Description

With complications of COPD paving a long runway for double-digit revenue growth, and profitability (finally!) inflecting upward, a major re-rating looks likely for Electromed.

Elevator Pitch

• Electromed’s SmartVest is a noninvasive device that treats bronchiectasis, an impaired ability of the lungs to move and clear out mucus. Once associated mainly with cystic fibrosis, bronchiectasis is gradually being recognized as a late-stage complication of chronic obstructive pulmonary disorder (COPD). Electromed estimates that 630,000 Americans could benefit from the type of therapy that SmartVest provides, with only 66,000 currently being treated. 
  
  
• While the market opportunity is large, it isn’t easy to change doctors’ habits. A two-and-a-half-year attempt to accelerate Electromed’s sales growth into the high double digits wound up adding more SG&A expense than incremental revenue, frustrating investors and sending Electromed’s valuation toward the bottom of the medical device industry.
  
  
• But the March restructuring of Electromed’s salesforce, along with other shareholder-friendly actions, has reversed this failing attempt. The resulting cost cuts boosted underlying profits substantially with no apparent toll on sales growth in the June quarter. We expect this pivot to boost earnings about 75% in the current fiscal year to $0.40 a share.
  
  
• As this inflection should close much of the gap between Electromed’s profitability and industry norms, we think it is likely that today’s gaping valuation discounts will close as well. At the industry’s 30x median forward P/E, the stock looks like a double to $12; at the median 4.0x forward EV/sales multiple, Electromed could nearly triple to $17.

Background

Electromed’s SmartVest uses high-frequency chest wall oscillation (HFCWO) to treat a respiratory condition known as bronchiectasis. Bronchiectasis is the inability of the lungs to clear mucus, leading to breathing difficulties, infections, and costly hospitalizations. HFCWO therapy pulses air through a vest to vibrate the lungs from the outside, allowing mucus to move and eventually be coughed out. 

Bronchiectasis is increasingly recognized as a late-stage complication of COPD. Compared with cystic fibrosis (the original application for HFCWO, with only 1,000 new diagnoses a year), the COPD addressable market is far larger. Electromed estimates there are 16 million COPD patients, 4.2 million with bronchiectasis (a cohort that is growing 9% a year), and 630,000 for whom HFCWO would be a cost-effective treatment…but only 66,000 of whom are currently being treated with HFCWO. For reference, while Electromed doesn’t disclose unit shipments, we estimate the company is selling roughly 4,000 units a year out of a total industry volume around 25,000.

With 16% of the domestic HFCWO market, Electromed is the smallest of three main players, but we believe the competitive environment is benign. In 2003, Hill-Rom acquired Advanced Respiratory, the first company to commercialize HFCWO, for 1.8x then-trailing sales. It’s still the leader with 47% of the market, but it has been a share donor over time. RespirTech, which entered the market in 2004 and holds a 33% share, grew rapidly for several years before its 2017 acquisition by Philips. Terms of the deal were not disclosed, but we have good sourcing for a transaction price near 3x sales even though RespirTech was not profitable. (By contrast, Electromed is currently trading at only 1.3x EV/TTM sales, and its stock would be worth $11-$12 a share if valued at the RespirTech acquisition multiple.)

We think the Philips-RespirTech deal validates the clinical value of HFCWO therapy, the market opportunity, and the barriers to entry. As products, SmartVest, The Vest (Hill-Rom’s brand) and InCourage (Philips’) are not hugely differentiated. SmartVest appears to have a few minor advantages—for example, its single hose connecting the vest to the pulse generator compared with the more cumbersome two-hose systems of its rivals—but these are not presently essential to Electromed’s success. Instead, the three companies compete primarily on their combination of sales (marketing to doctors and, to a lesser extent, directly to potential patients), reimbursement (getting a doctor’s prescription for HFCWO approved by Medicare, Medicaid, or private insurance), and customer service (training the patient for successful usage). If this combination of factors could be easily duplicated, Philips certainly had the financial resources to build an HFCWO business from scratch rather than buying RespirTech. We also note that AffloVest, a fourth competitor that launched in 2013 with different technology and a third-party distribution model, hasn’t gotten off the ground.

Rounding out a few other basic points, we note that Electromed has no debt, $7.8 million in cash ($0.93 a share), and seven straight years of positive free cash flow. The structure of governance is clean, with a nonexecutive chairman, no poison pill, and no staggered terms for directors. Three of the seven independent directors are material shareholders, collectively holding 16% of the stock. And with so much economic uncertainty these days, we certainly appreciate the defensive, noncyclical nature of Electromed’s business.

