Description

Long - Nuvectra (Nasdaq: NVTR)

Share Price: $6.10

FDSO: 10.3mm

Market Capitalization $62.6mm

Enterprise Value: $107.6mm

Note: We recognize that this idea is likely too small for many funds, but think it is a fantastic opportunity and risk/reward for personal accounts. Please view this recommendation as such.

Thesis Summary

1. We believe Nuvectra is a classic spinoff situation disguised as a high-risk, early-stage medical device company.

1. The Company has two main products with $1.6bn and $500mm end-markets both expected to grow at 10% annually.

2. Its primary product Algovita has already been approved by the FDA for commercial use starting in 1H2016 and is already being sold in Europe, even though the market valuation seems to imply a large likelihood that the product never even gets to market.

3. In connection with the spin, the Company entered into a 5-year supply agreement with its former parent Greatchbatch to manufacture and fully assemble Algovita. We believe the terms of the agreement demonstrate Greatbatch’s significant confidence in the product and operationally derisk the business considerably.

4. The Company has a valuable IP portfolio and also received bids for this portfolio during its spin-off process that imply a minimum valuation above the current market value, creating a great margin of safety.

5. In summary, we think this spinoff situation allows you to participate in all the upside optionality of two high-growth medical device products at a value price

6. We think Nuvectra can be a 5/6-bagger in the next 2-3 years.

Write-up

1. Nuvectra (“NVTR”) is a neuromodulation platform recently spun out of Greatbatch (NYSE: GB; “GB”) last month (March 2016)

1. GB shareholders received one share of NVTR for every 3 GB shares

2. Company’s primary product (Algovita) targets the $1.6bn spinal cord stimulation market (SCS) for chronic pain and set for commercialization this year and a secondary product (Pelvistim) targeting the $500mm sacral nerve stimulation market (SNS) for bladder & bowel control set for launch in 1Q2018. NVTR also believes that its neurostimulation will have valuable indications for deep brain stimulation (DBS), but we have not included that in our analysis given its long-dated nature in the pipeline.

1. In layman’s terms SCS therapy uses steady pulses of energy to the nerves in and around the spinal cord to generate paresthesia to “cover” areas of pain. Traditional SCS therapy is the go-to alternative after failed back surgery for chronic pain. First, a trial procedure is done using a trial stimulator (ASP ~$2k), which delivers electric pulses to leads connected to the spine externally. If this trial is successful then the full implantable SCS product is installed (conversion ~65-70%).

2. A picture of the Algovita product is below:

3. Both SCS and SNS end markets are growing rapidly: ~10% annually

4. SCS market has 4 players (market share shown below): Medtronic, Boston Scientific and St. Jude Medical, which provide very similar traditional SCS therapies, while Nevro is the disruptor in the market using a differentiated high-frequency stimulation therapy

5. SNS market opportunity is very attractive with only one player, Medtronic, allowing NVTR to more easily claim a piece of the market

6. NVTR has a highly experienced management team with neuromodulation roots developed at St. Jude Medical, one of Nuvectra’s four main SCS competitors, and a highly successful implantable medical device company which Nuvectra’s team helped grow to a $16bn market cap

7. The company believes Algovita has significant competitive advantages over other SCS systems including:

1. Algovita uses a differentiated neurostimulation technology platform that is user friendly and offers a broad set of capabilities.

2. Algovita’s product design is expected to minimize early therapy failures.

3. Algovita’s neurostimulation technology platform is designed to be upgradeable.

4. Future growth will derive from an expansion of the sales and marketing organization to promote awareness and demonstrate the value of Algovita among surgeons, referring physicians and patients

5. We believe the market is missing this opportunity for a couple reasons 1) market capitalization is clearly small, below the scope of many funds and sell-side coverage is limited and 2) the Company screens and is quickly labeled as a pre-commercial medical device manufacturer. In reality, the Company has already received FDA approval for its primary product and commercialization within the next few months is almost certain.

1. On November 30, 2015, GB announced receipt of premarket approval for Algovita from the FDA (if curious, summary of approval in appendix). NVTR expects to launch Algovita commercially in the United States during the first half of 2016

2. Outside of the United States, Algovita obtained CE mark approval in June 2014 and is indicated for the treatment of chronic intractable pain of the trunk or limbs

3. Algovita is reimbursable under existing SCS codes in the United States, the European Union and Australia, and has been commercially available to patients in Germany and several other European countries since November 2014.

