Conceptus Inc CPTS S W
January 26, 2008 - 8:59pm EST by
claude535
2008 2009
Price: 14.00 EPS
Shares Out. (in M): 0 P/E
Market Cap (in $M): 413 P/FCF
Net Debt (in $M): 0 EBIT 0 0
TEV ($): 0 TEV/EBIT
Borrow Cost: NA

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Description

 

SUMMARY

  • Single-product women’s health company trading at 29x 2009 consensus earnings that forecast a turn to profitability in 2008 and 65 cents of normalized EPS in 2009 based on strong adoption of the EssureTM non-invasive system for transcervical sterilization
  • Transcerivical sterilization market is significantly overestimated by management and sellside estimates due to factors limiting substitution of tubal ligation and growth in IUD sales
  • Market is significantly underestimating competition from soon-to-be- launched competitive product, Adiana, which has a high likelihood of displacing Conceptus due to Hologic’s dominance in the OB/GYN channel and compatibility with the Novasure system for Endometrial Ablation
  • Slowing physician procedure utilization confirms that Essure market potential is already pressured and upcoming DTC ramp-up is unlikely to be effective

Given the specialized nature of the Company’s product market and its importance to the short thesis, I’ll go into more background detail than is typical in a VIC write-up.  Those already familiar with the Company may want to skip to the “Investment Thesis” section.

 

ESSURE & THE TRANSCERVICAL STERILIZATION MARKET
 
Conceptus manufactures and markets Essure, the only FDA-approved medical device for transcervical sterilization.  Essure is a non-invasive alternative to tubal ligation (aka “tube tieing”) for women seeking permanent birth control / sterilization. Though low profile in popular media, tubal ligation (TL) is a high volume procedure for middle-aged, pre-menopausal women with approximately 600-700k procedures performed in the US every year. While traditional (open surgery) TLs generally required extensive hospital stays, recouperation times and the cost and risks associated with invasive surgery, more than 90% of US TLs are currently conducted laparoscopically and can be performed on an out-patient basis with 4-6 hours of recouperation.  Nevertheless, laparoscopic TL still requires the use of general anesthesia and must be performed in a hospital.
 
Essure was approved by the FDA in November 2002 and entered the market in early 2003.  Revenues remained nominal until 2005-2006 due to reimbursement issues.  By the end of 2006, Conceptus had successfully petitioned Medicare and national MCOs covering 90%+ of U.S. lives (as well as Canadian and several EU government plants) for reimbursement comparable to or better than TL and revenues grew by nearly 100% (to $42mm) in 2006 and are estimated to grow 54% (to $64mm) in 2007.
 
In the Essure procedure, a micro-coil, comprised of a pliable nitrinol stent (comparable to arterial stents used in angioplasty) laced with a thin PET (plastic) fiber is implanted within each fallopian tube by a gynecologist using a hysteroscope and catheter device.  By irritating the fallopian tissue, the micro-coil devices trigger a healing response that results in tissue growth around the coils over a subsequent 60-day period, yielding permanent occlusion of the tubes and preventing ovulation. Because the procedure can be performed through the cervix using a hysteroscope, the procedure does not require any incision and can be undertaken without anesthesia in a doctor’s office setting.  Because the devices are frequently incorrectly placed and, in a limited number of cases, fail to result in total occlusion of the tubes, the procedure requires a follow-up radio-imaging procedure, called a hysterosalpingram or HSG, 90 days following the procedure to confirm blockage. Incomplete occlusion can result in pregnancy but, more importantly, a significant risk of life-threatening ectopic pregnancy.
 
Wall Street analyst infatuation with Conceptus/ Essure revolves around the notion that it is a “golden triangle” product, ostensibly offering significant advantages to physicians, patients and payors relative to the standard of care – tubal ligation.  From a patient perspective, recovery time with Essure is shorter (2-3 hours versus 4-6 hours for laparoscopic TL and 1-2 days for traditional TL) and avoids the risks associated with general anesthesia.  From a physician standpoint, reimbursement is currently superior to TL (CMS $750 versus $450 to the physician net of equipment costs) and (if undertaken in the office) obviates the inconvenience of hospital-based medicine (e.g., travel, OR booking). As a result, Essure is marketed to physicians as critical procedure for building their office practices during a time when many are foregoing obstetrics due to insurance costs. For payors, Essure also avoids hospital facilities charges ($1000-$1500) and, with respect to traditional TL, the cost of patient hospitalization.  Consequently, support for higher physician reimbursement rates should persist in the absence of competitive products.
 
However, the Company has needed to devote substantial resources to grow the base of physicians certified to perform the procedure over the last 3 years.  As a prerequisite, ob/gyns first must be certified in the operation of a hysteroscope.  Currently only 15-20% of practicing US gynecologists are so qualified but this figure could increase to 30-33% over the next 5 years. To then be certified to specifically perform the Essure procedure, the FDA requires gynecologists to perform 4-5 supervised procedures over an 18-month period following formal didactic training. Conceptus bears the full costs of both physician training and procedure supervision.  Originally, Conceptus attempted to concentrate on group training of physicians at medical conventions and retreats but, amid poor conversion rates, began offering individualized training to requesting physicians.  In addition, to combat physician resistance to the capital costs of hysteroscopic equipment, Conceptus has structured bundling programs with the four largest equipment makers that allow physicians to structure equipment costs into a higher Essure product ASP.  Through these efforts, Conceptus has substantially grown the base of Essure-certified gynecologists over the last two years from 1,243 at 2005YE to 3,573 estimated at 2007YE.
 
Based on this progress and citing the need to drive consumer awareness of the procedure, in Q4 2007, Conceptus announced the launch of a $10mm DTC campaign covering 10 U.S. cities (4x 2007 spending).   In contrast to prior efforts at mass media spending (radio, internet, some TV), Conceptus will foot the entire price of this campaign and will not seek to share costs with physicians.
 
In addition, Conceptus announced in December that it exercised an option to repurchase its European distributor, Conceptus SAS, for $23.9mm.  The acquisition will add $7mm in incremental SG&A but nearly triple the price Conceptus receives on 21k non-U.S. procedures (from a $250mm wholesale price to average $700 European retail price), yielding $12-$13mm in incremental revenue/margin (a 23% return).
 
COMPETITION
 
As noted above, Essure currently enjoys a monopoly in transcervical sterilization and, therefore, current competition limited to traditional and laparoscopic tubal ligation. TL benefits from a rich history of intransigence in ob/gyn, which has consistently been among the slowest specialties to adopt new technology and procedures.  Within this context, TL represents a tried-and-true procedure with over 10 million procedures performed to date in the U.S (over 100 million globally), 30 years of clinical history and widespread patient acceptance.  Further, despite a higher incidence of adverse events (i.e., pregnancy), TL does not require a follow-up HSG test nor does it carry the same risk of ectopic pregnancy from incomplete fallopian occlusion.  In addition, because Essure requires placement of long microcoils in the fallopian tubes, there is a small but significant (<1%) risk of tube rupturing, which would require traditional (open) surgery to repair.
 
Furthermore, in regard to patients who come to regret sterilization (6% of total according to an ACOG study), Essure is actually “more permanent” than tubal ligation.  The procedure is completely irreversible versus current TL (which may be reversed through micro-surgery as currently performed) and is incompatible with later in vitro fertilization because placement of the microcoils extends into the uterus (versus TL where it generally remains an option for patients who later decide to attempt pregnancy after sterilization). 
 
Importantly, Essure (but not TL) is contraindicated for the most common and fastest growing hysteroscopic procedure, global endometrial ablation (~400k U.S. procedures/yr).  Endometrial ablation (“EA”) is a procedure in which low intensity heat is applied to the uterine wall to reduce menstrual bleeding.  Because Essure’s microcoils contain metal and protrude from the Fallopian tubes into the uterus, there is concern that the coils could super-heat and burn the tubes during the EA process.  While EA in formally only approved to treat patients with excessive bleeding, it is increasingly popular (off-label) as a “lifestyle” procedure for women (post-child bearing) with normal menstrual bleeding to reduce flow.  In fact, according to a Needham survey of 74 OB/GYNs, roughly 1 in 5 EA’s currently performed are lifestyle procedures and growth in the set is expected to drive 20-25% procedure growth annually over the next five years.  On that basis, EA procedures in the US will exceed TLs by 2011.
 
While the market for Essure in non-US territories (where it is approved – Canada/ EU/UK) is theoretically as large as the US, several factors have and likely will continue to restrain procedure growth to levels lower than in the U.S.  Essure is approved and reimbursable under the healthcare systems of Canada, the UK, France and Germany.  However, rates of hysteroscopic training in Canada and Europe are significantly lower (10-15%) among European gynecologists.  In addition, Conceptus (even following re-acquisition of SAS) lacks the sales infrastructure for physician training outside the United States. Moreover, IUD usage remains substantially higher (10% versus 1-2% than in the US), making it the dominant form of birth control for women in Essure’s target market
 
In addition to TL, two well-healed medical device manufacturers are poised to bring competing devices/procedures to market over the next 2.5 years.  In December, Hologic received FDA panel recommendation (10-3 vote) for approval of Adiana – a trancervical sterilization product it obtained through its acquisition of Cytyc in Q4 2007 – and should receive formal approval in Q1 for a launch in the middle of 2008.  In contrast to Essure, the Adiana procedure requires the insertion of only a small plastic matrix into the fallopian tube following exposure to RF heat and the device does not protrude into the uterus.  As a result, the procedure is compatible with endometrial ablation and in vitro fertilization.  Like Essure, Adiana is based on occlusion of the Fallopian tubes through a triggered healing response and requires a follow-up HSG exam to confirm success.
 
Conceptus has played down the competitive threat posed by Adiana based on (i) a belief that another player could improve total market penetration by raising awareness and (ii) inferior efficacy data for Adiana.  Specifically, in Adiana’s pivotal clinical trial, 6 of 570 (1.07%) patients who were told occlusion was successful following their HSG exam became pregnant after 1 year (versus zero pregnancies with Essure).  Extrapolating to 5 years based on incomplete clinical data, Adiana could have as high as a 1.8% cumulative pregnancy risk versus Essure’s 0.2% failure rate and 1.2% for TL.  However, 50% of failures in the Adiana study were due to physicians incorrect interpretation of the HSG follow-up exam (an element not tracked in the Essure trials), complicating a true head to head comparison.  In fact, the FDA panel that approved Adiana recommended tightening labeling for both products to emphasize the need for the follow-up exam.
 
In addition to Adiana, American Medical Systems (AMS) is beginning phase III pivotal trials for Ovion, a third transcervical sterilization system.  Ovion’s product is differentiated based on alleged advantages to the physician in easing the procedure, including the ability to use a flexible (versus rigid) hyster0scope and a catheter than can hold and dispense both micro-coils (requiring only one cervical insertion rather that two).  While unlikely to be a disruptive addition, it remains another competitor that should receive FDA approval by mid-2009. Ovion’s more important impact on Conceptus could be its ongoing patent litigation with the Company.  Ovion commenced infringement actions in 2003 and reached a partial settlement with the Company in 2004, in which Conceptus agreed to pay Ovion $4mm in retroactive royalties and 3.25% of revenues during the first 10 years (over $75mm) of Essure’s commercialization.  2008 will be the first year that Conceptus incurs this royalty (based on forecasted sales) and yet, analyst estimates forecast substantial margin expansion (e.g., from 74.5% to 79.7%) despite management caution and the predictable pressure of these royalties.  Moreover, prospective use of the patented technology is still being litigated (through the patent office) and, if Ovion (now AMS) prevails, Conceptus may be prevented in making upgrade modifications to the Essure system (rendering it a static product in a dynamic segment).  
 
