We are Infitialis, a research collective that systematically exposes fraud and folly in financial markets. Since August 2012, we have published ten meticulously researched exposés on companies that we believed had engaged in unscrupulous behavior or exhibited unsustainable market valuations. Below you will find our track record disclosing each of our exposes, the date of publication, and the subsequent price action following the publication of our research.
Each and every one of our reports has contributed to a profit with an average decline of 71% from the time of publication. Today, we present our highest conviction exposé yet highlighting folly in the form of a significant valuation bubble. More importantly, we present with the help of a whistleblower - very serious allegations of unscrupulous and potentially fraudulent activity on the part NASDAQ listed: Cyberonics, Inc. ("Cyberonics" or the "Company") (NASDAQ: CYBX). These detailed allegations have been documented in an amended complaint filed by the whistleblower in Massachusetts Federal Court just five days ago on January 16, 2013.
This is the first time these allegations and this lawsuit are being disclosed to the investing public as the Company failed to so even as the original complaint was filed on August 8, 2012 well within the disclosure period of the last 10Q.
CYBX: Our Highest Conviction and Most Asymmetric Expose Yet
In this report, we present the culmination of nearly two months of research into Cyberonics, Inc. which resulted in our belief that the Company will never grow into its current $1.5 billion valuation in the Bull case and may decline by 80% in the Bear case should any of the allegations in the whistleblower suit be proven in federal court.
We will start by objectively reviewing the science behind the CYBX device in an effort to understand whether the device actually works or is simply being marketed by the Company as the end all treatment for various medical conditions.
Next, we will provide an analysis on the effectiveness of the treatment for depression (a new frontier the Company has been touting for years). This analysis is important as the analyst community is currently relying on growth in the depression market to rationalize a mathematically irreconcilable share valuation.
Finally, we will unveil the very serious whistleblower allegations which we believe reveal the missing piece in the puzzle of the CYBX business model: Cyberonics management team incentivizes its sales organization to engage in unscrupulous and potentially deadly behavior all in an effort to juice its top line revenue while insiders sell unprecedented amount of stock into the market.
We will end the report with three valuation assumptions for : Bull, Base, and Bear that incorporate all the qualitative and quantitative data in this report.
Cyberonics, Inc. is a Houston, Texas based firm that is engaged in the design, development, and marketing of an implantable medical device that stimulates the vagus nerve. It is with this device that the firm markets a therapy for the treatment of refractory epilepsy and treatment-resistant depression (TRD). The treatment is aptly named "Vagus Nerve Stimulation Therapy" and is trademarked by the firm.
The VNS Therapy System consists of the implantable VNS Therapy Pulse Generator, the VNS Therapy Lead and the external programming system used to change stimulation settings. The lead and the pulse generator make up the implantable portion of the VNS Therapy System. Once implanted the device continually sends an electrical pulse up a wire into the vagus nerve in the neck at the base of the brain. The pulses usually last thirty seconds and occur every three to five minutes.
Demipulse Generator - The main component in the VNS Therapy
A graphic demonstrating how the device works
Exposed carotid sheath during an implant of the device
Valuation is a Bubble, Even With Whistleblower Allegations Aside
Before we get into any of the serious allegations brought on by the Whistleblower, we are going to make the case that isn't worth anywhere near $54 a share. In our view, the analysis leading up to the whistleblower revelations highlights the current asymmetry to the downside in the valuation of Cyberonics.
trades at an extremely high multiple of 41 times trailing twelve months net income of $36 million. Even when looking to 2013-2014 projected earnings is still very expensive at 34x and 30x earnings respectively. When comparing to peers such as Medtronic (MDT) and St. Jude Medical (STJ) which trade at an average multiple of 12x (CYBX) trades at a premium of over 240%. Adding insult to injury, quarterly revenues total in the millions while and quarterly revenues total in the billions.
PART I - Overview of Science behind CYBX Device The Science behind Vagus Nerve Stimulation (VNS) Is Inconclusive At Best In Our View
The science underlying the CYBX device is based on the hypothesis that stimulating the brain via the vagus nerve with electric pulses from a battery will prevent or reduce epileptic seizures and even depression. After spending nearly two months speaking with VNS experts, we were genuinely surprised that nobody had been able to explain how this all worked and whether it even did.
The more we dug the more we found red flags and skepticism in the scientific community as to the efficacy of VNS. Below are 11 well researched papers that discuss VNS and were sourced from academia, government, and private enterprise:
"But evidence is inconclusive about how this positive effect is achieved."
"Unfortunately, the only double-blind study gave rather inconclusive results."
"The exact mechanism of action of VNS is unknown."
"Both studies demonstrated statistically significant differences in efficacy..."
"The results, however, are inconclusive..."
"concluded that further clinical
trials are needed to confirm efficacy of VNS"
"VNS is not particularly effective acutely...."
"Reports of changes to the AED regimen were
inconclusive and no statistically significant change to the AED regimen following VNS
plus AED therapy was reported."
"For the outcome reduction of seizure frequency by at least 50% there was inconclusive evidence from case series"
"Change in quality of life (assessed using various instruments) ranged from none to modest.."
