|Shares Out. (in M):||23||P/E||120||104|
|Market Cap (in $M):||4,927||P/FCF||61||0|
|Net Debt (in $M):||0||EBIT||50||0|
|Borrow Cost:||General Collateral|
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I am recommending Inogen (“INGN” or the “Company”) as a short. I envision at least 20% downside from the current price during the next two years.
Inogen develops, manufacturers and markets portable oxygen concentrators (“POC”) used to deliver supplemental oxygen therapy to patients who suffer from chronic respiratory conditions. The POC is an alternative to stationary concentrators for which mobility is compromised. The stationary segment, also sometimes called “the delivery model,” depends on tanks and cylinders that have a finite amount of oxygen and must be delivered to the patient. Based on 2016 data, Inogen’s management believes the Company is the leading POC manufacturer globally. Management’s stated vision is to establish portable oxygen concentrators as the standard of care for ambulatory oxygen patients.
The bullish thesis is that less than 10% of the total addressable oxygen market in the U.S. used portable oxygen concentrators in 2016, and penetration of an expanding addressable oxygen therapy market will grow substantially during the next 7-10 years. There is clear evidence that POCs are becoming a larger piece of the market and investors have embraced INGN as the pure play, but at any price, to participate in this secular growth category. Part of the underlying growth reflects the reimbursement pressure that the HMEs have confronted and their growing awareness that the POC non-delivery model is not only viable but also advantageous. Some industry experts believe 60-65% penetration of the market could be achievable.
I have no doubt that the POC industry will continue to grow and INGN will continue to grow quickly as well, but as I will further describe below, I do not believe the investment community is adequately incorporating the intensifying competitive issues when evaluating what is essentially a one-product company with a valuation that is “priced for perfection”. Inogen is among my short investments that I characterize as “GAAP”, or “growth at any price.” Valuation is never the sole reason to be short a company but with a premium valuation comes high expectations and I think the elevated expectations for Inogen will soon be missed. I recognize that the Company is announcing earnings later today and this is not a call on Inogen missing upcoming results (though that would be very nice).
The Company’s current enterprise value, ~$4.7B inclusive of options and option proceeds, exceeds the entirety of the oxygen therapy market in the U.S. which Inogen estimated as $3-4B. At its current price, Inogen trades at 120x 2018E EPS, 104x 2019E EPS, and 84x 2020E EPS. EPS growth expected this year versus last is ~36%. As a multiple of revenue, the stock is trading at 14.5x 2018 estimated revenue and over 12x 2019. On an EBITDA basis, Inogen trades at 70x the upper-end of management’s outlook and almost 95x EBIT. The Company maintains a strong balance sheet and is not capital-intensive but the equity FCF yield is only ~1.5%. This company is indeed growing quickly, having grown both top-line and EBITDA by over 25% CAGR during the past two years. Moreover, growth is accelerating this year as revenue is expected to grow another ~30% and EBITDA by ~32% during 2018. That said, consensus for 2019 is for top-line growth to moderate to ~20% though I anticipate that those estimates could increase, and as they should at this valuation.
Management claims to have been taking share as they estimate that annual POC growth has been in the high-teens. It is difficult to discern what is the right multiple and since Inogen’s multiple has expanded by ~45% since the Company’s last earnings release, it could indeed expand more but I favor the likelihood of contraction, at least at some point in the medium-term. At this valuation, the market should already be discounting an expectation for strong growth. One approach I considered regarding valuation is to frame it with an illustrative DCF to arrive at what the market might be anticipating from Inogen based on FCF over the next 25 years. On that basis, the current valuation is derived from an assumption that top-line grows per annum at ~16%. Though of course possible, I don’t view this scenario as probable for the entirety of the period and there is little margin of safety given the current valuation.
The Company’s business model is not premised on a recurring software-like revenue stream nor an after-market revenue mix driven by an installed base. The business is growing quickly because the product serves a patient population that will continue to grow coupled with increased penetration of POCs as the market migrates to this better solution provided by Inogen as well as by other POC providers.
