalize mechanical valve market among “intermediate risk” patients over time. This is a very near-term catalyst, since this data was just released in April.

• Paul Capital continues to dump shares.

• It becomes clear in follow-up studies to the Proact trial, that the claims of the 2014 findings pertaining to anti-coagulation and lower needed warfarin levels do not persist. This could be a catalyst over the next six months.