I've had a love/hate relationship with Spectranetics (SPNC) for more than 15 years now. I've always loved the potential of the company's laser ablation products in markets like pacemaker/ICD lead removal and peripheral atherectomy, but I've hated the company's pattern of inconsistent execution and the inability to ever "get over the hump" and establish a true growth trajectory.
I expressed similar reservations about a year and half ago, and it turns out that my timing was precisely wrong, as the shares (along with the med-tech sector) began an impressive run that has seen better than 130% appreciation and several positive sell-side initiations. Curiously, my financial model has proven to be accurate in terms of revenue evolution and my estimates for margins and cash flow have proven too bullish. What has changed is investor sentiment and optimism around the company's ability to penetrate the lead removal and atherectomy markets.
Spectranetics is now valued as a med-tech growth stock, and if management can continue to deliver double-digit revenue growth it is not unreasonable to think that the shares will reach the low-to-mid $20s over the next 6 to 9 months (approximately a 20% return). Unfortunately, that potential is tempered by the realities of a challenging market and improving alternatives.
Hitting The Mark In Q2
Spectranetics didn't report a blockbuster second quarter, but it was good enough to maintain credibility that this is an emerging med-tech growth story.
Revenue rose 13%, with lead management revenue growth of 11% and vascular intervention growth of 9% (constant currency) supplemented with 34% growth in the "Laser System, Service & Other" category. While there are still many relevant companies left to report, these growth rates appear well ahead of overall cardiac rhythm management (CRM) and vascular intervention procedure growth rates for the quarter. It's also worth noting that revenue from U.S. peripheral vascular intervention rose 19% for the quarter.
Margins are still mixed. While the gross margin did improve a bit (up 30bp yoy), last year's operating income reversed to a loss as the company's R&D spending outstripped growth, due in part to the ongoing EXCITE U.S. clinical trial.
Lead Removal - If Not Now, When?
One of the frustrating issues with Spectranetics has been that the company has always addressed attractive-looking markets, but market adoption has never gone to plan. The company's lead removal business is a case in point.
While the leads used to connect a pacemaker or ICD to the heart can usually be left alone, occasionally they fail or become infected and ought to be removed. The problem is that doctors just don't do this as often as they should, even though the prognosis for these patients is poor. Even with a mortality rate in excess of 30%, infected leads are removed roughly 40% of the time. While it's true that mortality rates are still elevated even when leads are removed (probably because the infection has already established itself at that point), there is a solid and reproducible benefit to patient survival.
So why isn't this done more often? I can only speculate, but I wonder if the relatively rare incidence of lead infection (the literature runs from less than 1% to as high as 7%) and lead failure discourages doctors from learning the procedure or the hospital from acquiring the equipment. To that end, the well-publicized scandal surrounding St. Jude Medical's (STJ) faulty leads has only led to a modest positive inflection in growth.
Even so, there are credible arguments for ongoing growth in this market. Medtronic (MDT) was first to market with an MRI-safe pacemaker, and both Boston Scientific (BSX) and St. Jude look to follow. But while the new devices may be MRI-safe, the old leads are not and need to be removed. Likewise, should Boston Scientific's subcutaneous ICD and St. Jude's experimental leadless pacemaker succeed, lead removal could grow from the $60 million or so in annual revenue for Spectranetics and get closer to the $250 million to $300 million in theoretical market potential.
Cause For EXCITEment
Although Spectranetics is seeing adoption of its laser catheters in peripheral atherectomy grow, the opportunity has been there for a long time now and the company has seen mechanical atherectomy products from Covidien (COV) and Cardiovascular Systems (CSII) launch, accelerate past them, and leave them well behind in terms of market share.
The big "but" has been the in-stent restenosis application, and that is an increasingly significant opportunity for Spectranetics. Basically, here's the deal - as technologies (and clinical data) have improved, doctors have increasingly turned to stents to deal with blocked arteries in the leg. Covidien and Bard (BCR) remain leaders in this segment, but companies ranging from Boston Scientific to Medtronic to Abbott (ABT) and others have all targeted this badly-underserved market as a growth opportunity.
While these newer stents perform much, much better than older versions, in-stent restenosis (that is, a blockage within the stent) still remains a significant problem. This is an opportunity for Spectranetics to shine, as the early data on laser atherectomy for in-stent restenosis have not only been good, but better than the data from Covidien's mechanical atherectomy system.
To develop this opportunity, Spectranetics is following up the successful German PATENT study with the EXCITE study in the U.S., and the company hopes to have FDA approval to begin marketing this indication in 2014. Although I suspect there is already off-label usage for in-stent restenosis, I don't think it's significant, and this would open up a market that could be worth upwards of $700 million a year.
Opportunity Versus Reality
All told, I believe Spectranetics has (or will soon have) products and approvals to address markets worth as much as $1.5 billion a year. Compared to expected revenue of $155 million for 2013, that's a major growth potential if Spectranetics can increase adoption.
Alas, that "if" is the problem. I simply do not believe that Spectranetics is going to get all that much share in the "traditional" peripheral atherectomy market, even though reimbursement and the cost of the catheters make it economically attractive for out-patient practices. Likewise, I just don't see a catalyst for a big acceleration in lead removal - there are journal papers going back over 15 years advocating for the practice and it's still largely a niche procedure. That puts a lot of pressure on management to make the most of the peripheral in-stent restenosis potential, and my fear is that the launch of drug-eluting balloons in the coming years (in other words, no stents) could nip this opportunity in the bud.
Not surprisingly, my base case assumptions for Spectranetics are not favorable for the stock. But since I missed the big move over the last 18 months, let's consider a more optimistic/bullish case. Let's say that Spectranetics can get one-third of the theoretical lead removal market in 2019, as well as one-third of the in-stent restenosis market and about 20% of the peripheral atherectomy market. That works out to around $550 million in revenue in 2019 and a 10-year revenue growth rate of over 20%. Assuming that Spectranetics could generate industry standard free cash flow margins in the mid-teens that works out to a fair value of just under $24.
For better or worse, though, sell-side analysts and many (if not most) institutional investors don't evaluate growing med-tech stocks that way. Instead, they use revenue multiples. Allowing that Spectranetics is now a med-tech growth stock, it could fall into that valuation paradigm where 5x to 10x multiples come into play. Giving the stock the low end of that range (as it only barely qualifies on the basis of 10-12% expected growth), a $22 to $25 target seems reasonable (depending on whether you include net cash).
The Bottom Line
I'm sure it sounds like sour grapes to be still be skeptical after this big run in Spectranetics shares, but I just think the expectations are getting pretty heated for a company that has never managed to find the spark to accelerate from 10% growth to the 20% or higher that marks the real med-tech success stories.
Maybe this time is different, and maybe the EXCITE study will open the door to a major revenue opportunity. With the stock possibly still holding 15% to 30% upside, it could be one of the only bargains left in the growth segment of med-tech, but investors considering the shares need to appreciate that there are above-average risks and challenges with this idea.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within 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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