Description

Invuity is a medical device company with a core disposables business growing at 25%, constituting 91% of their revenue, which currently trades at a significant discount to its peer group, at only 2x revenue for 2018. While this may not seem cheap at first glance, it needs to be viewed in the context of the entire medical device industry, where the overwhelming majority of small-cap and micro-cap companies with similar high growth rates and high gross margins trade with multiples of between 3x and 7x revenue, with some outliers trading as high as 11x and even 18x revenues (see Valuation and Upside, at bottom). This discount to the peer group is partly due to double-digit declines in re-usable product revenue which have obscured the high growth rate in the disposable segment for nearly twelve months. It is also due to a recall of Invuity’s most popular product, PhotonBlade, initiated only weeks after its initial launch, which depressed disposable revenue in late 2017 just as sales were ramping up.  These setbacks, and others, occurring over the course of two years since Invuity’s IPO in June 2016, have resulted in a decline in Invuity’s stock price from a high of $14 in November 2016 to less than $3 earlier this month. Nevertheless, management continues to affirm its 2018 revenue guidance of $46 million, despite incredulity among investors, and has put in place an ambitious plan to halt the slide in re-usable revenues, cut operating expenses, and refocus the sales force.  Should the company be successful and achieve their revenue targets for the year, the wide gap between the market valuation of Invuity and the valuation of its peer group could mean significant upside for the stock.

Quick Overview of Product Line

Invuity provides illuminated medical devices for use by surgeons, solving the problem of how to illuminate the interior of the body during surgery without using overhead lamps or headlamps, both of which are inconvenient to use and cannot provide the same level of illumination as a lighting device positioned inside the body cavity. Each of the company’s products use a series of lenses – a “waveguide” – acting in a manner similar to fiber optics, to directly illuminate that portion of the body where the surgeon is immediately focused. The company’s retractors for example, which hold open the body orifice during open surgery, combined with a disposable waveguide attachment that slips onto the retractor itself, shine light directly into the body cavity from the edge of the retractor. The company’s aspirators, or suction devices, are illuminated near the tip of the device, enabling the surgeon to better see what he is suctioning. And finally, PhotonBlade, which is a device that makes incisions using radio frequency energy, is also illuminated at the tip, providing direct illumination of the area that requires the incision. No other method of illumination in the past has provided the same kind of lighting precision or ease of use during surgery and there has been a quick uptake by doctors and hospitals of the company’s products. The company’s offerings consist of the three product lines mentioned above: illuminated retraction, which contributes about 50% to single-use revenues; illuminated aspiration, which contributes 30%; and PhotonBlade, which contributes 20%. According to the company, the markets they are targeting have a combined size of about $1.25 billion, into which Invuity has achieved a penetration rate of only 3%.

It is worth taking a quick look at the company’s latest corporate presentation, pp 8-13, to see what these products look like and why they are so useful to surgeons.

http://investors.invuity.com/phoenix.zhtml?c=253978&p=irol-presentations

Competition

Illumination during surgical procedures has historically been provided by overhead lighting and headlamps, and this is still typically what the company encounters in the market when they go to sell their illuminated devices. There are other companies which offer illuminated tools but management describes these products as being “very, very deficient”. There are no serious competitors for the company’s illuminated aspiration devices, which still compete only against overhead lighting and headlamps. The sale of aspiration devices hinges entirely on whether Invuity can convince the surgeon and the hospital that it’s worth investing $300 to substitute illuminated aspiration for overhead lighting.

The situation is different in the illuminated retraction segment.  At the beginning of 2017, Medtronic entered the market with their RadiaLux illuminated retractors:

https://www.medtronic.com/us-en/healthcare-professionals/products/general-surgery/lighted-retractors/radialux.html

Radilux uses an LED lighting system which, according to Invuity, is an inferior technology that has been used in the past by a number of other, smaller competitors. But because of Medtronic’s size and channel muscle, the company is facing significant competition from Medtronic in illuminated retraction despite having the better product.

