Description

Overview

Japan Lifeline (JLL) is a medical device manufacturer and distributor, specializing in cardiovascular devices. This is not a deep value idea, especially after shares have appreciated +17% this month, but it is a quality business that remains undervalued at 15x cash earnings (Mar-21). JLL has a net debt neutral balance sheet and is growing top line at a 15% CAGR, with demographic tailwinds and a defensible position as a leading manufacturer/distributor of cardiovascular devices in a highly regulated market. This deserves an above-market multiple. Looking out 2 years and using its prior 3 year average 21x earnings, the equity should trade at JPY 2,500/share, a 33% premium to the current share price. Further upside is possible as the internally developed/manufactured products continues to scale, and as a brand new distribution agreement with Boston Scientific ramps up.

Business and Market

JLL covers four specialty areas. Half of its sales are from internally manufactured products and the other half is from the distribution of products from overseas manufacturers:

1. 51% of sales: Electrophysiology/Ablation (catheter systems for arrhythmia detection/treatment) This is the fastest growing division with the highest proportion of internally manufactured products.
2. 26% of sales: Vascular surgery grafts
3. 13% of sales: Cardiac rhythm management (i.e. pacemakers)
4. 11% of sales: Transvascular interventions (catheters, stents and guide wires)

JLL began as a trading company in 1981, importing medical devices for domestic use. This involves identifying demand, sourcing products and then guiding the products though Japanese regulatory approval on behalf of the foreign manufacturer. In the company’s own words, “JLL has acquired a high market share by taking on a role similar to that of a manufacturer, encompassing the introduction and marketing of new medical devices in Japan as well as sale of products.”

Japan is a relatively stringent regulatory market and JLL’s experience is a differentiated edge. In addition to this regulatory experience JLL has a nationwide sales force with relationships at all major hospitals. International manufacturers value this. Just this month, JLL began acting as the exclusive distributor of cardiac rhythm products for Boston Scientific, which abandoned its own on-the-ground initiative in Japan in favor of partnering with JLL. (More on this below).

JLL’s manufacturing capacity was launched in 1999 but took over a decade to scale. Today it has five facilities: three in Japan, one in China, and one JPY 2bn greenfield factory in Malaysia set to come online next year. JLL manufacturers electrophysiology and ablation catheters, surgical guidewires, vascular grafts and stent grafts. In 2012 it brought to market its first 100% in-house developed product, an Internal Atrial Cardioversion System. The company touts its close ties with Japanese medical institutions as a core advantage in developing and bringing to market new cardiovascular devices for the Japanese market. Today half of sales are from internally manufactured products, and the EBITDA margin has expanded accordingly from single digits ten years ago to ~25% today.

Japan has had universal healthcare since 1958. Reimbursement rates are set by the Ministry of Health, Labor and Welfare, and the nationalized healthcare insurance program covers up to 70% of medical costs. 80% of hospitals in Japan operate on a fee-for-service model using these nationalized reimbursement rates.

Special Treatment Medical Devices (STMD) are regulated and priced similarly to pharmaceuticals. This Ministry of Health presentation provides a good overview of pharma pricing mechanisms. The regulator looks at manufacturer and wholesaler ASPs, applies usefulness/innovation premiums if applicable, and most notably applies an adjustment if prices deviate +/- 25% from overseas prices  (US, UK, Germany, France and Australia). As per the table below, device reimbursement pricing differs from pharmaceutical pricing in two key ways: (1) devices are eligible for improvement premiums (of up to 20% based on incremental efficacy gains), and (2) devices are ineligible for future upward reimbursement adjustments based on overseas pricing.

Source: https://goddardhealth.com/reimbursement

Japan’s medical device market is JPY 2.9 trillion/year, constituting 6.3% of the NHI’s medical expense budget (2016 figures, source here). This percentage has remained stable for at least 35 years. It is fair to say that there is constant downward pressure on medical device prices, with new product introductions critical to achieving higher prices and/or margins. Notably, reimbursement prices are set by functional category, not by product brand or model. Government-induced price pressure is an ever-present risk to JLL’s profitability, but there is strong demand for continual product innovation to address a growing geriatric population that requires less invasive medical procedures and devices.

Operating performance

JLL’s margins have expanded as its mix has shifted. 20 years ago the firm was a pureplay distributor in a less complicated regulatory environment, earning low single-digit margins. Today half of the company’s sales are from internally-manufactured products and its distributed sales come from exclusive agreements that include higher-value product launch services. Management guide for the mix to shift slightly back towards distribution sales in the coming years due to new large distribution contracts, most notably with Boston Scientific. Operating profit margin, however, is expected to remain stable at ~23% thanks to (a) the maturation of higher-margin in-house offerings and (b) strong operating leverage on incremental distribution sales.

EBITDA margins of >23% certainly appear high for a company with 50% of sales in distribution, but JLL’s distribution business is more profitable than, for example, US distributors, due to its practice of entering exclusive contracts with foreign manufacturers, limiting these contracts to one partner per product category, and providing white glove product approval, launch and compliance services in addition to sales. This allows JLL to earn gross margins of 40%-50% for distributed products (versus ~20% in the US) and 70%-80% for internally-manufactured products. Group operating expenses of <40% of sales means JLL is able to earn up to 10% EBIT margins in distribution and >30% in manufacturing. 