"Overall, the data based on fiber type recruitment are discordant and do not readily lend itself to an explanation of the efficacy of vagus nerve stimulation"
"Although the exact mechanism by which vagus nerve stimulation reduces seizure frequency is not fully understood..."
"Studies have yielded inconclusive results regarding short and long-term efficacy..."
Following the plethora of skepticism we uncovered above we decided to study the actual FDA clinical trials that led to the approval of VNS as a viable treatment in humans. Our goal was to understand what the FDA was thinking when approving the device and whether was accurately representing the efficacy of the treatment to its patients and the investment community.
What we found was troubling. The efficacy of VNS therapy as measured scientifically in randomized trials was very weak and its approval as a treatment was met with unusual controversy. What we discovered on our own (no thanks to CYBX investor marketing material) was that VNS Treatment approval was limited only to the rarest cases of epilepsy (Refractory Epilepsy) and depression (Treatment Resistant Depression) representing a much smaller market opportunity than what the Company and Wall Street analysts tout.
FDA Clinical Trials For Epilepsy Confirm Limited Efficacy
Two multi-center, double blind, randomized trials (EO3 & EO5) evaluated the efficacy of VNS in refractory partial epilepsy, all patients were implanted with the device, and then randomized to high intensity or low-intensity treatment arms. The primary endpoint was change in seizure frequency after 12 weeks. The secondary endpoint was the percentage of patients who experienced a 50% reduction in seizure frequency, the "responder rate," a commonly used yardstick in epilepsy trials.
Both studies demonstrated statistically significant differences in efficacy between the high- and low intensity treatment arms. In EO3 (114 patients), the mean reduction in seizure frequency was 24.5% for the high-intensity group vs. 6.1% for the low-intensity group. The responder rate for the high-intensity group was 31%. In EO5 (196 patients), the high-intensity arm had a mean seizure reduction of 28% vs. 15% for the low-intensity arm.
Averaging out the two studies, we see that EO3 and EO5 studies demonstrated 23-31% of patients had >50% reduction in seizure number. Put differently, 70% of all patients experienced no change at all with only a quarter of the patients (75 out of 310 patients in the study) still having experienced a seizure but claiming that the seizure was about half as strong as what they remembered the seizures being prior to being surgically implanted with an electronic stimulator that shocked their brain for thirty seconds every three minutes. Needless to say, we are not talking about earth shattering science here which explains why the scientific community is so skeptical when it comes to VNS.
It's important to note that these already weak results were produced on the rarest subset of the epilepsy population (refractory epilepsy) which affects a total of 250,000 people as opposed to the general epilepsy population which is numbered in the millions and which the Company and Wall Street analysts tout as their target market in their regulatory filings.
We wonder why CYBX does not disclose the true size of its target market? Could it be that when applying the actual efficacy statistics on the true target population (25% x 250,000) we are left with only 62,500 potential patients who would actually benefit from the treatment based on the Company's own clinical trials? The Company currently has the VNS device installed in over 70,000 patients who might explain why have found dozens upon dozens of VNS patients complaining about lack of improvement and desire to remove the device from their body. This would also explain the rationale behind the allegations made by the Whistleblower and which we will expand on later in the report.
FDA Trials for Treatment Resistant Depression (TRD) Scientifically Inconclusive
We were even more disappointed when we learned of the TRD results. Quoting from award winning mental health journalist John Mcmanamy's view of the trials and subsequent FDA approval:
In 2001, Cyberonics enlisted 235 patients in a 12-week double-blind clinical trial (in which half of the devices were switched on and the other half left off), along with their current meds. Subjects had failed at least two and up to six different types of antidepressant treatments in their current episodes, had been in their current depression two or more years or had experienced recurring depression four or more times, with Hamilton depression scores of at least 20.
Said Cyberonics CEO Skip Cummins on a June 2004 conference call: "These were hopeless, desperate, suicidal patients, not expected to respond."
Unfortunately, the patients lived up to expectations. Trial results in early 2002 turned out to be a major disappointment, delaying indefinitely what had been considered imminent FDA approval (which had been granted fast track review). Undaunted, Cyberonics continued with the study with 205 patients, this time switching on all the devices. At the same time, the company enrolled 124 similarly depressed patients for treatment as usual without VNS. After 12 months, response rates for the VNS group on two different depression scales were 21 percent and 30 percent, respectively vs. 12 and 13 percent in the treatment as usual group. Remission rates were 16 and 17 percent for the VNS group vs. five and seven percent for those on treatment as usual.
Ordinarily, a study with this design and these results never would have made it past the FDA door man. Two randomized double-blind controlled studies with at least a 50 percent response is generally what it takes to get a panel to review a manufacturer's submission. This was but a single open trial, effectively comparing apples to oranges, with a mere 30 percent success rate (or putting it another way, a 70 percent failure rate), and the statistician and others on the panel reacted to the data in a matter akin to the membership committee at the Augusta National Country Club hearing of someone with a skirt on the premises.
Clearly this was not a normal FDA approval process as will be evidenced in our next section and the section entitled "Red Flags with CYBX Marketing to Patients". Nevertheless the Company continues to tout its VNS treatment as a legitimate therapy for depression. Even worst is the fact that Wall Street analysts have been touting CYBX as an entrant to the field while being completely oblivious to how inconclusive the science is.