The Company is not alone in this market and although Inogen management has done the best job at seizing the POC market to capitalize on its growth potential, the barriers to entry are low and existing and new entrants are elevating their approach to win share. The investment community is enamored with the secular growth trends being driven by the ongoing shift to POCs for oxygen therapy, but this seems to be without regard for the valuation ascribed to Inogen nor the competition that looms large.
The competitive forces are already being evidenced by declining ASPs at Inogen, which have been more than made up by volume growth but the magnitude of growth that Inogen has been generating recently is not a likely scenario as competitors seize part of the expanding market opportunity. At the current valuation I don’t think the market would accept any moderation of growth and/or set-back in execution without a dislocation to price.
If the Company were to impressively achieve 12% per annum top-line growth during the next 25 years, my illustrative DCF yields 40% downside to the stock. As I describe below, their product is not highly differentiated, Inogen has very few patents and spends an insignificant sum on R&D, barriers to entry are low and there is no argument that the Company will confront more competition, as Inogen management has acknowledged.
Inogen has seized a secular growth category with a strong brand-driven campaign and capitalized on a direct-to-consumer approach before anyone else but I very much doubt that this Company will sustain their relative lead with competitive forces intensifying.
From selected primary research, “this segment is hyper-competitive”…“there is little now that really differentiates one product from the other in the same class”… “this category has thus far been more of a game of marketing and distribution than technology prowess but think ResMed could alter landscape dynamics”… “the product is just a box with valves, manifolds, and tubes that manage oxygen delivery, the technology barrier is quite low”…“there are associated pricing pressures driven by Medicare”…“one should not expect Philips to remain satisfied with its share when observing the valuation placed on Inogen.”
At ~105x 2019E earnings and over 12x 2019E revenue, one might think that Inogen has no competition but that is far from the truth. By its own admission, management recognizes the market as “a highly competitive industry” and further notes that “given the relatively low barriers to entry in the oxygen therapy device manufacturing market, we expect that the industry will become increasingly competitive in the future.”
Management does anticipate “increased competition in the future as existing companies and competitors develop new or improved products and distribution strategies and as new companies enter the market with new technologies and distribution strategies.” Described below is some context regarding the competition.
· Chart Industries competes through its CAIRE portfolio to address multiple respiratory disease states and prescriptions, ranging from the small AirSep Focus to the ultra-compact AirSep FreeStyle and the AirSep FreeStyle 5 for higher oxygen flow applications covering a wider variety of patients. Industry experts have characterized the less-than-2 pound AirSep Focus as “best for mobility.” However, similar to Inogen’s One G4, the Focus is limiting without a continuous flow option. Chart recently launched its CAIRE FreeStyle Comfort in the POC segment and is also focused on both the transportable and stationary segments with its SeQual Eclipse for 24/7 capabilities and CAIRE Companion 5. Chart is currently conducting a strategic review that includes a possible divestiture of their oxygen-related product lines within the Biomedical segment. Respiratory therapy sales, at ~$125M, comprised 12.6% of total Chart sales in 2017. During its recent investor day, Chart management noted the POC category as its fastest growing and also highlighted that “this is a competitive space.” They also emphasized that their FreeStyle Comfort is an ideal product for CAIRE’s DTC strategy. Though management admitted there is work for CAIRE to do on the brand recognition front to improve its DTC positioning, they believe the DTC channel will support multiple competitors. During September 2016, CAIRE filed a lawsuit against Inogen alleging infringement on one patent which was recently settled for a value of $1M. In regards to Chart’s consideration of divesting this business, my research suggests that although secular industry growth is highly likely, their view of an intensifying competitive landscape with pricing pressure also looms. Chart is also more industrial and commercially focused from a channel perspective and therefore “someone else will likely do better at driving the channel strategies.” My research on this topic also leads me to believe that some at Chart envision that the competitive dynamics in the POC category will soon change as ResMed scales their focus on this business.
· DeVilbiss, a well-regarded provider of durable home medical equipment in the respiratory and sleep categories, was acquired by Drive Medical (now called Drive DeVilbiss Healthcare) in 2015. DeVilbiss has been around since the 1880s. They have been developing a battery-operated POC weighing less than five pounds but which is not expected to be released until late during Q4’18. Clayton, Dubilier & Rice invested in the company at the beginning of 2017 and is led by the former CEO of GE Industrial Solutions. Drive’s customer base of more than 15,000 dealers, home healthcare providers, healthcare distributors, retailers and e-commerce companies could empower DeVilbiss’ POC penetration into the marketplace more broadly. I can say it is not lost on CDR that there is a significant opportunity to capitalize on the growth in the POC category.
