CABG Medical, Inc. (pronounced “cabbage”) has a market capitalization of about $22 million and $33.6 million in net cash (net of all liabilities!) on its balance sheet. The company thus sells for approximately two thirds of its net cash. “So, what’s the problem?” The problem is that the alternative coronary bypass device it has spent the last several years perfecting developed significant occlusion problems during recent clinical trials. The company has suspended the trials and is diligently working to address the problem. What makes this story intriguing is that the CEO has a stellar reputation and record of success in the medical device industry and the company has more than enough cash to determine if the problem can be fixed. In addition, if the company decides not to proceed (which is a significant possibility) there should be sufficient cash to return shareholders cash equal to the current stock price. What the current stock price thus provides is essentially a free option on the success of the device.
Let’s first go through the arithmetic. The company had $33.6 million of net cash at the end of the 9/30/05 quarter. During the fourth quarter the company probably burned about $1.5 million in cash and in 2006 it expects to spend $6 to $8 million assessing the viability of improving the device. Let’s assume they spend $8 million in 2006. This would leave about $24.1 million at the end of 2006 or about $1.24 per share. With only eight employees and with a CEO with a pristine reputation to protect it should be easy to “fold up the tent” at that point and distribute the money to shareholders. This failure scenario provides a nice “margin of error” for us.
Who is this famous CEO? Manny Villafaña has more than 37 years experience in the medical industry. Here are the details of his background. I present the full details because I believe they are extremely relevant to this story. Mr. Villafaña founded ATS Medical, Inc. to develop, manufacture and market a next-generation pyrolytic carbon bileaflet mechanical heart valve and served as Chief Executive Officer, Chairman of the Board and a director from ATS Medical’s inception in 1987 through May 2004. From 1983 to 1987, Mr. Villafaña served as Chairman of GV Medical, Inc., a company co-founded by Mr. Villafaña to develop, manufacture and market the LASTAC System, a laser transluminal angioplasty catheter system. From 1976 to 1982, Mr. Villafaña served as President and Chairman of St. Jude Medical, Inc., a company founded by Mr. Villafaña to develop, manufacture and market a pyrolytic carbon bileaflet mechanical heart valve. From 1972 to 1976, he served as President and Chairman of Cardiac Pacemakers, Inc. (now a division of Guidant Corporation), a company founded by Mr. Villafaña to develop, manufacture and market a new generation of lithium powered pacemakers.
The logic here is that an individual like Mr. Villafaña should have the experience and resources to quickly assess the viability of fixing the problem and the incentive to cut his losses quickly if a solution becomes improbable. Given the tremendous success he has had in his career, why would he continue to push a failure?
What’s the product? CABG has designed an artificial coronary graft system that utilizes drug-eluting technologies known as the Holly Graft System as an alternative to coronary bypass surgery. The Holly Graft System is an artificial coronary artery graft designed to treat blockages in single or multiple coronary arteries from a single graft attached at one aperture to the aorta. Blood will flow into the Holly Graft System at the aorta, where the blood pressure is relatively high, and out of the Holly Graft System at the superior vena cava, where the blood pressure is relatively low. In between, blood will flow to one or more coronary arteries through vessel connections established by surgeons. It has been designed to create a high volume of blood flow through the main conduit to provide a reliable source of supply for each of the coronary arteries to which a connection is made. To maintain appropriate pressure in the system to feed the coronary arteries a flow limiter is incorporated at the outflow end to restrict the flow of blood into the vena cava.
Traditional coronary bypass surgery requires a ”second surgery” to harvest veins from the legs or radial arteries in the arm. This second surgery often leads to complication like pain, infection, edema, scaring and mobility problems. In addition, the delicate nature of the procedure is often exacerbated by the poor quality of available vessels, particularly in the elderly, the obese and diabetic individuals. Finally, 50-60% of all grafts tend to lose potency in five to seven years. The Holly Graft System eliminates the need for vein harvesting. The company believes the Holy Graft system provides several advantages to traditional surgery: 1) Increased flow due to a larger diameter than harvested vessels; 2) Artificial flow conduits that are disease free; 3) A flow limiter that maintains pressure within the graft; 4) Drug coatings on the vessels, similar to those used in drug-eluting stents, that prevent tissue build up and post operative occlusions.
What went wrong? The first human implant took place in Australia in November 2004. At beginning of 2005, the company was poised to begin extensive human trials in Australia and across Europe. As is customary, the company expected to begin marketing in international markets before seeking FDA approval in the US. On November 15, 2005 the company announced that the first enrollment of its international clinical trials of 35 patients resulted in twelve failed grafts due to occlusions in the graft. Suspecting that the failure was due the drug coating on the graft, the company replaced its initial aspirin and Plavix combination with an aspirin and warfarin combination and conducted a second enrollment group. The second enrollment group experienced 2 occlusion failures out of six grafts. The company suspended all trials and decided to aggressively seek a cause for the failures.
Where do we go from here? The company has focused all its resources in determining the cause of the failures. It has received several suggestions from clinicians regarding possible causes and solutions and has been encouraged to proceed by these doctors. The company believes major design changes are possible. The company expects that once it determines the cause of the problem, testing would have to start with three months of animal tests followed by twelve to eighteen months of human trials. What is the probability of finding a solution? I certainly don’t know, but I like the cost of taking the risk.
In summary, we have a company selling for two thirds of its net cash with sufficient cash to determine whether its technology is viable and enough cash left over to pay shareholders back the company’s current share price. I call this a free option on the success of the technology.
What can go wrong here? Mr. Villafaña becomes stubborn and despite failure decides to continue burning money in 2007 pursuing a flawed product. This seems unlikely given his reputation and experience. Does he want to destroy stellar reputation for a flawed product to simply collect a salary? (He does own about 37% of the shares outstanding and is certainly not in need of a salary.)
The results of the company’s testing and clinical trials in 2006.