Seeking Alpha
Long/short equity, biotech, healthcare, small-cap
Profile| Send Message| ()  

Thesis

Congestive Heart Failure (CHF) represents a $37 billion market opportunity. It's a gold mine that has barely been tapped by the medical devices currently offered by Thoratec (THOR) and HeartWare (HTWR). With Obamacare's Medical Device tax due to kick in January 2013, the Medtech industry stands poised for a year of M&A fueled growth that will eclipse Medtech's frenzied spree of M&A in 2012. Sunshine Heart (SSH) stands as a prime candidate for a buyout opportunity, given its current (under)valuation and positioning for a market that stands to be an absolute blockbuster.

Enter Sunshine Heart

Sunshine Heart stands in a unique position within the Medtech industry and the imminent Medical device tax. Its product, the C-Pulse system, is designed to address the unmet stage 3 CHF market. Within the US, CHF affects roughly 5.8 million people with 500,000 new diagnosed cases each year. It is an incredibly burdensome condition, on both patient and society, costing over $35 billion just in the US. Current treatments of CHF are offered by Thoratec and HeartWare and address solely stage 4 of the disease, which is to say 5% of the 5.8 million. In contrast to its competitor's products and its corresponding market size, Sunshine Heart's C-Pulse distinguishes itself from its competitors in that it addresses both Stage 3 and (partially) 4 CHF, which is to say >20%of the market. Unlike its competitors, Sunshine is still in its early development phase; however, it has recently received FDA approval for clinical trials based on the success of its pilot study in 2011.

Sunshine's Pilot Study and Positive Implications

The company's pilot trial of 20 patients was a resounding success:

In our pilot study, the average number of days in hospital was nine compared to 19 for patients who received a Left Ventricular Assist Device (LVAD). Our average number included those patients who received the C-pulse device both via minimally invasive approach and via a thoracotomy (which is a more invasive and requires additional post-operative care). Those patients who receive the C-pulse device implanted in a minimally invasive manner only require approximately four days in hospital.

Sunshine Heart's offering is notable in that it is much less invasive than competing products in addition to radically reducing the time spent overall within a hospital. Of the $35 billion mentioned above, hospitalization costs are the most expensive aspect of the costs associated with CHF. To continue, the study states:

Close to 15 percent of patients were rehospitalised for worsening heart failure at 12 months post implant, compared to 85 percent re-hospitalisation rate for the same patients in the 12 months prior to receiving implant.

It seems to imply that upon potential commercialization, C-Pulse will be adopted as the dominant or preferred LVAD (Left Ventricular Assist Device) in response to the Affordable Care Acts Hospital Readmission Reduction Program instituted as part of Obamacare this October. The program "incentivizes hospitals to ensure their heart failure related rehospitalization rates meet a defined benchmark of less than 24.7% at 30 days." Hospitals will be eager to adopt any approach that would reduce their risk of repayment of reimbursement as a penalty.

Most important was the safety profile and efficacy data from the 2011 pilot. The C-Pulse device demonstrated "no serious adverse events- device related deaths, strokes, bleeding," which leads to another point of comparison between Sunshine Heart and HeartWare's offering in that the FDA indicated an increased risk of stroke in their press release that approved the latter's HVAD line. Preliminary data from the pilot study stated that:

Overall patients showed a statistically significant improvement in heart failure status (1.2 Class improvement at 12 months) and quality of life measures. Two patients were permanently disconnected from the device after reporting no further heart failure symptoms and were discharged from a heart failure program.

The class improvement is astounding, in that it demonstrates the potential to reverse the progressive nature of CHF to less serious stages of the same condition. This has major implications for the profitability of Thoratec and HeartWare's offering. If Sunshine Heart's clinical trials continue to demonstrate reversal of CHF, C-Pulse can begin to be seen as prophylactic measure against stage 4 CHF. This would lead to a reduction of patients progressing to Stage 4, subsequently leading to the diminishment of Thoratec and HeartWare's market opportunity upon C-Pulse's commercialization.

Development of a new Value-creation Paradigm

2012 illustrated the development of a new paradigm in which large players in the sector used M&A for growth. M&A typically leads to a decrease in the share price of the acquiring company and a corresponding increase in the share price of the company being acquired. However, as evidenced in the M&A frenzy that took place this year, there has been a shift where shareholders of the acquiring company were handsomely rewarded following disclosures of acquisition. This sets the precedence of increasing M&A activity for the following year.

Obamacare's Medical Devices Excise Tax to fuel Medtech M&A in 2013

In addressing the Medtech market, focus must be drawn to the Medical device tax that is due to kick in January of next year. It's a portion of the Obamacare program that will charge a 2.3% tax to manufacturers on their gross or total receipts. This will result in a projected $30 billion hit to the medical device industry. Given that many medical devices are sold to healthcare providers under a multi-year contract, manufacturers will have to bear the full brunt of the tax. This is money that will have to be taken out of operations and R&D. This leads to a series of positive implications for Sunshine Heart.

As the medical device tax rolls into effect next year, major medical device manufacturers will have to perform the necessary cuts from operations, but more importantly their R&D. The cuts to the research and development of new potential sources of revenue will force major players in the industry to look for new ways to return capital to their investors, opening the door for M&A driven growth.

Addressing Sunshine Heart's Position with the Medical Devices Tax

Sunshine Heart stands in a unique position to benefit from the Medical Devices Tax.