· Gas Control Equipment (GCE), headquartered in Europe and founded in 1987, manufactures the Zen-O portable oxygen concentrator and has recently announced their new Clarity Connected Care online platform to leverage new technology that enables HME providers to monitor and optimize device performance. One industry insider suggested that this new development could alter the manner in which oxygen care is provided and monitored. Though GCE does not have a factory-direct model, one can purchase Zen-O directly online from at least three different distributors.
· Invacare’s respiratory business segment generated $107M of revenue in 2017, which comprised ~11% of total Invacare sales in 2017. Invacare’s POC brands are the SOLO and XPO and they recently launched a new POC they brand as Invacare Platinum Mobile. Inogen’s CEO Scott Wilkinson worked for Invacare from 2000-2005 as Group Product Manager to help launch Invacare’s $100M revenue oxygen product line segment. He was instrumental to the launch of the HomeFill business.
· Nidek Medical, founded in 1986, manufacturers the Nuvo Lite. It is sold in over 100 countries and is said to be among the best for home use but not as well-positioned towards mobility outside of the home.
· O2 Concepts was founded in 2008 and was the fifth or sixth POC at the time. O2’s Oxlife Independence offers the longest battery duration in its class which can last up to six hours without being recharged. Their product is noted as being the first to enable real-time remote diagnosis. Many industry experts characterized their product as having the best technology support. Many of those same industry experts characterized Inogen’s customer service as being an ongoing problem.
· Precision Medical, founded in 1984, manufactures the EasyPulse brand. Precision claims to have the lowest return and repair rate in the market, thereby emphasizing the product durability. Many industry experts characterized their product as “most user friendly.”
· ResMed primarily entered the oxygen therapy business in 2016 through its acquisition of Inova Labs which manufactured the LifeChoice and Activox brands but ResMed’s first internally-driven, branded portable oxygen concentrator is the newly-launched brand Mobi. At the end of April, ResMed was in the process of commencing a controlled product launch of Mobi and hence there has yet to be significant activity to calibrate the potential impact to Inogen. On ResMed’s most recent earnings call, they highlighted they are getting ready to scale this business with an emphasis to leverage the awareness amongst pulmonary doctors of the ResMed brand, quality, and reliability. Their aim is not to drive a factory-direct model but instead remain focused on the strong partnership ResMed has with the HME channel. When acknowledging that POC competitors were likely to read the earnings transcript, ResMed management said, “our model is going to be more partnership with the channel than what we’re seeing…from some others is competition with the channel.” This is more than a subtle reference to Inogen given the Company’s DTC dominance. In an effort to address channel conflict issues, Inogen has a private label brand distribution partner to focus on the HME channel. Although there has yet to be any impact from ResMed’s intention to focus resources, including its overall commitment to spend ~7% of revenue for R&D innovation (which is notably more than triple the percentage that INGN spent last year and of course on a much smaller revenue base), I believe that ResMed’s noted focus to achieve leadership across respiratory care, similar to what ResMed has achieved in sleep care, is a significant risk factor that looms for INGN shareholders. As evidence of ResMed’s intended focus on the oxygen therapy market, one can look at their FYQ3’18 investor presentation and see some of the slides they prioritized at the beginning to drive that discussion. As a $15B enterprise company with over 5,000 patents (note: Inogen had just 32 at year-end) and spending almost $150M per annum in total R&D, I ascribe a high probability that ResMed’s focus to “scale-up respiratory care” will be a competitive challenge to Inogen that the market is not effectively discounting. It is worth noting that there is only one overlapping sell-side analyst who covers both Inogen and ResMed, so the magnitude of competitive insights could be lower than otherwise.
