About the title
In my most recent article, "The Future For Sunshine Heart Just Got Brighter" I raised the prospect that treating angina, in addition to congestive heart failure (CHF), could double the market for Sunshine Heart's (NASDAQ:SSH) C-Pulse system.
The "Light Bulb" moment is the realization patients with angina or CHF, being routinely fitted with pacemakers, might sensibly be offered a C-Pulse to go with it, as part of the one surgical procedure. That could easily drive early acceptance and uptake of fully implantable C-Pulse systems that include a pacemaker. Getting early, large uptake is of far greater significance than an increase in market size, as C-Pulse already addresses a huge market. I expand on this aspect further below.
About this article
I have written much recently, and in the past, about the technical attributes of the Sunshine Heart C-Pulse system (see here and here). Perceived possible risks have been explored in depth and concerns substantially resolved or reduced. The recent PropThink interview with the SSH CEO, Dave Rosa, was particularly helpful for many in this regard.
With revenues expected to flow from EU sales commencing calendar 2014, it is time to look again at financial prospects.
To do this, I will first look at making assumptions for and determining estimates of -
- Size and potential share of target markets;
- Selling prices per unit;
- Cost of production per unit;
- Research & development (R&D) and Selling and G&A (SG&A) costs;
- Non-routine costs of growing the organization; and
- Capital expenditures and working capital requirements;
I will then quantify the above into projections of profits before tax, cash flows, and stock offerings to provide the necessary funding (please note the warning and explanation at end about long term projections, their purpose and limitations).
About the conclusions:
The long-term projections of profitability, per Tables 3.1 and 3.2 further below, indicate that Sunshine Heart could become profitable as early as 2018. Profits could further increase to ~$1bn by 2021 and further increase to ~$5.5bn in 2027. Under the scenario put forward, additional equity capital of $1.7bn would be needed in the period through year ended 2020.
Readers might be surprised to find, based on the assumptions, projections and calculations set out below, I have arrived at possible takeover values for Sunshine Heart at end of 2013 of between $3.0bn and $4.3bn
Not unlike a mining project, for Sunshine Heart, costs are heavily loaded to the front end and really significant revenues are still a way down the track. It would be absurd to value a mining project on the basis of projections not going much beyond start up, and so it is with the C-Pulse opportunity.
This is why my projections for current value will be far higher than projections limited to 5 years or less despite high discount rates in my calculations.
I am reminded that when Johnson and Boston Scientific were bidding for Guidant, just the difference between the high and low bid was $5.7bn and that makes a total bid of $3-$4bn for C-Pulse very much in the realms of possibility.
Please read on and form your own opinions about the projections of sales and profits through end of 2027, and the detailed supporting assumptions and decide for yourself whether $3-4bn for Sunshine Heart today is reasonable.
And now some detail on C-Pulse for those unfamiliar with this technology.
Sunshine Heart's C-Pulse system:
The Sunshine Heart C-Pulse system is a medical device to treat congestive heart failure by assisting the natural heart's pumping function. To further explain:
The C-Pulse system is not blood-contacting and does not take over for the heart. It employs proven counter-pulsation technology, to reduce the workload of the heart, and to create additional blood flow to the heart muscle. This provides ongoing permanent support and allows a tired heart muscle some opportunity to rest and recover, in a measurable way (NYHA Heart Failure class improvement). For further information see here and here.
Some results from the C-Pulse 20-person feasibility study (Data sources:Prospectus filed with SEC August 10, 2012 and Sunshine Heart Corporate Presentation October 2012):
- NYHA Heart Failure Class improvement - 12 patients (60%) at 6 months. (Subsequent to completion of the feasibility study 2 patients became asymptomatic and were weaned off the device and another 2 are being considered for weaning);
- Re-hospitalizations at 6 months 5% (compares to recent trial published control group re-hospitalization rate of over 40% with similar patient population at 6 months);
- Medication Reduction: Diuretics - discontinued, reduced or unchanged for all patients; Inotropes - 4/4 patents successfully weaned (within 48 hours).
Following on the successful completion of the feasibility trial, the FDA has approved a 388-patient pivotal trial addressing NYHA Class III and ambulatory Class IV CHF patients with targeted marketing approval in early 2017. The C-Pulse already has CE Mark approval for commercial sale in the EU. A post marketing approval trial is currently being conducted in the EU to establish reimbursement approval for implants.