In the PhotonBlade space, the roles are reversed. Medtronic was the first-to-market with the Peak PlasmaBlade, a non-illuminated device which uses RF energy pulses to make precise surgical incisions and simultaneously coagulate soft tissue.

https://www.medtronic.com/us-en/healthcare-professionals/products/general-surgery/electrosurgical/plasmablade-soft-tissue-dissection.html

But Invuity followed Medtronic into this space in late 2017 with the release of PhotonBlade, a directly competing product, which appears to be superior in its cutting ability to Medtronic’s PlasmaBlade, comes with built-in illumination at the tip, and does not require the extra expense of buying a $20,000 generator as it can simply plug into the hospitals’ existing generators.

https://invuity.com/products/photonblade/

http://investors.invuity.com/phoenix.zhtml?c=253978&p=irol-newsArticle&ID=2348984

PhotonBlade is now the largest contributor to growth in Invuity’s disposable revenue segment. It is such an easy sale for the reps to make, having a short sale cycle of only a few weeks as well as a clear advantage over Medtronic's PlasmaBlade that, to some extent, they have been focused on selling PhotonBlade at the expense of Invuity’s other products such as retractors and aspirators.

Reasons for Share Price Decline

On May 3rd, Invuity reported total first quarter revenue of $9.5 million, representing a growth rate of only 5.3% year over year. Disposable revenue was strong, up 22% in the quarter, but this was masked by a 38% decline in re-usable revenue and a complete absence of corporate revenue. As can be seen from the table below, re-usable revenue has been declining by double-digits in every quarter since Q1 2017 suppressing the company’s top line revenue growth even while disposable revenue has been increasing in the double digits.

The reason for the decline in reusable revenue was threefold:  First, the company began spreading its sales efforts among other disposable products, including aspirators and PhotonBlade, which diluted their focus on retractors. Second, beginning in 2017, the reusable retractor began to be bundled with the disposable waveguides, or discounted on a “buy one, get one free” basis when sold individually, reducing its ASP to about $450 per unit from $900. Finally, the company continues to see meaningful competition from Medtronic in their retractor segment as mentioned earlier, which has had both the effect of encouraging salespeople to spend their time on PhotonBlade, an easier sale, and to reduce the number of sales made overall.

But reuseable revenues were not the only problem in 2017. There was a noticeable drop in the growth of disposable revenue as well. This was partly due to the recall of PhotonBlade, which was launched in March of that year and recalled only three months later. The salesforce had geared up to sell PhotonBlade having been told by management that it would be one of the company’s hottest selling products. But at the end of the second quarter, after three months of generating leads and lining up new accounts, the sales team was told that PhotonBlade would be recalled and that they would have to go back to selling other products. This resulted in a significant drop in disposable revenue in Q3 and forced the company to cut guidance for the year. The other problem, alluded to earlier, was that the company’s reps had been left on their own to decide which products to sell in the field and ended up focusing most of their attention of PhotonBlade, since it was the easier sale to make and had a shorter sales cycle than selling illuminated retractors or aspirators. This led to a decline in the sales of the company’s other disposable products throughout 2017 as PhotonBlade became the reps’ main focus.

Aside from the declining growth in revenues in both disposable and reusable products, there were other factors that contributed to the stock’s decline from a post-IPO high of $14 in late September 2016 to a low of $2.35 in May of this year. Beginning in November, 2016, a little over a year after their IPO, management began revising their revenue estimates downward, not just once, but several times in a row, having regularly provided overly aggressive growth assumptions. Forward revenue guidance was first revised downward in Nov 2016 from a midpoint of $36 million to $32 million; in Q2 2017, the 2017 guidance was revised downward from a midpoint of $43 million to $41 million; and in Q3 of the same year it was revised downward yet again to $40.5 million. Management issued new guidance for 2018 in the Q4 press release targeting $46 million in total revenue for 2018 and growth in disposable revenue of 25%. But given their performance in previous periods, there is extreme skepticism as to whether their current guidance for 2018 is any more reliable than previous guidance. Management recently commented:

“Unfortunately, we've had a checkered history of delivering our results. We've grown the company significantly from when it was public, which is great, but unfortunately not at the rate or to the level that we've often conveyed to Wall Street.”

Certainly, in the most recent conference call, investors did not seem willing to take the latest revenue projections at face value. The interim CEO, Scott Flora, who replaced Invuity’s previous CEO on February 28th after the board of directors asked him to resign, did not do the best job of assuaging investors’ concerns, avoiding answers to several pointed questions about guidance and answering other questions with pre-prepared remarks that had little to do with the questions themselves. Sentiment took another turn south and the stock crashed to a low of $2.35 following the call.

Can Management Make their Numbers this Time?

After four consecutive quarters of double-digit declines, reusable revenue now represents less than 10% of total revenue, making it difficult for any further declines in reusable revenue, should there be any, to mask the high growth rate of the disposable segment. On top of this, management has refocused and re-incentivized the company’s salesforce to sell not only PhotonBlade, the company’s runaway success, but also the company’s other products as well, including reusable retractors and disposable aspirators. So it is hard to believe that reusable revenue will fall further from these already low levels. Also, by incentiving the salesforce to spend more of their time sellig the company's core disposable products instead of concentrating their efforts on PhotonBlade, management hopes that the growth in overall disposable revenue will benefit as well.

The new sales strategy will refocus the company’s direct salesforce on those accounts in major city-centers with the highest volume of procedures in order to maximize salesforce productivity. All other regions and outlying areas will be covered by an indirect sales channel of local and regional distributors. The company should then be able to sell more of their products across all categories while simultaneously reducing the salesforce and cutting operating expenses. Management believes the addition of the indirect sales channel will add incremental revenues beginning in the second half of the year.

A large part of the decline in the revenue for Q1 2018 was due to a complete absence of corporate revenue from Zimmer Biomet for whom the company manufactures a custom waveguide to work with Zimmer’s spine retractor. Biomet Zimmer had an overstock of the company’s waveguides at the end of 2017 and notified the company that they wouldn’t be buying additional waveguides until the second half of 2018. Therefore, neither Q1 nor Q2 this year will see any corporate revenue, which normally has a run-rate of about $250k to $500k per quarter.  According to management, corporate revenue from Biomet Zimmer should return in the second half of the year and their revenue guidance for the year includes approximately $800k from this source.

It is difficult to know whether management’s new strategy to re-align the salesforce will work as they intend or whether it ends up increasing the growth rate of retractors and aspirators at the expense of PhotonBlade. In particular, one wonders whether the desire of the salesforce to focus mostly on PhotonBlade is not a sign to management that this product should be the central focus of their business. Nevertheless, the company is the clear leader in illuminated surgical devices and has a compelling product line-up. Whether their new strategy works in whole, or in part, the company should do reasonably well across all their product categories in 2018 even if they fail to hit their guidance of $46 million. If for whatever reason the company misses their guidance for the year by a sizable amount, the consequences would not be good. They would need to renegotiate the revenue covenants under their lending facility and would probably end up doing a dilutive offering at a price lower than where the stock is today. But even if this happens, sentiment is so negative right now that there will likely be an opportunity to make money or breakeven on the investment at some point in the future, particularly if the medical device group continues to trade at lofty valuations. On the other hand, if they achieve their guidance, the stock has meaningful upside over a very short period of only 6 to 8 months based on the market valuation of its peer group.

Balance Sheet and Cash Flow Neutrality

The company had $33.5 million in cash and equivalents at the end of Q1, a term loan with an outstanding balance of $29.2 million, and a $10 million revolving line of credit with a balance of $4.4 million. The commitment on the line of credit can be extended to $20 million subject to the company meeting certain conditions. The revolver terminates on March 1, 2022, and the term loan must be paid in 36 equal installments beginning April 1, 2019. The term loan has a covenant, amended recently, that puts the company in default should they not meet their guidance of $46 million in 2018.

The following model is a back-of-the-envelope estimate of Invuity’s cash flow from operations over the periods 2018–2020. Assuming a continuation of their 25% growth rate in the disposable segment, unhindered by declining revenues in the reusable segment, the company should be capable of achieving cash flow breakeven at some point during 2020 at a run-rate of about $72 million in sales. This model needs be taken a bit with a grain of salt because we really have no idea whether growth trends closer to 20% or to 30%, but it does give a loose approximation of when the company should achieve a neutral cash flow position and would not be out-of-line with the company’s historical growth rates.

Q4 2018 – Near Breakeven?