· Respironics (a subsidiary of Philips) claims to have market leading positions with the largest range of respiratory offerings. Respironics serves the POC market through its brand SimplyGo and EverFlo. With a standard battery, the SimplyGo Mini can be directly purchased on-line for $2,495 in all but four states. In a direct comparison review by an industry expert two years ago, it was noted that both the SimplyGo Mini and Inogen One G3 are great portable oxygen concentrators, with most of their features being nearly “identical” across dimensions, weight, noise level and the warranty, but the SimplyGo Mini had approximately 90 minutes of additional battery life while Inogen’s product featured auto-adjusting technology to maximize the efficiency of oxygen delivery. Since Respironics recently updated its website to enable patients to buy direct, the potential impact is difficult to discern but it is another example of intensifying competition. A key advantage provided by Respironics is having the lightest POC on the market to offer both continuous flow and pulse dose oxygen delivery. Its SimplyGo has more than twice the oxygen output of any POC weighing ten pounds or less. Neither the Inogen One G3 or G4 has the capability to offer continuous flow oxygen delivery which some HMEs view as limiting. Inogen’s intended G5 product might address that limitation.
Oxygen therapy is typically recommended for people who have ailments, such as lung disease, cancer, or heart problems, which prevent the proper amount of oxygen from circulating in the blood. It must be prescribed by a physician. Portable oxygen concentrators offer oxygen therapy for patients who live active lifestyles. POCs come in two basic types—pulse flow and a combination of pulse flow and continuous flow oxygen. A pulse flow concentrator provides puffs of oxygen when the patient inhales. A continuous flow concentrator provides oxygen flow regardless of whether the patient is inhaling or exhaling. Many patients find that pulse flow is more comfortable because they don’t have to fight against incoming oxygen when they are exhaling. Patients that need continuous flow oxygen typically like the ability to switch between the two flows.
Based on 2016 Medicare data and management’s estimate of the ratio of the Medicare market to the total market, the Company estimated in its most recent 10K that the current total addressable oxygen therapy market in the U.S. is $3-4B. As of 2016, management estimated 2.5-3M patients in the U.S. with over 60% of such oxygen therapy patients being covered by Medicare. Management estimates that there are more than 2M long-term oxygen therapy patients outside the U.S. The number of patients in the U.S. is expected to grow by 7-10% per annum through 2021 as a result of earlier diagnosis of chronic respiratory conditions, demographic trends and longer durations of oxygen therapy. According to the Company, ~70% of U.S. oxygen users require ambulatory oxygen and the remaining 30% are considered stationary. Per the Company’s 10K, clinical data shows that ambulatory patients that use oxygen 24/7, regardless of whether such patients use POC or the delivery model, have approximately two times the survival rate and spend at least 60% fewer days annually in the hospital than non-ambulatory 24/7 patients.
Management estimates that more than 85% of ambulatory patients rely upon the delivery model (i.e., stationary oxygen concentrators). Per management, the disadvantages of the delivery model include the following: limited flexibility outside the home including some products not cleared for commercial aircraft use, restricted mobility and inconvenience within the home, and the high product costs driven by the requisite infrastructure to serve the stationary oxygen alternative. A large component of the POC segment growth is being influenced by reimbursement pressures that confront the HMEs and their growing awareness that the POC non-delivery model is not only viable but also advantageous.
There’s a big price difference between the home and portable oxygen concentrator. The cost of miniaturizing the technology plus the price of batteries makes portable versions much more expensive. Some POCs cost as much as $4,000 versus the home models starting at ~$800.
The Company’s revenue is primarily generated from the U.S. with ~22% generated from outside the U.S. Of the revenue derived from the U.S., ~45% represented cash-pay sales to consumers, 43% represented sales to traditional home medical equipment providers, distributors (including the Company’s private label partner), and resellers, and ~12% represented direct-to-consumer rentals. One customer, private label partner Applied Home Healthcare Equipment, represented over 10% of total revenue in both 2016 and 2017. The Company began a more concerted effort selling into the HME channel with its private label offering in 2015. There were two customers, one with $10.4M and the other with $6.5M, having a receivable balance of more than 10% of the Company’s net receivables at the end of 2017.