Description and size of the Heart Failure market:
Regardless of treatment, one-fifth of those diagnosed with congestive heart failure (CHF) will die within one year and one-half will be dead within five years. Only about 20 percent survive much longer than 8 to 12 years -- a prognosis worse than most cancers. For those that do survive, quality of life is often severely compromised (see here and here)
Congestive heart failure (CHF) is a progressive disease. Current FDA approved treatment for earlier stage CHF is only effective in slowing the worsening of heart failure.
The incidence and prevalence of chronic heart failure (CHF) in the United States is continually rising. There are approximately 5.7 million Americans living with the disease at any given time with an estimated 670,000 new cases diagnosed per year.
Heart failure population targeted by C-pulse system -
(1) NYHA Class III and ambulatory Class IV -
For the current FDA approved 388 patient pivotal trial, the CHF population targeted by C-Pulse is NYHA Class III and ambulatory Class IV. Estimated size of these markets is 1.5M CHF patients in the US and 3.7M in the EU (see here). (CHF population targeted by C-pulse system per prospectus filed with SEC, August 10, 2012, by Sunshine Heart);
(2) Angina -
Mr. Dave Rosa, CEO of Sunshine Heart, has also raised the prospect of a further market opportunity in angina in the recent PropThink interview referred to above.
This is a previously unidentified market with the potential to be even larger than the CHF market per (1) above. To understand just how significant this could be to C-Pulse, please refer to my above referenced article, "The Future For Sunshine Heart Just Got Brighter"
(3) Pacemakers -
The fully implantable C-Pulse system can be coupled with brady-tachy pacemaker technology, allowing for a novel, synergistic electrical-mechanical cardiac assist system (see here).
With fully implantable C-Pulse systems reaching large numbers, Sunshine Heart could come to control the supply of a large portion of the pacemaker market. This would be even more so if pacemakers were included in the C-Pulse system for treating angina (note the use of "system" because the C-Pulse lends itself to being the core element in a "Platinum" standard system of complementary medical device technologies to treat heart failure, with a view to retaining the natural heart).
It is reported that about 600,000 pacemakers are implanted each year worldwide and the total number of people with various types of implanted pacemakers has already crossed 3 million.
This pacemaker aspect alone could make control of C-Pulse technology of great interest to several pacemaker suppliers such as Medtronic (NYSE:MDT), Boston Scientific (NYSE:BSX) and St Jude Medical (NYSE:STJ).
Velocity of uptake - a "light bulb" moment
Getting physicians and their patients to elect for surgery instead of drug therapy, which just slows their progression to end stage heart failure, is always going to be a hard ask.
This will be particularly so with a new device with a novel approach. I liken it to the story of the "boiling frog phenomenon," which is often used as a metaphor for the inability or unwillingness of people to react to significant changes that occur gradually.
I have always considered that the fully implantable model would be absolutely vital to achieve uptake in very large numbers. Even then, I have always been very uncertain how long it might take. So much so that in my article, "Sunshine Heart: Potential '10 Bagger' In 4 Years, '100 Bagger' In 10 Years", I allowed for an additional $3bn+ of capital to be raised for market development and infrastructure building activities and a period of 12 years for Sunshine Heart to achieve just a 6% share of its target market of NYHA Class III and ambulatory Class IV per (1) above. To best illustrate my "light bulb" moment -
Case A - A CHF patient, being treated with drug therapy, is advised by their Physician there is a new device, the C-Pulse, which could allow them to cease all or most of their drug therapy, and potentially improve their CHF, but it will require surgery. The patient is quite uncertain and either declines to have surgery or defers a decision.
Case B - A CHF patient, being treated with drug therapy, is advised by their Physician that it is essential a pacemaker be fitted, and it is a relatively simple surgical procedure with ~600,000 implanted each year. The Physician further advises the pacemaker could be implanted as part of a fully implantable C-Pulse system incorporating a pacemaker. It would involve a bigger but still minimally invasive procedure and could allow them to cease all or most of their drug therapy, and potentially halt or reverse the progression of their CHF. The patient is already committed to a hospital stay for surgery and more readily agrees to take the further step of having the combined C-Pulse and pacemaker implanted.
