Darwinian Selection In Medical Devices: Brachytherapy Offers Investors Hope

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 |  About: Advanced Medical Isotope Corp. (ADMD), VAR
by: EnhydrisPECorp

The medical device field is facing strong headwinds in light of the newly implemented 2.3% medical device excise tax. The medical device excise tax went into effect January 1st of this year, and is levied on gross sales (not profits) of almost any FDA-registered device intended for human use-such as artificial hips, MRIs, and ultrasounds. Devices such as contact lenses, eyeglasses, and hearing aids, however, are exempt from the tax. The tax is part of the Patient Protection and Affordable Care Act of 2010, and is projected to raise approximately $40 B in revenue over a 10-year period to help pay for the new healthcare law.

Medical device companies have vehemently fought the tax with their powerful lobbying organizations, leading to a recent 79-20 vote in the Senate in favor of repealing the tax that was widely viewed as more of political showmanship than anything else. The roughly 8,000 medical device companies affected by this tax fear it will place an undue burden on the industry, and possibly lead to the loss of up to 45,000 jobs, and significant reductions in research and development. Spelling this out more clearly, the industry has posited that the tax will ultimately lead to higher health care costs, thus reducing the purchasing power of hospitals and patients alike (i.e., exactly the opposite effect intended by the Affordable Care Act). In turn, medical device manufacturers will sell fewer devices forcing them to reduce their workforce and R&D activities.

From an investor standpoint, this tax would thus appear to be a black mark against the sector as a whole. While I believe the tax is indeed going to have unintended negative consequences on medical innovation and profitability, I do believe there are significant opportunities for investors willing to be patient and wait out the political forces currently being imposed upon the field. Specifically, I believe the tax, in conjunction with the various cost-cutting provisions of the Affordable Care Act (e.g., bundling of services for reimbursement), are going to force hospital administrators to place a premium on "comparative effectiveness" of the medical devices they do choose to purchase. Simply put, hospitals are going to be seeking devices that give them the most bang for their buck. And this selection for comparative effectiveness, in my opinion, will lead to a Darwinian-like survival of the fittest period amongst companies within the industry. In effect, companies deemed to be manufacturing superfluous, redundant, or unnecessarily expensive devices are going to be left out in the cold. The winners, by contrast, will reap the rewards of a less competitive space. The goal for investors interested in what has historically been a profitable sector is crystal clear: find companies that will thrive under this harsher political and economic landscape.

Giving this some thought, I believe winners in this space will meet the following criteria:

1) The technology is cost-effective

2) The technology easily integrates with other high-priced capital systems already in place

3) The technology is mission critical for a large medical demand

4) The technology is not easily outdated and is cutting-edge

5) The device offers hospitals a competitive marketing advantage over potential competitors

Armed with these criteria, I recently researched the field looking for sub-sectors or individual companies that would exhibit steady growth despite the economic problems posed by Affordable Care Act. Not surprisingly, this task turned out to be much more difficult than I originally imagined, but after some careful thought, I believe that companies working on brachytherapy devices hold significant upside in the years to come.

Brachytherapy is a highly localized, precise, and increasingly high tech radiation therapy for cancer patients. Specifically, brachytherapy treats cancer by placing radioactive sources directly into or next to cancerous tissue, whereby enabling physicians to deliver a high dose with minimal impact on surrounding healthy tissues. Although brachytherapy has technically been around for nearly a century, it has truly come of age as a treatment modality in recent decades with the advent of advanced digital imaging technology (CT scans, MRIs, etc.) and mechanized remote afterloading systems that enable radiation oncologists a much greater degree of precision than ever before. These technological advances have made brachytherapy a highly successful and cost-effective treatment for cancers of the prostate, cervix, endometrium, breast, skin, bronchus, esophagus, and head and neck, as well as soft tissue sarcomas and several other types of cancer. Analysts are thus projecting the global brachytherapy market to exhibit a steady 3% a year growth rate until 2018, when the market is expected to reach a total value of $322 million. Most importantly for investors, most of this growth is expected to occur in emerging markets unaffected by the vagaries of the Affordable Care Act.