4. While not yet FDA approved, Pelvistim will use a very similar approval path to Algovita so its likelihood of success is also very high.

6. Through the mechanics of the spinoff, GB ensured that NVTR’s capitalization was well-positioned to successfully launch its first two commercial products.

1. GB provided them with $75mm of cash a $40mm delayed draw term loan (3 draws) and a $5mm revolving credit facility, or $130mm of post-spin liquidity to fund R&D and sales and marketing spend

2. We want to point out that in thinking about NVTR’s market enterprise valuation, we did not deduct the Company’s $75.2mm cash balance, which is viewed as working capital required to fund commercialization and we assumed that all debt facilities needed to be fully funded. These points could be debated, but we wanted to be certain we were taking the most conservative approach.

5. NVTR exhibited classic spinoff dynamics

1. GB is a $1.0bn market cap medical device components manufacturer focusing on cardiac and orthopedic therapies.

2. NVTR began trading with a $97mm market cap likely too small for many investors in the $1.0bn parent and the perceived emerging growth profile differed from GB’s diversified OEM supplier profile

3. Many GB investors immediately sold their shares decreasing the share price by ~50% in 4 days of trading. The shares have rebounded, but are still 30% lower than their price post-spin.

6. We believe the spin-off happened for two main reasons: 1) NVTR’s required salesforce and R&D spend to ramp their product ($45mm according to Company guidance in ’16) would obscure the financials of the more mature GB business 2) NVTR is a direct competitor to 2 of GB’s 4 largest customers, creating a material conflict

1. GB manufactures components like batteries, capacitors and leads for large multi-national OEMs like Abbott, J&J and Medtronic and Stryker. GB’s customers also include Medtronic, Boston Scientific and St. Jude Medical (in fact, St. Jude and Medtronic are 2 of GB’s 4 largest customers).

2. Obviously we are cautious to avoid spinoff situations where we believe the parent company is “throwing out” a bad business through a spin. We think just the opposite is the case here.

1. Aside for the reasons for the spinoff mentioned above, it is a good sign that the shares in the new NVTR entity were given to existing shareholders as opposed to new ones through a rights offering and that GB management has yet to sell a share.

7. In connection with the spin-off , NVTR entered into a supply agreement with GB pursuant to which GB would manufacture and supply fully assembled Algovita systems for the next 5 years with automatic 1 year renewals. We believe that not only does this supply agreement materially reduce operational risk for NVTR, but also represents a significant vote of confidence in NVTR’s likelihood of commercial success and growth

1. The supply agreement reduces the operational risk of NVTR’s business

1. GB already has set up tooling at 3 different manufacturing facilities in the United States

2. GB initially developed the Algovita technology so will have better efficiency with less defects/waste

3. NVTR won’t have to look for a third-party manufacturer or worse manufacture in-house and the agreement reduces the risk of any potential delays in commercialization this might cause

4. While supply agreement theoretically arms-length terms will likely be better than a third-party agreement given that GB management incentives are aligned with NVTR shareholders.

2. We view the length of the contract (5 years with automatic 1 year extensions) as an extremely positive sign for NVTR

1. No one understands Algovita technology better than GB since they developed it

2. The supply agreement requires that GB maintain the manufacturing facilities and equipment required to produce Algovita in significant volumes for at least 5 years

3. Importantly, the supply agreement does not set minimum volume purchasing requirements, only reduced rates as NVTR’s purchases per year increase (the Company has these rates under seal with the SEC)

4. We find it extremely unlikely that GB would contractually bind themselves to investing in a manufacturing facility and 5 years’ worth of maintenance capital without any guarantee of sales volumes unless they were highly confident in Algovita’s future sales prospects.

8. GB invested over $125 million dollars in NVT’s IP portfolio. This portfolio provides a nice margin of safety in the event (we believe unlikely) that NVTR’s SCS and SNS commercialization fails to gain traction

1. Patent portfolio consists of 107 U.S. patents, 77 pending U.S. patent applications, 49 foreign patents and 43 pending foreign patent applications including the patents and applications that cover the IP underlying its neurostim technology platform

2. NVTR also licenses 25 U.S. patents, 13 pending U.S. patents, 11 foreign patents and 33 pending foreign patent applications covering the intraspinal stimulation, SNS and DBS fields providing a high-margin, recurring revenue stream of what we estimate is $5-7mm. We think the licensing business can grow 5-10% a year as the company begins efforts licensing its remaining existing patents as well as its pending ones. We think this business is conservatively worth $40-50mm

3. During the Company’s spinoff process, management suggested that they received bids close to their cost basis in NVTR that they turned down because management deemed them “unattractive”. This would mark the EV at around $125mm or 16% above where the Company currently trades.

9. Our revenue projections for Algovita are shown below. For fear of false precision, we want to emphasize that these projections are most useful to illustrate the magnitude of the Algovita opportunity relative to NVTR’s current market value. Fortunately, as you’ll see in the valuation section we don’t need precision for this idea to work extremely well.

1. The Company guided to 225 sales representative territories – in our modeling we ramp to 80% of that (180 reps) by 2020. If you think this growth in reps is aggressive see Nevro’s growth in reps post-launch below. They were able to add and train 48 reps in less than 7 months.

2. We sensitized the sales per rep, which is $136k ramping to $630k by 2020 in our base case as the reps gain selling experience with the product. Another way to think about this is that reps will sell 6 units ($22k each) in year 1 and 30 units by year 2020 annually. It is very hard to have precision in these rep productivity numbers, but Nevro reports sales per rep of $1-$1.5mm already, and their product is still in its first year of commercialization. We think a ~90% sales discount to that is highly conservative.

3. Additionally, we are very impressed with the backgrounds of NVTR’s sales force. A simple LinkedIn search shows that all of the reps thus far come from a selling background at St. Jude Medical and some indicate that they had sold $2-3mm in St. Jude neuromodulation product per year. This gives us further conviction in modeling a number 1/20th of that with an ostensibly better product.

10. Valuation

1. The market uses EV/sales multiples for early stage medical devices. Nevro is by far closest comp. It trades at 8.3x 2016E sales and 5.2x 2017E sales. We used 1-year forward multiples based on 2018E sales figures, to find a target shares price for FYE 2017. We chose a range of 4.5-5.5x for Algovita and 5.0x-6.0x for Pelvistim (higher multiple because of earlier stage in its commercialization cycle), which is a material premium to Nevro’s 8.3x 1-year forward multiple. Nevro deserves a premium multiple because of its more innovative product and clinical trial success thus far.

2. Point is, regardless of the multiple you choose to use the returns here can be astounding. See our valuation analysis below. Even ignoring Pelvistim who commercialization is set to begin in 1Q2018 and some might argue has inherently more risk of success, our base case is a 4-bagger. With Pelvistim, our base case yields a 5-bagger.

3. We have also excluded the licensing value of the Company’s patent portfolio and any option value related to the DBS opportunity.

Conclusion

I’m not trying to suggest that Nuvectra is a great business or even that it has a great product or pipeline. However, I do think this is among the most asymmetric risk/rewards I have seen in a while. This is a $63mm medical device manufacturer with one already FDA-approved product with a very real path to being worth $300-$400mm over the next few years. In the tail downside case that the product is a complete failure, the Company has a $30mm current net cash balance, a patent licensing business doing close to $5mm in growing revenue and a valuable patent portfolio, all of which provide downside protection. It has a second product, which we believe has a high probability of commercialization by early 2018 and could be worth another $100mm. It is rare to find a stock with 6-bagger potential and this kind of margin of safety.

Appendix

Algovita FDA Approval Summary

A. Effectiveness Conclusions

The evaluation of efficacy was conducted using prospective studies relevant to Algovita SCS System features and indications. A total of five (5) studies based on 4 subject populations (1 article reported on the same subjects at a later time point) and 202 patients were qualitatively reviewed. The majority of patients had either intractable limb pain or FBSS and SCS treatment was demonstrated to be effective in each of the five studies. The results of the review support the effectiveness of SCS therapy in treating patients who suffer from chronic, intractable pain of the trunk and/or limbs.

B. Safety Conclusions

The clinical evidence provided to support safety of the Algovita SCS System includes 1) a systematic literature review of clinical research conducted on comparable devices, 2) a qualitative evaluation of the peer-reviewed published clinical research relevant to fully implantable SCS systems, 3) a quantitative meta-analysis of safety and efficacy using relevant clinical studies, and 4) post-market surveillance and safety assessment analysis using complaints and MAUDE databases for fully implantable SCS systems similar to the Algovita system.

