Description

Kensy Nash is a growth company trading at a value price. In short, the value of a single product line can come close to justifying the current valuation, while the opportunity in what remains outside of this single product line represents significant incremental value relative to the current price.

Kensey Nash came public in 1995 on the prospects of a core product called Angio-Seal. The Angio-Seal is a femoral artery closure device and today is best characterized as representing KNSY's base business. The Angio-Seal is an alternative to the traditional method of using manual pressure to stop bleeding in the leg after an interventional or diagnostic procedure that requires the insertion of a catheter through the femoral artery. The device consists of three components- a collagen plug, a plastic anchor and suture, each of which is resorbable into the body over time.

The entire process is simple to perform and takes only two minutes – this compared to the traditional technique in which 15 minutes of manually applied pressure is applied followed by four hours of sandbag pressure. The principal advantages of using the Angio-Seal are that the patient is discharged sooner and the nurse that had previously been required to administer the manual pressure is freed to serve other patients.

KNSY initially licensed the product to American Home Products, who subsequently sold rights to the product to Kendall Healthcare. Both of these marketing collaborations were unsuccessful. In 1999, marketing rights to the product found their way into the hands of St. Jude Medical, who has been very successful in its marketing of the Angio-Seal.

St. Jude will likely do in excess of $325 million in Angio-Seal sales in 2005 and has been growing Angio-Seal at double digit rates every year since acquiring rights to the product. St. Jude currently has in excess of 60% market share for arterial closure devices and dominates the market. The economics of the collaboration are such that KNSY earns a royalty of 6% on each unit sold and has a contractual commitment from St. Jude that St. Jude will buy a certain percentage of parts to make the Angio-Seal device.

The agreement with St. Jude on royalties extends until 2017, the year the basic patents expire. The agreement to purchase biomaterials from KNSY was recently renewed and extended through 2010. This is noteworthy inasmuch as St. Jude was not obligated to extend the purchase agreement; having done so demonstrates that the biomaterials are not an easy-to- duplicate commodity.

Biomaterials-excluding Angio-Seal
Collagen based products are based on highly processed bovine tissue. Orthovita (VITA-OTC) partnered with KNSY to develop the VITOSS product line, which helps promote bone growth in spinal fusion cases. The product is manufactured by KNSY and is marketed by Orthovita. KNSY receives manufacturing revenues as well as royalties.

Polymer based products are medical grade plastics that can be molded into various shapes such as screws and plates. The largest customer is Arthrex, a privately held medical device company focused on orthopedics.

Tri-Activ- is KNSY’s most exciting opportunity and addresses a potential $1 billion+ dollar market opportunity when including both coronary stenting as well as carodid stenting. Blood clots and debris have the tendency to break off as a stent is being placed and can cause either a stroke or a heart attack. The TriActiv device serves to create a “safe space” with the use of a ballon, and flushes and extracts any loose particles from the vessel. Clinincal trials have demonstrated the benefits of the TriActiv system in the coronary area and are underway for carodid stenting.

The current annual run-rate of competitors’ devices, principally Boston Scientific and Medtronic, amount to $100 million- all derived from the coronary market. Unlike the KNSY solution, competitors’ solutions are based on filter technology, which is believed by many to not remove quite as much of the debris as the TriActive’s flushing mechanism. This will prove increasingly important in the carodid stentiung area, which, while emerging, is potentially the largest and most lucrative. There are 500,000 carodid surgeries performed per year. If the entire market were to convert to stenting- and one assumed an ASP for the KNSY TriActiv device of $1,500, that would translate into an annual market of $750 million. Even modest penetration of this market would be a major homerun for KNSY. Unlike the Angio-Seal and biomaterial businesses, TriActiv represents KNSY’s first effort to market its own product.

Biomaterial sales in fiscal 2005 (year ending June) of $20 million (not including the Angio-Seal bio-materials) are expected to be flat in 2006 due to inventory corrections at the two primary OEM customers- Orthovita and Arthrex. In 2007, biomaterial sales are expected to increase to $28 million as the inventory correction will have run its course by then. Most importantly, the greatest indicator that the flatness in OEM sales in fiscal 2006 will be transient is that end user sales by the OEMs have grown consistently. Royalties from biomaterial sales are expected to be $3 million in fiscal 2006 and $6 million in 2007. TriActiv sales are expected to be $10 million in Fiscal 2007 and could grow rapidly thereafter depending mostly upon how large the carodid opportunity.

Reported earnings were flat between fiscal 2004 and 2005- at $1.06 per share. Earnings were flat even as product sales increased and end user sales of Angio-Seal increased 20%. Royalty income was flattish despite the healthy rise in end user sales of Angio-Seal due to the decline in royalty rate from 9% in 2004 to 6% in 2005. Imprtantly, the decline to 6% was based on cumulative shipments.

The stock declined from the $30 range to the low $20 range due to a disappointing September earnings report. Lower than expected September quarter earnings were mostly related to lower than expected biomaterial sales, caused by inventory buildups at the major customers. These inventory issues should be resolved by the back half of the fiscal year. In addition, large incremental biomaterial customers are expected to come on stream by then. Current earnings are also being depressed by heavy R&D spending,( all of which is being spent on growth initiatives, such as Biomaterials and TriActiv, and virtually none on Angio-Seal) and higher SG&A expenses related to the TriActiv launch.



VALUATION
The recommendation to purchase KNSY is premised on the fact that the Angio-Seal franchise has a net present value of $15/share when using a discount rate of 10%. If one includes the value from the $3.20 per share in cash- one is left with an implied value for the rest of the business of $5 per share or $60 million. There is substantial value remaining in the biomaterials business as well as the upside potential inherent to the Tri-Active opportunity.

The assumptions made in arriving at the $15 NPV is as follows: I used 2006 as the first year of my calculation and had first year royalty of $21 million and first year Angio-Seal component sales of $16 million. I further assumed a gross profit margin of 100% on royalties and 60% on component sales. I assumed top line growth of 7% between 2006 and 2017, with zero terminal value. I also assumed that the agreement to purchase components would be renewed and in effect between 2011 and 2017. In the event that it is not renewed it would take $2.00 off of the NPV calculation.


While not as useful, one can look at the earning power of the Angio-Seal Franchise currently. If the company were to shut down its efforts save for milking the AngioSeal product line, the company would generate royalty income of $21 million in 2006 and Angio-Seal component revenue of $16 million. Assuming 100% gross profit on the royalties and gross profit of 60% on the component sales, one ends up with gross profit of $31 million. Assuming a 30% tax rate one ends up with net earnings of $20 million or EPS of $1.75.

So now that we have discussed what the base Angio-Seal business is worth- what is the remaining business worth? As stated previously, the market is implying a value of $5/share or $60 million or, in the worst case of STJ not renewing the purchase agreement in 2010, $7/share or $84 million. In light of the fact that KNSY’s biomaterial business is viable and growing with a rich pipeline and in light of the fact that TriActive, while ultimately still not proven, has a billion dollar+ market opportunity, I believe that KNSY is a bargain at the current price.

Catalyst

Resumption of growth in biomaterial sales
positive progress in carodid stenting trial using TriActiv FX(newer more elegant version of TriActiv)