Japan Lifeline (JLL) is a medical device manufacturer and distributor, specializing in cardiovascular devices. This is not a deep value idea, especially after shares have appreciated +17% this month, but it is a quality business that remains undervalued at 15x cash earnings (Mar-21). JLL has a net debt neutral balance sheet and is growing top line at a 15% CAGR, with demographic tailwinds and a defensible position as a leading manufacturer/distributor of cardiovascular devices in a highly regulated market. This deserves an above-market multiple. Looking out 2 years and using its prior 3 year average 21x earnings, the equity should trade at JPY 2,500/share, a 33% premium to the current share price. Further upside is possible as the internally developed/manufactured products continues to scale, and as a brand new distribution agreement with Boston Scientific ramps up.
Business and Market
JLL covers four specialty areas. Half of its sales are from internally manufactured products and the other half is from the distribution of products from overseas manufacturers:
51% of sales: Electrophysiology/Ablation (catheter systems for arrhythmia detection/treatment) This is the fastest growing division with the highest proportion of internally manufactured products.
26% of sales: Vascular surgery grafts
13% of sales: Cardiac rhythm management (i.e. pacemakers)
11% of sales: Transvascular interventions (catheters, stents and guide wires)
JLL began as a trading company in 1981, importing medical devices for domestic use. This involves identifying demand, sourcing products and then guiding the products though Japanese regulatory approval on behalf of the foreign manufacturer. In the company’s own words, “JLL has acquired a high market share by taking on a role similar to that of a manufacturer, encompassing the introduction and marketing of new medical devices in Japan as well as sale of products.”
Japan is a relatively stringent regulatory market and JLL’s experience is a differentiated edge. In addition to this regulatory experience JLL has a nationwide sales force with relationships at all major hospitals. International manufacturers value this. Just this month, JLL began acting as the exclusive distributor of cardiac rhythm products for Boston Scientific, which abandoned its own on-the-ground initiative in Japan in favor of partnering with JLL. (More on this below).
JLL’s manufacturing capacity was launched in 1999 but took over a decade to scale. Today it has five facilities: three in Japan, one in China, and one JPY 2bn greenfield factory in Malaysia set to come online next year. JLL manufacturers electrophysiology and ablation catheters, surgical guidewires, vascular grafts and stent grafts. In 2012 it brought to market its first 100% in-house developed product, an Internal Atrial Cardioversion System. The company touts its close ties with Japanese medical institutions as a core advantage in developing and bringing to market new cardiovascular devices for the Japanese market. Today half of sales are from internally manufactured products, and the EBITDA margin has expanded accordingly from single digits ten years ago to ~25% today.
Japan has had universal healthcare since 1958. Reimbursement rates are set by the Ministry of Health, Labor and Welfare, and the nationalized healthcare insurance program covers up to 70% of medical costs. 80% of hospitals in Japan operate on a fee-for-service model using these nationalized reimbursement rates.
Special Treatment Medical Devices (STMD) are regulated and priced similarly to pharmaceuticals. This Ministry of Health presentation provides a good overview of pharma pricing mechanisms. The regulator looks at manufacturer and wholesaler ASPs, applies usefulness/innovation premiums if applicable, and most notably applies an adjustment if prices deviate +/- 25% from overseas prices (US, UK, Germany, France and Australia). As per the table below, device reimbursement pricing differs from pharmaceutical pricing in two key ways: (1) devices are eligible for improvement premiums (of up to 20% based on incremental efficacy gains), and (2) devices are ineligible for future upward reimbursement adjustments based on overseas pricing.
Japan’s medical device market is JPY 2.9 trillion/year, constituting 6.3% of the NHI’s medical expense budget (2016 figures, source here). This percentage has remained stable for at least 35 years. It is fair to say that there is constant downward pressure on medical device prices, with new product introductions critical to achieving higher prices and/or margins. Notably, reimbursement prices are set by functional category, not by product brand or model. Government-induced price pressure is an ever-present risk to JLL’s profitability, but there is strong demand for continual product innovation to address a growing geriatric population that requires less invasive medical procedures and devices.
JLL’s margins have expanded as its mix has shifted. 20 years ago the firm was a pureplay distributor in a less complicated regulatory environment, earning low single-digit margins. Today half of the company’s sales are from internally-manufactured products and its distributed sales come from exclusive agreements that include higher-value product launch services. Management guide for the mix to shift slightly back towards distribution sales in the coming years due to new large distribution contracts, most notably with Boston Scientific. Operating profit margin, however, is expected to remain stable at ~23% thanks to (a) the maturation of higher-margin in-house offerings and (b) strong operating leverage on incremental distribution sales.
EBITDA margins of >23% certainly appear high for a company with 50% of sales in distribution, but JLL’s distribution business is more profitable than, for example, US distributors, due to its practice of entering exclusive contracts with foreign manufacturers, limiting these contracts to one partner per product category, and providing white glove product approval, launch and compliance services in addition to sales. This allows JLL to earn gross margins of 40%-50% for distributed products (versus ~20% in the US) and 70%-80% for internally-manufactured products. Group operating expenses of <40% of sales means JLL is able to earn up to 10% EBIT margins in distribution and >30% in manufacturing.
The operating leverage is clear and management guide for SG&A to continue declining as a % of sales. Over the last 5 years revenue has grown at a 13% CAGR while operating expenses have only grown at an 8.5% CAGR. Most notably labor costs only grew at a 6% rate and has accordingly declines as a % of sales (red line):
Source: Thomson Reuters data
JLL management annually update a rolling 5 year plan. The most recent plan outlines a 14.5% sales growth CAGR and stable operating profit margin: