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This is written with serious investors in mind. I'm a former reporter, private investigator and institutional equity analyst who digs deep to find niche undervalued and undiscovered securities. I manage money for individuals, institutions and family offices via my business Long Cast Advisers. This blog is part decision-diary, part investment observations and part general musings about Philadelphia sports. It should not be viewed as a solicitation for business or a recommendation to buy or sell securities.

Friday, December 30, 2016

A New Book and a New Idea ($IVTY, $MDT)

I recently received a gift in the mail, a copy of this out of print book by former CIA intelligence analyst, Richards Heuer. The book is influenced by Kahneman and Tversky but framed primarily around the decision making part of analysis and not just the analysis of decision making.

It is a dense read with fewer "cognitive party tricks" than the pages of so many other popular books on the subject, but it's fascinating, even as I'm only halfway through it.

Since I've recently sold some positions and also have some new clients, I have the "high class problem" of having capital to put to work. So the book arrived just as I'm searching for new ideas and as a result, the aspect of the book that's come into sharpest focus is the relative nature of observations and its relationship to decision making.

We all know that colors have a relative nature, changing depending on the background. And we all know there is a relative nature to sound, to speed, to taste, to time, etc.

Concurrently, the book also introduced to me the concept of "bounded rationality", which describes our tendency to frame things in a specific way, then solve for the problem within that arbitrary frame. For example, my wife often poses questions at me along the lines of  "would you rather do this or that?" as if those are the only two options available, and without articulating the problem she's trying to solve. (I'll acknowledge the difficulty of being married to an over-analytical spouse when all she wants to do is go out for dinner).

Reflecting on these aspects of decision making is critical for the obvious reason that ours is a decision making business and few people do it well consistently. Though the first year of my firm provides a good start, consistency is measured in years not months, and I still have a lot to prove.

Furthermore, the returns we put up isn't some theoretical experience; I have a fiduciary obligation and professional responsibility to grow my client's capital and avoid losses on their hard earned money. It's important to get it right and I better not screw it up!

So with these new insights into the relative nature of observations, it comes to mind that the search I've been conducting for new ideas may be rife with biases I'd never before considered. Here I am reading Q's and K's, learning about businesses, screening, modelling, reading, reviewing ... and saying "no" over and over ... and up percolates an emotional experience, let's call it "frustration", about not finding good ideas.

Frustration can lead to impatience ... and then perhaps the relative nature of observations takes over ... and I'm suddenly comparing the next idea to the last idea instead of to an objective benchmark. Each idea is independent of the other - and I should be more eager to preserve cash for the right idea than rush into the wrong one - but what if I'm suddenly framing them relative to each other and thus distorting the analysis?

The problem with all this is twofold: First, the potential lack of awareness that fatigue and relativity can drive decisions. Second, because most of the stocks I tend to buy are lonely trades where validation can be incredibly delayed, I might not know whether I'm "right or wrong" about a stock for months, if not years. I'd rather hold cash than be wrong ... but I'd like to not miss opportunities to be right.

All of a sudden the obvious and well discussed theories behind deep value investing are crystalized: If you buy companies for less than its asset value, you don't have to worry so much about the future. It's an easy philosophy on paper but less so in practice, because some "deep value" businesses absolutely suck and the good ones don't trade for below their asset values for long. Value, as we all know, is infrequently obvious.

This all calls to mind something Howard Marks wrote about "the future":

"It would be convenient to say that adherence to value investing permits investors to avoid conjecture about the future and that growth investing consists only of conjecture about the future, but that would be a considerable exaggeration. After all, establishing the current value of a business requires an opinion regarding its future, and that in turn must take into account the likely macro-economic environment, competitive developments and technological advances. Even a promising net- net investment can be doomed if the company’s assets are squandered on money- losing operations or unwise acquisitions.

There’s no bright-line distinction between value and growth; both require us to deal with the future. Value investors think about the company’s potential for growth, and the “growth at a reasonable price” school pays explicit homage to value. It’s all a matter of degree. However, I think it can fairly be said that growth investing is about the future, whereas value investing emphasizes current day considerations but can’t escape dealing with the future."

The future, the fact that nobody knows it, and the risks associated with its possible outcomes are important considerations in all investments. One I've been considering - Invuity - which makes lighted surgical equipment for the operating room, recently sold off b/c of weaker than expected guidance for 2017 (the near future), but I think it may represent a compelling long term opportunity.