Thus, it is our belief that VNS will never be viewed as a legitimate treatment for depression as the scientific data has proven its lack of efficacy. This is yet another argument in favor of the asymmetry to the downside in the valuation of as most market participants believe the company is about to embark on this new frontier and have already factored that prediction into the valuation.
Weak Results Mean FDA Approves VNS Treatment For ONLY Rarest Cases of Epilepsy and Depression Known As Treatment Resistant Depression and Refractory Epilepsy
At the end of the day what CYBX shrewdly pursued and subsequently obtained approval for was the ability to offer this esoteric treatment to the smallest and rarest cases of what are two of the most well known disorders.
Herein lies the crux of what actually is. Contrary to the way in which the Company presents itself to investors, CYBX devices are not approved by the FDA for the treatment of depression or epilepsy. Rather, CYBX devices are approved only for the rarest cases of untreatable epilepsy known as "refractory epilepsy" or the rarest cases of depression known as "Treatment Resistant Depression" or "TRD.
From a business perspective this represents a huge difference as we have demonstrated with epilepsy (250k refractory population vs. 2-3 million with general epilepsy).
We believe that CYBX purposely excludes these terms from its marketing material in order to confuse the investing public. When using the words "FDA Approved" and "Depression" or "Epilepsy" (as we will prove the Company consistently does when presenting to investors) the majority fail to grasp that the Company is only approved to treat the rarest, untreatable, forms of those disorders.
Put differently, when every other FDA approved treatment fails for depression or epilepsy, only then should patients begin to entertain the idea of implanting a VNS device. Unfortunately as CYBX's own FDA trials confirmed even for that tiny segment of the overall population the device will only be effective on roughly 25%. And in this case the word "effective" is highly subjective as it means they will continue to have seizures that will feel about half as strong post implantation of an electronic device that "stimulates" their brain every three minutes.
In our view, slide #5 from the most recent CYBX investor presentation is troubling and in direct violation of securities laws. The same descriptions can be found in the most recent 10K filed with the SEC.
Note the way in which the Company describes itself using the umbrella terms "Epilepsy" and "Depression" to describe the target market for its VNS Therapy.
The Company should be explicitly stating that the VNS Treatment has been only approved for "Refractory Epilepsy" and "Treatment Resistant Depression".
What is apparent to us is that a majority of investors in CYBX are unaware that the target markets for VNS are a very small subset of the overall epilepsy and depression populations.
Actual Patient Testimonials Highlight Additional Red Flags
At this stage of our investigation we began to uncover dozens of patients that were disappointed with the VNS treatment and attempted to remove the device from their body. This revelation led to our internalization of a thesis that from a scientifically proved efficacy perspective CYBX had already reached every potential person in the US that it could impact. This is again based on the results of efficacy from the clinical trial multiplied by the actual target market. Our readers may remember that we completed a similar analysis on (MLNX) when we published our exposé in September 2012.
Patient #1 Eric M.
By way of background, last November I had my pulse generator and a portion of the lead removed (it was originally put in for treatment resistant depression). It was partially removed because (1) the device didn't help; and (2) one of the plastic clamps holding the lead in place was protruding out from my neck and was about to rupture. Ever since the surgery I have experienced plugged ears and constant and painful headaches. None of the doctors had any idea why this was happening so we thought there might be an off chance that the remaining part of the device still implanted was the cause.
So this past June I made the decision to have the remainder of my VNS device (i.e. the coil wrapped around the nerve and a portion of the lead) removed. After the surgery, the surgeon told me it was a complete success--that there hadn't been any complications and that the nerve was completely intact. Despite this, my voice is a raspy whisper (the doctor did warn that there was a 5% chance of this happening). I have now had two EMG tests and both have determined that my left vocal cord is paralyzed--meaning there is no nerve communication with the left vocal fold. However, it seemed like the risk of voice loss would only happen if the vagus nerve was severed or cut during the operation. But my surgeon specifically said this didn't happen. So I guess my question is: why do I not have a voice
But I would have to say that the worst part of all this is not the voice loss but the fact my headaches are still there and are getting worse. They are constant, painful and make normal activities difficult and unenjoyable--and getting rid of them was the only reason I had the remainder of the device removed in the first place.
Source: VNS Patient Board
Patient #2 Nancy B.
Hi Carol! I'm here for the exact same reason that you are. Although I have epilepsy, I never got the vns device, my younger sister did, and it almost killed her. She had hers implanted in 2008 and although it has been taken out she is still suffering from the side effects. She, unfortunately, developed a psychosis after the implant and had to spend almost a year in a psychiatric hospital because none of her doctors believed that it was caused by the device. We have no history of psychosis in our family and she was a registered nurse before the implant, so I think if she was psychotic beforehand someone at the hospital would have noticed.
Source: VNS Patient Board
Patient #3 Dennis
As of 9/30/08 there have been a total of 8442 adverse events reported to the FDA dealing with the VNS. That sure seems like an awful lot of reports when you consider that there are approx 40,000 implants worldwide. Keep in mind that a large number of events go unreported.