Inogen is focused on its direct-to consumer (“DTC”) strategy in the U.S. Of the 78% in total revenue mix that was derived from the U.S. last year, Inogen’s DTC mix was ~45%. The Company’s management believes “we are the only manufacturer of portable oxygen concentrators that employs a direct-to consumer strategy in the United States.” However, that statement from the Company’s 10K is not true as some competitors have also launched their own DTC strategy. In fact, during the most recent investor day presentation at Chart Industries which competes through CAIRE and its brands AirSep and SeQual, Chart management included a slide pertaining to their focus on growing their Direct-to-Consumer channel. Chart launched its eCommerce platform in November 2017 and is licensed to sell direct in 48 states. Though market share data does not exist, it is not a leap of faith to assert that Inogen has developed a dominant share of the DTC channel. Since adopting its DTC strategy in 2009, Inogen has directly sold or rented over 362,000 of its oxygen concentrators as of year-end 2017.
I do find it notable to highlight the recurring comment I heard during primary research conducted with some former Inogen employees and some competitors. The specific comment was that Inogen is “a glorified telemarketer”. Inogen’s management was very smart at seizing the opportunity to drive a category brand with the end user and to go direct before anyone else. Two individuals said their strategy reminded them of NutriSystem, another compared their advertising strategy to “Mr. Pillow,” and another cited the analogy of Blue Apron. It is perhaps not a coincidence that one can see each of those companies pushing their products during early morning commercials, as I have seen on networks like CNBC. These are just some anecdotal comments of course and there are so many highly profitable business models driven by such marketing-driven approaches, and I applaud Inogen’s success with it (though I think the market is grossly overpaying for it). I am not trying to disparage their strategy but I do question the sustainability of it at historical levels of leads and conversions against the competitive landscape when well-capitalized competitors are elevating their own approaches in both the critical HME channel and some in the DTC channel.
Inogen’s management is not ignoring such competition, they have accelerated their pace of recruiting internal sales representatives, up almost 50% from the end of 2016 to 263 at the end of 2017. The Company increased its sales and marketing expense by over 35% in 2017, and spent 20.3% on sales and marketing, which was an increase of 180 basis points of revenue from 2016. Inogen’s media and advertising costs more than doubled in 2017, from $6.2M to $12.5M, but this is still just 5% of revenue.
While Inogen has done a great job growing the cash pay market through both direct and telemarketing to capture some patients, the vast majority of patients are serviced by traditional HMEs. As Inogen’s CEO said, “HME providers turn to portable oxygen concentrators to lower their operating costs in the face of insurance reimbursement reductions.” The CFO said, “we’re more cautious on the B2B side…we do expect average selling prices to decline over time particularly in the B2B side of the business as we see volumes increase. This is a price sensitive industry and with the competitive bidding pricing, continuing reimbursement pressures, we expect that to translate into manufacturing pricing pressure as well.” The CFO added that “when we look at competitive approaches price is a very common point for us to compete on and we have been able to maintain a small premium versus the competition, because our product is perceived to be of higher value both from a patient preference side as well as the reliability standpoint.” I think the word choice “perception” is critical as Inogen management has done an admirable job at branding Inogen with the end-user through its media and advertising to drive that “perception.” However, in multiple discussions with HMEs and also medical practitioners, there is not a widely-held belief by those who will influence the acceleration of POC adoption through the HME channel that Inogen’s product is that much better, if at all, versus the others. One individual said, “With regards to the options, they all seem similar but focused on small areas of difference in each class. It really is more about the specific requirements of the patient and although Inogen has the most brand recognition with the patient, I think it’s more about them highlighting the mobility advantages of the POC than why Inogen is better than other POCs so our job is to match the right product to the patient’s needs and Inogen has some limitations, particularly with regards to continuous flow which some patients find necessary.” This individual went on to highlight his interest to learn more about the Mobi from ResMed which only recently launched.
As Inogen’s CEO has indicated, the path of HMEs shifting to POCs from stationary oxygen therapy is “bumpy” but there is no doubt that it is happening. In a survey conducted by Needham research last year, the biggest factors that were limiting HMEs from converting to POCs were the magnitude of initial investment, reliability issues with POCs, their own difficulty transitioning away from tanks, POCs were less profitable than tanks, and patient co-payments were higher with POCs. At the time of the survey, only 36% of HMEs contacted said they planned to increase POC use. I am convinced, as I think the market is by virtue of Inogen’s valuation, that HMEs will continue to shift towards POCs but, as noted by the CEO, that trajectory could be “bumpy.” An equity trading at ~105x next year’s earnings might not be discounting the possibility of anything short of continued smooth growth.