At $6.00, Invuity (ticker: IVTY) has a $100M market cap and is trading at ~2.5x 2017 sales guidance of $40M-$42M, a future that implies 35% topline growth. This is - I believe - a “capitulation price” for a company innovating in an overlooked and undervalued area of the surgical equipment market and in an industry where stocks tend to trade in the range of 2x-10x sales.

The company’s core product is an engineered piece of plastic that delivers cool bright light with a wide field and few shadows directly into the cavity of a surgical "field". This piece of plastic – for simplicity sake let’s just call it a widget for now – either clips onto a reusable retractor that the company sells or is built into the company’s version of ubiquitous operating room tools like "yankauers" and "bovies".

The company has two types of sales; a "capital" sale - an expensive piece of reusable equipment - and a "disposable" sale (ie recurring) via the handheld equipment and clip on widget. These products together improve visualization - a surgeon’s ability to see - in non-laproscopic / non-robotic procedures.

The company currently markets these products into four narrow verticals: Breast oncology, orthopedic surgeries, thoracic and spine procedures. Some procedures like "nipple sparing masectomies" and "anterior hip arthroplasties" are particularly well suited for the device as they are fairly technical and involve smaller incisions for open surgery, making "visualization" difficult.

These procedures benefit the patients via less scarring and/or faster recovery times so the concurrence of the new procedure's acceptance and the improved equipment may help grow their use and thus demand for the equipment, etc. (Note that despite the negative bias towards the anterior approach in this link, it acknowledges speedier recovery for the anterior approach as well as the greater difficulty with visualization).

B/c of the NSM procedure the company has had the greatest traction with breast oncology - about 40% of sales - but has under-penetrated the more lucrative spine and orthopedic procedures.

This is still a small company - not just in market cap but in actual size - selling just a few products into a few narrow verticals. At 3Q16, the most recent quarter, the company had 65 salespeople, many of them with the company for less than a year, selling into 700 accounts. Small, yes, but on a relative basis, compared with last year, this reflects 25% growth in salespeople, 50% growth in accounts, and a 63% increase in procedures per quarter, to 26,000 from 16,000 in 3Q15.

In 1H17, the company will launch one new product - the “PhotonBlade” - a lighted version of Medtronic’s PEAK PlasmaBlade, which will have the "light widget" built in and a tip that causes less scarring. The company believes this product will allow the company to further penetrate breast oncology and spine market.

It is worth noting here that IVTY’s head of R&D, Paul Davison, was the head of R&D at PEAK Surgical, before it was acquired by Medtronic in 2011. At the time of the 2011 acquisition, PEAK had $20M in sales and was acquired for a 6x sales multiple.

So what don't we know?

I have talked to a number of doctor's about the product for qualitative background. One, whom I respect and admire greatly, insists on caution with the investment. "They're not the first to try to do this," he says. "There've been people trying to come up with better lights on surgical tools for more than 30-years."

My response: "That's proof it's a problem searching for a solution."

Several other doctors I talked with expressed enthusiasm for the product; "Tt would be awesome if it did what they say it does" but they all universally blanched at the price.

And price is an issue. The company charges a huge 10x premium for their lighted product. Their disposable yankauers and bovies as well as the clip on widgets (called “waveguides”) cost $250 to $300 compared to non-lighted versions of the same products, which cost under $25.

In a market with thin margins for hospitals and risk that ACA will disappear, it seems ridiculous to think hospitals will pay this much for disposable plastic. The product pricing is the first of many obvious reasons why this company fails.

Yet, despite the premium and all the other obvious reasons, the company is on track to sell $24M of these disposable plastic products in '16 (and $8M in reusable products that the widgets clip into), all at +70% gross profit margins. And these are pure cost to the hospital; there is no CPT code that allows the hospital to get reimbursed for its use.

The reasons for the company's potential success are less obvious. Again, this investment depends on a future. But experience indicates that it takes time – and costs money - to introduce a new premium product to the market and for the market to adopt it. It takes time for a salesperson to “mature” and an account to “mature”. It takes time for doctors to see the light and press a hospital Value Analysis Committee to buy for them a premium priced piece of equipment.

And yes, the costs of selling currently exceed the revenues, but perhaps there is overlooked promise in the early operating evidence, particularly with the recurring revenue disposable widgets and most particularly at 3Q16, where the ratio of incremental sales to incremental marketing spend reached an inflection point and increased to 48%.