 
INVESTMENT THESIS
 
#1: Management and sellside estimates of the addressable market for Essure are too high and the market is already substantially penetrated
 
Management and analysts uniformly focus on US TL procedures – 600-700k/year – as the addressable market for Essure.  Based on an estimated 46k procedures performed in 2007, they size Essure’s penetration at 7%, providing ample room for growth.  Similarly, they look at physician adoption (6,700 and 3,600 physician trained and certified, respectively, out of 35,000 US OB/GYNs) and see similarly headroom.  Based on the Company’s continued commitment to physician training and recent ramp-up of DTC spending, such headroom generally leads analysts to continue Conceptus’ 50%ish procedure growth in 2008 with hyper-growth (e.g., 40% in ‘09, 30% in ‘10) for a long-run procedure growth of over 25%.  For example, consensus revenue estimates $137mm in 2009 equate to roughly 90 thousand US procedures[1] -- over a 40% CAGR.  On a longer-term basis, 2009 consensus EPS of 64.5 cents approximates FCF (negligible depreciation, capex or working capital) and yields a FCF multiple of 25x – implying a perpetuity growth rate of 14% based on Conceptus’ WACC of 18%. 
 
However, the blanket assertion that Essure is marketable to all patients and physicians who would otherwise undergo/perform TL overlooks several factors that dramatically curtail market potential. First, of the 600-700k TLs performed in the US each year, 100k are actually performed (on a pre-planned basis) during caesarian birth and an additional 200-250k are performed postpartum (1-2 days) following natural child birth (while a patient is still in the hospital).  Beyond the expediency of the patient and doctor already being in the hospital, uterine expansion during pregnancy re-positions fallopian tubes in a favorable position for laparoscopic TL.  Consequently, none of these 300-350k cases represent a viable case for use of Essure because none of its convenience or cost advantages are relevant.  In addition, as noted above, 6% of TL patients later regret their sterilization decision. Such patients should be dissuaded from undertaking Essure given that it is 100% irreversible.  Combining all such factors, the truly relevant procedural market for Essure is less than half that asserted by the Company and bullish sellside analysts.
 
Addressable Market
Procedures Low High
Annual Tubal Ligations (US))     600,000     700,000
TL performed with Caesarian    (100,000)    (100,000)
TL performed post-partem    (200,000)    (250,000)
TL Preferred (6%)      (18,000)      (21,000)
    282,000     329,000
Practitioners
U.S. Gynocologists       35,000       35,000
% trained in hysteroscopy 20% 33%
       7,000       11,550
 
In addition, looking at the addressable market solely on the basis of procedures or physicans misses the critical point that both have to align for Essure to actually displace a  TL procedure.  Simply put, while roughly 280k-320k candidates for TL each year might theoretically view Essure as a more attractive option, they are very unlikely to consider (much less undertake) the procedure unless their OB/GYN is trained in the procedure or inclined to refer them to another physician.  With only 20% (growing to 33% by 2012) of US OB/GYNs having the requisite hysteroscopic training needed to even pursue Essure certification, absent a very buoyant referral market, the addressable market further shrinks to 92k-109k procedures.  Of the seven Essure-practicing OBGYNs with whom I spoke in dilligencing this investment, none had ever performed a procedure on a refered patient.  Even allowing for a high referral practice (20-40% according to ob/gyns consulted), the addressable market for Essure in the US is only 130k-200k procedures/yr.
 
U.S. Market Potential -- Sensitivity to Physican Referals
Referral Rate of Non-Trained Gynocologists
Annual Procedure Potential (k)
      280,000       290,000     300,000     310,000     320,000 330000
0%        92,400        95,700       99,000     102,300     105,600   108,900
20%       129,920       134,560     139,200     143,840     148,480   153,120
40%       167,440       173,420     179,400     185,380     191,360   197,340
60%       204,960       212,280     219,600     226,920     234,240   241,560
80%       242,480       251,140     259,800     268,460     277,120   285,780
100%       280,000       290,000     300,000     310,000     320,000   330,000
 
Against this market potential, current Essure procedure volumes are far more penetrated (23-35%) and 2009 consensus estimates of 90k procedures (45-69% penetration) are inconsistent with the Company continuing to grow earnings at 15% per year in subsequent years.  Amid such penetration, the Company should be challenged to grow procedures above a 20% CAGR through 2009 and more than 5% in subsequent years, even if (i) it comprises substantially the entire market for transcrvical sterilization and (ii) transcervical sterilization captures its entire theoretically addressable market
 
#2.  Physican utilization rates are already showing signs that demand for Essure is even more limited and the Company’s new DTC campaign will do little to drive procedure growth
 
While Essure has enjoyed high procedure growth to date, it tracks substantially below those implied by the growth in its certified physician base as evidenced by declining utilization rates.  While overall utilization (all procedures/all practitioners) has moderately declined since Q2 2006, it has fallen much more dramatically for seasoned practitioners (certified >1 year), which exclude built-in procedural demand driven by certification requirements (4 procedures over 18 months) and utilization requirements in bundled contracts (estimated 10 procedures in the first year).  Stripping out these physician-driven procedures, utilization among seasoned practitioners has declined in every quarter since Q2 2006 for a cumulative decline of 27%.
 
Utilization Analysis

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

2006

 

2007E

 

Utilization (procedures/month)

Mar

Jun

Sep

Dec

2006

Mar

Jun

Sep

DecE

2007E

Certifying Physcians

 

 

 

 

0.21x

0.18x

0.17x

0.22x

0.22x

0.22x

0.22x

0.22x

0.22x

0.22x

Certified Physicians

 

 

 

 

1.25x

1.43x

1.41x

 

 

 

 

 

 

 

 

 

 

 

 

< 1 Year

0.80x

0.80x

0.80x

0.80x

0.80x

0.80x

0.80x

0.80x

0.80x

0.80x

 

 

 

 

 

>1 Year

1.46x

1.81x

1.81x

1.79x

1.72x

1.58x

1.45x

1.39x

1.31x

1.43x

All Practitioners

 

 

 

 

0.67x

0.83x

0.84x

0.86x

0.80x

0.71x

0.76x

0.77x

0.80x

0.76x

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Total Procedures

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Certifying Physcians

 

 

 

 

        1,163

        1,083

        1,148

        1,619

        5,013

        1,701

         1,823

        2,011

        2,044

        7,578

Certified Physicians

 

 

 

 

        4,652

        6,134

        7,052

        7,906

      25,744

        8,302

         8,901

        9,818

       11,544

      38,565

 

 

 

 

 

< 1 Year

           967

        1,310

        1,606

        1,966

        5,849

        2,398

         2,664

        2,844

        3,958

      11,863

 

 

 

 

 

>1 Year

        3,685

        4,824

        5,446

        5,940

      19,895

        5,905

         6,237

        6,974

        7,586

      26,702

 
Physicians we spoke with cited issues related to the HSG follow-up as likely reasons for the declines in utilization.  They were frustrated with the need to pester patients to undergo the exam and coordinate with reading radiologists, the frequency of inconclusive results that require re-testing and the risk of ectopic pregnancy if they were misread.  They also raised the incompatibility with EA as a substantial concern given that the most common age for this procedure (peri-menopausal) is slightly later than the average age when patients consider TL. 
 
Nor is Conceptus’ recent foray into DTC spending likely to siginificantly drive increased utilization.  For starters, while the $10mm program represents a 4x increase in the Company’s marketing budget, it remains relatively puny in the universe of DTC medical device / procedure spending. By comparison, 2007 marketing spend by LCA-Vision 9the nation’s largest LASIK provider) was approximately $68mm to cover only 50% more DMAs (15 versus 10). Particularly in light of how diffuse Conceptus’ target patient population is (women 33-45 with 2+ children), there is a substantial risk that the program is simply sub-scale.
 
Moreover, consulted physicians were strongly convinced that patient awareness driven Conceptus’ recently launched DTC campaign would have a negligible impact on utilization.  They noted that Essure is already included in any discussion of sterilization by physicians who perform the procedure and its evaluation in patient-doctor consultations generally defers to physician’s (not patient’s) comfort with the procedure given individual patient histories and anatomical factors. Put differently, few patients would inclined to press their OB/GYN to perform an in-office sterilization procedure over their physician’s preference for an out-patient hospital procedure when other factors (efficacy, recovery time) are only marginally different.
 
Without a reversal of the declining utilization trend, Essure procedures are permanently range-bound by the number of hysteroscope- trained OBGYN (12k by 2012) to approximately 185k procedures.  More importantly, unless they improve, the profit potential of the procedure will be insufficient to drive further physician adoption.  If seasoned physicians only perform 15 procedures per year (1.3x/month), physicians contemplating certification weigh the commitment of undertaking 2-3 weeks of part-time didactic training followed by 4-5 supervised procedures for the prospect of earning an incremental $11k per year ($750 margin per in-office procedure) – not very compelling.
 
#3 Adiana is an under-appreciated threat to Essure and there is a high likelihood that it will displace Essure as the dominant transcervical sterilization device
 
As noted above, Conceptus and bullish analysts downplay the competitive threat from Adiana by focusing on Essure’s superior clinical efficacy and the Company’s 5-year head start in the market.  However, the OB/GYN’s we spoke with did not believe that an efficacy differential that was in the realm of tubal ligation (e.g., 1-2% failure rate) was significant enough to prefer one device over another.  They noted the same comparability issues raised by the FDA panel and were agnostic on differential efficacy between the two products pending both companies’ publication of 5-year data (in late 2009).  Remember, these were all OBGYNs certified in Essure.  Moreover, all physicians said they would be inclined to switch to a procedure that was compatible with endometrial ablation.
 
The reason is simple physician practice economics – with over 400k EA procedures performed annually, utilization rates among practicing physicians are roughly 8x greater than those for Essure. Medicare reimbursement rates average $2185 nationally (9% higher than Essure) with the amortized capital costs of the most popular RF transmitting device (Novasure) approximately the same as Essure’s device kit ($1250/procedure).  The EA procedure takes 90 seconds, has a satisfaction rate of 91% and is one of the few gynecological procedures promising net growth to physicians as peri-menopausal women pursue it for lifestyle reasons. In contrast to transcervical sterilization, EA provides physician practices with a “growth product” and a critical mass of current procedure demand. As the most common transcervical in-office procedure, EA is simply a lot more important to physician office practices than transcervical sterilization.  Faced with the option of a transcervical sterilization product that precludes this cash cow business and one that permits it, the choice is relatively clear.
 
To make matters worse (for Conceptus), both Adiana and the dominant system in the EA market, Novasure, are owned by Hologic (both were acquired in the Cytyc acquisition last year). In 2007, Novasure was used in approximately 95% of physician offices providing EA and had a estimated procedure market share of 75%.  The RF transcervical devices used in EA are essentially the same as those used in the first stage of the Adiana procedure, making it likely Hologic will seek to integrate the two procedures onto one common platform.  Beyond the physical device, Hologic can (an undoubtedly will) leverage the medical overlap between the two procedures – the fact that pre-menopausal women should be on permanent birth control or sterilized prior to undergoing EA – to drive Adiana sales. Even cross-selling the other way should prove a gentile way for gynecologists to tacitly introduce EA as a lifestyle procedure that they can not actively promote as such.  Whereas physicians using Novasure in their practice cannot ethically market the procedure to patients without clinically excessive menstrual bleeding, informing patients about the procedure as part of consulting with them about sterilization options that may impact their ability to get the procedure in the future is not only ethically permissible – it’s required. By integrating the marketing of Adiana with Essure, Hologic can assist physicians in growing the off-label use of a cash cow procedure while leveraging its market leadership in EA to one in transcervical sterilization.
 
