Description

https://www.dropbox.com/s/5hs7r2c339ugm2v/Medistim%20Write-Up.pdf?dl=0

MEDISTIM ASA – Leader in intraoperative surgical guidance & quality assessment

Briefing

I really like Medistim. It is not optically cheap so it screens poorly + micro cap with low trading volume and small float + listed in Norway + provides a mission-critical service + has an over 30-year proven business model + operates as a de facto monopoly in a large and growing underdeveloped market + has a strong balance sheet that shows net cash + cash generative and asset light with capex <6% of sales and ROCEs >20% + insiders own a sizeable portion of the company + currently underearning as some investments that now accrue to P&L will be discontinued + low-cost optionality to capture vascular market

MEDI does not look optically cheap by any metric. 31x trailing earnings – or 21x LTM EBIT for a Norwegian small cap with limited float and liquidity does not sound like owning the Sorcerer’s Stone. Yet if all what mattered was just looking cheap, computers would have taken over our job long ago. Interestingly the fact that there’s a breed of investors who are stock screening-monkeys makes the company underfollowed.

MEDI serves a large underpenetrated market. While MEDI’s market penetration in Germany and the Nordic countries is 70% and even above 80% in Japan, penetration in the US is below 20%. There are historical reasons for that gap but there is a great potential opportunity in the US. I also think there is a side benefit from investing in underpenetrated markets, namely the opportunity to own a company for a lengthy period without eroding its margin of safety regardless subsequent price appreciation. Companies with strong moats and large addressable markets remind me of the Groundhog Day. Most investors find it unnatural to own a company for five years – not to say over 10 – while sell-side analysts rarely model growth rates for their terminal values far above GDP growth. Years later the company in question might have widen its moat and still grow abnormally. And then after these facts the modelers surprisingly – or not – stick again to GDP long term growth rates in their updated spreadsheets. Just check some of the sell-side reports on the company and see how they reach their NOK 70-74 target share price. Of course these dynamics generally translate into prolonged periods of undervaluation.

Monopoly in a niche. MEDI has by far the best technology in the industry and long lasting relationships with surgeons and hospitals, which combined with the mission-critical nature of its products increases switching costs and thus poses high barriers to entry. Interestingly, I think the market is too small to be interesting for the large players when it comes to medical devices. For example, Siemens’s and GE annual R&D expense is ~$5B, almost 200x MEDI’s current sales. But I find it difficult that given their size – over €100B market cap Siemens and ~$250B GE – any of them is willing to spend the time and resources to capture a €200-500m market. For an 800-pound gorilla it simply makes more economic sense to buy rather than replicate.

Insider ownership. Insiders own ~26% of MEDI’s shares, with The Chairman in particular holding 22%. High insider ownership is always a relevant factor to align interests, but when it comes to small cap investing I find it critical as there is generally more information asymmetry risk.

Brief Industry Overview

Serious cardiac diseases often require coronary artery by-pass graft surgery (CABG), a procedure to restore normal blood flow to an obstructed coronary artery. CABG usually takes

hours, the patient life is at stake as evidenced by the 2-3% mortality rates and best-fated patients generally face weeks of convalescence.

There is still no objective diagnostic method required to ensure proper blood flow while the patient is still in surgery. As crazy as it sounds surgeons can use their intuition and fingertip to feel for pulsation in the new graft, as if their fingers could accurately measure the blood flow.

Interestingly the technology and equipment for that purpose exist. Transit Time Flow Measurement (TTFM) is the leading measurement method for measuring blood flow1. TTFM is

safe for the patient, crucial for deciding whether a graft is well-functioning or not, and it allows for improvement of graft failure during operation. Overall it reduces the likelihood of further procedures that would be life-threatening for patients and costly for insurers and hospitals.

Not compulsory from a legal perspective TTFM’s adoption rates by country diverge widely. While TTFM is standard practice in Japan and most European countries, where penetration rates range from 70 to 80% the US rarely uses the technology. It is a paradox that in the largest market, where 1 of every 3 bypass procedures worldwide take place, still more than 80% of the interventions rely on a surgeon’s fingers to measure blood flow. This is central to the thesis.

Additionally the trends are great for the industry and conversely not so good for the society. Cardiovascular diseases still lead the global list of causes of death comprising ~1/3rd of the total. The World Health Organization estimates that more than 17m people die each year from cardiovascular diseases, and of those 7.4m are coronary-heart related. Despite those numbers seem to be very high, the truth is that survival rates have dramatically increased in developed countries since the 1960s. As a single data point ~30,000 coronary interventions - which I think it is sort of a decent proxy to measure the number individuals suffering from the disease - are conducted every year in the UK2, more than three times as many as a decade ago. Such a dramatic increase in patients is mostly a result of the aging population and unhealthy behaviors such as poor diets and physical inactivity. The good news is that nowadays while the ~80,000 individuals that died on last year from coronary diseases is still a high number, it does compare very favorably with the ~120,000 deaths in 2001 and the 166,000 in 1960. It is safe to extrapolate those trends to the US3 and to other developed areas. The shrinking mortality rates are mostly the result of preventative therapies and in surgical practice, with MEDI being one of the culprits.