I found some interesting information while searching the MAUDE reports. What stands out most is the number of unexplained deaths. Out of the 763 reported deaths, 254 list the cause as "Unknown" and there are 73 listed as "SUDEP". That's 327 deaths without a decent explanation. It doesn't take an Einstein to realize that something ain't right with that picture. How can the FDA be letting this go on? I was nearly killed by the damn thing. I wonder if my death would have been listed as "Unknown" or "SUDEP"
Source: VNS Patient Board
These are only a few of the examples we have encountered. We cannot think of another FDA approved device that has had so many negative reviews by its patients. We suggest readers don't just take our word for it and review these postings for themselves. A simple Google search for "how to remove VNS" will produce dozens of more entries by disappointed patients who were duped into getting the device surgically implanted under the belief that it could be easily removed.
After reading several of these entries we began to wonder whether this VNS device is much more dangerous than being marketed by CYBX and we were surprised to uncover the following information.
VNS Device Linked To More Than 900 Deaths
As part of our research into the VNS Device, we discovered this investigative article from the British Medical Journal written by Jeanne Lenzer and Shannon Brownlee. The piece entitled "Medical Devices That Can Kill" went on to document that over 900 deaths had been linked to the VNS device representing a relatively high nominal mortality rate given the device was only implanted in roughly 50,000 patients at the time.
The piece went on to make some serious accusations about CYBX, such as:
"Although Cyberonics conducted post-approval studies, none of the studies submitted to the FDA included mortality data. The FDA did not specifically require Cyberonics to submit mortality data as part of the follow-up study, merely to 'characterize morbidity and mortality"
As a follow-up to this 2008 article, we searched the FDA s MAUDE database for "manufacturer: Cyberonics" and selected "Death" from the drop-down menu and found 1,296 reported incidents of death associated with the VNS device as of 01/18/13 with 13 deaths in December 2012.
At this stage it should be apparent that VNS treatment carries serious potential risks to patients. This is yet another point that we believe has been completely ignored by market participants that have irresponsibly bid up the valuation to 41x last year's net income. This is especially true when considering that the majority of implants occurred in the last two years meaning that any potential backlash by patients as a class would only become a relevant event in the future.
Aside from patient complaints and independent investigative reports, we found yet another red flag that pertained to the marketing of the VNS device by Cyberonics. As part of this discovery, we also came across CYBX's staunchest critic: Consumer Advocacy Group Public Citizen, who actually petitioned the FDA to revoke approval of VNS Treatment and called the treatment "A Cruel Hoax".
VNS Treatment A "Cruel Hoax"
The more we dug into CYBX's past, the more disappointed we were as to how many red flags were buried in this Company's past. In September 2006 the consumer advocacy Public Citizen in what was an unusual step sent a 24 page letter to the FDA petitioning for the immediate revocation of VNS Treatment for TRD.
The key takeaways from the letter were that the FDA in approving VNS for TRD overruled more than 20 FDA officials who had reviewed the data and recommended against FDA approval. Quoting from the letter:
"The facts and circumstances...raise legitimate questions about the FDA's decision to approve that device for treatment of TRD."
"Instead of relying on comprehensive scientific evaluation of its scientists and medical officers, it appears that the FDA lowered its threshold for evidence of effectiveness"
These are very serious allegations brought on by one of the most reputable consumer advocacy groups in the United States. The letter goes on to disqualify VNS as a valid scientific treatment. Below find another paragraph from the letter which we recommend be read in its entirety:
Given these highly irregular aspects of the approval process at the FDA, it is appropriate that the FDA revisit its ill-advised decision to approve VNS for TRD. To have an ineffective device on the market (and an expensive, surgically implanted one at that) does no favors for those suffering from TRD. To allow the continued marketing of this device is to perpetrate a cruel hoax on those patients.
Quoting from this article written by the Examiner which covered the Public Citizen saga we see that even FDA staff described Cyberonics behavior as "abusive":
Cyberonics was so aggressive in promoting vagus nerve stimulation that FDA staff described their behavior as "abusive"; at one point, Cyberonics told the FDA that withholding approvalcould leave patients feeling like they had no option but suicide. The campaign included, according to Public Citizen, a "full-court press of misleading advertising, training sessions in its use for physicians, presentations at the American Psychiatric Association annual meeting, case managers to help secure reimbursement for individual patients, abuse of FDA employees, misleading clinical trial write-ups, ghost-written review articles and company-generated favorable local media coverage."It was a superior sales pitch for an entirely unproven device. Unfortunately, many people still believe it."
At this stage of our research we are beginning to see overwhelming evidence that VNS is not only inconclusive as a treatment option but that its entire route to market was filled with provocative events and met with significant resistance.. For further reading we also recommend this article which goes on to describe the VNS advertisement as misleading.
Part I Conclusion
Based on the evidence we have presented in this section we believe the science underlying VNS is at best inconclusive. One of us has a background in psychology and we can't help but think of the analogies to a placebo (sugar pill) as the effects of a constant barrage of electric shocks to the brain (30 seconds long and every 3 minutes) are so difficult to gauge. Clearly VNS is no stent or pacemaker as evidenced by the lack of efficacy but also the difficulty in explaining exactly how it works. On that note we are reminded of one of our favorite quotes by Albert Einstein:
"If you can't explain it to a six year old, you don't understand it yourself."
