The last company I featured as a takeover prospect was a telecommunications play now trading at 7 month highs, 40% higher from where I profiled it less than a month ago. Today I focus my attention on a small medical device company that I believe will be pursued by a major player in the industry at many multiples of its current price. The name of this company is Sunshine Heart (SSH).
The leaders in the medical device industry have recently been implicated in major setbacks with respect to their cardiac devices that seriously threaten to stunt their growth in the foreseeable future. Meanwhile, Sunshine Heart, an early-stage company that makes a less invasive device in this multi-billion dollar market, has had a landmark year, achieving a number of highly significant milestones. The market has been richly rewarding companies that engage in strategic acquisitions, as I will detail below. Sunshine Heart is an ideal fit for one of the big players in the industry, and the cheapest in the space. Based on the recent flurry of M&A in the sector, the insanely low valuation of Sunshine Heart, and the recent setbacks of other companies in the sector, I fully expect one of the big players to swoop in and offer to purchase Sunshine Heart at a hefty premium.
The Sunshine Heart Breakthrough
Sunshine Heart's lead device is the C-Pulse® Heart Assist System, an implantable, non-blood contacting, heart assist therapy for the treatment of moderate to severe heart failure which can be implanted using a minimally invasive procedure. Analysts who cover the cardiovascular market and follow Sunshine Heart have estimated the conservative market for the C-Pulse device is in excess of $2.5 billion. Others have already written in detail about the science behind the C-Pulse technology, and can be accessed here, here, and here.
Sunshine Heart has had a landmark year, meeting or exceeding expectations on virtually every front. In July, Sunshine provided an update for the first patient to reach the two-year follow up mark for the C-Pulse Heart Assist System. "I witnessed this patient experience an amazing recovery of function," commented Dr. Andrew Kao, Heart Failure Cardiologist at St. Luke's Hospital in Kansas City, MO. "The first time I met him, he could not walk or even say a few words without extreme perspiration and shortness of breath. After C-Pulse implantation, he can do many more activities -- he can walk around comfortably and also has improved self-confidence. He and his family are extremely grateful for this amazing chance at a renewed life."
The company also announced in July that it had received CE Mark approval for its C-Pulse Heart Assist System, allowing for commercialization of the technology in Europe and certain countries in Asia and Latin America, representing a patient population of 3.7 million. Just recently, Sunshine achieved another huge milestone, receiving unconditional FDA approval for its U.S. pivotal trial.
Troubles at HeartWare and St. Jude
Companies such as HeartWare (HTWR) and St. Jude (STJ) have recently been plagued with serious questions over the safety of their respective devices. St. Jude is trading near 9 year lows on continued safety concerns beleaguering the company. An FDA inspection discovered significant problems with the company's testing and oversight of the Durata, an electrical wire that connects an implanted defibrillator to a patient's heart. "It's becoming increasingly difficult to defend Durata," one Wall Street analyst, Lawrence Biegelsen of Wells Fargo Securities, recently wrote in a note to investors in which he downgraded St. Jude stock to hold from buy.
HeartWare, another big player in cardiac devices, has had its own share of troubles. The same Wells Fargo analyst also just downgraded HeartWare, after the company was forced to place a warning about increased incidence of strokes on the instructions for its HVAD pump. The analyst believes this may have a material effect on sales for HeartWare's lead device. The firm further contends that there is now a greater chance that HeartWare's device will not be approved as a destination therapy.
Here is where Sunshine Heart comes to the rescue, as the company's technology would perfectly complement one of these major players. The C-Pulse is less invasive and targets a different subset of patients, so a HeartWare, St. Jude, or Thoratec would both expand their reach and not have to deal with the issues (stroke, device degradation) their current devices face because of their invasive nature.
M & A on Fire in the Sector
On recent reports that Baxter is in talks to medical-equipment maker Gambro for approximately $4 billion, Baxter stock surged almost 3 dollars. There are a couple of significant points to take away from this story.
(1) The market has been richly rewarding the acquirer (not just the buyout target) when it views the acquisition as a smart, strategic, synergistic one. Witness the massive spike in Watson Pharmaceuticals shares back in March (over 10 percent) following reports that it was in talks to buy Swiss drugmaker Actavis.
(2) M&A in the medical equipment sector is heating up, and big pharma are more inclined to go on buying sprees when they witness other companies doing so (especially when their rivals' stock surges following the announcement). In October, McKesson (MCK) announced that it was purchasing PSS Medical at a substantial premium (and MCK stock surged as much as 5 points that day).