With ResMed’s intent to “scale-up” and their depth of influence with both the HME channel and the medical community, I believe ResMed’s Mobi and other products that ResMed introduces will have a greater impact to Inogen than the market is discounting and Inogen’s management is admitting (although their insider selling might be more demonstrative of their concern than what they say). During the Q4’17 call in response to a question regarding Mobi, Inogen’s CEO said, “We still don’t know anything about their specifications. So, we’re just as anxious with all of you to understand the product better.”
During 2016, it was estimated that Inogen’s share of POC sales to HMEs was 25-30%. Although there is no clear market share data, Inogen’s management recently communicated, during its Q4’17 earnings call, its belief that their market share is about 50% of the overall POC market, and this has increased from the low 40s over the last couple of years. During that same call, the CFO said “we’re not assuming any material change in our market share penetration or percent at that 50% or so level.” This is the core tenet of the short thesis. For a product that lacks significant differentiation, where by management’s own admission the barriers to entry are low and the expectation for increased competition from existing and new providers is high, where pricing is already declining per unit, within a regulatory framework that is likely to further pressure pricing, and within the competitive landscape are two much larger companies (ResMed and Philips) who could choose to drive volume and their own share at Inogen’s expense to secure their own positioning, I don’t think the notion of maintaining 50% share in the medium-term will prove practical.
As part of its HME channel strategy, the Company has a private label partner to whom Inogen sells its product at a lower price to enable that partner to also profit as they drive the HME penetration. During 2017, it was estimated that more than half of Inogen’s domestic B2B business was being sold to traditional HMEs through its private label partner Allied Home Healthcare. Allied’s OxyGo and OxyGo Fit are the private label versions of the Inogen G3 and G4.
The oxygen therapy market will continue to grow and the POC category within it should grow more quickly; this growth is widely expected which has prompted competitors like ResMed to pursue the market and it would not be surprising to witness other strong new entrants as well. The barriers to entry are low. The technology is not a hurdle and as Inogen has noted, “given the relatively straightforward regulatory path in the oxygen therapy device manufacturing market, we expect that the industry will become increasingly competitive in the future.”
Inogen definitely has the brand advantage to continue its success in the DTC channel and the pursuit by others in penetrating this channel is too nascent to discern the potential impact. I view ResMed’s intention to “scale-up” as a meaningful competitive threat to Inogen in the HME category and my perspective is validated by discussions with numerous HMEs. There is plenty of market growth for each of the aforementioned competitors to succeed but the expectations ascribed by investors to each is very different as evidenced by their respective valuations, even when adjusting for growth prospects.
Though it is indisputable that Inogen is participating in a growth market, the Company’s valuation seems to imply that Inogen’s dominance in the DTC channel will not be marginalized by the competition nor the possibility of productivity challenges. Management has done an admirable job at driving its DTC strategy through effective media advertising to generate leads and converting leads to sales through its sales organization. The sales organization was 177 reps at the end of 2016 and will likely double within two years. The number of reps was up by almost 50% by the end of 2017. It typically takes 4-6 months for reps to reach full productivity. However, some research on employee engagement fails to resonate a glowing portrait.
From an employee perspective, where the median employee’s total annual compensation was less than $42,000 per the latest proxy, the reviews on Glassdoor are not very admirable and the overall rating of 2.7 has been trending down from slightly over 3 achieved earlier this year. The growth trajectory at Inogen has been impressive but a review of recent Glassdoor comments coupled with primary research conducted with former employees leads me to believe that the Company could soon stumble because the velocity of growth is too difficult for Inogen to effectively implement. Some specific comments from Glassdoor (since May 8th) are shared below, and although these are just anecdotal, the comments that follow are consistent with the substance of my discussions with former employees.