(1) In contrast to the $150,000 price tag attached to the LVADs offered by its competitors, C-Pulse is currently priced at $59,000. This is significant in that CHF is increasingly prevalent among older demographics, and it just so happens that Medicare typically reimburses LVAD Medical devices (and their associated costs) only up to $130,000(Look under Third Party Reimbursement on page 14). Therefore, in order to receive Thoratec or HeartWare's LVAD, senior citizens would have to pony up $20,000 of their own money. This leads to an added incentive of senior citizens electing to choose C-Pulse over other alternatives in an effort to avoid spending personal money.

(2) The nature of Sunshine's product is novel, and because it is not generic, its novelty will command a premium price and maintain the strong margins that characterize the heart-device market.

(3) Ultimately, because of Sunshine's current position in product development, which is to say the clinical trial phase, it will remain shielded from the tax until its C-Pulse system is approved, preventing additional monetary concerns during its clinical trial.

C-Pulse's Market Opportunity and Sunshine's (Under)Valuation

Medtech analysts over at Craig Hallum, Canacord, Cowen, and RBS Morgans who cover the cardiovascular market have estimated "the conservative market for the C-Pulse device is in excess of $2.5 billion." I believe this figure is far too conservative. Here are the figures: the number of CHF patients in the US is at 5.8 million and growing, with 20% at stage 3 and 5% at stage 4. Sunshine Heart has stated that its C-Pulse device is currently being sold at $59,000 while its being evaluated in premarket and post-marketing clinical trials, in comparison to the average $150,000 of other Class 4 LVADs (which happens to be in excess of the $130,000 reimbursement level offered by Medicare for these devices and procedures). Now assuming incredibly low market penetration rates (Keep in mind that Sunshine will be uncontested in the Stage 3 CHF-Market) of 25% and 10% for Stage 3 and 4, respectively, I arrive at these figures.

# of patients in the US with CHF

5,800,000

% of CHF patients at Stage 3

20%

% of CHF patients at Stage 4

5%

# of Stage 3 CHF patients

1,160,000

# of Stage 4 CHF patients

290000

Conservatively Estimated Penetration % of Stage 3

25%

Conservatively Estimated Penetration % of Stage 4

10%

Currently stated cost of C-Pulse

$59,000.00

Estimated gross revenue

$18,821,000,000.00

Estimated Profit Margin

16%

Estimated Untaxed Profits

$3,011,360,000.00

I based the profit margin off of the current LVAD leader, Thoratec, and its figure of 18%. Based off of extremely conservative figures, I'm sure you'll agree that Sunshine Heart's C-Pulse potential market is way above current estimates of $2.5 billion.

Using DCF to arrive at a fair value for Sunshine Heart using very conservative inputs of: A discount rate of 25%, Negative cash flows (from financing its clinical trials) for the first two years of ($20 million and $30 million), followed by positive cash flows of $5 million (less than 90 C-Pulse units), $100 million(<1700 units), and $200 million(<3400 units), I arrive at a fair value of slightly above $92 million! Representing a disconnect of $27 million, or to put it in terms of percentage - a whopping 41% missing from the current market capitalization of Sunshine Heart.

Despite a potential blockbuster, investors have continued to ignore the merits of Sunshine Heart. With a current market capitalization of approximately $65 million, it's a farcry from what it should be valued at. To put that figure in perspective, HeartWare's shares traded up from $34 to $63 in the year of 2010 (Up until July 16 2010, before clinical trials even began) That represents a market capitalization increase from roughly $450 million to $900 million, two years before the possibility of commercialization…

The Buyout Opportunity present in Sunshine Heart

With the conditions proving ripe for Sunshine Heart's acquisition, we have to ask what price would be appropriate in the possibility of a buyout. There is the obvious risk of clinical trials not demonstrating the same results given by its 2011 pilot trial. Fortunately, HeartWare provides a metric of comparison. If it can be said that HeartWare is roughly 2 to 3 years ahead of Sunshine Heart in terms of its developmental stage, then we see that HeartWare had a valuation of roughly $200 million at the stage Sunshine is currently at. This is over triple the current valuation of Sunshine.

At the same time, Thoratec may reiterate its attempt at acquisition; in 2009 Thoratec made an attempt to acquire HeartWare in an effort to consolidate its position as the leading provider of LVADs. Unfortunately, the FTC challenged the proposed acquisition out of the fear that it would allow for a monopoly on the commercial sale of LVADs. The denial of the acquisition led to the consequent stagnation of Thoratec's share prices as HeartWare began challenging its position. With HeartWare's imminent commercialization, Thoratec could look to acquire Sunshine Heart as a method of re-establishing dominance in the LVAD sector.

Possible suitors

Other than the obvious acquirers of Thoratec and HeartWare, other large Medtech players may look into acquiring Sunshine Heart as an accelerated entry into what appears to be a gold mine. Possible suitors include St. Jude (STJ), Covidien (COV), Medtronic (MDT), all companies sporting over $1 billion in cash on their balance sheets. Given that these are all established medical device companies, an expansion of their portfolio of revenue-drivers through acquisitions appears to be necessitated by medical device tax mentioned earlier. I don't believe that the buyout is a question of if, but rather when, who, and at what price? As it stands, the potential deal looks to be a win-win for the shareholders of both Sunshine Heart and the acquiring company.

Source: Is Sunshine The Solution To Device Tax Blues?