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Avram Fisher, Founder & Portfolio Manager of Long Cast Advisers, is a former equity analyst at CSFB and BMO covering industrials and business services. He has prior experience in private equity; as a corporate governance analyst; as a writer; reporter and private investigator; and as a lifeguard and busboy (I still clear plates when my kids don't). This blog is an open book of ideas about patient investing and about starting up a small-cap focused RIA. It is part decision-diary, part investment observations and part general musings. Nothing on this blog is a solicitation for business nor a recommendation to buy or sell securities. It is simply a way to organize and share thoughts with an expanding audience of independent, patient and talented small cap investors. www.longcastadvisers.com

Thursday, February 1, 2018

Letter to Invuity Management ($IVTY)

There is no lacking for investment ideas, or the newsletters pitching them. Most of it is "noise" and it is enough to give anyone brain damage.

"Noise" not b/c they are bad ideas - who am I to say what is a good idea or bad idea - but b/c we all have limited capital and therefore must choose our investments wisely so as to get a return that compounds faster than the rate of inflation, perhaps even in excess of market returns over time and while still permitting a sound night of sleep.

So when I've already made a decision to become a part owner of a company, unless something materially changes, I intend to own that company indefinitely. I don't want to churn ideas. I certainly don't want brain damage, though this business can cause it for sure.

Safe to say, it is easiest to own companies whose values only go up. When their values go down, investors have three choices: Sell, buy more or do nothing. That decision should be based on a reassessment: Was I right or wrong with my initial consideration? And where are we now?

A good guide is the simple question: "What have I missed?" A most poor (though frequent) option is to seek out fellow investors who only reassert an initial thesis without comprehension or curiosity of what they're all doing wrong or what has changed for the worse. Better to focus on "what are we missing" than the company of misery.

I am writing this with Invuity in mind. It is now back to trading with a $4 handle and I am reassessing what to do.

I do not believe there is an intrinsic flaw with the product but I do believe management is entirely culpable. They have acted with the kind of behavior that I regard as "stupid". Short term focused. Capital destructive. I've written them a letter which I include below.

When I consider what to do, I reflect on the following:

A year ago, when I initially wrote about the company and started acquiring it, the stock traded with a $4 handle. However, back then, the company had $34M in net cash and therefore an EV substantially below its market cap.

As we revisit the same $4 handle today, it is important to keep in mind that the balance sheet is entirely different now. Currently, the company has $5M in net debt. Thus, despite a similar stock price, the EV is about 2x what it was a year ago.

I initially bought this a year ago at ~2x EV / GP when it had $21M in trailing GP. A price I considered a steal. Today they have $28M in trailing GP

Thus, for the stock to revisit my initial valuation - a potential scenario (what isn't a potential scenario?) - the stock would have to get to $3 on the nose. I expect it has the potential to get there when they report 4Q17 / year end earnings ... and miss guidance. I have no particular insight into whether or not they will miss guidance, but they have done so fairly consistently for quite sometime, so why shouldn't they again?

I continue to believe they have a winning product and evidence suggests as much. The letter below is intended to express my hope that they will get righteous for the customers first and foremost and then enrich themselves on their success, and not focus on the latter without due consideration for the former.


Dear Chairman:

It is my belief that a product that solves a long-standing problem for its customers, sold at a reasonable price, and at a margin that generates profits for its manufacturer is generally a good starting point for a winning investment, especially when that investment can be purchased at a low multiple.

At ~2x sales, I believe Invuity has these initial ingredients, which is why I and my clients are holders of roughly 35,000 shares.

But good products alone are not enough to weigh the odds favorably for long term success. The investment world is littered with the detritus of mismanaged companies that HAD terrific products. Rather, long term investment success requires executives and managers who make sound capital allocation decisions to generate growth and cash flow, towards the eventual goal of self-funding operations.

[I included here a footnote ... "I urge you strongly to read Amazon’s shareholder letter from 1997 to fully understand and internalize what it means to invest for the long term so you can reflect on the many ways Invuity can improve in this regard."]

