|Shares Out. (in M):||9||P/E||26||15|
|Market Cap (in $M):||51||P/FCF||43||18|
|Net Debt (in $M):||-8||EBIT||3||5|
With complications of COPD paving a long runway for double-digit revenue growth, and profitability (finally!) inflecting upward, a major re-rating looks likely for Electromed.
Electromed’s SmartVest uses high-frequency chest wall oscillation (HFCWO) to treat a respiratory condition known as bronchiectasis. Bronchiectasis is the inability of the lungs to clear mucus, leading to breathing difficulties, infections, and costly hospitalizations. HFCWO therapy pulses air through a vest to vibrate the lungs from the outside, allowing mucus to move and eventually be coughed out.
Bronchiectasis is increasingly recognized as a late-stage complication of COPD. Compared with cystic fibrosis (the original application for HFCWO, with only 1,000 new diagnoses a year), the COPD addressable market is far larger. Electromed estimates there are 16 million COPD patients, 4.2 million with bronchiectasis (a cohort that is growing 9% a year), and 630,000 for whom HFCWO would be a cost-effective treatment…but only 66,000 of whom are currently being treated with HFCWO. For reference, while Electromed doesn’t disclose unit shipments, we estimate the company is selling roughly 4,000 units a year out of a total industry volume around 25,000.
With 16% of the domestic HFCWO market, Electromed is the smallest of three main players, but we believe the competitive environment is benign. In 2003, Hill-Rom acquired Advanced Respiratory, the first company to commercialize HFCWO, for 1.8x then-trailing sales. It’s still the leader with 47% of the market, but it has been a share donor over time. RespirTech, which entered the market in 2004 and holds a 33% share, grew rapidly for several years before its 2017 acquisition by Philips. Terms of the deal were not disclosed, but we have good sourcing for a transaction price near 3x sales even though RespirTech was not profitable. (By contrast, Electromed is currently trading at only 1.3x EV/TTM sales, and its stock would be worth $11-$12 a share if valued at the RespirTech acquisition multiple.)
We think the Philips-RespirTech deal validates the clinical value of HFCWO therapy, the market opportunity, and the barriers to entry. As products, SmartVest, The Vest (Hill-Rom’s brand) and InCourage (Philips’) are not hugely differentiated. SmartVest appears to have a few minor advantages—for example, its single hose connecting the vest to the pulse generator compared with the more cumbersome two-hose systems of its rivals—but these are not presently essential to Electromed’s success. Instead, the three companies compete primarily on their combination of sales (marketing to doctors and, to a lesser extent, directly to potential patients), reimbursement (getting a doctor’s prescription for HFCWO approved by Medicare, Medicaid, or private insurance), and customer service (training the patient for successful usage). If this combination of factors could be easily duplicated, Philips certainly had the financial resources to build an HFCWO business from scratch rather than buying RespirTech. We also note that AffloVest, a fourth competitor that launched in 2013 with different technology and a third-party distribution model, hasn’t gotten off the ground.
Rounding out a few other basic points, we note that Electromed has no debt, $7.8 million in cash ($0.93 a share), and seven straight years of positive free cash flow. The structure of governance is clean, with a nonexecutive chairman, no poison pill, and no staggered terms for directors. Three of the seven independent directors are material shareholders, collectively holding 16% of the stock. And with so much economic uncertainty these days, we certainly appreciate the defensive, noncyclical nature of Electromed’s business.
Why Electromed Isn’t a Value Trap Anymore
Electromed has been pitched on VIC once before, with unfortunate timing—just 2 weeks before and less than 3% away from what is still the stock’s all-time closing high. Since then, the stock has lagged just about any benchmark that might apply. Why was the stock a value trap then? And more important, why is it not a value trap now?
The flaw in the 2016-17 bull case was that it assumed Electromed’s plan to rapidly expand its salesforce would pay off with faster revenue growth. The opportunity appears to be massive relative to Electromed’s current size. With pulmonologists and other respiratory specialists still very early in the adoption of diagnosing and treating COPD patients for bronchiectasis, it would seem that simply getting the word out to doctors is the most important step.
However, realizing the HFCWO market opportunity is not that simple. Doctors are notoriously slow to change their practices. Not just anyone can walk into a clinic, tell a doctor he or she is failing to diagnose patients correctly, and then successfully pitch a not-exactly-new product to rectify this failure. Moreover, basic HFCWO technology has been around for more than 30 years and has long been part of the standard of care for cystic fibrosis (1,000 new diagnoses in the U.S. per year). There is not yet a similar agreed-upon standard of care for bronchiectasis in the far larger COPD population.
So while Electromed expanded its sales staff from 30 people to 52 between June 2016 and December 2018, contributing greatly to a 43% cumulative rise in trailing 12-month SG&A expense, TTM revenue rose only 32%. This clobbered profitability, with TTM EBITDA (adjusted for one-offs) falling 19% during this two-and-a-half-year stretch. While the company remained profitable, its return on equity slipped from 15% in fiscal 2016 to less than 9% for fiscal 2018 and 2019. At that level, investors had plenty of reason to doubt that growth would result in value creation for shareholders.