Why Electromed Isn’t a Value Trap Anymore

Electromed has been pitched on VIC once before, with unfortunate timing—just 2 weeks before and less than 3% away from what is still the stock’s all-time closing high. Since then, the stock has lagged just about any benchmark that might apply. Why was the stock a value trap then? And more important, why is it not a value trap now?

The flaw in the 2016-17 bull case was that it assumed Electromed’s plan to rapidly expand its salesforce would pay off with faster revenue growth. The opportunity appears to be massive relative to Electromed’s current size. With pulmonologists and other respiratory specialists still very early in the adoption of diagnosing and treating COPD patients for bronchiectasis, it would seem that simply getting the word out to doctors is the most important step.

However, realizing the HFCWO market opportunity is not that simple. Doctors are notoriously slow to change their practices. Not just anyone can walk into a clinic, tell a doctor he or she is failing to diagnose patients correctly, and then successfully pitch a not-exactly-new product to rectify this failure. Moreover, basic HFCWO technology has been around for more than 30 years and has long been part of the standard of care for cystic fibrosis (1,000 new diagnoses in the U.S. per year). There is not yet a similar agreed-upon standard of care for bronchiectasis in the far larger COPD population.

So while Electromed expanded its sales staff from 30 people to 52 between June 2016 and December 2018, contributing greatly to a 43% cumulative rise in trailing 12-month SG&A expense, TTM revenue rose only 32%. This clobbered profitability, with TTM EBITDA (adjusted for one-offs) falling 19% during this two-and-a-half-year stretch. While the company remained profitable, its return on equity slipped from 15% in fiscal 2016 to less than 9% for fiscal 2018 and 2019. At that level, investors had plenty of reason to doubt that growth would result in value creation for shareholders.

This divergence makes the stock’s weak performance over the past few years easy to understand. We believe that when embarking on the salesforce expansion, Electromed’s management and board had a theory of value creation that emphasized sales growth as the driver of the stock and, ultimately, the multiple on a sale of the company to a strategic acquirer. (In other words, what worked out for rival RespirTech.) To be fair, today’s stock market often permits or even encourages many other sorts of companies to increase revenue without regard to current profits. Investors appeared to support Electromed’s growth strategy during fiscal 2017, with the stock price rising from $4-$5 to more than $7. But as growth failed to improve during fiscal 2018 and 2019, Electromed’s stock price sagged right along with EBITDA.

It may be reasonable to blame Electromed’s management for sticking too long with a strategy that wasn’t paying off, but the more important point is that the failing strategy has been replaced. Key actions in the last nine months include the following:

• In December 2018, Electromed’s vice president of sales, John Kowalczyk, left the company. We suspect he made his move shortly before being pushed out; in any event, Electromed didn’t have to pay him any severance. He had been tasked with executing the company’s salesforce expansion, yet we can’t help but note that sales growth slowed sharply soon after he arrived, never improved in any lasting fashion, and improved after his departure. (In addition to obviously poor sales productivity for new hires, we are also aware of heightened turnover in the salesforce during his tenure.)
  
  
• Along with announcing Kowalczyk’s departure on the Feb. 13, 2019, quarterly call, CEO Kathleen Skarvan stopped referring to sales productivity in merely conceptual terms. Instead, the company’s own productivity metric became a feature in that and subsequent quarterly releases, and Skarvan made it clear that no further material expansion of the sales staff would take place until productivity reached the company’s target of $750,000-$850,000 in annual sales per field sales rep. (We like it when a company takes a critical internal statistic out from behind the curtain, thus asking investors to hold it accountable.)
  
  
• Skarvan, who deserves credit for pulling the company out of far worse circumstances in 2013 and 2014, took direct control of the salesforce upon Kowalczyk’s departure and shrank the salesforce to 42 employees from 52 in March. On the next conference call on May 8, she said this restructuring would have “minimal impact to revenue.”
  
  
• In April, Electromed hired a new vice president of sales, Bud Reeves, with a solid institutional sales background including Respironics (CPAP machines) and Philips Healthcare (after it acquired Respironics). Furthermore, unlike his predecessor in the seat, Reeves is a registered respiratory therapist.
  
  
• In August, Electromed added two medical device industry veterans to its board of directors. The previous board was light on healthcare experience: Excluding Skarvan, only one of the five incumbent independent directors had backgrounds that included the manufacture or sale of medical products.
  