Moreover, Hologic will do so with the largest and most efficient independent salesforce organization exclusively targeting women’s health providers.  Following the Cytyc acquisition, Holigic operates a force of over 675 reps – nearly 7x Essure’s salesforce (95 after 3 years of more than 40% annual growth in headcount).  Beyond its numbers (roughly one rep per 50 practicing physicians), Hologic markets the most complete set of advanced medical devices/products for OB/GYN offices – including its flagship digital mammography systems, biopsy equipment, osteoperosis diagnostics, cerivical cancer screening, radio-treatment systems for breast cancer and other surgical equipment in addition to Novasure and Adiana.  This permits Holigic to freshly detail physician offices far more frequently than a single-product salesforce possibly can.  Not surprisingly, Hologic’s rep productivity ($1.9mm sales/rep pro forma in 2007), dwarfs that of Conceptus ($677k sales/rep). Hologic’s management team is generally considered the best among pure-play women’s health companies (Cytyc’s was the second best) and has grown Hologic’s topline at a 34% CAGR for the past decade, predominantly through organic growth driven by achieving successive market dominance in targeted device markets – e.g., mammography, biopsy, radio-therapy, EA.  Product merits aside, it is difficult to imagine a more problematic case of competitive entry for a single product company.
 
#4  IUDs are making a come back and should pressure the entire female sterilization market
 
After well-publicized issues with the Dalkon Shield in late 1970’s, IUD usage in the US fell from 10-11% of all female contraception (including sterilization, 38.4mm women) to current share of 1-2% (5mm devices).  Of that incremental 8-9% share, approximately two-thirds went to tubal ligation (currently 28% of all contraception). However, the two IUDs currently marketed in the US, Mirena (hormone-based) and Paraguard (copper) have each enjoyed 20+% growth since they were introduced in the market (3-4 years ago). Having to surmount very high regulatory scrutiny based on their pedigree, physicians are now very comfortable prescribing them and these current generation devices address the physical discomfort issues that had limited penetration of prior IUDs.  With full reversibility, 99.9% efficacy, a 5-10 year product life and, in the case of Mirena, demonstrated ancillary benefits in lightening menstruation, they offer a compelling alternative to sterilization.  If their use in the US resurges to levels currently observed internationally, the same as those in the 70s, with the same share coming from the sterilization market, sterilization market share should decline by approximately 21% (6% of 28%).  While this will occur over several years, it bodes poorly for continued growth in the transcervical market.
 
#5 Uniform expectations of stable pricing are uncertain in a new competitive market
 
Management and Street estimates uniformly assume stable pricing over the next 3-5 years based on Essure’s cost savings proposition to payors.  In addition, several analysts note that Hologic traditionally hasn’t directly competed on price when it enters new product segments.  This seems a rather heroic assumption for a product that, as of yet, has not had any competition.  To be sure, Medicare and MCOs have an incentive to drive adoption of transcervical sterilization through attractive reimbursement while the market remains predominantly driven by growth in physician adoption.  With the entrance of new players and saturation of the addressable physician market (i.e., 6,700 trained Essure physicians of  7-11,000 hysteroscopically trained ob/gyns),  payors can push down reimbursement levels to those comparable to TL and force competing device providers eat this loss with minimal risk of loss in volumes to TL.  If reimbursement rates are brought down to parity with TL (physician component) and device markets eat this loss, ASP could decline from $1,299 to under $1k.
 
PROJECTED FINANCIAL PERFORMANCE & VALUATION
 
Upside Case
 
·        Penetration of addressable market (175k US procedures) grows from 23% to 85% by 2012 as Conceptus certifies substantially all US ob/gyns with hysteroscopic training by 2012
·        DTC campaign is highly effective and the declining trend in physician utilization reverses with seasoned practitioners averaging 1.4 procedures/month
·        Adiana FDA approval is delayed by one year; Adiana and Ovion capture only minimal share (15% and 5%) by 2012
·        Pricing remains stable with 3% growth in 2008
·        International procedure volumes remain 45-50% of US volumes with some interim decline based on management’s US focus; margins improve due to re-acquisition of SAS
·        Gross margin grows to 85% (from 75%) by 2010 in line with bullish analyst estimates
·        SG&A stabilizes to 5% annual growth, declining as a percent of sales from 88% (2007) to 49% (2012), based on no acceleration of DTC spending
·        R&D remains $5-6mm per year
 
 
Upside Case                        
        2008E          
($ in millions, except per share data) 2004 2005 2006 2007E MarE JunE SepE DecE 2008E 2009E 2010E 2011E 2012E
Sales $11.6 $21.2 $41.9 $64.4 $26.0 $28.8 $31.3 $35.3 $121.4 $164.8 $181.8 $189.6 $197.1
     Cost of Sales 7.1 8.4 14.0 16.4 5.2 5.8 6.3 7.1 24.3 27.9 27.3 28.4 29.6
Gross Profit 4.5 12.8 27.9 48.0 20.8 23.0 25.1 28.3 97.2 136.9 154.5 161.2 167.6
    R&D 4.1 4.3 4.4 5.7 1.4 1.4 1.5 1.7 6.1 7.4 7.9 8.2 8.5
    SG&A 27.1 31.3 43.3 56.6 22.8 20.6 18.9 17.3 79.6 79.6 83.6 87.8 92.2
     Operating Expense 31.1 35.5 47.7 62.3 24.2 22.0 20.4 19.0 85.7 87.0 91.5 96.0 100.7
Operating Income (26.6) (22.7) (19.8) (14.3) (3.4) 1.0 4.7 9.3 11.5 49.9 63.1 65.2 66.8
     Interest & other income 0.6 0.9 1.3 2.7 0.5 0.5 0.5 0.5 2.0 2.0 2.0 2.0 2.0
Pretax Income (26.1) (21.8) (18.5) (11.6) (2.9) 1.5 5.2 9.8 13.5 51.9 65.1 67.2 68.8
     Income Tax 0.0 0.0 0.0 0.0 0.0 0.0 0.6 1.2 1.8 18.7 23.4 24.2 24.8
     Tax Rate 0% 0%     0% 0% 12% 12% 6% 36% 36% 36% 36%
     Options Expense (tax effected)     6.1 6.1 1.5 1.5 1.5 1.5 6.0 6.0 6.0 6.0 6.0
Net Income - From Operations 1     (18.5) (11.6) (2.9) 1.5 4.5 8.6 11.7 33.2 41.6 43.0 44.1
Net Income - X-Options (26.1) (21.8) (12.4) (5.5) (1.4) 3.0 6.0 10.1 17.7 39.2 47.6 49.0 50.1
Shares Outstanding 24.7 26.8 29.0 29.6 30.0 30.2 31.8 31.8 30.9 32.3 33.1 33.2 33.2
EPS - From Ops 1     ($0.64) ($0.39) ($0.10) $0.05 $0.14 $0.27 $0.36 $1.03 $1.25 $1.30 $1.33
EPS - X-Options ($1.06) ($0.82) ($0.43) ($0.19) ($0.05) $0.10 $0.19 $0.32 $0.56 $1.21 $1.44 $1.48 $1.51
                 
                 
 Free Cash Flows                  
 EBIT         (22.7)       (19.8)       (14.3)        (3.4)          1.0          4.7          9.3        11.5        49.9        63.1        65.2        66.8
 TA EBIT         (22.7)       (19.8)       (14.3)        (3.4)          1.0          4.1          8.1        10.8        31.9        40.4        41.7        42.8
 +Depreciation & Amortization            1.1          1.4          1.6          0.4          0.4          0.4          0.4          1.7          1.8          1.9          2.0          2.1
 - Capex          (2.4)        (1.3)        (3.4)        (0.9)        (0.9)        (0.9)        (0.9)        (3.5)        (3.5)        (4.0)        (4.0)        (5.0)
 + Options Expense             -            6.1          6.1          1.5          1.5          1.5          1.5          6.0          6.0          6.0          6.0          6.0
 +  NOL Utilization               -             -             -            0.5          1.6          3.0          5.1        11.6        14.6        15.0        15.4
 + Changes in WC            2.2        (1.8)          5.2           -             -             -             -             -             -             -             -             -  
 Free Cash Flows        (21.8)      (15.4)        (4.8)        (2.4)         2.6         6.8       12.2       20.1       47.9       58.8       60.8       61.3
 
 
Base Case
·        Total market penetration continues at its three year historical rate (8 percent per year)
·        DTC campaign is ineffective and physician utilization rate continues to decline into 2008
·        Adiana (2008) and Ovion (2010) capture substantial share (33% and 15% by 2012) but Essure remains the dominant system
·        Physician recruitment stalls (to 500 new ob/gyns per year) because procedure volumes (based on penetration) are too low generate required utilization (e.g., 0.5 –0.9x procedures per month); as a result, only ¾ of scope-trained ob/gyns are trained on Essure by 2012
·        International procedure volume grows at 25% per annum to achieve parity with the US by 2012
·        Pricing declines by 2% per annum due to competition with gross margins remaining flat due to scale efficiencies (conservative)
·        SG&A reverts to pre-DTC spending / lower training levels (2006) in 2009 and grows at 5% thereafter
 
Base Case                          
Fiscal Year End - December         2008E          
($ in millions, except per share data) 2004 2005 2006 2007E MarE JunE SepE DecE 2008E 2009E 2010E 2011E 2012E
Sales $11.6 $21.2 $41.9 $64.4 $17.9 $19.8 $21.4 $24.0 $83.2 $96.0 $100.9 $107.6 $115.7
     Cost of Sales 7.1 8.4 14.0 16.4 4.6 5.1 5.5 6.1 21.2 24.5 25.7 27.4 29.5
Gross Profit 4.5 12.8 27.9 48.0 13.4 14.8 16.0 17.9 62.0 71.5 75.2 80.2 86.2
    R&D 4.1 4.3 4.4 5.7 1.0 1.0 1.0 1.2 4.2 4.3 4.4 4.7 5.0
    SG&A 27.1 31.3 43.3 56.6 22.8 20.6 18.9 17.3 79.6 56.6 59.4 62.4 65.5
     Operating Expense 31.1 35.5 47.7 62.3 23.8 21.6 19.9 18.5 83.8 60.9 63.8 67.1 70.5
Operating Income (26.6) (22.7) (19.8) (14.3) (10.4) (6.8) (4.0) (0.6) (21.8) 10.6 11.4 13.1 15.6
     Interest & other income 0.6 0.9 1.3 2.7 0.5 0.5 0.5 0.5 2.0 2.0 2.0 2.0 2.0
Pretax Income (26.1) (21.8) (18.5) (11.6) (9.9) (6.3) (3.5) (0.1) (19.8) 12.6 13.4 15.1 17.6
     Income Tax 0.0 0.0 0.0 0.0 0.0 0.0 (0.4) (0.0) (0.4) 4.5 4.8 5.4 6.3
     Tax Rate 0% 0%     0% 0% 12% 12% 6% 36% 36% 36% 36%
     Options Expense (tax effected)     6.1 6.1 1.5 1.5 1.5 1.5 6.0 6.0 6.0 6.0 6.0
Net Income - From Operations 1     (18.5) (11.6) (9.9) (6.3) (3.0) (0.1) (19.4) 8.1 8.6 9.7 11.3
Net Income - X-Options (26.1) (21.8) (12.4) (5.5) (8.4) (4.8) (1.5) 1.4 (13.4) 14.1 14.6 15.7 17.3
Shares Outstanding 24.7 26.8 29.0 29.6 30.0 30.2 31.8 31.8 30.9 32.3 33.1 33.2 33.2
EPS - From Ops 1     ($0.64) ($0.39) ($0.33) ($0.21) ($0.10) ($0.00) ($0.64) $0.25 $0.26 $0.29 $0.34
EPS - X-Options ($1.06) ($0.82) ($0.43) ($0.19) ($0.28) ($0.16) ($0.05) $0.04 ($0.44) $0.43 $0.44 $0.47 $0.52
                 