After reviewing the handful of public companies working on brachytherapy treatments, I believe two companies (Varian Medical Systems and Advanced Medical Isotope Corporation) offer intriguing opportunities for investors in the medical device sector, and stand apart from their peers as possible investment vehicles. In this article, I first give a brief overview of each company's brachytherapy activities, and then provide my reasons for believing that each company is a strong buy at current levels.

Varian Medical Systems (NYSE:VAR) is a California-based medical device and software manufacturer that focuses on treatments for cancer using radiotherapy, radiosurgery, proton therapy, and brachytherapy. Varian produces a number of FDA approved brachytherapy devices and software including applicators, afterloaders, and treatment planning systems, amongst others. Varian presently enjoys a 40% share of the brachytherapy market according to the company's marketing materials, making it second only behind Elekta (OTCPK:EKTAF). Elekta has gained its top position primarily through acquiring Nucletron, the prior market share leader in 2011. Even so, Varian believes it can gain another 10% of market share in the afterloader segment alone based on the strength of its 5th generation GammaMedplusix 3/24 afterloader.

The GammaMed afterloader is Varian's lead brachytherapy franchise, and has a stellar track record extending back over 40 years. Essentially, the GammaMedplus platform has become an industry standard, which gives Varian a substantial competitive advantage over new devices entering the market. Moreover, the GammaMedplus platform was designed to be a direct competitor to Nucletron's microSelectron digital, which is the current market share leader in the afterloader segment of the market. In order to add value to the GammaMedplus platform, Varian is now offering a modified version of the platform that can operate up to 24 channels, a significant upgrade over the typical 3 channels of most other platforms. This additional capacity gives hospital tremendous flexibility when growing their high dose rate (HDR) brachytherapy business.

Varian's brachytherapy business is further bolstered by its impressive array of image guided brachytherapy treatments (IGBT) (Acuity™ BrachyTherapy Suite™ integrated IGBT solution), treatment planning software (BrachyVisionTM, AcurosTM, VitesseTM, and VariseedTM), and numerous applicators. As such, Varian has made itself an industry leader and a one-stop shop in the brachytherapy market. Indeed, the immense scope and complexity of their brachytherapy business is simply too vast to be properly summed up in a short Seeking Alpha article. Suffice to say, Varian is setting itself up nicely to take advantage of a growing medical demand in a cost effective, technologically integrated manner. Furthermore, the fact that the GammaMed afterloader has become an industry standard provides investors with an economic moat that should be make the company immune to political changes in the healthcare sector.

VAR Fundamental and Technical Analysis

At the end of the 2012 fiscal year, VAR had cash and cash equivalents of $755 million. As such, the company has more than adequate resources to continue executing its developmental, manufacturing, and commercial operations. On the technical side, the stock is in deep oversold territory with a RSI of 28 and trading nearly 7% below its 50 day SMA at the time of writing this article. Percent shares of the float currently short sit at 4.40%, which is well below the average of the biotech sector in general. Nevertheless, Varian boasts an other-worldly 96% institutional holding of outstanding common shares, showing the confidence institutions have in the future of VAR. Analysts have an average price target of $78 per share, well below current levels at the time of writing this article. This brief fundamental and technical analysis strongly suggests that VAR is a strong buy at current levels, and looks to be an excellent long-term investment in the biotech space.

Advanced Medical Isotope Corporation (OTCPK:ADMD) is a tiny company (Market Cap = $10 million) engaged in the production and distribution of medical isotopes and medical isotope technologies. While ADMD's core business lies in the manufacturing and distribution of medical isotopes, the company recently decided to enter the brachytherapy market with a novel device called "RadioGel". On February 5th of this year, ADMD announced that the company had submitted data to the FDA on RadioGel as the initial step in a pre-market review, and requested a collaborative meeting with the agency.