Q4 2018 can be modelled a bit more reliably. Assuming the company hits their 25% growth targets, revenues would rise from 11.2 million in Q4 2017 to 14 million in Q4 2018. Cash on hand should be about $15 million at year-end, while total negative cash flow for Q4, including interest expense, would be only $2.6 million. A result showing a small cash loss would be a signal to investors that the company can achieve profitability without endless dilution, particularly when seen against a backdrop of $20 million in total liquidity, of which at least $15 million would be in cash, and the rest in the form of availability on the revolver. Here are the back-of-the-envelope numbers for Q4:

Q4 Cash Flow from Operations

Q4 Revenue...........................$14.0 million  ($11.2 million Q4 2017 x 1.25%)

Gross Margin.......................................66%

Gross Profit..............................$9.2 million

Op Ex........................................$13 million

Non-cash items........................$1.2 million          

CF from Operations................$(2.6) million

Cash Balance – End of Q4 2018

Cash Balance – end of 2017...............$21 million

Proceeds from stock offering...............$21.7 million

CF from operations 2018....................$(26.7 million)  see 2018 model above

Capex..................................................$(1 million)

Cash Balance – end of 2018...............$15 million

Total liquidity – end of 2018.................$15 million cash + $5.6 million revolver  (or some combination)

Valuation and Upside

In their Q1 press release on May 3rd, Invuity management stated that they “continue to expect revenue of greater than $46 million” in 2018, implying an overall growth rate of 16.4% year over year, and “disposable revenue to grow in excess of 25%”. Disposable revenue is now 91% of the company’s business so it is likely that total revenue growth will continue to trend toward the 25% growth rate in disposable revenue. Gross margins were 70.3% during 2017, 69.3% in the first quarter of 2018, and were forecast to be in the “mid-sixties” for all of 2018.

Assuming management hits these targets, the company may trade closer in-line with other companies in the medical device space exhibiting similar revenue growth and gross-margin characteristics. The table below contains a random sampling of 35 small-cap and micro-cap companies in the medical device space. The revenue growth rate for each of these companies in 2018, shown in column 12, and their 2018 gross margins shown in column 13, were taken directly from management’s guidance in either their latest conference calls or press releases. Therefore, the EV/sales ratio calculated in the far right-hand column is the ratio of current enterprise value to management’s 2018 revenue guidance.

The average EV/sales ratio for the entire group of 35 companies using this method is 5.10, with 51% having an EV/sales ratio above 4, and 26% having an EV/sales ratio above 5. Also interesting is that among the subset of companies which expect double-digit growth in revenues for 2018 and which have gross margins greater than 65% (12 in all, highlighted in red), there was not one that traded with an EV/sales ratio of less than 3x, implying that the market is willing to give medical device companies with these characteristics a minimum valuation of 3x sales. The only medical device company I could find with 2018 revenue guidance in the double-digits combined with gross margins above 65%, and which is currently trading at an EV/sales ratio less than 3x is Invuity, which currently trades at a ratio of 2.0 based on management’s 2018 guidance of $46 million in sales.

If IVTY were to hit their sales targets at the end of the year and trade at the lowest multiple awarded to companies in its subspace with similar revenue growth rates and gross margins, the expected stock price would be $5.63 per share, which is a return of 60% in six to eight months:

3x hypothetical 2019 guidance of $57.5 million (implying 25% growth yoy) = $172.5 million

Subtract end-of-year Net Debt of $17 million = $155.5 million

Divided by fully-diluted shares of 27.6 million = $5.63 per share

At a multiple of 4x sales, which is the minimum multiple awarded to greater than 80% of the stocks in the subgroup (highlighted in red), the stock would trade at $7.72, for 121% upside.

Catalyst

• Management achieves their stated revenue guidance of $46 million at year-end
• Sufficient revenue growth is shown each quarter sequentially that makes hitting the year-end target of $46 million look inevitable
• YOY growth in revenues from re-usable products turns positive
• Corporate revenues from Biomet Zimmer return in the second half of the year
• PhotonBlade continues to be a category killer and its growth is not slowed by management’s reorganization of the sales structure
• Significant revenues from indirect sales begin to appear in the second half