A similar scenario could apply to angina patients who require a pacemaker to be implanted.
So, at least in the earlier stages of market development and growth, rather than C-Pulse being a tool to corner the market for pacemakers, it is possible that C-Pulse will best gain traction by being complementary to the fitting of a pacemaker.
The already wide acceptance of a pacemaker implant should drive sales of a combined C-Pulse and pacemaker fully implantable system.
When this is understood, the C-Pulse technology could be of even greater interest to Medtronic, Boston Scientific, and St Jude Medical (see (2) above).
Below are detailed assumptions for revenues and costs, followed by a 14 year projection of profits and cash flows based on those assumptions.
Assumptions Item 1 - Size and potential share of target markets
I will first calculate the potential share of target markets based on US statistics, and then extrapolate the results to the EU market. I will not include estimates for the "rest of the world".
I will only include NYHA Class III and ambulatory Class IV in the target markets for this exercise. I will not include estimates for angina or pacemaker potential sales referred to above, even though these could potentially more than double the projected number of implants and increase the projected selling price of the system for the pacemaker inclusion.
That will leave a very sizeable amount of "blue sky."
Table 1 - Projections of annual sales potential in the US & EU
Assumptions Item 2 - Selling prices per unit:
The C-Pulse device is currently sold for $59,000 while it is being evaluated in pre marketing and post marketing clinical trials (see here). I will assume $59,000 per unit through end of 2017.
Beyond the trial stage it is expected to be sold at ~20% above the trial price, which would result in a price of ~$70,000.
I am assuming that with high volumes there will be volume and other discounts, and I have adopted an arbitrary 10% discount, which would bring the price back to $63,000 for 2018 on.
Assumptions Item 3 - Cost of production per unit:
The reimbursement amount for trials (per 2. above) is based on cost of producing small quantities, so I will use $59,000 as cost per unit through end of 2017.
The C-Pulse is a relatively simple device compared to an LVAD where tolerances are measured at the sub-micron level.
The main working parts of the C-Pulse are tried and tested high-tech plastic. It should readily lend itself to low cost mass production once volumes are achieved. It is worthwhile repeating an answer from the CEO of Thoratec from the Thoratec Q4 2012 Earnings Call transcript -
Well, PVAD is actually a pretty high gross margin product. It's plastic for the most part.
I choose to use a gross margin of 75%, just slightly lower than Medtronic gross margin percentage, as a basis for projecting Sunshine Heart C-Pulse gross margin percentages once a reasonable volume of sales is achieved from 2018 on. In my projections I will use a lower 72.5% to allow for the medical device tax.
At a selling price of $63,000 and a gross margin of 75%, the COGS for a single C-Pulse system would be $15,750 per unit. I believe that will in time prove to be an enormously conservative estimate, particularly at higher volumes. With apologies to all those involved in its design and development, this is a very smart but relatively simple device, a "better mousetrap."
Assumptions Item 4 - Research & Development (R&D) and Selling & G&A (SG&A) costs
Table 2 below, summarizes data, for sales, SG&A and R&D, from the 2012 financial statements of Thoratec, Medtronic and Johnson & Johnson (Certain non-recurring and other expense items are not included. So Income from Operations differs from reported Earnings Before Tax).
From Table 2, above, we can see that combined SG&A and R&D costs for year ended 2012 for Thoratec, Medtronic, and Johnson and Johnson were respectively 43.9%, 43.9% and 44.1% (very similar in total amount).
I choose to use the Medtronic percentages as a basis for both SG&A and R&D costs for C-Pulse.
C-Pulse will almost certainly have far lower long-term R&D costs than Thoratec. Thoratec and HeartWare (NASDAQ:HTWR) are in a continuing game of catch up with each other, involving completely new next generation models that require huge amounts of R&D money in both design and in lengthy trials.
Adopting the higher Medtronic SG&A cost percentage provides a measure of conservatism.
Assumptions item 5 - Non-routine costs of growing the organization
The relevant line in the Tables of projections further below is "Establishment & ramp up costs" and total cost allowed is $20,000 multiplied by the yearly increase in C-Pulse numbers sold over all 14 years of the projections. As SSH is starting from a zero sales base, and I am projecting maximum yearly sales of 305,000, the amount provided over the 14 year period is a total of $6.1bn.