The operating leverage is clear and management guide for SG&A to continue declining as a % of sales. Over the last 5 years revenue has grown at a 13% CAGR while operating expenses have only grown at an 8.5% CAGR. Most notably labor costs only grew at a 6% rate and has accordingly declines as a % of sales (red line):

Source: Thomson Reuters data

JLL management annually update a rolling 5 year plan. The most recent plan outlines a 14.5% sales growth CAGR and stable operating profit margin:

Source: Japan Lifeline company presentation, June 26, 2019.

The growth in this 5-year plan is underwritten by expected double-digit growth for patient cases of atrial fibrillation (AF), which will drive double digit growth in Electrophysiology (EP) and Ablation (ABL) sales, JLL’s biggest division. EP/ABL products were 30% of group sales in 2012, 50% today, and are guided to be 70% by FY24 (see two charts, below). The EP/ABL division has the highest proportion of internally manufactured products, driving margin expansion.

The strong growth of EP/ABL procedures is a global phenomenon as growing geriatric populations lead to higher occurrences of arrhythmia which require minimally invasive treatments such as catheter ablation. The global cardiac ablation market is expected to grow at a 12.4% CAGR from 2019-2025 (source). 

Source: Japan Lifeline company presentation, June 26, 2019.

In November 2018 JLL signed an exclusive distribution agreement with Boston Scientific for all products relating to cardiac rhythm management (CRM), effective September 2019 (i.e. this month). The first of these products was approved in Japan and began sales early in May of this year. Boston Scientific replaces the previous exclusive agreement JLL had with MicroPort, which had a smaller product catalog and inferior R&D capabilities. JLL expects strong sales growth on the back of Boston Scientific’s larger range of products. It’s notable that Boston Scientific had an internal sales/marketing team in Japan but elected to shift to JLL, which will be absorbing employees and entirely taking over the sales/marketing function. CRM sales fell in FY19 following the 2018 announcement of the Boston Scientific contract as customers refrained from buying soon-to-be obsolete MicroPort inventory from JLL. Analysts have approached this transition as a risk despite management guiding to a quick rebound in FY20 and strong organic growth thereafter. Replacing MicroPort with Boston Scientific appears to be a clear mid/long-term positive.

Below is management’s guidance for FY20:

Brief comment on the balance sheet, cash generation and capital allocation: In recent years free cash flow has been heavily re-invested into the business as JLL built out its internal manufacturing capabilities and grew its distribution business (which is working capital intensive as you’d expect). The company operates a “stable” dividend policy with a payout ratio of ~30% and has maintained a near net-cash neutral balance sheet for the last 3 years during this growth phase. This is likely to continue for the mid-term and I assume no cash build, despite the potential for JPY 6bn/year on normalized growth capex.

Valuation

If one assumes no change in leverage (i.e. all post-dividend free cash is invested in growth) and management’s guidance, shares of JLL are trading at 7x forward EBITDA and 12x earnings (on FY24 figures). Guidance infers a 15% sales CAGR and stable margins of ~23% (EBITDA). I normally wouldn’t put much weight on a management team’s 5-year forecast, but critically in this case the growth catalysts are heavily front-loaded. There is decent visibility towards these targets thanks to (1) the new Boston Scientific contract and (2) continued growth of internal products, all of which is fueled by a growing demographic demand for less invasive cardiac procedures and medical devices. An attractive operating leverage dynamic has already been proven and should continue to be margin accretive.

I believe this growth, margin profile and business model deserves an above-market multiple. On its prior 3-year average of 21x earnings the shares would trade at JPY 2500 for FY22 figures and JPY 3000 for FY24. Not screaming cheap but a 10% IRR from today’s share price for a quality business with a long runway of growth. If shares trade back down to the recent lows of JPY 1600/share the equity would trade at 10x future earnings and 6x EBITDA, which is a bit more exciting.

JLL has historically traded >20x earnings and at the high-end of its peer group. This seems justified given its unique capabilities as a hybrid distributor/manufacturer with a best-in-class sales network, stronger growth and higher margins. Over the last 18 months it has derated to the low-end of this range. By comparison, JLL now trades in-line with Ship Healthcare, a medical distribution company with 5% margins and mid single-digit sales growth:

Risks

Insurance reimbursement reductions are a perpetual risk and reality for this business that must be offset by new product introductions. Delays in bringing new/innovative overseas products to the Japanese market, and/or elevated government initiatives against healthcare costs would depress margins. There is no denying that JLL’s margins are higher than pureplay distributor peers and I have no unique insight to confidently confirm that its hybrid business model and value-added services justify this premium (but this argument does seem to make sense).

The product portfolio appears diverse enough to not be dependent on the success or failure of any single product, but certain divisions are expected to drive growth. As per the table below, the JPY 54m sales target for FY20 is heavily dependent on Cardiac Rhythm Management products rebounding from a FY19 lull on the back of the new Boston Scientific contract. Any interruption would impact performance. Meanwhile high teen sales growth for EP/Ablation is widely expected to continue thanks to the under-penetration of those procedures/devices, but similarly any slowdown in this strong growth poses a risk.

Finally, I have no insight into the quality of management, but note that the President/CEO Keisuke Suzuki has been with the firm since at least 1987, has been CEO since 2005, and owns 3.1% of the equity. The top 5 shareholders own 30% of the equity. At US$1.5bn market cap it’s tempting to think that JLL is simply being lumped in with its pure-play distributor competitors and that the weakness of 2019 (largely caused by the Boston Scientific transition) was interpreted as a sign of competitive underperformance.

Catalyst

Sales growth from new Boston Scientific distribution contract. Continued growth of EP/ABL device sales.