As this article goes to print, another deal is in the works: Merit Medical Products has struck a deal to acquire Thomas Medical Products Inc. from GE Healthcare for $167 million in cash. Thomas Medical specializes in cardiac devices. This sector is red hot for M&A, and SSH is the best of the smaller players that remains independent.
Australian-based analyst Scott Power, in an interview with the Life Sciences Report, contends that, "An obvious buyer of this business would be Thoratec, Heartware or some other large company looking to expand its device pipeline into later-stage heart failure."
So why wouldn't a prospective suitor wait until Sunshine Heart completes its U.S. trials before making a move? (1) Acquirers may prefer to oversee the trials themselves. (2) Acquirers could be worried that another suitor would "beat them to the punch" and snatch Sunshine up first. (3) If the trials ultimately prove successful, an acquirer would in all likelihood have to pay well north of $150 to have a chance of succeeding in its bid. At the current valuation disconnect, Sunshine is a dirt cheap option for one the major players that could ultimately pay off huge for them. And based on Sunshine's pilot study, that's an option they should be salivating over right now.
Smart Money & Strong Hands
The latest Institutional Ownership data show that shares of Sunshine Heart finally seem to be in strong hands. As the fast money has indiscriminately sold, no less than 15 institutions have increased their holdings over the past quarter, whereas only one institution has decreased its position. Two directors have also purchased shares of the company at higher prices. Moreover, technical-minded investors will notice that Sunshine Heart has tested and held $6-6.2 support.
Sunshine Heart has the risks typical of early stage biotech/medical device companies. These include clinical risk, device failure, and equity dilution (though Sunshine has sufficient operating capital for the foreseeable future). Sunshine will likely need one additional capital raise on the chance it remains independent through the completion of the pivotal trial. However, in my mind, it would be much more economical for a company like HeartWare to pony up $20-30 million for the trial, rather than wait and spend $1.5 billion for the company after-the-fact.
So precisely how much would an acquirer be willing to pay for Sunshine Heart in a buyout scenario? In order to arrive at a fair value, we can examine a number of relevant metrics, including the historical market value of comparable companies at similar stages of development, and the present value of the company using a risk-adjusted revenue model. With respect to the former, Dan Rosenblum (of sharkbiotech.com and thestreet.com) has noted: "At a similar point in its development cycle, HeartWare sported a market cap of over $200 million." This would represent 3 1/3 times the current share price of Sunshine, or approximately $22 share. The highly respected, biotech-focused boutique research firm Summer Street has a $26 target on Sunshine Heart, based on "valuation of comparative companies." Craig-Hallum uses a discounted, probability-weighted revenue model conservative model, to arrive at a conservative estimated fair value of $18 (and this was calculated prior to the company achieving its most recent milestones).
These fair value estimates so far above the current share price of Sunshine Heart may seem wildly optimistic. However, the reason so many biotechnology companies get taken over at massive premiums is that the market simply fails to recognize their full potential, resulting in large players in the industry, with the requisite scientific expertise, pouncing on the opportunity. The list of eye-popping takeovers is almost endless. Bristol-Myers (BMY) paid a 163 percent premium to purchase Inhibitex. Gilead (GILD) shelled out $137 for Pharamasset when the stock was trading at $72. The premiums that acquirers are willing to pay for small and micro-cap targets (like Sunshine Heart) are often even more astronomical. Eli Lilly (LLY) paid a 250% premium for SGX Pharmaceuticals. Kosan Bio was purchased by Bristol-Myers at a 300% premium. Glaxo paid 4 times times the closing price of Genelabs. And the list goes on and on.
Investors in Sunshine Heart have an opportunity to invest on the ground floor of a possible future multi-billion dollar blockbuster. However, well before that materializes, I believe one of the larger players in the field will make an offer its shareholders can't refuse. Based on the valuation metrics cited above, I would expect a takeover bid at $22-26 (the median of the fair value estimates listed above) sufficient to garner the support of SSH stakeholders. This would represent a big win for SSH holders, and a no-brainer for a Heartware, St. Jude, Thoratec, or Medtronic. The only question is who will be first to offer their pocket change to acquire a company that has already proved itself time and time again, and that has serious potential to be the "next big thing" in cardiology.
Disclosure: I am long SSH.