                 
 Free Cash Flows                  
 EBIT         (22.7)       (19.8)       (14.3)       (10.4)        (6.8)        (4.0)        (0.6)       (21.8)        10.6        11.4        13.1        15.6
 TA EBIT         (22.7)       (19.8)       (14.3)       (10.4)        (6.8)        (3.5)        (0.5)       (20.5)          6.8          7.3          8.4        10.0
 +Depreciation & Amortization            1.1          1.4          1.6          0.4          0.4          0.4          0.4          1.7          1.8          1.9          2.0          2.1
 - Capex          (2.4)        (1.3)        (3.4)        (0.9)        (0.9)        (0.9)        (0.9)        (3.5)        (3.5)        (4.0)        (4.0)        (5.0)
 + Options Expense             -            6.1          6.1          1.5          1.5          1.5          1.5          6.0          6.0          6.0          6.0          6.0
 +  NOL Utilization               -             -             -             -             -             -             -            2.8          3.0          3.4          3.9
 + Changes in WC            2.2        (1.8)          5.2           -             -             -             -             -             -             -             -             -  
 Free Cash Flows        (21.8)      (15.4)        (4.8)        (9.4)        (5.8)        (2.4)         0.5      (16.3)       13.9       14.2       15.8       17.0
 
Downside Case
·        Adiana displaces Essure as dominant system, Essure’s market share declines to 20% by 2012
·        New physician recruitment ceases in 2008 as undecided ob/gyns adopt Adiana or wait for standard to emerge; trained Essure physicians continue through certification with approximately half of scope-trained ob/gyns certified in Essure by 2012
·        Based on procedure volumes, utilization declines to anemic levels (0.2x/month)
·        Overall market penetration same as Base Case
·        Pricing declines by 5% per year with 80% flow-through to gross margins, reflecting continued reimbursement pressure (on physicians) and competition among device makers
 
 
Downside Case                        
Fiscal Year End - December         2008E          
($ in millions, except per share data) 2004 2005 2006 2007E MarE JunE SepE DecE 2008E 2009E 2010E 2011E 2012E
Sales $11.6 $21.2 $41.9 $64.4 $15.0 $16.6 $18.0 $20.3 $69.9 $67.3 $54.7 $35.5 $29.7
     Cost of Sales 7.1 8.4 14.0 16.4 3.8 4.2 4.6 5.2 17.8 19.5 18.1 13.1 12.0
Gross Profit 4.5 12.8 27.9 48.0 11.2 12.4 13.4 15.1 52.1 47.8 36.7 22.3 17.7
    R&D 4.1 4.3 4.4 5.7 0.8 0.8 0.9 1.0 3.5 3.0 2.4 1.5 1.3
    SG&A 27.1 31.3 43.3 56.6 22.8 20.6 18.9 17.3 79.6 56.6 59.4 62.4 65.5
     Operating Expense 31.1 35.5 47.7 62.3 23.6 21.4 19.8 18.3 83.1 59.6 61.8 63.9 66.8
Operating Income (26.6) (22.7) (19.8) (14.3) (12.5) (9.1) (6.3) (3.1) (31.0) (11.8) (25.1) (41.6) (49.1)
     Interest & other income 0.6 0.9 1.3 2.7 0.5 0.5 0.5 0.5 2.0 2.0 2.0 2.0 2.0
Pretax Income (26.1) (21.8) (18.5) (11.6) (12.0) (8.6) (5.8) (2.6) (29.0) (9.8) (23.1) (39.6) (47.1)
     Income Tax 0.0 0.0 0.0 0.0 0.0 0.0 (0.7) (0.3) (1.0) (3.5) (8.3) (14.3) (17.0)
     Tax Rate 0% 0%     0% 0% 12% 12% 6% 36% 36% 36% 36%
     Options Expense (tax effected)     6.1 6.1 1.5 1.5 1.5 1.5 6.0 6.0 6.0 6.0 6.0
Net Income - From Operations 1     (18.5) (11.6) (12.0) (8.6) (5.1) (2.3) (28.0) (6.3) (14.8) (25.3) (30.2)
Net Income - X-Options (26.1) (21.8) (12.4) (5.5) (10.5) (7.1) (3.6) (0.8) (22.0) (0.3) (8.8) (19.3) (24.2)
Shares Outstanding 24.7 26.8 29.0 29.6 30.0 30.2 31.8 31.8 30.9 32.3 33.1 33.2 33.2
EPS - From Ops 1     ($0.64) ($0.39) ($0.40) ($0.28) ($0.16) ($0.07) ($0.92) ($0.19) ($0.45) ($0.76) ($0.91)
EPS - X-Options ($1.06) ($0.82) ($0.43) ($0.19) ($0.35) ($0.23) ($0.11) ($0.03) ($0.72) ($0.01) ($0.27) ($0.58) ($0.73)
                 
                 
 Free Cash Flows                  
 EBIT         (22.7)       (19.8)       (14.3)       (12.5)        (9.1)        (6.3)        (3.1)       (31.0)       (11.8)       (25.1)       (41.6)       (49.1)
 TA EBIT         (22.7)       (19.8)       (14.3)       (12.5)        (9.1)        (5.6)        (2.8)       (29.2)        (7.6)       (16.1)       (26.6)       (31.4)
 +Depreciation & Amortization            1.1          1.4          1.6          0.4          0.4          0.4          0.4          1.7          1.8          1.9          2.0          2.1
 - Capex          (2.4)        (1.3)        (3.4)        (0.9)        (0.9)        (0.9)        (0.9)        (3.5)        (3.5)        (4.0)        (4.0)        (5.0)
 + Options Expense             -            6.1          6.1          1.5          1.5          1.5          1.5          6.0          6.0          6.0          6.0          6.0
 +  NOL Utilization               -             -             -             -             -             -             -             -             -             -             -  
 + Changes in WC            2.2        (1.8)          5.2           -             -             -             -             -             -             -             -             -  
 Free Cash Flows        (21.8)      (15.4)        (4.8)      (11.4)        (8.0)        (4.5)        (1.7)      (25.0)        (3.3)      (12.2)      (22.6)      (28.3)
 
Valuation
An important feature of Conceptus’ Upside (bull) case is that, while EPS grows to a healthy $1.33 by 2012, it has nowhere left to go.  Both from a physician and procedure, the market for transcervical sterilization is fully penetrated.  Consequently, the only means for the Company to grow its topline would be to (i) take market share, (ii) invest substantially in subsidizing gynecologist’s basic training in hysteroscopetry (to grow the physician base), (iii) achieve unrealistically high referral rates by untrained ob/gyns or  (iii) obtain regulatory clearance for Essure in additional international markets.  All of these avenues are exceptionally costly and would raise analyst concerns that the Company was burning cash in Hail Mary exercises to continue its growth.  Consequently, while the Upside Case represents performance substantially in line with bullish sellside estimates through 2012 (express or implied), the key difference in outlook is that, well before that date, it should become abundantly clear that future growth in not viable.
 
With a market beta of over 2.5x and modest debt, Conceptus has an exceptionally high CAPM-based cost of capital (18%).  At such a WACC, a Conceptus short has negligible downside even in an Upside case:
 
         Discounted Cash Flow Analysis
 Operating Case  Upside  Base  Downside
 Perpetuity Growth Rate 0.0% 0.0% 0.0% 0.0% 3.0% 5.0% 0.0% 3.0% 5.0%
 Discount Rate 18.0% 18.0% 18.0% 18.0% 18.0% 18.0% 18.0% 18.0% 18.0%
 Terminal FCF Multiple 5.6x 5.6x 5.6x 5.6x 6.7x 7.7x 5.6x 6.7x 7.7x
 PV of Cash Flows      171.5     171.5     171.5       24.0      24.0       24.0      (64.9)      (64.9)       (64.9)
 PV of Terminal Value         326        326        326         90       108        125       (152)       (182)        (210)
 Total Enterprise Value         497        497        497        114       132        149       (217)       (247)        (275)
 Net Debt         (22)        (22)        (22)        (22)       (22)         (22)         (22)         (22)          (22)
 Total Equity Value         476        476        476         92       110        127       (239)       (269)        (297)
 Intrinsic Value Per Share $15.85 $16.10 $15.85 $2.90 $3.48 $4.11 $0.00 $0.00 $0.00
 Current Share Price $13.96
 Gross Return (Short) -14% -15% -14% 79% 75% 71% 100% 100% 100%
 
At a more conventional, though arbitrary, 12% WACC and 0-5% perpetuity FCF growth, CPTS shares are worth $4-8/share with an Upside risk to $22 and Downside potential of a bagel if Hologic is successful in overtaking the segment
 
 
       Discounted Cash Flow Analysis
 Operating Case  Upside  Base  Downside
 Perpetuity Growth Rate 0.0% 0.0% 0.0% 0.0% 3.0% 5.0% 0.0% 3.0% 5.0%
 Discount Rate 12.0% 12.0% 12.0% 12.0% 12.0% 12.0% 12.0% 12.0% 12.0%
 Terminal FCF Multiple 8.3x 8.3x 8.3x 8.3x 11.1x 14.3x 8.3x 11.1x 14.3x
 PV of Cash Flows      192.0     192.0     192.0       29.4      29.4       29.4      (71.7)      (71.7)       (71.7)
 PV of Terminal Value         496        496        496        137       183        236       (230)       (307)        (394)
 Total Enterprise Value         688        688        688        166       212        265       (302)       (379)        (466)
 Net Debt         (22)        (22)        (22)        (22)       (22)         (22)         (22)         (22)          (22)
 Total Equity Value         666        666        666        145       191        243       (324)       (400)        (488)
 Intrinsic Value Per Share $22.20 $22.53 $22.20 $4.55 $6.01 $7.87 $0.00 $0.00 $0.00
 Current Share Price $13.96
 Gross Return (Short) -59% -61% -59% 67% 57% 44% 100% 100% 100%
 
OTHER CONSIDERATIONS
 
Acquisition Risk
Would a large medical products company pay substantially more for Conceptus than a standalone valuation would warrant?  It is worth noting upfront that two of the largest competitors serving the women’s health market (Hologic and AMS) already have competitive products.  More diversified players that serve the segment, most notably J&J, might place a premium on Essure based on (i) their enhanced ability to market it into the dominant platform (i.e., achieve the Upside Case) and (ii) realize substantial cost synergies in sales and marketing.  Looking at those synergies, the lion’s share of Conceptus’ SG&A is spent on physician recruitment and training (roughly $30mm of 2008E SG&A) with an additional $15mm spent of sales infrastructure, $15mm on marketing and $20mm in core G&A expenses.  Of these amounts, only the sales infrastructure and, perhaps, half of the G&A expense could realistically be saved in consolidation ($25mm or $16mm after tax).  On the other hand, an acquirer would need to forego approximately $210mm in accrued NOLs (est. as of 12/31) that could otherwise shelter future taxable income due to change of control rules.  Based on average forecasted tax savings (under the upside case) of $15mm over the next five years, this essentially amounts to a wash – NOL disallowance effectively offsets cost synergies.  Consequently, even an acquiror who was supremely confident that they could drive strong penetration and share retention (i.e., the Upside Case) should not be willing to pay more than the DCF valuation.  In addition, while it represents a development stage product and company, the acquisition price paid for Adiana by Cytyc in February 2007 -- $215mm, with $60mm upfront, $35mm upon FDA approval and $130mm in earnouts) – strongly suggests that such an acquirer might not pay much more that the current market price.
 

 

Insider Sales
On the same day that Hologic received FDA panel approval for Adiana (12/13), Conceptus’ CEO, Mark Sieczkarek made his first stock sale ever (31k shares for $611k), disposing of roughly half his holdings at the time (though he received equivalent RSUs from his 2007 distribution. In addition, the Company’s Chairman, Kathryn Tunstall, sold a total of 53k shares for proceeds of nearly $1mm over the second half of 2007, more than half her holdings in the Company.
 


[1] Based on 30k international procedures at a current (post-SAS acquistion) ASP of $700 and a US ASP of $1298.

