With second quarter results in hand, Novadaq (NVDQ) continues to look like a rare med-tech story with both very strong growth and large addressable markets trading at something close to a reasonable valuation. "Reasonable" is a subjective assessment, of course, it will take many years of exceptional growth for Novadaq to earn its valuation, but I believe the company's strong portfolio of surgical imaging technologies can drive that growth.
Fine On Revenue, Light On Margins
It may be an exaggeration to say that the Street only cares about Novadaq's revenue growth today, but it wouldn't be much of an exaggeration. To that end, I expect management's somewhat cautious commentary about the capital equipment environment to give investors more reason for pause than the slight underperformance in gross margin and higher opex spending.
Revenue jumped another 50% this quarter, with product sales up 58%. Novadaq saw strong SPY system sales (revenue up 108%), while disposables were also up a healthy 40% (or about 8% to 9% sequentially).
Gross margin rose about a point, but that was also about a point lower than where many sell-side analysts had modeled the quarter. At this point, that's not enough of a discrepancy to merit much investigation, though it sounds like higher than expected SPY system sales played a role. Novadaq also spent more on SG&A than expected, but this is common to the point of cliché with small-cap med-techs in the process of ramping up their direct sales efforts. All told, the company consumed about $0.6 million in cash from its operations (before net working capital) and that's a more relevant metric to follow for the time being.
Share Continues To Grow In The Core Market, Will Other Markets Follow?
The biggest question for Novadaq right now is whether or not the company can replicate the success it has had with its SPY imaging system in breast reconstruction, helped by marketing partner LifeCell. From 13% penetration at the end of 2012, use! of SPY in breast reconstruction has grown to 15% and management is expecting to hit 20% in 2014 - a critical breakpoint that could see significant incremental adoption.
Because it gives the surgeon a way of visually confirming perfusion, SPY has been shown to lead to significant reductions in complications. Another recent study showed that complication rates fell from over 26% to 5% when SPY was used, resulting in a $3,500/patient cost benefit - suggesting that Novadaq is exceptionally cost-effective (it costs about one-third of its expected complication benefit on a per-procedure basis).
Similar benefits have been shown in other trials using the same technology in surgeries like rectal cancer and gall bladder removal. This is why the company is upping its sales and marketing spending - to support its direct marketing efforts with the Luna (wound care) and Pinpoint (minimally invasive surgery) iterations of the technology. All told, these markets could be worth almost 10x the current breast reconstruction opportunity, so it's worth spending the money in my opinion.
The question is one of adoption. There aren't a lot of comparable systems out there, and Novadaq has a pretty good patent estate, but other companies in the endoscopy (Karl Storz, Olympus, Stryker (SYK), for instance) or imaging space (including GE (GE) and Philips (PHG)) could offer some resistance. There's also the question of status quo - while Novadaq's technology makes a surgeon's life easier (and the outcome more certain), they are creatures of habit and gaining acceptance for new procedures often takes longer than you would think it should.
Adding Technology, But Cautious On Cap Spending
With the quarterly announcement, Novadaq also announced the acquisition of the Trapper surgical imaging system from Digirad (DRAD). The Trapper is essentially a scintigraphy system, and it allows physicians to visualize radionuclide-infused tissue in real time. This could be particularly useful in imaging lymph nodes and ! tumors an! d it is a logical addition to Novadaq's portfolio. While the company didn't pay much ($2 million, plus $1 million in contingent payments and royalties over five years), Novadaq already as a meaningful direct sales launch effort to manage, and there is some risk of the company trying to run before it's able to walk at a steady pace.
On an unrelated note, management did sound some caution on its Firefly product and capex spending in general. Firefly is an imaging technology that uses Novadaq technology on Intuitive Surgical's (ISRG) daVinci robots. It's now shipping on about 80% of Intuitive system, and the recent issues with Intuitive's system placements (and system guidance) have worried some that Novadaq will see spill-over. Novadaq's exposure to Intuitive is largely on the front end, as it gets about $15,000 per placement versus only about $125 per procedure. All told, Firefly is a small part of Novadaq's business (more of an affirmation of the technology than a big near-term revenue opportunity) and I would argue that despite management's caution about capex spending, the 175 SPY systems placed this quarter was a positive sign that hospitals will find the money for the systems they really want.
How Big Can It Get?
If Novadaq were to get complete penetration of its known market opportunities today, that would work out to over $1.5 billion in annual revenue just from the disposable packs. Novadaq is never going to get 100% of course, but then the markets the company addresses are also going to grow over time as minimally-invasive procedures take share from conventional open surgeries.
I'm still looking for Novadaq to post long-term growth of over 40% a year in sales, which is admittedly a very large number, but one that works out to about $750 million in 2022 revenue. I also expect this company to see very solid profitability, with long-term free cash flow margins of 20% or better. On a fully-diluted basis, that works out to about $18 per share today. Were the company's technolo! gy to rea! lly catch on, it's conceivable that Novadaq could double that revenue target by 2022, suggesting fair value into the mid-$20s. All of that said, at around 13x 2014 revenue (on a fully-diluted basis), it may seem harder to some to argue that Novadaq is strikingly cheap today.
The Bottom Line
Novadaq is still very small and very much unproven (though 15% share in breast reconstruction procedures is a good start), and the company absolutely has to deliver with its direct sales effort. I believe they will, though, and while Novadaq is absolutely not a stock for the nervous or risk-averse, I still think there's money to be made over the long-term in Novadaq shares.
Disclosure: I have no positions in any stocks mentioned, but may initiate a long position in NVDQ over the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article. (More...)
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