· “growing so quickly it’s caused some growing pains and leadership is stretched thin”
· “sweat shop”
· “way too many sales reps and few too leads”
· “the mass hiring has led to some growing pains for the company…the process of working with the billing team for insurance sales is completely broken”
· “hiring is outpacing the lead sources”
· “this is a company that is so far out of touch with the customer service effort that it is mind blowing, the service is so bad at this point that they are having sales reps try, and take customer service calls just so you are not on hold for 30 to 40 minutes”
· “glorified telemarketer”
Through my investment experience, it is not uncommon to see high-growth companies struggle with managing such growth effectively and there are frequently transitions towards improved management that eventually scales a business more appropriately. Inogen might in fact get there but at the current valuation, to the extent the Company soon struggles to adapt to its growth, whether because of questionable customer service or the difficulty to generate adequate leads for the growing sales force, or get those leads efficiently converted by an inexperienced sales force, the equity market might be less-than-forgiving at the current valuation.
One example of the Company struggling with its growth in the past is when, on March 11, 2015, INGN announced an audit investigation into accounting matters. The stock declined precipitously to bottom at 18% the next day and still closed down 16% within ten days from the audit investigation announcement. For context, the medical device index rose 3.5% during that period. HME News reported that the investigation into accounting practices could be representative of the potential “landmines” manufacturers face when selling direct to consumers. Industry experts said then that billing Medicare for products provided to beneficiaries is a whole different ballgame than billing HME providers. Don Davis, president of Duckride Advisors, said that “in a business like Inogen’s, where there is significant growth, it has the potential of distorting revenue.” The accounting issue stemmed from a “material weakness” with respect to internal control over the review of sales order documentation supporting the DTC sales and rentals prior to revenue recognition. The Company’s auditor BDO was replaced by Deloitte & Touche and remediation was completed as of December 31, 2015. The stock obviously more than recovered from that dislocation but the key takeaway is that with tremendous growth there is often numerous challenges to execute appropriately and setbacks have and could also be forthcoming. Investors should be less-than-forgiving as the valuation has ascended to the current multiple.
From a product innovation perspective, using R&D as the barometer, Inogen spent less than 4% more in 2017 versus 2016, and in fact spent only 2.1% of revenue on R&D which was less than the 2.5% spent in 2016. The Company is valued like a technology-driven darling, among the highest of the high-flyers, and this is despite NOT having any technology edge. Competitors like ResMed and Chart which each compete in numerous other segments spend 7% on R&D, as does healthcare device company Medtronics. Respironics parent Philips spends 10%. Inogen’s historical product cycle has been approximately every two years for a new product launch. The timing of a G5 product is likely to be late 2018 or early 2019. The focus of the G5 might be to enhance battery life and to reduce noise, both among the key issues that are important to patients. The other key issues for patients are product weight and size. A limitation across Inogen’s portfolio of products has been the level of flow rate. Inogen does not offer a continuous flow rate product and although management has not admitted this being a major limitation given the improved product flow rate of their upgrades, the HME market views a continuous flow rate product as relevant and the Company might develop a product to service that market segment. In the absence of such, management has probably over-estimated the magnitude of the addressable market.
During the Q4’17 call, in acknowledging pricing pressure (down 9% in 2016 and 4% in 2017), the CFO noted an expectation to leverage increased volume into lower materials and labor costs to offset that ASP pressure. However, it’s notable that during the following quarterly earnings call, management also acknowledged that the 25% proposed tariff then would impact components in the Company’s products such as lithium-ion batteries and circuit-board components. These rising input costs might be transitory but at Inogen’s valuation, expectations are inherently very high and the market could become impatient with margin contraction. Last quarter, gross margin declined by ~130bps and EBITDA margin declined by almost 110bps, although a mix shift directed away from rental revenue was a large component of that decline.
The notion that Inogen is just a “glorified telemarketer” is not the short thesis. They do sell a product that works, and their market segment is growing quickly, but the competition is intensifying and it is highly unlikely that Inogen’s growth rate won’t moderate sometime soon, in the medium-term, because of such competition. The Company will still grow quickly but if the growth rate moderates or the market becomes more rationale about value, both of which are likely I think in the medium term, this stock should re-rate significantly. The Company has done a great job of driving the POC category but that profit pool won’t be as dominated by Inogen for very long.