Catalyst

- Launch of Competitive Product (Adiana, Mid-2008)
- Slowing physician utilization
    sort by   Expand   New

    Description

     

    SUMMARY

    Given the specialized nature of the Company’s product market and its importance to the short thesis, I’ll go into more background detail than is typical in a VIC write-up.  Those already familiar with the Company may want to skip to the “Investment Thesis” section.

     

    ESSURE & THE TRANSCERVICAL STERILIZATION MARKET
     
    Conceptus manufactures and markets Essure, the only FDA-approved medical device for transcervical sterilization.  Essure is a non-invasive alternative to tubal ligation (aka “tube tieing”) for women seeking permanent birth control / sterilization. Though low profile in popular media, tubal ligation (TL) is a high volume procedure for middle-aged, pre-menopausal women with approximately 600-700k procedures performed in the US every year. While traditional (open surgery) TLs generally required extensive hospital stays, recouperation times and the cost and risks associated with invasive surgery, more than 90% of US TLs are currently conducted laparoscopically and can be performed on an out-patient basis with 4-6 hours of recouperation.  Nevertheless, laparoscopic TL still requires the use of general anesthesia and must be performed in a hospital.
     
    Essure was approved by the FDA in November 2002 and entered the market in early 2003.  Revenues remained nominal until 2005-2006 due to reimbursement issues.  By the end of 2006, Conceptus had successfully petitioned Medicare and national MCOs covering 90%+ of U.S. lives (as well as Canadian and several EU government plants) for reimbursement comparable to or better than TL and revenues grew by nearly 100% (to $42mm) in 2006 and are estimated to grow 54% (to $64mm) in 2007.
     
    In the Essure procedure, a micro-coil, comprised of a pliable nitrinol stent (comparable to arterial stents used in angioplasty) laced with a thin PET (plastic) fiber is implanted within each fallopian tube by a gynecologist using a hysteroscope and catheter device.  By irritating the fallopian tissue, the micro-coil devices trigger a healing response that results in tissue growth around the coils over a subsequent 60-day period, yielding permanent occlusion of the tubes and preventing ovulation. Because the procedure can be performed through the cervix using a hysteroscope, the procedure does not require any incision and can be undertaken without anesthesia in a doctor’s office setting.  Because the devices are frequently incorrectly placed and, in a limited number of cases, fail to result in total occlusion of the tubes, the procedure requires a follow-up radio-imaging procedure, called a hysterosalpingram or HSG, 90 days following the procedure to confirm blockage. Incomplete occlusion can result in pregnancy but, more importantly, a significant risk of life-threatening ectopic pregnancy.
     
    Wall Street analyst infatuation with Conceptus/ Essure revolves around the notion that it is a “golden triangle” product, ostensibly offering significant advantages to physicians, patients and payors relative to the standard of care – tubal ligation.  From a patient perspective, recovery time with Essure is shorter (2-3 hours versus 4-6 hours for laparoscopic TL and 1-2 days for traditional TL) and avoids the risks associated with general anesthesia.  From a physician standpoint, reimbursement is currently superior to TL (CMS $750 versus $450 to the physician net of equipment costs) and (if undertaken in the office) obviates the inconvenience of hospital-based medicine (e.g., travel, OR booking). As a result, Essure is marketed to physicians as critical procedure for building their office practices during a time when many are foregoing obstetrics due to insurance costs. For payors, Essure also avoids hospital facilities charges ($1000-$1500) and, with respect to traditional TL, the cost of patient hospitalization.  Consequently, support for higher physician reimbursement rates should persist in the absence of competitive products.
     
    However, the Company has needed to devote substantial resources to grow the base of physicians certified to perform the procedure over the last 3 years.  As a prerequisite, ob/gyns first must be certified in the operation of a hysteroscope.  Currently only 15-20% of practicing US gynecologists are so qualified but this figure could increase to 30-33% over the next 5 years. To then be certified to specifically perform the Essure procedure, the FDA requires gynecologists to perform 4-5 supervised procedures over an 18-month period following formal didactic training. Conceptus bears the full costs of both physician training and procedure supervision.  Originally, Conceptus attempted to concentrate on group training of physicians at medical conventions and retreats but, amid poor conversion rates, began offering individualized training to requesting physicians.  In addition, to combat physician resistance to the capital costs of hysteroscopic equipment, Conceptus has structured bundling programs with the four largest equipment makers that allow physicians to structure equipment costs into a higher Essure product ASP.  Through these efforts, Conceptus has substantially grown the base of Essure-certified gynecologists over the last two years from 1,243 at 2005YE to 3,573 estimated at 2007YE.
     
    Based on this progress and citing the need to drive consumer awareness of the procedure, in Q4 2007, Conceptus announced the launch of a $10mm DTC campaign covering 10 U.S. cities (4x 2007 spending).   In contrast to prior efforts at mass media spending (radio, internet, some TV), Conceptus will foot the entire price of this campaign and will not seek to share costs with physicians.
     
    In addition, Conceptus announced in December that it exercised an option to repurchase its European distributor, Conceptus SAS, for $23.9mm.  The acquisition will add $7mm in incremental SG&A but nearly triple the price Conceptus receives on 21k non-U.S. procedures (from a $250mm wholesale price to average $700 European retail price), yielding $12-$13mm in incremental revenue/margin (a 23% return).
     
    COMPETITION
     
    As noted above, Essure currently enjoys a monopoly in transcervical sterilization and, therefore, current competition limited to traditional and laparoscopic tubal ligation. TL benefits from a rich history of intransigence in ob/gyn, which has consistently been among the slowest specialties to adopt new technology and procedures.  Within this context, TL represents a tried-and-true procedure with over 10 million procedures performed to date in the U.S (over 100 million globally), 30 years of clinical history and widespread patient acceptance.  Further, despite a higher incidence of adverse events (i.e., pregnancy), TL does not require a follow-up HSG test nor does it carry the same risk of ectopic pregnancy from incomplete fallopian occlusion.  In addition, because Essure requires placement of long microcoils in the fallopian tubes, there is a small but significant (<1%) risk of tube rupturing, which would require traditional (open) surgery to repair.
     
    Furthermore, in regard to patients who come to regret sterilization (6% of total according to an ACOG study), Essure is actually “more permanent” than tubal ligation.  The procedure is completely irreversible versus current TL (which may be reversed through micro-surgery as currently performed) and is incompatible with later in vitro fertilization because placement of the microcoils extends into the uterus (versus TL where it generally remains an option for patients who later decide to attempt pregnancy after sterilization). 
     
    Importantly, Essure (but not TL) is contraindicated for the most common and fastest growing hysteroscopic procedure, global endometrial ablation (~400k U.S. procedures/yr).  Endometrial ablation (“EA”) is a procedure in which low intensity heat is applied to the uterine wall to reduce menstrual bleeding.  Because Essure’s microcoils contain metal and protrude from the Fallopian tubes into the uterus, there is concern that the coils could super-heat and burn the tubes during the EA process.  While EA in formally only approved to treat patients with excessive bleeding, it is increasingly popular (off-label) as a “lifestyle” procedure for women (post-child bearing) with normal menstrual bleeding to reduce flow.  In fact, according to a Needham survey of 74 OB/GYNs, roughly 1 in 5 EA’s currently performed are lifestyle procedures and growth in the set is expected to drive 20-25% procedure growth annually over the next five years.  On that basis, EA procedures in the US will exceed TLs by 2011.
     
    While the market for Essure in non-US territories (where it is approved – Canada/ EU/UK) is theoretically as large as the US, several factors have and likely will continue to restrain procedure growth to levels lower than in the U.S.  Essure is approved and reimbursable under the healthcare systems of Canada, the UK, France and Germany.  However, rates of hysteroscopic training in Canada and Europe are significantly lower (10-15%) among European gynecologists.  In addition, Conceptus (even following re-acquisition of SAS) lacks the sales infrastructure for physician training outside the United States. Moreover, IUD usage remains substantially higher (10% versus 1-2% than in the US), making it the dominant form of birth control for women in Essure’s target market
     
    In addition to TL, two well-healed medical device manufacturers are poised to bring competing devices/procedures to market over the next 2.5 years.  In December, Hologic received FDA panel recommendation (10-3 vote) for approval of Adiana – a trancervical sterilization product it obtained through its acquisition of Cytyc in Q4 2007 – and should receive formal approval in Q1 for a launch in the middle of 2008.  In contrast to Essure, the Adiana procedure requires the insertion of only a small plastic matrix into the fallopian tube following exposure to RF heat and the device does not protrude into the uterus.  As a result, the procedure is compatible with endometrial ablation and in vitro fertilization.  Like Essure, Adiana is based on occlusion of the Fallopian tubes through a triggered healing response and requires a follow-up HSG exam to confirm success.
     
    Conceptus has played down the competitive threat posed by Adiana based on (i) a belief that another player could improve total market penetration by raising awareness and (ii) inferior efficacy data for Adiana.  Specifically, in Adiana’s pivotal clinical trial, 6 of 570 (1.07%) patients who were told occlusion was successful following their HSG exam became pregnant after 1 year (versus zero pregnancies with Essure).  Extrapolating to 5 years based on incomplete clinical data, Adiana could have as high as a 1.8% cumulative pregnancy risk versus Essure’s 0.2% failure rate and 1.2% for TL.  However, 50% of failures in the Adiana study were due to physicians incorrect interpretation of the HSG follow-up exam (an element not tracked in the Essure trials), complicating a true head to head comparison.  In fact, the FDA panel that approved Adiana recommended tightening labeling for both products to emphasize the need for the follow-up exam.
     
    In addition to Adiana, American Medical Systems (AMS) is beginning phase III pivotal trials for Ovion, a third transcervical sterilization system.  Ovion’s product is differentiated based on alleged advantages to the physician in easing the procedure, including the ability to use a flexible (versus rigid) hyster0scope and a catheter than can hold and dispense both micro-coils (requiring only one cervical insertion rather that two).  While unlikely to be a disruptive addition, it remains another competitor that should receive FDA approval by mid-2009. Ovion’s more important impact on Conceptus could be its ongoing patent litigation with the Company.  Ovion commenced infringement actions in 2003 and reached a partial settlement with the Company in 2004, in which Conceptus agreed to pay Ovion $4mm in retroactive royalties and 3.25% of revenues during the first 10 years (over $75mm) of Essure’s commercialization.  2008 will be the first year that Conceptus incurs this royalty (based on forecasted sales) and yet, analyst estimates forecast substantial margin expansion (e.g., from 74.5% to 79.7%) despite management caution and the predictable pressure of these royalties.  Moreover, prospective use of the patented technology is still being litigated (through the patent office) and, if Ovion (now AMS) prevails, Conceptus may be prevented in making upgrade modifications to the Essure system (rendering it a static product in a dynamic segment).  
     
     
    INVESTMENT THESIS
     
    #1: Management and sellside estimates of the addressable market for Essure are too high and the market is already substantially penetrated
     
    Management and analysts uniformly focus on US TL procedures – 600-700k/year – as the addressable market for Essure.  Based on an estimated 46k procedures performed in 2007, they size Essure’s penetration at 7%, providing ample room for growth.  Similarly, they look at physician adoption (6,700 and 3,600 physician trained and certified, respectively, out of 35,000 US OB/GYNs) and see similarly headroom.  Based on the Company’s continued commitment to physician training and recent ramp-up of DTC spending, such headroom generally leads analysts to continue Conceptus’ 50%ish procedure growth in 2008 with hyper-growth (e.g., 40% in ‘09, 30% in ‘10) for a long-run procedure growth of over 25%.  For example, consensus revenue estimates $137mm in 2009 equate to roughly 90 thousand US procedures[1] -- over a 40% CAGR.  On a longer-term basis, 2009 consensus EPS of 64.5 cents approximates FCF (negligible depreciation, capex or working capital) and yields a FCF multiple of 25x – implying a perpetuity growth rate of 14% based on Conceptus’ WACC of 18%. 
     