As we conclude Part I investors should be questioning whether CYBX is even viable as a business given the shaky science its one trick pony device is based on and the plethora of red flags we highlighted.
In the next section of the report, we will delve into the business model of CYBX and quantify why we believe that under no circumstance will the Company ever grow into its current valuation of $1.5 Billion.
Again it is important to remember that our efforts in Part I and Part II of this report are solely for the purpose of highlighting the asymmetry to the downside of this idea. Should the allegations in the whistleblower lawsuit we will be unveiling in Part III be proven as true then the entire company may be sued into oblivion.
PART II: CYBX The Business
CYBX employs a relatively simple business model. The Company acquired the intellectual property associated with the VNS treatment from its founder, Mr. Jacob Zabara, for a 3% annual royalty fee and produces the devices in its relatively "low tech" manufacturing facility in Houston Texas. The device costs just under $2,000 per unit to produce and is sold to patients for between $10,000-$15,000. This explains how CYBX is able to report 90%+ gross margins.
As far as we are concerned the crux of the business model is the direct sales organization which is compensated in a manner that is highly dependent on meeting sales goals. Our research uncovered a sales organization populated by individuals with little to no experience in the medical industry. But what the Cyberonics sales team lacks in formal medical education they make up with steak house dinners and fine wine (further documented in Part III) while they voraciously pitch surgeons on implanting as many VNS devices as possible in their respective sales areas.
Patent Expiration Means Guaranteed Competition and Pricing Pressure
Infitialis spent over two months researching this idea and in the process read nearly every sell-side report. since 2008. In our view sell-side analysts have done a terrible job at communicating to market participants the current state of CYBX's intellectual property. Specifically, on July 16, 2011 the Zabara Patents which covered VNS treatment for epilepsy expired. Quoting from the CYBX 10K:
The epilepsy patent expired on July 16, 2011 in the U.S. and, as a result, we discontinued paying this royalty. Also, as a result of the epilepsy patent expiration, competitors may enter this market. For instance, a company based in Europe, Neurotech, SA, has obtained CE Mark approval for a device capable of vagus nerve stimulation, however the device is not yet marketed. Another company, CerebralRx Ltd. based in Israel, developed an implantable device capable of vagus nerve stimulation and has CE Mark approval. CerebralRx has initiated commercialization efforts in several European countries.
It took little time to find several other examples of formidable competition facing CYBX. For example Medtronic Inc. has submitted an FDA pre-market approval application for its Activa Neurostimulator for the treatment of epilepsy. As for depression a Bloomberg Businessweek article published just yesterday discussed a competitor Brainsway Ltd. as expecting to reach an agreement this quarter with a medical device company to market its non-evasive stimulation therapy device.
As we previously discussed, our view is that the science has proven VNS lacks efficacy as a valid treatment option for depression. That being said, in a world where patients believe this stuff works a strong argument can be made that the non-evasive devices will be the favored choice given the lack of potential side effects and no need to undergo surgery.
The expiration of patents coupled with increased competition are two serious events that CYBX investors are not appropriately discounting. With over 90% of sales being derived from refractory epilepsy patients the current market valuation of $1.5 Billion foolishly assumes that CYBX will continue to gain a 90% market share in 40 years. We can't help but think of the analogies to the scenario and how that ended for investors. As noted economist Robert Shiller has highlighted rarely does investing at 40x earnings result in positive returns over time. This is most certainly true for companies that do not even retain protection of their intellectual property.
VNS Treatment Has Already Reached Its Target Market While Performance Indicators Lack Adequate Transparency
By more accurately presenting the target market for refractory epilepsy (contrary to the CYBX 10K disclosure of 3 million patients) we have established that CYBX is no St. Jude nor will it ever be as a one product company.
But we believe there is more to this story than meets the eye. As we previously alluded, the VNS treatment simply doesn't work for TRD while it showed a 25% success rate (subjectively defined as having a seizure that was weaker) on epilepsy patients. If there ever was a place for VNS it is (until the non-evasive devices enter the market) in the epilepsy market and not in the TRD market. Herein lies the predicament: with 70,000 patients CYBX has essentially exceeded its target market and we believe there is little room for organic growth in new patients going forward.
We believe that CYBX and its management team are well aware of this fact and as a result led by Chief Executive Officer Daniel Moore have reinvented the Company. Specifically, CYBX has been able to convince Wall Street analysts that it has magically transformed into a razor/razor blade business model by prominently featuring the following paragraph in its 10K (the third paragraph under General Business description)
The VNS Therapy pulse generator and lead are surgically implanted into patients generally during an outpatient procedure. The battery contained in the generator has a finite life, which varies according to the model as well as the stimulation parameters for each patient. At or near the end of the useful life of a battery, a patient may, with the advice of a physician, choose to implant a new generator, which may be done with or without replacing the original lead.
As we will demonstrate in our valuation models we believe this shift amounts to nothing more than a "spin" on the story of Cyberonics in order to rationalize its irrational valuation.
After carefully reviewing the business for nearly two months we are confident that the business model is now at the stage where it is more reliant on Battery Replacements than new implants of devices. This point is very important as it begins to tie in with the Whistle Blower allegations in Part III.