The 2019E P/E of almost 105 and 2020E P/E of almost 85 is vulnerable to contract with any set-back, whether induced by the competitive issues I have sought to highlight, an execution set-back because the growth has become too difficult to effectively capture, or a general market decline in which growth stocks are more likely to suffer disproportionately. On just a NASDAQ market decline from a couple of weeks ago when both FB and TWTR sold off hard on specific earnings news, it’s worth noting that Inogen declined by over 9% on no specific news from peak-to-trough. I think there is a passive investment dynamic one can ascribe to Inogen’s decline during that week just as Inogen has greatly benefitted from being among the names purchased by fund flows to momentum and/or growth. No one knows when that chase will end but this Company is among the storied “GAAP” stocks that I think will suffer accordingly when valuation matters again. I like that the frothy valuation at Inogen offers some protection (though I know it can get worse in this market) as a stock that I think is beyond “priced for perfection” and the slightest miss relative to escalating expectations should reward the short side.
Insider selling has been a recurring pattern since the Company’s IPO in 2014. During the past three years, insiders have sold almost $100M at an average price of ~$78. In fact, approximately 40% of those shares were sold three years ago at an average of ~$46.50. During the past two years, insider sales have been executed at an average of $98. These sales exclude the additional ~$4.5M posted this past Friday. Since almost all insider selling has been through a 10b5, one might deduce less significance from all the selling but I deem it worthy of highlighting given the magnitude of it and at much lower levels. I wonder if management is surprised by what the market is willing to pay for its shares.
Based on solid Q1 results, management raised its 2018 outlook on April 30th, and since then the stock has appreciated by ~45%, or ~$1.3B. This $1.3B of additional value was driven by increased guidance of 4-5% of top-line, EBITDA, and net income. The Company is likely to beat consensus estimates but this should be expected in light of a consistent pattern of upside surprises and the premium valuation, so the magnitude of such upside should matter more to the market, assuming the market is rationale which admittedly I harbor some concern given numerous distortions and therefore recommend this short be sized accordingly. Management has noted that Q2 is an easier comp for the Company in the DTC channel than Q3 or Q4.
There are of course numerous risks being short Inogen. That which gives me the biggest concern is that this market is enamored with top-line growth more than ever during my career as a professional investor and regardless of valuation, the stock will just keep going higher as the multiple expands. I mitigate this concern to some extent by how I size the position and own out-of-the-money call options as a risk management measure. I am also concerned that the management team, given the stock currency, could (and I think should) use it to diversify away from being a one-product business. To some extent, this concern is mitigated by the notion that a prudent seller would not take this currency for the sale of their business but of course management could tap the equity market to effectuate a transaction. This would presumably be a short-term catalyst and I would have to evaluate the quality of the business being acquired. The investment community might not react favorably at first to a path of diversification although I think it could be prudent over the longer term. There is of course the possibility that the competition does not execute effectively and Inogen’s market share expands even more coupled with the secular industry growth. I think that’s already how the market perceives the opportunity but the lack of competitive-driven catalysts would cause me to trim or cover the position as then the thesis would be more about valuation and that is of course a dangerous short thesis. Given the quality of competitors, I have ascribed a high probability that at least a subset of them will gain share accordingly, and likely at Inogen’s expense. I should also note that although this is not a crowded short, it is relatively tightly-held and there might be nothing that causes the largest owner VC firm Novo A/S to sell its stake. The top five shareholders comprised 50% of the outstanding shares and only one was a seller in Q1. The top ten shareholders comprised 60% of ownership and only three were sellers in Q1. Among the top ten shareholders are the conventional names that engage more in the “art” of passive investing and I don’t know if fundamental deterioration or valuation would cause them to sell their shares. As has been well-documented, shorting has never been more difficult and those inherent risks of course apply. Lastly, I will highlight that Citron Research put a short piece out on INGN on May 24thwith a “generous target of $95.” The stock declined almost 10% on the report but has never looked back. The momentum with Inogen as a stock is certainly an ongoing risk, and especially in this market.
Execution challenges (e.g., sales rep productivity)
Intensified competition, especially coming from ResMed, takes market share
Ongoing pricing pressure that leads to both gross and operating margin contraction
Moderation of top-line growth, slower adoption by HMEs
Under-reserved for lifetime warranties
Normalized market that is more rationale about valuation
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