    However, the blanket assertion that Essure is marketable to all patients and physicians who would otherwise undergo/perform TL overlooks several factors that dramatically curtail market potential. First, of the 600-700k TLs performed in the US each year, 100k are actually performed (on a pre-planned basis) during caesarian birth and an additional 200-250k are performed postpartum (1-2 days) following natural child birth (while a patient is still in the hospital).  Beyond the expediency of the patient and doctor already being in the hospital, uterine expansion during pregnancy re-positions fallopian tubes in a favorable position for laparoscopic TL.  Consequently, none of these 300-350k cases represent a viable case for use of Essure because none of its convenience or cost advantages are relevant.  In addition, as noted above, 6% of TL patients later regret their sterilization decision. Such patients should be dissuaded from undertaking Essure given that it is 100% irreversible.  Combining all such factors, the truly relevant procedural market for Essure is less than half that asserted by the Company and bullish sellside analysts.
     
    Addressable Market
    Procedures Low High
    Annual Tubal Ligations (US))     600,000     700,000
    TL performed with Caesarian    (100,000)    (100,000)
    TL performed post-partem    (200,000)    (250,000)
    TL Preferred (6%)      (18,000)      (21,000)
        282,000     329,000
    Practitioners
    U.S. Gynocologists       35,000       35,000
    % trained in hysteroscopy 20% 33%
           7,000       11,550
     
    In addition, looking at the addressable market solely on the basis of procedures or physicans misses the critical point that both have to align for Essure to actually displace a  TL procedure.  Simply put, while roughly 280k-320k candidates for TL each year might theoretically view Essure as a more attractive option, they are very unlikely to consider (much less undertake) the procedure unless their OB/GYN is trained in the procedure or inclined to refer them to another physician.  With only 20% (growing to 33% by 2012) of US OB/GYNs having the requisite hysteroscopic training needed to even pursue Essure certification, absent a very buoyant referral market, the addressable market further shrinks to 92k-109k procedures.  Of the seven Essure-practicing OBGYNs with whom I spoke in dilligencing this investment, none had ever performed a procedure on a refered patient.  Even allowing for a high referral practice (20-40% according to ob/gyns consulted), the addressable market for Essure in the US is only 130k-200k procedures/yr.
     
    U.S. Market Potential -- Sensitivity to Physican Referals
    Referral Rate of Non-Trained Gynocologists
    Annual Procedure Potential (k)
          280,000       290,000     300,000     310,000     320,000 330000
    0%        92,400        95,700       99,000     102,300     105,600   108,900
    20%       129,920       134,560     139,200     143,840     148,480   153,120
    40%       167,440       173,420     179,400     185,380     191,360   197,340
    60%       204,960       212,280     219,600     226,920     234,240   241,560
    80%       242,480       251,140     259,800     268,460     277,120   285,780
    100%       280,000       290,000     300,000     310,000     320,000   330,000
     
    Against this market potential, current Essure procedure volumes are far more penetrated (23-35%) and 2009 consensus estimates of 90k procedures (45-69% penetration) are inconsistent with the Company continuing to grow earnings at 15% per year in subsequent years.  Amid such penetration, the Company should be challenged to grow procedures above a 20% CAGR through 2009 and more than 5% in subsequent years, even if (i) it comprises substantially the entire market for transcrvical sterilization and (ii) transcervical sterilization captures its entire theoretically addressable market
     
    #2.  Physican utilization rates are already showing signs that demand for Essure is even more limited and the Company’s new DTC campaign will do little to drive procedure growth
     
    While Essure has enjoyed high procedure growth to date, it tracks substantially below those implied by the growth in its certified physician base as evidenced by declining utilization rates.  While overall utilization (all procedures/all practitioners) has moderately declined since Q2 2006, it has fallen much more dramatically for seasoned practitioners (certified >1 year), which exclude built-in procedural demand driven by certification requirements (4 procedures over 18 months) and utilization requirements in bundled contracts (estimated 10 procedures in the first year).  Stripping out these physician-driven procedures, utilization among seasoned practitioners has declined in every quarter since Q2 2006 for a cumulative decline of 27%.
     
    Utilization Analysis

     

     

     

     

     

     

     

     

     

     

     

     

     

     

     

     

     

    2006

     

    2007E

     

    Utilization (procedures/month)

    Mar

    Jun

    Sep

    Dec

    2006

    Mar

    Jun

    Sep

    DecE

    2007E

    Certifying Physcians

     

     

     

     

    0.21x

    0.18x

    0.17x

    0.22x

    0.22x

    0.22x

    0.22x

    0.22x

    0.22x

    0.22x

    Certified Physicians

     

     

     

     

    1.25x

    1.43x

    1.41x

     

     

     

     

     

     

     

     

     

     

     

     

    < 1 Year

    0.80x

    0.80x

    0.80x

    0.80x

    0.80x

    0.80x

    0.80x

    0.80x

    0.80x

    0.80x

     

     

     

     

     

    >1 Year

    1.46x

    1.81x

    1.81x

    1.79x

    1.72x

    1.58x

    1.45x

    1.39x

    1.31x

    1.43x

    All Practitioners

     

     

     

     

    0.67x

    0.83x

    0.84x

    0.86x

    0.80x

    0.71x

    0.76x

    0.77x

    0.80x

    0.76x

     

     

     

     

     

     

     

     

     

     

     

     

     

     

     

     

    Total Procedures

     

     

     

     

     

     

     

     

     

     

     

     

     

     

    Certifying Physcians

     

     

     

     

            1,163

            1,083

            1,148

            1,619

            5,013

            1,701

             1,823

            2,011

            2,044

            7,578

    Certified Physicians

     

     

     

     

            4,652

            6,134

            7,052

            7,906

          25,744

            8,302

             8,901

            9,818

           11,544

          38,565

     

     

     

     

     

    < 1 Year

               967

            1,310

            1,606

            1,966

            5,849

            2,398

             2,664

            2,844

            3,958

          11,863

     

     

     

     

     

    >1 Year

            3,685

            4,824

            5,446

            5,940

          19,895

            5,905

             6,237

            6,974

            7,586

          26,702

     
    Physicians we spoke with cited issues related to the HSG follow-up as likely reasons for the declines in utilization.  They were frustrated with the need to pester patients to undergo the exam and coordinate with reading radiologists, the frequency of inconclusive results that require re-testing and the risk of ectopic pregnancy if they were misread.  They also raised the incompatibility with EA as a substantial concern given that the most common age for this procedure (peri-menopausal) is slightly later than the average age when patients consider TL. 
     
    Nor is Conceptus’ recent foray into DTC spending likely to siginificantly drive increased utilization.  For starters, while the $10mm program represents a 4x increase in the Company’s marketing budget, it remains relatively puny in the universe of DTC medical device / procedure spending. By comparison, 2007 marketing spend by LCA-Vision 9the nation’s largest LASIK provider) was approximately $68mm to cover only 50% more DMAs (15 versus 10). Particularly in light of how diffuse Conceptus’ target patient population is (women 33-45 with 2+ children), there is a substantial risk that the program is simply sub-scale.
     
    Moreover, consulted physicians were strongly convinced that patient awareness driven Conceptus’ recently launched DTC campaign would have a negligible impact on utilization.  They noted that Essure is already included in any discussion of sterilization by physicians who perform the procedure and its evaluation in patient-doctor consultations generally defers to physician’s (not patient’s) comfort with the procedure given individual patient histories and anatomical factors. Put differently, few patients would inclined to press their OB/GYN to perform an in-office sterilization procedure over their physician’s preference for an out-patient hospital procedure when other factors (efficacy, recovery time) are only marginally different.
     
    Without a reversal of the declining utilization trend, Essure procedures are permanently range-bound by the number of hysteroscope- trained OBGYN (12k by 2012) to approximately 185k procedures.  More importantly, unless they improve, the profit potential of the procedure will be insufficient to drive further physician adoption.  If seasoned physicians only perform 15 procedures per year (1.3x/month), physicians contemplating certification weigh the commitment of undertaking 2-3 weeks of part-time didactic training followed by 4-5 supervised procedures for the prospect of earning an incremental $11k per year ($750 margin per in-office procedure) – not very compelling.
     
    #3 Adiana is an under-appreciated threat to Essure and there is a high likelihood that it will displace Essure as the dominant transcervical sterilization device
     
    As noted above, Conceptus and bullish analysts downplay the competitive threat from Adiana by focusing on Essure’s superior clinical efficacy and the Company’s 5-year head start in the market.  However, the OB/GYN’s we spoke with did not believe that an efficacy differential that was in the realm of tubal ligation (e.g., 1-2% failure rate) was significant enough to prefer one device over another.  They noted the same comparability issues raised by the FDA panel and were agnostic on differential efficacy between the two products pending both companies’ publication of 5-year data (in late 2009).  Remember, these were all OBGYNs certified in Essure.  Moreover, all physicians said they would be inclined to switch to a procedure that was compatible with endometrial ablation.
     
    The reason is simple physician practice economics – with over 400k EA procedures performed annually, utilization rates among practicing physicians are roughly 8x greater than those for Essure. Medicare reimbursement rates average $2185 nationally (9% higher than Essure) with the amortized capital costs of the most popular RF transmitting device (Novasure) approximately the same as Essure’s device kit ($1250/procedure).  The EA procedure takes 90 seconds, has a satisfaction rate of 91% and is one of the few gynecological procedures promising net growth to physicians as peri-menopausal women pursue it for lifestyle reasons. In contrast to transcervical sterilization, EA provides physician practices with a “growth product” and a critical mass of current procedure demand. As the most common transcervical in-office procedure, EA is simply a lot more important to physician office practices than transcervical sterilization.  Faced with the option of a transcervical sterilization product that precludes this cash cow business and one that permits it, the choice is relatively clear.
     
    To make matters worse (for Conceptus), both Adiana and the dominant system in the EA market, Novasure, are owned by Hologic (both were acquired in the Cytyc acquisition last year). In 2007, Novasure was used in approximately 95% of physician offices providing EA and had a estimated procedure market share of 75%.  The RF transcervical devices used in EA are essentially the same as those used in the first stage of the Adiana procedure, making it likely Hologic will seek to integrate the two procedures onto one common platform.  Beyond the physical device, Hologic can (an undoubtedly will) leverage the medical overlap between the two procedures – the fact that pre-menopausal women should be on permanent birth control or sterilized prior to undergoing EA – to drive Adiana sales. Even cross-selling the other way should prove a gentile way for gynecologists to tacitly introduce EA as a lifestyle procedure that they can not actively promote as such.  Whereas physicians using Novasure in their practice cannot ethically market the procedure to patients without clinically excessive menstrual bleeding, informing patients about the procedure as part of consulting with them about sterilization options that may impact their ability to get the procedure in the future is not only ethically permissible – it’s required. By integrating the marketing of Adiana with Essure, Hologic can assist physicians in growing the off-label use of a cash cow procedure while leveraging its market leadership in EA to one in transcervical sterilization.
     
    Moreover, Hologic will do so with the largest and most efficient independent salesforce organization exclusively targeting women’s health providers.  Following the Cytyc acquisition, Holigic operates a force of over 675 reps – nearly 7x Essure’s salesforce (95 after 3 years of more than 40% annual growth in headcount).  Beyond its numbers (roughly one rep per 50 practicing physicians), Hologic markets the most complete set of advanced medical devices/products for OB/GYN offices – including its flagship digital mammography systems, biopsy equipment, osteoperosis diagnostics, cerivical cancer screening, radio-treatment systems for breast cancer and other surgical equipment in addition to Novasure and Adiana.  This permits Holigic to freshly detail physician offices far more frequently than a single-product salesforce possibly can.  Not surprisingly, Hologic’s rep productivity ($1.9mm sales/rep pro forma in 2007), dwarfs that of Conceptus ($677k sales/rep). Hologic’s management team is generally considered the best among pure-play women’s health companies (Cytyc’s was the second best) and has grown Hologic’s topline at a 34% CAGR for the past decade, predominantly through organic growth driven by achieving successive market dominance in targeted device markets – e.g., mammography, biopsy, radio-therapy, EA.  Product merits aside, it is difficult to imagine a more problematic case of competitive entry for a single product company.
     