The company estimates that over ~700,000 CABG take place every year worldwide, and my estimates – and MEDI’s - is the US alone captures ~240,000. MEDI’s Global share is 30% and share in the US is just ~18%, and the rest belongs to Surgeonfingerland. The company estimates that cardiac is a >NOK2B market.

Interestingly MEDI has just entered the vascular vertical. The vascular market is slightly smaller than the cardiac one with ~600,000 procedures – i.e. carotid endarterectomy, peripheral bypass & arteriovenous graft surgeries – and the company thinks this is a NOK1B market. As the principles are the same it can leverage its existing products & network for low incremental costs.

Products

MEDI and Transonic, US based, are the only players that supply TTFM technology in the market. However, I think that MEDI’s products are superior as not most but all doctors I have visited have

1 The impact of intraoperative transit time flow measurement on the results of on-pump coronary surgery. Department of Cardiovascular Surgery, Ataturk University School of Medicine, Erzurum, Turkey.

2 Cardiovascular Disease Statistics 2009 & 2016, British Heart Foundation

3 Trends in Cause of Death after Percutaneous Coronary Intervention, Division of Cardiovascular Diseases, Mayo Clinic, Rochester, MN, Division of Biomedical Statistics and Informatics, Mayo Clinic, Rochester, MN, Division of Cardiovascular Disease, Mayo Clinic, Jacksonville, FL

clearly stated that MEDI is their first and only choice. I think there are two main reasons for their choice. First, MEDI offers integrated ultrasound imaging while Transonic does not. Imaging is MEDIS’s unique selling point and guides surgeons to detect vessels, provides more data on the flow and helps for a better assessment of the surgery outcome. It is simply a superior platform. Second, Transonic’s products are more oriented towards research institutions and labs and not that much to a surgical room. Evidence of MEDI’s dominance is its leading position in every geography with a 30% global share vs. Transonic 5%, which in fact has diminished over time.

There used to be a third player, Em-tec, a German med tech company, but its competitive disadvantage vs. MEDI became obvious after the company reached a sales & service agreement with MEDI in April 2016 for their main product on flow measurement, Sono TT. You can find the agreement here, https://www.em-tec.com/products/sonott-flowlab/. The take out is essentially that Em-tec decided to retreat from the market and MEDI uses Em-tec lower ASP machines as a stepping stone to enter some emerging markets like India, where coincidentally Em-tec’s devices have gained some traction under the MEDI’s brand.

In short there is certainly no comp by any standard with MEDI products depth and breadth.

Model & Monetization

In Europe and RoW MEDI generally sells the apparatus upfront and the user buys then as many probes as it needs for procedures. As the company has already made a profit with the sale and does not run inventory risk there are no binding contracts on future probe purchases. Even in some cases where the large initial payment does not make much economic sense there is also a policy among many hospitals in Europe that equipment used in the hospital shall be hospital property, so hospitals have no choice but acquire the platform.

On the contrary, the US follows a “per usage” model rather than a “sale + consumables” model in order to reduce frictions in the sale process. The platform is placed in the clinic free of charge and then it pays per procedure but commits to a minimum amount of annual procedures. Minimum usage per device and year in the contracts is 100 procedures, which gives minimum revenue of ~NOK214K ($25K) per platform.

For control purposes, every time a procedure takes place the system requires the introduction of a smart card that MEDI sells. I think this model is more appropriate for the US for two reasons. First the US healthcare system works more on a cost-per-patient basis. More importantly the market is so fragmented that despite a higher number of total procedures the number of procedures per clinic is notably lower than in Europe or Asia, which makes it more challenging to sell something that requires a large initial outlay.

Attrition rates are 0, meaning that once a surgeon recognizes the value of the technology he never discontinues its use. So the real challenge for MEDI is convincing surgeons and for that purpose it is clearly better to sell direct. MEDI sells direct in the US, Germany, Norway, Denmark, the UK and since recently in Spain, and via distributors for the rest of the world, but the company has stated plans to open new offices in markets with large untapped potential and/or where adoption has proven to be more difficult. I think this represents significant upside as in many cases distribution partnerships have just not worked. In the US for example, MEDI entered a distribution agreement with Medtronic in 2001. It worked well at the beginning but as Medtronic is a large company and it was struggling with its own business, distributing MEDI’s products became largely irrelevant in the list of priorities. ~$4m sales after 8 years translates in my view to ~150-200 installed platforms for a market the company thinks comprises ~5,000 addressable clinics - yet it will address first ~1,250 given their structure and volumes - with the potential for several installations per clinic. You judge. So in 2008 MEDI discontinued the agreement and decided to sell direct in the US. Now it has reached ~$11m sales and 450-460 installed base. In Spain where MEDI operated through a local distributor there was a different challenge. Cardiac products rapidly gained traction with 80 units in place, with my estimates of addressable clinics in 80-90. So the market got saturated and then the distributor tried to place units for the vascular market. It has not worked out so since a couple of months ago MEDI goes direct in Spain as well.

