Value Investors Club / LIVANOVA PLC (LIVN)

Description

Livanova – Long Idea

Summary:

Livanova is a sum-of-the-parts story waiting to happen, both due to underlying valuations and the

resulting improvements in operational execution that would be allowed to take place in the event of the

right transaction(s). Operationally, LIVN has backed itself into a corner in which it has been forced to

bury itself in expensive debt to stay afloat, despite some incredibly promising pipeline assets.

However, given the resulting valuation that LIVN trades at, the company is also uniquely positioned to

amputate some of its business lines that have been dead weight to both management focus and

shareholder value, while removing its soul-crushing levels of debt with a nearly neutral impact to EPS.

The resulting business would consist of a teens-growth product line with extremely high margins with

several de-risked pipeline assets that will propel growth in the long run. I think that activism

involvement is likely if the right investors come along, assuming LIVN doesn’t see this obvious move

itself.

Business Overview & Competitive Landscape

Livanova is a medical device business with $2.2B in market capitalization and roughly $1.1B in 2019

sales. Its business is divided into a cardiac surgery segment and a neuromodulation segment.

Cardiac Surgery (~60% of revenue)

The Cardiac Surgery business resembles those of many other larger companies. Through this segment

LIVN sells heart-lung machines, cannulas, and other circulatory supplies as well as surgical heart valves.

This is the part of the business most would consider the “boring” side of medical devices. The items in

the LIVN Cardiac portfolio are largely commoditized, meaning that pricing pressures are more intense

here than in other areas of medtech. The only way supplies companies generally win in commodity

device markets are by volume. The problem for LIVN is these kinds of businesses require heavy

investment and operational excellence. Investments include acquisitions and R&D to add to the

portfolio (gives the sales rep another reason to call surgeons). Having a constantly growing portfolio also

has the flywheel effect of keeping talented sales reps around since they won’t feel like they are fighting

a losing battle.

LIVN has stumbled operationally here. While it was clearly aware of the hospital supply playbook (grow

via M&A/R&D for new products), its underlying growth hasn’t seen the benefit of these acquisitions. In

2018 acquired CardiacAssist for $254M and reported constant currency revenue growth of 7.2% for the

full year. Assuming a 5x sales multiple for the business, the numbers imply that LIVN’s underlying

growth would have been about 2% in 2018. In 2017, growth was still under 3%. In 2019, revenue

actually declined in the segment. This is all under the broader market backdrop for supplies being ~5%

volume growth each year offset by 1-2% of pricing headwinds, implying that LIVN has seen a

combination of the following:

• Exposed to weak niches (surgical heart valves) with declining end markets (in favor of TAVR)

• Lack of benefit from acquisitions

• Share loss

That said, Cardiac Surgery also accounts for only a small fraction of EPS, with single-digit operating

margins in most year, largely driven by higher SG&A costs. In 2019 EPS was $3.08, of which I estimate

Cardiac to be about 50c or 16-17%.

Neuromodulation (~40% of revenue)

Neuromodulation, on the other hand, is much more exciting at LIVN. The business came from the

combination of Sorin and Cyberonics in 2015 which included these assets.

LIVN’s core neuromodulation product is vagus nerve stimulation (VNS) therapy, which involves

implanting a small device with a lead that attaches to the vagus nerve on your spine. Using small

electrical shocks, VNS therapy stimulates the nerve, generating a variety of effects. The therapy has

been used since the prior decade for treatment-resistant epilepsy. After an epileptic patient has tried 4-

5 drugs, they are able to be put on VNS therapy, either separately or in addition to the drugs for an

incremental effect. The results of the therapy are well-understood and this has been a high-growth

business for LIVN. The product itself generates high gross margins at a $32k price point (25k device, 7k

for the leads). The segment as a whole has reached operating margins as high as 50% in previous years.

There is also platform potential for LIVN’s therapy. In 2005, researchers, noticed that patients

experience better moods on the therapy, ultimately leading to a trial for treatment-resistant depression

(TRD). The results were strong enough for an FDA approval, but CMS refused to cover the therapy since

the trial that was done to show data was not a randomized, controlled trial. As such, very few patients

ever got VNS for TRD.

That changed in 2018 when after a long-term study (still not randomized controlled but against

treatment-as-usual) was released, as well as a quality of life analysis showing that incremental

improvements from the therapy made a different, even if clinically they weren’t considered that

significant. CMS agreed to revisit its non-coverage decision, and eventually demanded an RCT (CMS

covers the trial implants) with a transition to a registry (therapy is covered outside trial with follow-up

data required). The key difference with an RCT is that the control group is getting sham therapy instead

of treatment at all, implying that results for those patients are likely to be much worse (which bodes

well for the VNS study) unless a placebo can last 1+ years. This trial is currently underway and LIVN is

expecting a transition to a registry in 2022.

TRD is a huge opportunity for LIVN. Roughly 7% of the US population has clinical-grade depression, and

anywhere from 10-33% of these are determined to be drug-resistant. At the low end, this could mean a

target population of 1.6M patients, which implies a revenue opportunity around $48 billion. LIVN is also

examining VNS’s effects in heart failure patients, which several neuromodulation companies are also

trying to do with different nerves (CVRx is one such company which targets the carotid baroreceptor

with a similar device).

LIVN also has another neuromodulation asset, ImThera, which is hypoglossal nerve stimulation (HNS) for

obstructive sleep apnea (OSA). This is a $10B market, and we know HNS works because a public

company (Inspire Medical) already has a therapy on the market with excellent clinical data. LIVN has

struggled to move forward in commercializing the market, so I am excluding Imthera for the purpose of

this case. That said, by the time LIVN gets to market, INSP may have already built the opportunity for

LIVN.