At first glance, the company's problematic financials certainly make it difficult to find a clear-cut reason to speculate on this stock. Moreover, ADMD has dropped from a 52-week high of 30 cents to approximately 11 cents, and has announced needing another $1.5 million in funding to keep the lights on. Even so, I believe ADMD's RadioGel is a potentially disruptive technology that is certainly worth a look by aggressive investors. In fact, my investment thesis for this company centers around the fact that the sector has been consolidating of late (e.g., Elekta buying Nucletron, Oncura forming a partnership in the prostate cancer sector with Theragenics Corp (NYSE:TGX)). As such, I firmly believe an FDA approval of RadioGel, would lead to either a lucrative licensing deal, or a straight-up buyout that would be a premium to today's PPS.

I believe RadioGel is a pioneering technology in the brachytherapy sector because it holds marked clinical advantages over traditional implants. Specifically, RadioGel's list of clinical advantages include but are not limited to the following:

- Yttrium-90 has a half-life of only 2.7 days

- Yttrium-90 has considerably clinical evidence showing efficacy against inoperable liver tumors

- Ytrrium-90 has shown promise in reducing tumors in a variety of cancer types

- Yttrium- 90 is a beta-emitter, making it safer for clinicians and patients alike

- No metal casings to deal with

- Gel is biodegradable and can thus be easily reabsorbed by the body

- Gel forms a solid lattice that holds the Yttrium-90 in place and is thermally reversible

To put this into context, I believe that patients given a choice between a surgically implanted medical casing with a long-lived isotope such as iridium-192 or a gel that dissolves in a few days, the patient is going to choose RadioGel every time. Given that the clinical research thus far is painting a promising picture for yttrium-90 in a diverse array of cancers, I believe RadioGel has a strong chance to become the standard of care in brachytherapy procedures. Unfortunately, I wasn't able to get an estimate on the timeframe for FDA review of RadioGel, but instead was informed by the agency that they cannot currently comment on a device that is "under-review". Based on historical precedence, however, I think RadioGel could be approved before the end of 2013.

ADMD Fundamental and Technical Analysis

ADMD is primarily a developmental stage company, and as such, its fundamentals are not exactly confidence inspiring. Specifically, the company had revenue of $247,968 for the year ended December 31, 2012, down from $393,603 for the year ended December 31, 2011. This marked decrease in revenue was the result of the decrease in consulting revenues between years. Moreover, ADMD had operating expenses for the twelve months ending on December 31, 2012 of $6,118,661. The company had $10,704,593 of negative working capital at the end of fiscal year 2012, and has informed investors that approximately $1.5 million will need to be raised from the capital markets to keep the company afloat. Even so, the technicals suggest the stock is ready for a turnaround. Specifically, ADMD currently has an RSI of nearly 6, suggesting it is way oversold. Shares of ADMD are also down greater than 60% year to date. Overall, ADMD looks to be a decent value buy here, as the dilution announcement earlier this year appears to have already pushed the stock to extremely low levels. Therefore, I believe now is an excellent time to begin accumulating a position in ADMD for aggressive investors, especially in light of the fact that RadioGel could be approved before year's end.

Conclusion

The medical device industry is undoubtedly going to be put to the test by the Affordable Care Act, causing a Darwinian-like fight for reimbursement premiums and market share in a tough economic climate. Yet, the brachytherapy sub-sector, in my opinion, holds a handful of promising companies due to the sector's steady growth rate (i.e., cancer rates are projected to only increase), and given that the therapy meets the cost-effective standards espoused by the new healthcare law. Of the public companies working on brachytherapy treatments, I believe Varian Medical Systems clearly holds an economic moat over smaller competitors based on the fact that many of its brachytherapy treatments have become the standard within the industry. Furthermore, shares of VAR are presently undervalued, and analysts believe the stock holds great promise for long-term gains. I agree with their analysis, and see shares of VAR ending the year much higher than where they are currently.

The microcap company American Medical Isotope Corporation also caught my eye during the review of this sector based on its recent submission of data to the FDA for its potentially ground-breaking medical device RadioGel. I strongly believe that RadioGel will cause this company to be quickly gobbled up by a competitor, or possibly result in a lucrative financing deal. Historically speaking, companies within the sector haven't shied away from acquiring competitors with promising technologies. Investors with a high tolerance for volatility that comes with penny stocks should thus put ADMD at the top of their Watch List. I believe ADMD has the potential to double or even triple before year's end, especially if RadioGel is approved by the FDA.

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.