    #4  IUDs are making a come back and should pressure the entire female sterilization market
     
    After well-publicized issues with the Dalkon Shield in late 1970’s, IUD usage in the US fell from 10-11% of all female contraception (including sterilization, 38.4mm women) to current share of 1-2% (5mm devices).  Of that incremental 8-9% share, approximately two-thirds went to tubal ligation (currently 28% of all contraception). However, the two IUDs currently marketed in the US, Mirena (hormone-based) and Paraguard (copper) have each enjoyed 20+% growth since they were introduced in the market (3-4 years ago). Having to surmount very high regulatory scrutiny based on their pedigree, physicians are now very comfortable prescribing them and these current generation devices address the physical discomfort issues that had limited penetration of prior IUDs.  With full reversibility, 99.9% efficacy, a 5-10 year product life and, in the case of Mirena, demonstrated ancillary benefits in lightening menstruation, they offer a compelling alternative to sterilization.  If their use in the US resurges to levels currently observed internationally, the same as those in the 70s, with the same share coming from the sterilization market, sterilization market share should decline by approximately 21% (6% of 28%).  While this will occur over several years, it bodes poorly for continued growth in the transcervical market.
     
    #5 Uniform expectations of stable pricing are uncertain in a new competitive market
     
    Management and Street estimates uniformly assume stable pricing over the next 3-5 years based on Essure’s cost savings proposition to payors.  In addition, several analysts note that Hologic traditionally hasn’t directly competed on price when it enters new product segments.  This seems a rather heroic assumption for a product that, as of yet, has not had any competition.  To be sure, Medicare and MCOs have an incentive to drive adoption of transcervical sterilization through attractive reimbursement while the market remains predominantly driven by growth in physician adoption.  With the entrance of new players and saturation of the addressable physician market (i.e., 6,700 trained Essure physicians of  7-11,000 hysteroscopically trained ob/gyns),  payors can push down reimbursement levels to those comparable to TL and force competing device providers eat this loss with minimal risk of loss in volumes to TL.  If reimbursement rates are brought down to parity with TL (physician component) and device markets eat this loss, ASP could decline from $1,299 to under $1k.
     
    PROJECTED FINANCIAL PERFORMANCE & VALUATION
     
    Upside Case
     
    ·        Penetration of addressable market (175k US procedures) grows from 23% to 85% by 2012 as Conceptus certifies substantially all US ob/gyns with hysteroscopic training by 2012
    ·        DTC campaign is highly effective and the declining trend in physician utilization reverses with seasoned practitioners averaging 1.4 procedures/month
    ·        Adiana FDA approval is delayed by one year; Adiana and Ovion capture only minimal share (15% and 5%) by 2012
    ·        Pricing remains stable with 3% growth in 2008
    ·        International procedure volumes remain 45-50% of US volumes with some interim decline based on management’s US focus; margins improve due to re-acquisition of SAS
    ·        Gross margin grows to 85% (from 75%) by 2010 in line with bullish analyst estimates
    ·        SG&A stabilizes to 5% annual growth, declining as a percent of sales from 88% (2007) to 49% (2012), based on no acceleration of DTC spending
    ·        R&D remains $5-6mm per year
     
     
    Upside Case                        
            2008E          
    ($ in millions, except per share data) 2004 2005 2006 2007E MarE JunE SepE DecE 2008E 2009E 2010E 2011E 2012E
    Sales $11.6 $21.2 $41.9 $64.4 $26.0 $28.8 $31.3 $35.3 $121.4 $164.8 $181.8 $189.6 $197.1
         Cost of Sales 7.1 8.4 14.0 16.4 5.2 5.8 6.3 7.1 24.3 27.9 27.3 28.4 29.6
    Gross Profit 4.5 12.8 27.9 48.0 20.8 23.0 25.1 28.3 97.2 136.9 154.5 161.2 167.6
        R&D 4.1 4.3 4.4 5.7 1.4 1.4 1.5 1.7 6.1 7.4 7.9 8.2 8.5
        SG&A 27.1 31.3 43.3 56.6 22.8 20.6 18.9 17.3 79.6 79.6 83.6 87.8 92.2
         Operating Expense 31.1 35.5 47.7 62.3 24.2 22.0 20.4 19.0 85.7 87.0 91.5 96.0 100.7
    Operating Income (26.6) (22.7) (19.8) (14.3) (3.4) 1.0 4.7 9.3 11.5 49.9 63.1 65.2 66.8
         Interest & other income 0.6 0.9 1.3 2.7 0.5 0.5 0.5 0.5 2.0 2.0 2.0 2.0 2.0
    Pretax Income (26.1) (21.8) (18.5) (11.6) (2.9) 1.5 5.2 9.8 13.5 51.9 65.1 67.2 68.8
         Income Tax 0.0 0.0 0.0 0.0 0.0 0.0 0.6 1.2 1.8 18.7 23.4 24.2 24.8
         Tax Rate 0% 0%     0% 0% 12% 12% 6% 36% 36% 36% 36%
         Options Expense (tax effected)     6.1 6.1 1.5 1.5 1.5 1.5 6.0 6.0 6.0 6.0 6.0
    Net Income - From Operations 1     (18.5) (11.6) (2.9) 1.5 4.5 8.6 11.7 33.2 41.6 43.0 44.1
    Net Income - X-Options (26.1) (21.8) (12.4) (5.5) (1.4) 3.0 6.0 10.1 17.7 39.2 47.6 49.0 50.1
    Shares Outstanding 24.7 26.8 29.0 29.6 30.0 30.2 31.8 31.8 30.9 32.3 33.1 33.2 33.2
    EPS - From Ops 1     ($0.64) ($0.39) ($0.10) $0.05 $0.14 $0.27 $0.36 $1.03 $1.25 $1.30 $1.33
    EPS - X-Options ($1.06) ($0.82) ($0.43) ($0.19) ($0.05) $0.10 $0.19 $0.32 $0.56 $1.21 $1.44 $1.48 $1.51
                     
                     
     Free Cash Flows                  
     EBIT         (22.7)       (19.8)       (14.3)        (3.4)          1.0          4.7          9.3        11.5        49.9        63.1        65.2        66.8
     TA EBIT         (22.7)       (19.8)       (14.3)        (3.4)          1.0          4.1          8.1        10.8        31.9        40.4        41.7        42.8
     +Depreciation & Amortization            1.1          1.4          1.6          0.4          0.4          0.4          0.4          1.7          1.8          1.9          2.0          2.1
     - Capex          (2.4)        (1.3)        (3.4)        (0.9)        (0.9)        (0.9)        (0.9)        (3.5)        (3.5)        (4.0)        (4.0)        (5.0)
     + Options Expense             -            6.1          6.1          1.5          1.5          1.5          1.5          6.0          6.0          6.0          6.0          6.0
     +  NOL Utilization               -             -             -            0.5          1.6          3.0          5.1        11.6        14.6        15.0        15.4
     + Changes in WC            2.2        (1.8)          5.2           -             -             -             -             -             -             -             -             -  
     Free Cash Flows        (21.8)      (15.4)        (4.8)        (2.4)         2.6         6.8       12.2       20.1       47.9       58.8       60.8       61.3
     
     
    Base Case
    ·        Total market penetration continues at its three year historical rate (8 percent per year)
    ·        DTC campaign is ineffective and physician utilization rate continues to decline into 2008
    ·        Adiana (2008) and Ovion (2010) capture substantial share (33% and 15% by 2012) but Essure remains the dominant system
    ·        Physician recruitment stalls (to 500 new ob/gyns per year) because procedure volumes (based on penetration) are too low generate required utilization (e.g., 0.5 –0.9x procedures per month); as a result, only ¾ of scope-trained ob/gyns are trained on Essure by 2012
    ·        International procedure volume grows at 25% per annum to achieve parity with the US by 2012
    ·        Pricing declines by 2% per annum due to competition with gross margins remaining flat due to scale efficiencies (conservative)
    ·        SG&A reverts to pre-DTC spending / lower training levels (2006) in 2009 and grows at 5% thereafter
     
    Base Case                          
    Fiscal Year End - December         2008E          
    ($ in millions, except per share data) 2004 2005 2006 2007E MarE JunE SepE DecE 2008E 2009E 2010E 2011E 2012E
    Sales $11.6 $21.2 $41.9 $64.4 $17.9 $19.8 $21.4 $24.0 $83.2 $96.0 $100.9 $107.6 $115.7
         Cost of Sales 7.1 8.4 14.0 16.4 4.6 5.1 5.5 6.1 21.2 24.5 25.7 27.4 29.5
    Gross Profit 4.5 12.8 27.9 48.0 13.4 14.8 16.0 17.9 62.0 71.5 75.2 80.2 86.2
        R&D 4.1 4.3 4.4 5.7 1.0 1.0 1.0 1.2 4.2 4.3 4.4 4.7 5.0
        SG&A 27.1 31.3 43.3 56.6 22.8 20.6 18.9 17.3 79.6 56.6 59.4 62.4 65.5
         Operating Expense 31.1 35.5 47.7 62.3 23.8 21.6 19.9 18.5 83.8 60.9 63.8 67.1 70.5
    Operating Income (26.6) (22.7) (19.8) (14.3) (10.4) (6.8) (4.0) (0.6) (21.8) 10.6 11.4 13.1 15.6
         Interest & other income 0.6 0.9 1.3 2.7 0.5 0.5 0.5 0.5 2.0 2.0 2.0 2.0 2.0
    Pretax Income (26.1) (21.8) (18.5) (11.6) (9.9) (6.3) (3.5) (0.1) (19.8) 12.6 13.4 15.1 17.6
         Income Tax 0.0 0.0 0.0 0.0 0.0 0.0 (0.4) (0.0) (0.4) 4.5 4.8 5.4 6.3
         Tax Rate 0% 0%     0% 0% 12% 12% 6% 36% 36% 36% 36%
         Options Expense (tax effected)     6.1 6.1 1.5 1.5 1.5 1.5 6.0 6.0 6.0 6.0 6.0
    Net Income - From Operations 1     (18.5) (11.6) (9.9) (6.3) (3.0) (0.1) (19.4) 8.1 8.6 9.7 11.3
    Net Income - X-Options (26.1) (21.8) (12.4) (5.5) (8.4) (4.8) (1.5) 1.4 (13.4) 14.1 14.6 15.7 17.3
    Shares Outstanding 24.7 26.8 29.0 29.6 30.0 30.2 31.8 31.8 30.9 32.3 33.1 33.2 33.2
    EPS - From Ops 1     ($0.64) ($0.39) ($0.33) ($0.21) ($0.10) ($0.00) ($0.64) $0.25 $0.26 $0.29 $0.34
    EPS - X-Options ($1.06) ($0.82) ($0.43) ($0.19) ($0.28) ($0.16) ($0.05) $0.04 ($0.44) $0.43 $0.44 $0.47 $0.52
                     