I am writing because I want our company to avoid the fate of detritus that plagues so many other promising small companies simply on account of poor decisions by its executives and managers. With your public equity returns down nearly 70% since the IPO concurrent with a nearly +70% return for the IHI Medical Device ETF, I am certainly not alone in my concerns.

Fortunately, I do not believe there are many issues that need resolving. Unfortunately, the issues seem to emanate from the core and culture of the wrong ways of doing business: Short term-ism, impatience, “Wall Street” pandering, and disregard for customers and shareholders concurrent with overly generous compensation for executives and directors.

This must change.

You and the Board and the Executives must engage your full facilities of good capital allocation. Reverse the trends of short-term decision making and focus instead on the long-term growth of the company, for benefit of the company’s customers first and foremost. When your customers knock down the doors to get your product, you, your employees and your shareholders will all benefit.

The issues I observe that lead me to write this letter all reflect an absence of clear, simple thinking on the long-term development of the company and its markets:

1. Location. The decision to locate product assembly in one of the highest-cost regions in one of the highest cost cities in the country is inexplicable. This is not a tech company vying for high skilled talent.
2. Executive comp. Phil is wildly overpaid, both in comparison to similarly sized companies in the same industry and on an absolute basis. A company this size should not be paying $1.5M to its CEO, nor should it be compensating its Directors as generously as it does. I’m sure you could point to many small successes that you believe justifies this compensation, but until Invuity is on a path towards funding its own growth, you are not successful.
3. Sales strategy. In the last year, and despite the company’s infancy, Invuity has had two different heads of sales and embarked on two different sales strategies. I appreciate that the new sales strategy is intended to create a more durable selling-culture for the company. But if this is true, why did the company initially pursue a strategy of stuffing channels through experienced mercenary hires? I imagine you were trying to show a “fast start”, which leads one to wonder, for whose benefit? It appears like a decision driven by short term-ism.
4. Guidance. Personally, I see no reason to provide guidance at all but I accept that those without imagination cling to “business as usual”. That you consistently miss your own guidance however … what is there to say about that?

Were these failings simply examples of growing pains, this letter would not be warranted, for the patient investor endures these knowing that smart, self-reflective and adaptable management turns early missteps into future strides. Unfortunately, our management appears to be missing opportunities to adapt and improve. Rather it seems intent on continuing to promote its decisions as sound despite ample evidence to the contrary.

I am a shareholder of this company because the product solves a long-standing problem. Doctors I’ve talked with who have used the product overwhelmingly approve. Those who haven’t overwhelmingly respond: “If it does what they say it can do, that would be amazing.” (The two criticisms I most often hear from customers of your lighted yankauers and bovies are that they are too expensive or that the disposability creates unnecessary waste.)

I am also attracted to the optionality in this investment. First, despite so-called “obvious problems” such as …

The product is too expensive for cost conscious customers
The equipment doesn’t have a CPT code so it is not reimbursable
The environment is not ripe for hospitals to spend money on discretionary products

… you’ve grown sales from $7M / year in 2013 to $32M / year in 2016, or 65% CAGR, and over the same period, gross profits have grown 95% CAGR. Something is working.

Furthermore …

If you can generate +70% gross profit margins in Potrero Hill, I imagine what you can generate assembling in a low cost region and when you actually achieve scale.
If you’re doing 31k procedures / quarter selling an expensive item to just a few verticals, I imagine what you could be doing if you sought ubiquity, selling at a lower price but across many more procedures, and helping so many more patients as well.
Finally, I consider what $30M in gross profits and a novel new product portfolio might be worth to a company with an existent sales force, run by a management focused on wise capital allocation.

In short, I own this because I look beyond yesterday’s and today’s poor decisions, with the expectation that in the future, better stewardship of capital – by you or someone else - will unlock the value.

At the current rate, a new capital raise will be required in 12-18 months. I simply want to ensure that the allocation of current and future capital is put to its best and highest use, through a reorientation of goals and expectations towards a more long term focus, a more customer-centric focus and bounded by patient and wise capital allocation,


-- END -- 


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