Figuring this out was not easy as CYBX management has been unusually opaque with their discloser of unit sales. Specifically the company does not disclose what percentage of unit sales are battery replacements vs. new installations. Fortunately, management has included two figures in their investor presentations through which we were able to reconstruct what we believe are the actual figures.
Sifting through historical presentations over the last two years we found that CYBX continually tallies both its patients and total device implants on slide 4 of its presentations to hedge funds and institutional investors. By comparing the two figures over time we could subtract the patient number from total unit sales with the difference either being battery replacements or churn. Either way this would finally highlight what percentage of unit sales were derived organically. It is important to note that this information is not disclosed in the Company's 10K. Investors reading the 10K would see the following opaque disclosure for unit sales:
As you can see CYBX treats both newly implanted devices and battery replacements as the same unit sale via a simple aggregation of Unit Sales. We wanted to know whether our theory was correct which was that the majority of unit sales are now being derived from battery replacements as opposed to newly implanted devices. Using those two figures we have been able to reconstruct what percentage of sales were battery replacements vs. new implanted device. The results are as follows:
|January 2013 Investor Presentation (click to enlarge)||November 2012 Investor Presentation (click to enlarge)|
|September 2012 Investor Presentation (click to enlarge)||February 2012 Investor Presentation (click to enlarge)|
As the investor presentations prove from February 2012 to January 2013 (11 months) CYBX patients grew by only 8,000 while device implants grew by 17,000! Thus Infitialis estimates that as much as 50% of all sales are now being derived from battery replacements!
Insider Sales Confirm Bubble
As our readers know we believe that insider activity on a company is often the best gauge when determining whether a company is overvalued. On that front CYBX insiders did not disappoint. Remember, these are the people that walk into work every day and have the best view towards whether the market valuation correlates to that of the actual business.
For the year ended 2012 CYBX insiders sold over $34.4 million worth of stock. This shocking amount matches the company's entire net income last year. It is our opinion that when Company insiders who together own less than 5% of the Company sell stock worth approximately 100% of the Company's profits in a given year that is a "heads I win tails you lose" proposition and is yet another significant red flag which bodes negatively for CYBX investors.
Had insiders owned a meaningful stake in the business one might understand the need for diversification, but with CYBX there appears to be a sense of urgency on the part of management to get rid of their stock as quickly as it vests. Take this transaction reported on the day the amended whistleblower complaint was filed:
In this transaction CEO Daniel Moore unloads 7,000 shares for total proceeds of $369,000. This amount was not included in our 2012 tally but may be something regulators look into when they decide whether the company had a duty to disclose the whistleblower lawsuit to its investors.
Part II Conclusion
By now readers should be questioning not only the science behind VNS but also the business model of Cyberonics and whether it warrants a $1.5 Billion valuation.
For us the key takeaways from Part II are that CYBX is not the high growth, high margin, medical company it purports to be as the business model has shifted from tapping a new market to managing churn and re-monetizing the existing base of patients. It is with this takeaway that we present Part III of this report which will for the first time unveil the allegations made by Andrew Hagerty, a former Cyberonics employee who sued the company in Massachusetts Federal Court.
PART III: Andrew Hagerty vs. Cyberonics - The Whistleblower Event That Could Cut CYBX by 80%
We will now describe the details surrounding the Whistleblower allegations as documented in this amended complaint filed on Wednesday, January 16, 2013 in Massachusetts Federal Court. As far as we know this is the first time the whistleblower event is being made public. We ask each of our readers to read the complaint in its entirety as it goes into great detail and does a better job of explaining the allegations.
As readers will recall from Parts I and II of this report these are the primary risks to the CYBX business:
- The Target market appears to have been saturated at 74,000 installs while we believe the device does not work for TRD and the market opportunity for refractory epilepsy is 50-60,000 installs based on the science.
- Based on our reconstruction of the company's top line the business model has completely shifted with up to 50% of the company's revenues being battery replacements in existing patients vs. unit sales to new patients.
- Cyberonics employees are engaging in outright fraud and misrepresentation by coercing surgeons to prematurely schedule battery replacements as part of a directive to accelerate battery replacement revenue by upper management formally implemented in 2007. PRIOR TO 2007 CYBERONICS DID NOT COMPENATE SALESPEOPLE FOR BATTERY REPLACEMENT SALES IN EXISTING PATIENTS.
- Hagerty presents a convincing account of how Cyberonics salespeople directed surgeons to replace all batteries that were five years old regardless of their remaining lifespan in direct violation of FDA standards which required each battery to be tested by a physician.
- Hagerty claims that certain salespeople within Cyberonics personally called patients who had VNS treatment and scared them into replacing their batteries prematurely. As a result Physicians called Cyberonics asking why they were receiving random calls from scared patients.
- Hagerty documents a luxurious steak house dinner he attended where a surgeon (Dr. Ahmed Khan) complains to Hagerty's Manager Craig Yannuzzi that a Cyberonics salesperson had instructed the back office at Dr. Khan's practice to prematurely schedule battery replacement examinations for VNS Patients. Khan who was disgusted and outraged by the practice subsequently halted these cold calls to patients.