This divergence makes the stock’s weak performance over the past few years easy to understand. We believe that when embarking on the salesforce expansion, Electromed’s management and board had a theory of value creation that emphasized sales growth as the driver of the stock and, ultimately, the multiple on a sale of the company to a strategic acquirer. (In other words, what worked out for rival RespirTech.) To be fair, today’s stock market often permits or even encourages many other sorts of companies to increase revenue without regard to current profits. Investors appeared to support Electromed’s growth strategy during fiscal 2017, with the stock price rising from $4-$5 to more than $7. But as growth failed to improve during fiscal 2018 and 2019, Electromed’s stock price sagged right along with EBITDA.
It may be reasonable to blame Electromed’s management for sticking too long with a strategy that wasn’t paying off, but the more important point is that the failing strategy has been replaced. Key actions in the last nine months include the following:
Skarvan’s bold assertion about the salesforce restructuring was proven correct on Aug. 27, when the company reported results for its June quarter. The headline numbers were good enough, with total revenue growth picking back up to 9.3% year-over-year, rebounding from the 3.4% Y/Y growth rate in the March quarter. Earnings per share rose to $0.13 versus $0.11 a year earlier. Beneath the surface, even more progress is visible. For better or worse, Electromed doesn’t deal in non-GAAP adjustments, but it does disclose unusual items in its press releases and 10-K and 10-Q filings. We’re happy to call out several one-timers that reveal a much sharper upturn in underlying performance.
We’ll grant that Electromed is a small company with plenty of quarter-to-quarter variability in results. For example, the June 2018 quarter looked like an inflection point when it was reported, and the resulting runup in the stock was very short-lived. But back then, the hiring spree was still in full swing, and rather than being a true breakout, the upswing in revenue was shortly shown to be less than one standard deviation within the trend.
By contrast, financial progress in the June 2019 quarter demonstrates the benefits of cost control and productivity—factors much more within management’s control than a hoped-for surge in revenue. This is why we are confident that the inflection point in profitability has passed, setting the stage for much higher earnings.
Electromed is targeting low-double-digit revenue growth again in fiscal 2020 and for the next few years, which strikes us as quite reasonable. The company estimates that the prevalence of bronchiectasis is rising at 9% a year, so 10%-12% revenue growth doesn’t require much improvement in average selling prices, market share, or even the willingness of more doctors to diagnose bronchiectasis in COPD patients and prescribe HFCWO therapy. Indeed, we think that the company’s past growth has relied more on the growth in the addressable market than management’s efforts to step on the gas. In fiscal 2016, for example, the size of the salesforce held relatively steady—31 people at the beginning of the year, 30 at the end—yet total sales rose 18.5%.
However, the primary driver of our earnings growth expectations is improving margins. Based on our discussions with management about fiscal 2020, we expect SG&A to grow at half the pace of revenue, while gross margin (76.2% in fiscal 2019) drifts up toward the company’s long-term expectation of a range slightly below 80%. The resulting wedge indicates that earnings should pull out of a four-year stagnant spell with style.
Beyond fiscal 2020, we believe profitability will continue to improve, albeit at a more moderate pace. In Exhibit 4, we have modeled a 7.3% rise in SG&A costs in fiscal 2021 (two thirds of the revenue growth rate) and 8.8% in fiscal 2022 (four fifths). The resulting operating leverage drives the company’s EBITDA margin to roughly 21%, matching today’s industry median. We also expect returns on equity to reach the mid double digits, even without backing out excess cash.
The inflection in profitability we observe in Electromed’s recent performance sets the stage for a higher stock price—considerably beyond the approximately 12% gain since results for the June 2019 quarter were released on Aug. 27.
The medical device industry is a large and diverse lot, but we believe that median multiples for the GICS Health Care Equipment & Supplies industry provide a useful frame of reference. Slicing and dicing across five valuation yardsticks, the only thing that’s clear is that Electromed is very cheap—not just on our expectation for improved results in fiscal 2020, but even on its actual performance for fiscal 2019. As shown in Exhibit 5, Electromed ranks in the group’s bottom decile on EV/EBITDA and especially EV/gross profit (a proxy for potential value for an acquirer with synergies to realize), near the bottom decile on trailing EV/sales and price/earnings, and bottom quintile on price/book.
Part of what is striking about these ultra-low multiples is that while the trend in Electromed’s profitability was unfavorable until the June 2019 quarter, the absolute level of performance for the company was not so bad.
Compared with current industry medians on the metrics in Exhibit 6, Electromed’s only serious weak spot is its bottom-quartile EBITDA margin of 12%, and we grant that merits some valuation discount when considering only past performance. However, as we expect the company’s EBITDA margin will close nearly half of the shortfall versus peers in fiscal 2020 and potentially match the group median of 21% within three years, the stock’s valuation discounts ought to shrink and perhaps disappear entirely.
Our best estimate of Electromed’s fair value is $12, which is based on (1) the group’s forward P/E of 30 multiplied by our fiscal 2020 EPS estimate of $0.40, and (2) a trailing EV/sales ratio of 3.0x, in the range of what we believe Philips paid for RespirTech as noted earlier. However, virtually any valuation scenario we can come up with indicates substantial upside potential. Were Electromed to trade all the way up to the median valuation multiples shown in Exhibit 7, the stock’s value ranges from $8 to $17. But even if the stock closes only half the current discounts, its value still ranges from $7 to $11.
In all, we think Electromed is well positioned to leave its previous status as a value trap in the dust, with significant value likely to be realized by shareholders in the process.