The risks of the device are based on nonclinical laboratory and animal studies as well as a meta-analysis included 23 studies with 20 subject populations (3 articles reported on the same subjects at later time points) and a total of 1670 subjects. The majority of patients in the safety meta-analysis had either FBSS or CRPS I.

The findings with respect to surgical interventions were reported with ranges in Table 8. Revisions were the most common surgical intervention and occurred at a rate of 25.8% (13.7% to 40.1%). Revisions were most often secondary to lead migration, followed by lead-related events, such as lead connection failure and lead fracture. Though smaller in number, IPG revisions required for battery replacement or IPG repositioning also contributed to the revision rate. System explants (without replacement), occurred at 5.2% and were typically due to infection, and to a lesser extent, inadequate pain relief. Finally, system explants (with replacement) occurred at

5.1% and were most often the result of infection.

The rates of occurrence for the ten adverse events appropriate for meta-analysis correspond to the surgical intervention rates determined by the meta-analysis and are consistent with trends reported in large systematic literature review of 2520 patients (Cameron, 2004) stimulation issues 41.1%, pain over implant site 29.2%, lead migration 10.2%, ineffective pain control with the permanent implant 9.4%, lead fracture/failure 5.7%, infection 5.3%, skin problems at the implant site 3.2%, CSF leak 3.0%, IPG malfunction 2.3%, and seroma 1.4%. (The range for these adverse events can be found in Table 10.) In any cases where there was statistical evidence of publication bias, with one exception, the bias was in the more conservative direction where larger studies reported lower rates of adverse events than studies with smaller sample sizes.

The rates of occurrence for adverse events from the meta-analysis corresponded to the surgical intervention results and are consistent with trends reported in the literature. The most common complications were stimulation issues, pain at implant site, lead

migration, and ineffective pain control. Additionally, the results of the Medical Device Reporting (MDR) analysis of patient events, IPG events, and system events were consistent with the results above, and indicate relatively stable reporting of these well-known events.

The results of the systematic review and meta-analysis support the safety of SCS therapy in treating patients who suffer from chronic, intractable pain of the trunk and/or limbs. The Algovita system is similar to SCS systems approved by the FDA.

C. Benefit-Risk Conclusions

The probable benefits of the device are also based on data collected in a systematic literature review conducted to support PMA approval as described above. Five (5) articles based on four (4) subject populations (1 article reported on the same subjects at a later time point) were used to demonstrate the effectiveness of the Algovita SCS system for the treatment of chronic intractable pain of the trunk and/or limbs. Effectiveness was demonstrated by an improvement in pain using a VAS score. The

magnitude of literature reported pain relief ranged from 30 to 50%. In the Kumar 2008 article, pain relief lasted through two years. It would be expected that subjects with chronic pain would experience a similar benefit.

As described above, the risks were evaluated in a systematic literature review and meta- analysis. This resulted in safety information on 1670 patients implanted with SCS systems. The safety information provided was consistent with the well-known safety profile of SCS systems.

Additional factors to be considered in determining probable risks and benefits for the Algovita device included the open label design of the clinical studies during FDA review. In some of the studies reviewed, open label studies may cause an overestimation of the treatment effect in investigator and subject ratings. Also, open label studies do not assess the magnitude of the placebo response, regression to the mean, the effect of changes in medications or other treatments to alleviate pain or changes in the underlying severity of the pain disorder. SCS is an option for patients who do not have adequate pain relief from medications and/or other treatments for

pain.

In conclusion, given the available information above, the data support that for the use of the Algovita SCS as an aid in the management of chronic intractable pain of the trunk and/or limbs the probable benefits outweigh the probable risks.

D. Overall Conclusions

The data in this application support the reasonable assurance of safety and effectiveness of this device when used in accordance with the indications for use. The results from the clinical evaluation support reasonable assurance of the safety and efficacy of the Algovita SCS System, as well its long-term performance, when used in a manner consistent with its labeling and intended use. The evidence supporting the safety and effectiveness of the Algovita SCS System is based on a foundation of 30 years of clinical research and experience as documented in the literature with fully implantable SCS systems and the similarities of the Algovita system to market released implantable SCS systems. The results from comprehensive pre-clinical testing show that the Algovita SCS System performs as intended.

Catalyst

1)  2016 quarterly earnings should demonstrate the sales trajectory of Algovita

2) In February 2017 NVTR will report preliminary post-clinical trial results for Algovita

3) Pelvistim FDA approval should come in mid 2017