There are no direct device competitors to LIVN’s VNS therapy. The one competitive nuance is that in

epilepsy, when a new drug is approved it lengthens the funnel of patients, causing one-time hits to

growth for LIVN as patients try the new drug. The most recent example of this was in 2019 when GW

pharma’s Epidiolex was released, which sent growth flat in 1Q19 and negative in 2Q19.

Why now?

The TRD story has been well-known by investors since mid-2018, when the stock ran into the mid-100s.

However, as underlying performance in the cardiac business remained weak and investors realized the

TRD trial was going to take longer than initially expected, the stock plummeted, and is now trading

around $50. Investors likely would want to own LIVN for depression, but the base business is too ugly to

ignore.

However, COVID created additional issues for LIVN. Given all the investment LIVN had been doing for

TRD trials and shaky performance elsewhere, COVID put the company in a precarious situation. As a

debt maturity came close, LIVN had to seek financing in a tough market for companies that don’t fit the

“quality” narrative. The refinancing and additional debt raised puts a massive damper on LIVN’s EPS

outlook:

While LIVN will stay afloat thanks to the raise, EPS is taking a ~20% hit for it, and the debt must be paid

eventually. It is also worth noting that most of the healthcare names in the market that didn't participate fully in the post-March run we have seen have been companies with considerable leverage, and post-raise LIVN is at ~3.7x 2019 EBITDA and 6.25x LTM.

COVID also showed us that it is clear that LIVN is struggling operationally. Below is a peek at 2Q at LIVN with some annotations:

As you can see, LIVN's cardiac business managed to do worse than peers even when the whole industry was on lockdown.

This all explains why LIVN’s share price is $50 (25x NTM Street EPS numbers) despite such a major

potential therapy (or 3) in the pipeline.

In my opinion, this represents opportunity. One of several things can happen that would lead to considerable upticks

in LIVN’s stock price:

1. LIVN survives, pays down its debt, and investors start to assign more value to the pipeline. This

would result in a multiple that blends the ugly cardiac business with the true value of LIVN’s

neuromodulation business.

a. Under this scenario, neuromodulation outgrows its slower half and mixes to make LIVN

look like a much more attractive asset over time.

b. If things improve in LIVN’s Cardiac business, there is always the possibility of a

refinancing to jumpstart the earnings picture at LIVN.

2. LIVN begins to sell assets in Cardiac to larger or more specialized players in order to accelerate

debt repayment.

a. Under this scenario, investors get closer to a pure-play neuromodulation business, most

of which are getting much higher multiples than LIVN gets (LIVN gets less than 3x

EV/NTM sales vs NVRO, INSP, and AXNX at 10x, 25x, and 12x respectively).

b. LIVN currently pays more in EPS for its debt than it gets in EPS from its Cardiac business.

c. A look at LIVN’s history and its cash flow statement show that Cardiac is also a huge part

of the reason that FCF conversion has sat in the high 30% territory for a long time, which

is likely very troubling to investors. This would naturally change if the business units

involved were sold.

3. An activist comes along and forces LIVN to do #2, or just forcing the company to operationally

improve LIVN.

a. There are some activists who have been poking around in medical devices. Starboard

made quick money off of MMSI, for example, by simply paying basic attention to

operational excellence.

b. LIVN’s COO Damien McDonald was made CEO during its last departure and no one has

entered the role since. An activist could push the company to make simple

organizational changes that would likely jumpstart performance.

There are plenty of players who would be willing to buy LIVN’s cardiac portfolio off of it. Most supplies

companies have M&A baked into their overall strategy. Even if done piece-by-piece, LIVN would likely

stand to benefit in a big way. If LIVN sold the whole thing for just 2x sales, it would have enough to pay

down all of its debt with $500M left over, and all of its pipeline assets intact and well-funded.

I believe VNS today at LIVN is worth between $60-$70 per share (20-40% upside from 10/7/2020 close).

One can get there using a DCF which shows depression worth $25/share at 50% probability of success

and epilepsy worth the rest. This assumes a 9% cost of capital and a 3% terminal growth rate with LIVN

doing $600M in revenue for TRD if the trial is a success (which is still only a couple percent of TAM, and I

have a fair amount of conviction that TRD will be covered by medicare given what we know already).

One can also get there by isolating LIVN’s neuromodulation operating income and assuming heavy

spend on trials with no success in HF, and get to $60 at 25x 2021 NOPAT, which is absurdly low for a

business that grows in the double-digit territory.

Overall, I think that given the EPS carnage that LIVN has experienced and a reasonable multiple on those

earnings, most of the downside in LIVN has been realized, with several major drivers of upside taking

place over the next 18 months which will improve both the fundamental picture and the sentiment

around the stock. If sees any of the above scenarios I listed (and one is more of a when than an if), I think $60-$70 is more of a floor than a

ceiling.

Risks: Leverage, trial failure in TRD, prolonged COVID-related damage to business requiring additional funding.

I hold a position with the issuer such as employment, directorship, or consultancy.
I and/or others I advise do not hold a material investment in the issuer's securities.

Catalyst

TRD success/updates, cardiac asset sales, acivist involvement, improvement in performance in cardiac business (top line).

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			2020	2021
Price:	49.90	EPS	1.22	2.19
Shares Out. (in M):	49	P/E	na	22.7
Market Cap (in $M):	2,433	P/FCF	na	na
Net Debt (in $M):	-200	EBIT	96	164
TEV (in $M):	2,233	TEV/EBIT	na	13.5