MEDI has a current stalled base of around 2,350 platforms. The company does not disclose much but after speaking to the company and hospitals I have a vague view that 440-450 are in the US, ~200 in Japan, ~140 in the rest of Asia, ~150-200 in Germany, 80 in Spain and the rest unevenly distributed between the Nordics, the UK and RoW. Not central to the thesis, the UK is a relatively large untapped market with Meditim’s products just being used in 5-6% of the times.

Apart from its core business MEDI distributes third party medical products just in the Nordics – unalike things like optical equipment, breast implants, sterilization and cardio products. Like you I do not like this legacy business that makes 1/4th of sales, but the truth is that it was a former CEO’s decision to get into it and the business is not that bad with 40% and 10% Gross and EBIT Margins, ~12-13% pre-tax ROA and virtually no maintenance capex requirements. It does not seem to pose a great distraction from management as sales now essentially come from historic inertia. Management would sell this side of the business if a decent offer comes across but in the meantime it is something that just adds to the bottom-line with no major pain attached.

History and current situation

Founded in 1984 MEDI went public in 2004 so that the founder Kari Pah could sell her 20% stake. The owners then decided to bring a new CEO in substitution of Arne Grip, Pah’s right hand. Kari Krogstad joined the company as CEO in 2009. The Chairman Øyvin A. Brøymer owns ~22% of the company and is on the Board since 2000.

I think part of the reason for the CEO change was the previous management team made capital allocation mistakes that were very avoidable especially given the quality and potential of the core business. In 2005, the company acquired the electronic stethoscope maker Meditron. Stethoscopes are essentially a commodity and not really related to blood flow devices. The mitigating factors are that MEDI only paid ~NOK2m for what essentially was already a distressed company at the time, that Meditron is no longer in operation as MEDI exited in 2012 and that the current management team is very conscious of the mistake the company made in the past. Indeed the CFO – that remained after the new CEO took over and is with the company since 2001 – was very open to admit that he belonged to the team that made that bad decision and he was even the one who brought the topic up.

Another questionable decision from previous management was entering the third-party distribution business for the Nordics in 2003. It was a clear drift from the main business and Arne, rather than retreating after some time added to his bet by buying in 2006 Kir-Op, a distributor of medical devices. MIDI paid ~NOK24m this time, not small money for a company with ~NOK100m sales & NOK18m net income by that time. I think this was the deciding episode for the CEO change.

Despite these swings the core business is terrific. Sales, EBIT and EPS have compounded at 11,13 and 14% CAGR since IPO, boosting the share price from NOK10 to 70 in the period. And now the company has a great opportunity to capture a sizable proportion of the US market and make its platform also a standard for the vascular segment.

Investment Thesis

I think MEDI’s current market cap is only justified if (i) MEDi’s products do not really gain more traction in the US and (ii) initiatives to capture the vascular vertical do not work out and (iii) the company makes silly capital allocation decisions. I think that none of the three will happen. Just ~18% of the ~240,000 CABG procedures that happen in the US every year rely on a MEDI apparatus, an anomaly only comparable to the UK market which is 1/8th of the US market size. There are cultural reasons for the low penetration. Unlike Europe’s, the US cardiovascular medical ecosystem is quite decentralized. Surgeons have in many cases their small clinics and do not ascribe to a hospital on a permanent basis. Lower relative numbers of resident physicians for larger clinics – the ones for which a MEDI’s machine makes economic sense - mean that there are fewer people who actively place orders. Why bothering understanding the benefits of a machine that one will not use in his practices? As far as I understand this is something structural and not likely to change.

However there are two conditions that did not exist before and have started to play out. First the Care Affordable Act introduced the Readmissions Reduction Program4 in 2012, which requires CMS5 to reduce payments to IPPS6 hospitals with excess readmissions. Specifically CMS has introduced reductions in reimbursements to hospitals when patients are readmitted within 30 days of a procedure. On top of that and specific to CABG the program states: “In the FY 2015 IPPS final rule, CMS finalized the expansion of the applicable conditions beginning with the FY2017 program to include patients admitted for coronary artery bypass graft (CABG) surgery in the calculation of a hospital’s readmission payment adjustment factor”. So what this amendment basically means in short is that clinics have now a strong incentive to reduce readmissions of patients coming out from a CABG and I truly think MEDI’s machines will be a critical factor to satisfy that incentive.