- Worst of All Allegations: Hagerty backed by yet another Cyberonics employee Janet Holland alleges that Cyberonics salespeople were present and illegally participated in the battery life examination process and REMOVED THE BATTERY FROM THE WAND COMPONENT OF THE TESTING DEVICE IN A MANNER THAT DID NOT RAISE SUSPICION BUT RESULTED IN AN INDICATION OF A WEAK BATTERY SUBSEQUENTLY CAUSING AN IMMEDIATE SCHEDULING OF A BATTERY REPLACEMENT SURGERY AND RESULTING IN A COMMISSION TO THE SALESPERSON.
Steak and Lead
One of the worst allegations in the lawsuit takes place at a luxurious steak dinner attended by Dr. Ahmed Khan a Neurosurgeon who specializes in implanting VNS devices, Andrew Hagerty and Craig Yannuzzi a regional manager for Cyberonics.
Over a bottle of the finest cabernet sauvignon and the porcini dusted steaks Dr. Khan alerts Craig Yannuzzi that Gary Muenzen (one of the highest grossing sales associates at CYBX) had instructed Dr. Khans office staff to make calls to patients scheduling battery replacements. When Dr. Khan was made aware of Gary Muenzen's actions he indicated that he had become "humiliated and disgusted." Quoting directly from Mr. Hagerty's Whistleblower lawsuit:
These are shocking allegations. But what is more troubling about this whole setup is how CYBX sales people are dining with surgeons at five star restaurants. We believe this incident highlights the type of reckless behavior that ultimately leads to patients being unnecessarily implanted with VNS devices. Using Google we found that Cyberonics sales people frequently host and pay for dinners while pitching VNS. In this press clipping from 2005 we found Craig Yannuzzi's name again in connection with a dinner sponsored by Cyberonics for the Developmental Disabilities Nurses Association (NJDDNA):
A Myriad of Allegations That Highlight Unscrupulous and Fraudulent Activity
We have only highlighted a small portion of the allegations in the lawsuit. We urge everyone to read the complaint in its entirety in order to fully understand the severity of these allegations.
Links to Whistle Blower Lawsuit:
Infitialis Believes The Andrew Hagerty Allegations As They Reconcile With Red Flags We Uncovered
Our track record is very important to us and when we publish a report we leave no stone unturned. Upon encountering the whistleblower Andrew Hagerty we immediately initiated an all encompassing background check. We found no infractions that would in any way impede on his credibility.
Hagerty the father of a child who had refractory epilepsy took a job as a sales associate with Cyberonics in May of 2010. After excelling at the company Hagerty was promoted to salesperson and was eventually in charge of sales for the areas of: Rhode Island, Vermont, and Massachusetts. As the lawsuit reads, once Hagerty discovered CYBX employees were engaging in these practices he immediately brought it to the attention of his superiors. Not only did they refuse to act but they fired Hagerty once he didn't meet his sales figures which he explains could not be met unless he engaged in the unethical practice of scaring existing patients into prematurely replacing batteries.
We initiated our own investigation into Cyberonics and it was only after encountering aspects of the business that were consistent with these allegations that we decided to publish this piece. It was important for us to establish that CYBX sported both a bubble valuation as well as a sketchy business model that was relying on controversial science and misrepresentations to the market. Ultimately what convinced us that these claims might be valid was how well they reconciled with the various red flags we highlighted in Part I and II of this report.
The claims in Andrew Hagerty's lawsuits could prove terminal to CYBX because they allege that over the last 5 years a large portion of battery replacements were done prematurely in order to increase the velocity of sales at Cyberonics. These claims would be fairly easy to prove in court as there are several ways to confirm whether battery replacements occurred prematurely with the easiest one being a simple analysis of the date of initial implantation vs. date of battery replacement. Another way that Hagerty himself suggests in the suit would involve testing the old batteries which must be stored by Cyberonics as part of FDA guidelines.
Once this story gains enough publicity patients will organize in a class and sue Cyberonics. Such an event would severely impact the business given the uber generous valuation that has been bid up to by market participants. In the next section we will explore what a relatively conservative settlement with patients would translate into as far as the share price is concerned.
CYBX Valuation Scenarios
Ultimately we are security analysts and our job is to incorporate both the qualitative and quantitative data in this report in a manner that provides a range for intrinsic value. As we approach the end of the report it is now time to provide our valuation scenarios for CYBX.
We believe there are three possible scenarios that need to be modeled in order to project intrinsic value for CYBX. We have split them up into Bull, Base, Bear:
Under the bull case we completely disregard any of the whistleblower allegations. We also assume that VNS treatment for refractory epilepsy will remain a valid option for this rarest subset of the population with epilepsy. Being the bull case we continue to project that CYBX will grow its top line at a rate of 15% per annum while adjusting net income margins to last year's 17% reflecting what we believe is a permanent shift in the model to lower margin battery replacements (up to 47% of the business by our estimates) due to the fact that the installed base has already reached the maximum point of scientific efficacy. In keeping with the spirit of the bulls we even project that CYBX shares outstanding will decline by 1.5 million shares reflecting over $75 million in buybacks an amount that would equate to the majority of the company's cash. Finally we apply a rather generous 15x multiple which is roughly 3x more than that awarded to Medtronic and St. Jude .