  
• Also in August, Electromed announced agreements with two distributors of home medical equipment (HME). Until now, the vast majority (92% in fiscal 2019) of SmartVest sales have been made directly to patients, bypassing third-party channels and contributing to gross margins in the mid- to high 70s. But Electromed’s market share is not equally distributed across the U.S., and some geographic areas have been very tough to crack. Though the HME agreements are unlikely to generate meaningful sales in the upcoming year—it’ll take at least that long to train distributors on how to sell and obtain reimbursement for SmartVest—we think the main benefit of these agreements is that it takes the pressure off Electromed to increase its own sales presence in historically poor-performing regions.

Skarvan’s bold assertion about the salesforce restructuring was proven correct on Aug. 27, when the company reported results for its June quarter. The headline numbers were good enough, with total revenue growth picking back up to 9.3% year-over-year, rebounding from the 3.4% Y/Y growth rate in the March quarter. Earnings per share rose to $0.13 versus $0.11 a year earlier. Beneath the surface, even more progress is visible. For better or worse, Electromed doesn’t deal in non-GAAP adjustments, but it does disclose unusual items in its press releases and 10-K and 10-Q filings. We’re happy to call out several one-timers that reveal a much sharper upturn in underlying performance.

• Electromed’s June 2019 quarter was lapping 19.8% year-over-year core growth—the highest in more than two years—in the June 2018 quarter, when a one-time $703,000 benefit to sales in the June 2017 quarter is backed out. There appears to be some seasonality developing in the business as it grows: COPD-related bronchiectasis is being diagnosed more frequently during the cold and flu season, and the resulting SmartVest prescriptions are then filled and shipped more frequently in the April-June quarter. Even so, the two- and three-year stacks were the best in a year.
  
  
• With more sales and fewer field sales reps, Electromed’s metric of sales productivity surged to an annualized $908,000—up 29% Y/Y and suddenly above the company’s $750,000-$850,000 target. We think the June quarter reflects seasonal strength in addition to improved productivity and expect this metric to dip back into the target range during the next three quarters. But while Skarvan had previously indicated that moving into this targeted range was a prerequisite for any future expansion of the salesforce, she isn’t taking a single quarter as a green light. In the remainder of fiscal 2020, Electromed aims only to fill four open sales positions, which is consistent with the plan for 38 field sales reps plus 4 regional managers that was articulated on the March quarter conference call.
  
  
• In the June 2019 quarter, Electromed recorded $117,000 worth of accelerated depreciation of leasehold improvements for a rented building that is being replaced with a new, Electromed-owned property. By contrast, in the June 2018 quarter, Electromed booked a $406,000 refund of ACA medical device excise taxes as a credit to SG&A, where the expense had previously been recorded.
  
  
• On straight reported GAAP, operating income for the June 2019 quarter rose modestly to $1.5 million in 2019 from $1.3 million in 2018. After backing out the one-offs disclosed by management, operating income nearly doubled to a quarterly record of $1.6 million (18.6% margin) from $859,000 (10.9%) a year earlier. Operating cash flow of $1.4 million hit an all-time high as well; free cash flow would have too, if not for $1.1 million of unusual capital spending for an expansion of Electromed’s headquarters.

We’ll grant that Electromed is a small company with plenty of quarter-to-quarter variability in results. For example, the June 2018 quarter looked like an inflection point when it was reported, and the resulting runup in the stock was very short-lived. But back then, the hiring spree was still in full swing, and rather than being a true breakout, the upswing in revenue was shortly shown to be less than one standard deviation within the trend.

By contrast, financial progress in the June 2019 quarter demonstrates the benefits of cost control and productivity—factors much more within management’s control than a hoped-for surge in revenue. This is why we are confident that the inflection point in profitability has passed, setting the stage for much higher earnings.

Electromed is targeting low-double-digit revenue growth again in fiscal 2020 and for the next few years, which strikes us as quite reasonable. The company estimates that the prevalence of bronchiectasis is rising at 9% a year, so 10%-12% revenue growth doesn’t require much improvement in average selling prices, market share, or even the willingness of more doctors to diagnose bronchiectasis in COPD patients and prescribe HFCWO therapy. Indeed, we think that the company’s past growth has relied more on the growth in the addressable market than management’s efforts to step on the gas. In fiscal 2016, for example, the size of the salesforce held relatively steady—31 people at the beginning of the year, 30 at the end—yet total sales rose 18.5%.

However, the primary driver of our earnings growth expectations is improving margins. Based on our discussions with management about fiscal 2020, we expect SG&A to grow at half the pace of revenue, while gross margin (76.2% in fiscal 2019) drifts up toward the company’s long-term expectation of a range slightly below 80%. The resulting wedge indicates that earnings should pull out of a four-year stagnant spell with style.