Management expects to keep sales staff flat into 2017 and focus on going “deeper” into existing accounts and were this to happen, we would see continued revenue scaling and then perhaps we are just now seeing the inflection and impact of more salespeople and more accounts on revenues.

Yet, the market is most skeptical as signs of success are improving. That skepticism, which underlies the low multiple, is driven by a variety of issues I'll lay out below:

1. The proximate issue with the recent decline in the stock price was a guidance shortfall. On the 3Q16 earnings call, mgmt guided to 35% topline growth in 2017 down from expectations of 50% growth, and this led to the stock’s capitulation. The stock was trading towards $13 heading into the quarter and hit $4.50 on the earnings release.

The 3Q16 sell-off reflected the market’s focus on the weak guidance. Through the lens of a DCF model, such a response makes total sense: If T+1 income is lower, the whole valuation declines. But from a qualitative perspective, there should be no point in investing in this company at any price – regardless of what the DCF says - nor under any circumstance without the belief that IVTY’s usefulness to its customers will grow over time, along with its sales and eventually profits.

What drives long term growth of a company – qualitatively - is a problem identified and solved at a price the customer can afford. We see evidence in the operations that the company’s illumination products are indeed solving a problem and they are generating traction on the valuable recurring revenue side of the business. But ...

2. Price seems to be a major issue.

A former employee I talked with said cost is the single biggest obstacle with "going deeper". This person said as they "get deeper" into accounts and sell more into each hospital, eventually the invoices roll up to the CFO who pushes back.

In addition, every doctor I talked with - bar none - expressed shock at the cost.

The company says the better lighting enables doctors to perform surgeries faster and therefore do 1-2 more per day. A response I got from another doctor was polite laughter: "If I were to make a list of items that slows down my [thoracic] surgeries, lighting would be like item 1,700."

The company also said interestingly, "when we show up on the CFO's desk, it means we're doing something right." Reminds me of the old saying: "Salesmanship begins when the customer says no."

3. In addition to being high priced, there's no CPT code for the product, so hospitals don't get reimbursed for their use. And hospitals aren't rolling in cash to spend on expensive equipment.

4. And recently there seems to be a lot of salesperson turnover.

5. And surgical procedures are supposedly moving away from open towards laproscopic and robotic

My response on these four items is that these issues are not "new". 

A brief look at a scuttlebutt message board for pharma sales reps shows people talking about the high product pricing, employee turnover, competition, etc. since at least 2014. In the interim, sales have grown from $14M to $32M. 

Meanwhile, the cost / benefit analysis of robotic surgeries doesn't appear to be compelling (though as long as insurance covers it, hospitals will do it). 

More broadly, product price is a solvable problem. They can continue down the path of a $250-$300 ASP, scratching for sales within the four narrow verticals and with the new product expected to come out in 1H17, they can offer bundled pricing. 

Or, they can lower prices. These products are cheap to make and if the product is desired, the potential for ubiquitous access across all hospital channels at a lower price is an attractive investment option, though even more attractive at the higher price. 

6. Ultimately though, the skepticism is bound - like life itself - by the limits of time. The company is unprofitable, running at losses of $40M in 2016 on sales of $32M and gross profit margins +70%. It also has $14.5M of outstanding debt at 12.5% interest, held by Healthcare Royalty Partners, a medspace investment firm that also owns 5% of the stock. And although the company has $34M in net cash on the balance sheet, it is still cash flow negative so at some point, there will be a future dilution event.

This is no walk in the park, but startups with losses and debt are not unusual, and this isn't the first rodeo for the management team - lead by CEO Phil Sawyer and CFO Jim Mackaness - who have prior experience running growth distribution businesses.

Nobody knows the future, but at ~2x 2017 sales, the stock market appears skeptical about the prospects due to losses, debt, the recent guidance shortfall, and issues that are not new.

That skepticism overlooks what appears to be some traction in the recurring revenue business and the traction is new, the evidence of success is new, the favorable relationship between the sales and cost curves are new and trending in the right direction.

Sure, my biases and frustrations, hubris about my successes, shame about my losses, all may have contributed to this idea floating up to a level of thinking that ... maybe it's totally irrational. A yankauer for $250? A plastic widget with some special light? Hospitals spending money on stuff they don't get reimbursed for?

Maybe I've talked myself into a bad idea ... but when the market is already valuing this as a bad idea ... and the evidence suggests that its not failing ... it seems to offer a favorable possibility for those armed with information and an uncommon perspective.

 - END –


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