It is truly amazing to see just how overvalued is. Even when modeling the business under the rosiest scenarios that project an installed base of 95,000 in 2015 (a figure we believe defies logic as it would represent nearly 50% of the entire refractory epilepsy population) we still cannot arrive at a valuation which is anywhere near $50 a share for CYBX. Instead when incorporating 3 monster 15% growth years, substantial share buybacks, and a very rich 15x forward earnings multiple we are left with a range of between $23-$31 a share that the company would only achieve between 12 and 36 months. In other words even when incorporating these incredibly rosy inputs investors will have to wait between 1 and 3 years for CYBX to have a fair value of $23-30 a share. How any responsible analyst could arrive at a price target exceeding $35-40 is beyond us. Once again this scenario is very reminiscent to the one which plagued in the fall of 2012. Since then the company has had to guide down and analyst targets were reduced by 30-50% and the shares have declined by nearly 60%.
Under the base case we assume as evidenced by our qualitative research that the lack of scientific efficacy of the VNS treatment leads to a more realistic growth trajectory for CYBX. We peg that rate at a generous 10% a year. Moreover we incorporate the whistleblower event in a very muted way projecting that as a result of the allegations the company will have to reserve only several million dollars in legal fees however in the process no share buy backs will be implemented given the defensive way in which management will need to treat capital.
Once again it is amazing to see how changing only two inputs affects the valuation so much. This confirms the asymmetry to the downside that is built into CYBX and how irreconcilable the current $1.5 Billion valuation is. What we see is that even when growing at an impressive 10% a year and keeping the share count at 28 million (incorporating yet another naive assumption that there will be no stock/option grants in 3 years) CYBX should only be worth between $21-$25 in the next 12-36 months. Again, even in the base case we assume that the whistleblower allegations how no true impact on the business and dismiss the event as a short-term nuisance.
The allegations brought on by Andrew Hagerty amount to nothing short of a monumental negative event for CYBX. These game changing allegations have until today been unknown to the analyst community and market participants. These allegations as evidence by our work make a lot of sense and corroborate with both the weak science underlying VNS as well as battery replacements forming a larger component of sales.
We believe that responsible long investors in this name will now have to incorporate these allegations into their valuation models in a manner that provides sufficient margin of safety. As for our model we decided the best way to incorporate such allegations would be in the form of an easily modeled onetime cash settlement with the class of patients that were duped into early battery replacement. We have conservatively estimated this class at $100 million or $3.57 per share. We also reduce growth rates to just 5% reflecting once again an ultra conservative view that once these allegations are publicized there will be significant backlash to VNS contributing to muted growth as opposed to the complete demise of the Company. Finally we reduce the multiple awarded to CYBX from 15x net income to that of Medtronic and St. Jude (12x).
The results indicate that under the bear case CYBX will only be worth between $12.65 and $14.32 over the next 12-36 months. Averaging out all three valuation scenarios we are left with an intrinsic value estimate of between $13.48-$26.72.
Finally, when weighing all three valuation scenarios equally at 33.3% probability we are left with a fair value estimate of $21.21 for CYBX representing roughly 60% downside risk from current levels
As evidenced in this exhaustive report we believe that long investors should stay away from Cyberonics, Inc. as there are significant risks to the downside. Speculative investors should consider shorting shares of as we estimate 2015 fair value at $21.21 a share vs. the current market price of $50.
Make no mistake about it - The whistleblower lawsuit we highlighted today represents a major event. Any responsible investor in CYBX will have to take a serious look at these allegations and how they incorporate into their overall thesis on the company.
We have presented enough data to establish that CYBX had significant downside risks associated with its valuation even before the whistleblower allegations. It is only on the merit of this data that we are comfortable saying that is our highest conviction idea ever.
Finally, we leave you with the Top Reasons to Sell/Short :
- As exclusively unveiled in this report - Whistle Blower Andrew Hagerty, a former Cyberonics employee, makes a convincing case that CYBX employees fraudulently induced patients to prematurely undergo surgery to replace batteries in their devices. These claims include detailed accounts of coercion on the part of sales people as well as the manipulation of testing tools used to gauge the battery levels. Each battery replacement is sold to the patient for $12,000-15,000, and costs only $2,000.
- Science underlying VNS is inconclusive and subjective. We cannot remember any other medical device that had such a provocative history. Moreover the FDA Maude database highlights an unusually high death rate that has yet to be addressed by the company or discounted by market participants.
- As with sell-side analysts covering completely misunderstand the true dynamics underlying the business. VNS does not work for TRD and will never be a valid treatment option while the epilepsy market opportunity has been fully addressed explaining the business model shift from new installations to battery replacements.
- Insider selling of nearly $35 million in one year (amounting to the sum total of 2012 Net Income) confirms that even the insiders disagree with analysts as far as this bubble valuation is concerned.
- At 41x T12M Earnings shares have been bid up to a mathematically irreconcilable valuation. Even under the rosiest growth scenarios we cannot understand how any analyst could arrive at a price target that exceeds $32 a share. When incorporating the actual dynamics of the business and the whistleblower event we believe that shares of are worth no more than $21.20 a share.