Beyond fiscal 2020, we believe profitability will continue to improve, albeit at a more moderate pace. In Exhibit 4, we have modeled a 7.3% rise in SG&A costs in fiscal 2021 (two thirds of the revenue growth rate) and 8.8% in fiscal 2022 (four fifths). The resulting operating leverage drives the company’s EBITDA margin to roughly 21%, matching today’s industry median. We also expect returns on equity to reach the mid double digits, even without backing out excess cash.

Valuation

The inflection in profitability we observe in Electromed’s recent performance sets the stage for a higher stock price—considerably beyond the approximately 12% gain since results for the June 2019 quarter were released on Aug. 27. 

The medical device industry is a large and diverse lot, but we believe that median multiples for the GICS Health Care Equipment & Supplies industry provide a useful frame of reference. Slicing and dicing across five valuation yardsticks, the only thing that’s clear is that Electromed is very cheap—not just on our expectation for improved results in fiscal 2020, but even on its actual performance for fiscal 2019. As shown in Exhibit 5, Electromed ranks in the group’s bottom decile on EV/EBITDA and especially EV/gross profit (a proxy for potential value for an acquirer with synergies to realize), near the bottom decile on trailing EV/sales and price/earnings, and bottom quintile on price/book.

Part of what is striking about these ultra-low multiples is that while the trend in Electromed’s profitability was unfavorable until the June 2019 quarter, the absolute level of performance for the company was not so bad.

Compared with current industry medians on the metrics in Exhibit 6, Electromed’s only serious weak spot is its bottom-quartile EBITDA margin of 12%, and we grant that merits some valuation discount when considering only past performance. However, as we expect the company’s EBITDA margin will close nearly half of the shortfall versus peers in fiscal 2020 and potentially match the group median of 21% within three years, the stock’s valuation discounts ought to shrink and perhaps disappear entirely.

Our best estimate of Electromed’s fair value is $12, which is based on (1) the group’s forward P/E of 30 multiplied by our fiscal 2020 EPS estimate of $0.40, and (2) a trailing EV/sales ratio of 3.0x, in the range of what we believe Philips paid for RespirTech as noted earlier. However, virtually any valuation scenario we can come up with indicates substantial upside potential. Were Electromed to trade all the way up to the median valuation multiples shown in Exhibit 7, the stock’s value ranges from $8 to $17. But even if the stock closes only half the current discounts, its value still ranges from $7 to $11.

In all, we think Electromed is well positioned to leave its previous status as a value trap in the dust, with significant value likely to be realized by shareholders in the process.

Notable Risks

• Reimbursement. Medicare sets the reimbursement rate for HFCWO therapy, which is currently about $12,000. Medicaid and private insurance carriers (including Medicare Advantage and privately administered state Medicaid programs) generally pay somewhat less but tend to be anchored to the Medicare reimbursement rate. Given that successful HFCWO therapy prevents costly hospitalizations, and the HFCWO reimbursement rate has been steady or gently rising in recent years, we regard a material reimbursement cut in the foreseeable future as a low-probability but potentially high-impact event.
  
  
• Competition. Hill-Rom and Philips have far larger sales, research, and financial resources than Electromed, but their vast size also dilutes their focus on the relatively small HFCWO market.
  
  
• Management discipline. Given the difficult experiences of the past few years, we expect Electromed to exercise much more restraint in the future growth of its salesforce. However, this turnaround in financial discipline is very recent, and so far we only have one quarter of results to measure management’s commitment. We think any future attempts to radically accelerate revenue growth through salesforce expansion would involve margin compression and be regarded negatively by investors.
  
  
• “The law of small numbers.” While we think the inflection in profitability described above is real and durable, Electromed’s small stature means that natural quarterly variations of a few hundred thousand dollars one way or the other can have a meaningful impact on the bottom line and, potentially, on investors’ reaction to results.

Catalyst

• Substantial earnings growth, especially for the current fiscal year (ending June 2020).
  
  
• Recognition of an inflection in profit margins and returns on equity, meaning that today’s steep valuation discounts should no longer be justified.
  
  
• Possible initiation of sell-side research coverage. We’ve noticed that a couple of boutique analysts have participated in quarterly conference calls over the last year.
  
  
• Possible sale of the company. While we have no insight into if or when this might take place, we can at least note that a higher public valuation makes a deal more likely by shrinking the premium an acquirer would be obliged to pay in a fairly priced transaction.