                     
     Free Cash Flows                  
     EBIT         (22.7)       (19.8)       (14.3)       (10.4)        (6.8)        (4.0)        (0.6)       (21.8)        10.6        11.4        13.1        15.6
     TA EBIT         (22.7)       (19.8)       (14.3)       (10.4)        (6.8)        (3.5)        (0.5)       (20.5)          6.8          7.3          8.4        10.0
     +Depreciation & Amortization            1.1          1.4          1.6          0.4          0.4          0.4          0.4          1.7          1.8          1.9          2.0          2.1
     - Capex          (2.4)        (1.3)        (3.4)        (0.9)        (0.9)        (0.9)        (0.9)        (3.5)        (3.5)        (4.0)        (4.0)        (5.0)
     + Options Expense             -            6.1          6.1          1.5          1.5          1.5          1.5          6.0          6.0          6.0          6.0          6.0
     +  NOL Utilization               -             -             -             -             -             -             -            2.8          3.0          3.4          3.9
     + Changes in WC            2.2        (1.8)          5.2           -             -             -             -             -             -             -             -             -  
     Free Cash Flows        (21.8)      (15.4)        (4.8)        (9.4)        (5.8)        (2.4)         0.5      (16.3)       13.9       14.2       15.8       17.0
     
    Downside Case
    ·        Adiana displaces Essure as dominant system, Essure’s market share declines to 20% by 2012
    ·        New physician recruitment ceases in 2008 as undecided ob/gyns adopt Adiana or wait for standard to emerge; trained Essure physicians continue through certification with approximately half of scope-trained ob/gyns certified in Essure by 2012
    ·        Based on procedure volumes, utilization declines to anemic levels (0.2x/month)
    ·        Overall market penetration same as Base Case
    ·        Pricing declines by 5% per year with 80% flow-through to gross margins, reflecting continued reimbursement pressure (on physicians) and competition among device makers
     
     
    Downside Case                        
    Fiscal Year End - December         2008E          
    ($ in millions, except per share data) 2004 2005 2006 2007E MarE JunE SepE DecE 2008E 2009E 2010E 2011E 2012E
    Sales $11.6 $21.2 $41.9 $64.4 $15.0 $16.6 $18.0 $20.3 $69.9 $67.3 $54.7 $35.5 $29.7
         Cost of Sales 7.1 8.4 14.0 16.4 3.8 4.2 4.6 5.2 17.8 19.5 18.1 13.1 12.0
    Gross Profit 4.5 12.8 27.9 48.0 11.2 12.4 13.4 15.1 52.1 47.8 36.7 22.3 17.7
        R&D 4.1 4.3 4.4 5.7 0.8 0.8 0.9 1.0 3.5 3.0 2.4 1.5 1.3
        SG&A 27.1 31.3 43.3 56.6 22.8 20.6 18.9 17.3 79.6 56.6 59.4 62.4 65.5
         Operating Expense 31.1 35.5 47.7 62.3 23.6 21.4 19.8 18.3 83.1 59.6 61.8 63.9 66.8
    Operating Income (26.6) (22.7) (19.8) (14.3) (12.5) (9.1) (6.3) (3.1) (31.0) (11.8) (25.1) (41.6) (49.1)
         Interest & other income 0.6 0.9 1.3 2.7 0.5 0.5 0.5 0.5 2.0 2.0 2.0 2.0 2.0
    Pretax Income (26.1) (21.8) (18.5) (11.6) (12.0) (8.6) (5.8) (2.6) (29.0) (9.8) (23.1) (39.6) (47.1)
         Income Tax 0.0 0.0 0.0 0.0 0.0 0.0 (0.7) (0.3) (1.0) (3.5) (8.3) (14.3) (17.0)
         Tax Rate 0% 0%     0% 0% 12% 12% 6% 36% 36% 36% 36%
         Options Expense (tax effected)     6.1 6.1 1.5 1.5 1.5 1.5 6.0 6.0 6.0 6.0 6.0
    Net Income - From Operations 1     (18.5) (11.6) (12.0) (8.6) (5.1) (2.3) (28.0) (6.3) (14.8) (25.3) (30.2)
    Net Income - X-Options (26.1) (21.8) (12.4) (5.5) (10.5) (7.1) (3.6) (0.8) (22.0) (0.3) (8.8) (19.3) (24.2)
    Shares Outstanding 24.7 26.8 29.0 29.6 30.0 30.2 31.8 31.8 30.9 32.3 33.1 33.2 33.2
    EPS - From Ops 1     ($0.64) ($0.39) ($0.40) ($0.28) ($0.16) ($0.07) ($0.92) ($0.19) ($0.45) ($0.76) ($0.91)
    EPS - X-Options ($1.06) ($0.82) ($0.43) ($0.19) ($0.35) ($0.23) ($0.11) ($0.03) ($0.72) ($0.01) ($0.27) ($0.58) ($0.73)
                     
                     
     Free Cash Flows                  
     EBIT         (22.7)       (19.8)       (14.3)       (12.5)        (9.1)        (6.3)        (3.1)       (31.0)       (11.8)       (25.1)       (41.6)       (49.1)
     TA EBIT         (22.7)       (19.8)       (14.3)       (12.5)        (9.1)        (5.6)        (2.8)       (29.2)        (7.6)       (16.1)       (26.6)       (31.4)
     +Depreciation & Amortization            1.1          1.4          1.6          0.4          0.4          0.4          0.4          1.7          1.8          1.9          2.0          2.1
     - Capex          (2.4)        (1.3)        (3.4)        (0.9)        (0.9)        (0.9)        (0.9)        (3.5)        (3.5)        (4.0)        (4.0)        (5.0)
     + Options Expense             -            6.1          6.1          1.5          1.5          1.5          1.5          6.0          6.0          6.0          6.0          6.0
     +  NOL Utilization               -             -             -             -             -             -             -             -             -             -             -  
     + Changes in WC            2.2        (1.8)          5.2           -             -             -             -             -             -             -             -             -  
     Free Cash Flows        (21.8)      (15.4)        (4.8)      (11.4)        (8.0)        (4.5)        (1.7)      (25.0)        (3.3)      (12.2)      (22.6)      (28.3)
     
    Valuation
    An important feature of Conceptus’ Upside (bull) case is that, while EPS grows to a healthy $1.33 by 2012, it has nowhere left to go.  Both from a physician and procedure, the market for transcervical sterilization is fully penetrated.  Consequently, the only means for the Company to grow its topline would be to (i) take market share, (ii) invest substantially in subsidizing gynecologist’s basic training in hysteroscopetry (to grow the physician base), (iii) achieve unrealistically high referral rates by untrained ob/gyns or  (iii) obtain regulatory clearance for Essure in additional international markets.  All of these avenues are exceptionally costly and would raise analyst concerns that the Company was burning cash in Hail Mary exercises to continue its growth.  Consequently, while the Upside Case represents performance substantially in line with bullish sellside estimates through 2012 (express or implied), the key difference in outlook is that, well before that date, it should become abundantly clear that future growth in not viable.
     
    With a market beta of over 2.5x and modest debt, Conceptus has an exceptionally high CAPM-based cost of capital (18%).  At such a WACC, a Conceptus short has negligible downside even in an Upside case:
     
             Discounted Cash Flow Analysis
     Operating Case  Upside  Base  Downside
     Perpetuity Growth Rate 0.0% 0.0% 0.0% 0.0% 3.0% 5.0% 0.0% 3.0% 5.0%
     Discount Rate 18.0% 18.0% 18.0% 18.0% 18.0% 18.0% 18.0% 18.0% 18.0%
     Terminal FCF Multiple 5.6x 5.6x 5.6x 5.6x 6.7x 7.7x 5.6x 6.7x 7.7x
     PV of Cash Flows      171.5     171.5     171.5       24.0      24.0       24.0      (64.9)      (64.9)       (64.9)
     PV of Terminal Value         326        326        326         90       108        125       (152)       (182)        (210)
     Total Enterprise Value         497        497        497        114       132        149       (217)       (247)        (275)
     Net Debt         (22)        (22)        (22)        (22)       (22)         (22)         (22)         (22)          (22)
     Total Equity Value         476        476        476         92       110        127       (239)       (269)        (297)
     Intrinsic Value Per Share $15.85 $16.10 $15.85 $2.90 $3.48 $4.11 $0.00 $0.00 $0.00
     Current Share Price $13.96
     Gross Return (Short) -14% -15% -14% 79% 75% 71% 100% 100% 100%
     
    At a more conventional, though arbitrary, 12% WACC and 0-5% perpetuity FCF growth, CPTS shares are worth $4-8/share with an Upside risk to $22 and Downside potential of a bagel if Hologic is successful in overtaking the segment
     
     
           Discounted Cash Flow Analysis
     Operating Case  Upside  Base  Downside
     Perpetuity Growth Rate 0.0% 0.0% 0.0% 0.0% 3.0% 5.0% 0.0% 3.0% 5.0%
     Discount Rate 12.0% 12.0% 12.0% 12.0% 12.0% 12.0% 12.0% 12.0% 12.0%
     Terminal FCF Multiple 8.3x 8.3x 8.3x 8.3x 11.1x 14.3x 8.3x 11.1x 14.3x
     PV of Cash Flows      192.0     192.0     192.0       29.4      29.4       29.4      (71.7)      (71.7)       (71.7)
     PV of Terminal Value         496        496        496        137       183        236       (230)       (307)        (394)
     Total Enterprise Value         688        688        688        166       212        265       (302)       (379)        (466)
     Net Debt         (22)        (22)        (22)        (22)       (22)         (22)         (22)         (22)          (22)
     Total Equity Value         666        666        666        145       191        243       (324)       (400)        (488)
     Intrinsic Value Per Share $22.20 $22.53 $22.20 $4.55 $6.01 $7.87 $0.00 $0.00 $0.00
     Current Share Price $13.96
     Gross Return (Short) -59% -61% -59% 67% 57% 44% 100% 100% 100%
     
    OTHER CONSIDERATIONS
     
    Acquisition Risk
    Would a large medical products company pay substantially more for Conceptus than a standalone valuation would warrant?  It is worth noting upfront that two of the largest competitors serving the women’s health market (Hologic and AMS) already have competitive products.  More diversified players that serve the segment, most notably J&J, might place a premium on Essure based on (i) their enhanced ability to market it into the dominant platform (i.e., achieve the Upside Case) and (ii) realize substantial cost synergies in sales and marketing.  Looking at those synergies, the lion’s share of Conceptus’ SG&A is spent on physician recruitment and training (roughly $30mm of 2008E SG&A) with an additional $15mm spent of sales infrastructure, $15mm on marketing and $20mm in core G&A expenses.  Of these amounts, only the sales infrastructure and, perhaps, half of the G&A expense could realistically be saved in consolidation ($25mm or $16mm after tax).  On the other hand, an acquirer would need to forego approximately $210mm in accrued NOLs (est. as of 12/31) that could otherwise shelter future taxable income due to change of control rules.  Based on average forecasted tax savings (under the upside case) of $15mm over the next five years, this essentially amounts to a wash – NOL disallowance effectively offsets cost synergies.  Consequently, even an acquiror who was supremely confident that they could drive strong penetration and share retention (i.e., the Upside Case) should not be willing to pay more than the DCF valuation.  In addition, while it represents a development stage product and company, the acquisition price paid for Adiana by Cytyc in February 2007 -- $215mm, with $60mm upfront, $35mm upon FDA approval and $130mm in earnouts) – strongly suggests that such an acquirer might not pay much more that the current market price.
     

     

    Insider Sales
    On the same day that Hologic received FDA panel approval for Adiana (12/13), Conceptus’ CEO, Mark Sieczkarek made his first stock sale ever (31k shares for $611k), disposing of roughly half his holdings at the time (though he received equivalent RSUs from his 2007 distribution. In addition, the Company’s Chairman, Kathryn Tunstall, sold a total of 53k shares for proceeds of nearly $1mm over the second half of 2007, more than half her holdings in the Company.
     


    [1] Based on 30k international procedures at a current (post-SAS acquistion) ASP of $700 and a US ASP of $1298.

    Catalyst

    - Launch of Competitive Product (Adiana, Mid-2008)
    - Slowing physician utilization

    Messages


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    Entry01/26/2008 09:05 PM
    Memberclaude535
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