And Mr. Trump’s plans? Well, I will not enter here into a political debate about Obamacare’s costs and benefits, especially since I am not American and not 100% familiar with the underlying implications of each plan. But what I can say is that Mr. Trump has not succeeded so far as he has not secured the necessary support from the House and much more importantly, even if Obamacare was finally repealed I believe policies related to reimbursement on readmissions are not as controversial and thus less likely to be modified – both patients and the government interests are aligned – as regulations linked to the level of subsidies, the contribution and benefits to different income brackets or the way insurance marketplaces should work or not.

The second factor that is gradually coming into scene is an increasing consciousness of the actual benefits of MEDI’s platforms. In late 2015 MEDI decided to invest ~NOK9.2m (~€1m) on the REQUEST study, which stands for REgistry for QUality AssESsmenT with Ultrasound Imaging and TTFM in Cardiac Bypass Surgery. The study comprises more than 1,000 patients and several hospitals in the US and Europe and the idea is to provide more visibility on the actual benefits that MEDI machines provide, secure documentation on the workflow and quantify the actual ROI (i.e. cost savings) for each hospital. The company states that an official study will be available at the end of the year, and with these results in hand it is much more likely that US healthcare authorities impose new regulations and insurance companies implement requirements that foster a widespread use of MEDI apparatus.

So considering these dynamics it does not come by surprise that MEDI is now expanding its salesforce in the US. In 2015-16 it hired 6 salesmen for the US, which is a lot considering it only had 12 for that purpose. And it plans to hire even more if results justify it. I truly think that is just a matter of time for “Mira” to have crowds of cardiac surgeon claimants.

4 Section 3025 of the Affordable Care Act added section 1886(q) to the Social Security Act

5 Government agency that administers Medicare and Medicaid

6 Inpatient Prospective Payment Systems

Regarding the vascular vertical – both in Europe and the US – let me reverse the question. Are there any potential reasons why it might not work as well as in cardio? I think there is mainly one. Measuring blood flow is not that critical in vascular procedures for quality assessment so adoption is more discretionary. Let assess that argument. Vascular comprises ~8% of sales and commercial efforts have been mostly restricted to some countries in Europe. It has worked in two places, Germany and the Nordics, and it has not in one, Spain. Incidentally MEDI has high penetration for cardio in each 3 countries and in Spain was the only one of the three where it sold through a local distributor rather than direct. The local distributor openly told me that their edge is in cardio and not vascular, but they had tried to place vascular devices in some hospitals. On the other hand vascular surgeons at the hospitals told me that they did not even know the product so it is clear to me that the problem derived from the distribution channel and now that MEDI sells direct in Spain I think it will work here and in the other places that have a direct distribution system.

Finally, when it comes to capital allocation I think it is safe to assume the CEO will not drift apart from the core business as her predecessor did – she and the CFO stated it and her actions are aligned with her words insofar. She has now been CEO for 8 years and there are no warning signs. She has given back cash via dividends unless the funds were used for operations – i.e. the company just cut the dividend in 2013-14 as the Mira platform demanded significant investments before it was launch. Share count is slightly lower than when she took over.

Valuation

The company itself does not have a clear view of the actual installed base at every point in time as it partly sells through distributors. I provide a very conservative valuation.

Base Assumptions

• Each unit in the US sticks just to the minimum usage per year of 100 procedures ($25,000), which I consider virtually impossible as soon as one single unit be above that limit. But just assume this on grounds of conservatism.

• The company is not even 100% successful selling platforms to its initial target of 1,250 hospitals in the US and sells only to 1,000.

• The company disclosed that in the US it has on average ~1.3 platforms per hospital. I will use that number it is very conservative prospectively as the average target hospital has more than 1-2 cardiac surgeons (some have up to 8) and several operating rooms.

• Third party sales have historically grown ~7% CAGR, but given that in 2015 a distribution contract to distribute Medtronic’s products in the Nordics was not renewed and MEDI was active distributing Medtronic’s products I assume that third-party sales will remain flat.

• Confer no value to ultrasound imaging probes – ultrasound probes are ~80-90% more expensive than traditional probes. Indeed, it has significant market potential.

• I assign virtually no value to the Vascular vertical. I assume: i) the installed base does not grow and the company does not develop new vascular probes. The “book value” - PV of expected lifetime of ~8 years - is NOK7m.

By 2020 I estimate that the company will have an installed base of 1,300 units in the US translating into ~NOK280m sales and ~240m of capital sales & probes to RoW. Third party sales ~NOK68m.

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

Catalyst

- Accelerated penetration in the US

- Growth in vascular vertical