This $20,000 is over and above normal SG&A per (4) above. Staff can't be hired, trained and put to work in a day. The same goes for the initial staff employed to hire and train the staff and all the support staff required as an organization undergoes rapid growth.
The $20,000 will be applied to projections of future incremental yearly sales, $8,000 3 years prior, $8,000 2 years prior and $4,000 in the year immediate prior to the incremental increase to recognize much of these costs must be incurred ahead of the year of sale
Assumptions Item 6 - Capital expenditures and working capital requirements
There will also be a need for considerable equipment, infrastructure and working capital in order to execute plans.
An amount of $15,000 per C-Pulse has been allowed and will be applied to projections of future incremental sales, $5,000 2 years prior, $5,000 1 year prior and $5,000 in the year of the incremental sale to recognize much of these costs must be incurred ahead of the year of sale. Total allowed over the 14 year projection is $4.6bn.
As mentioned above, in my previous projections for my article, "Sunshine Heart: Potential '10 Bagger' In 4 Years, '100 Bagger' In 10 Years", I allowed for an additional $3bn+ of capital to be raised for both non-routine costs and infrastructure building. In the current projections this amount is reduced to $1.7bn, due mainly to taking into account internally generated cash flows, but the timing of new equity requirements has been brought forward.
Projections for years 2014 to 2027
Projections for the 8 years 2014 to 2021, based on the foregoing detailed Assumptions, Items 1 through 6, are shown in Table 3.1 below.
The balance projections for the 6 years 2022 to 2027 are shown further below in Table 3.2, but it is the projections in Table 3.1 that I first wish to comment on.
The Board and Management of Sunshine Heart have clearly indicated their willingness and preference to go it alone. They have taken steps to prevent a hostile takeover, but have also not ruled out entertaining a suitable offer.
The projections below are merely an order of magnitude estimate of what might unfold if Sunshine Heart were to go it alone with C-Pulse, and were prepared to raise and spend large amounts of money to grow an organization that would have the capabilities to aggressively grow sales of C-Pulse systems.
Sunshine Heart very well might not take the course reflected above. It could instead elect to conserve cash and grow organically, and in fact be profitable by as early as 2018. Year 2018 in Table 3 shows an underlying profit of $86M. If there were nil, or a lesser amount, of the largely discretionary "Establishment & ramp up" costs, the projections would forecast an operating profit in 2018.
Table 3.1 - Projections for Sunshine Heart C-Pulse for years 2014 to 2021
Now, I think it is likely that Sunshine Heart will, at some stage, receive an acceptable takeover offer.
Johnson & Johnson recently indicated an interest in acquiring heart related technology provided the price is reasonable. The projections for years 2022 to 2027 per Table 3.2 indicate the potential future size of this opportunity would make it attractive to any number of bidders, including the three companies involved in pacemakers, as mentioned above.
Table 3.2 - Projections for Sunshine Heart C-Pulse for years 2022 to 2027
It is worthwhile taking a look at what valuation might be put on the company today, based on Table 3 projections.
Takeover value from a Sunshine Heart point of view
Table 4 below shows some calculations for a Net Present Value (NPV) of Sunshine Heart at discount rates of 15% over 8 years applied to 2021 terminal value, and a higher 20% applied to 2027 terminal value. Terminal values are based on a calculated Market Cap value of SSH at end of 2021 and 2027. The Market Cap based terminal values are derived from EBT PE ratios applied to the projected underlying earnings for 2021 and 2027 per Tables 3.1 and 3.2.
These terminal values are then discounted back to present value using risk adjusted discount rates. For the sake of conservatism, a further 30% is deducted from the calculated NPV to allow for unidentified risks and uncertainties.
The resulting estimates give takeover values for Sunshine Heart at end of 2013 of between $3.0bn and $4.3bn.
Now that is the value from a Sunshine Heart point of view. From a Johnson & Johnson or similar large organization's point of view the value would be far higher.
Table 4 - Estimated takeover value range for Sunshine Heart at end of 2013
Takeover value from a Johnson & Johnson point of view
The projections in Table 3.2 above show Operating Income of $5.5bn in 2027. That would put Sunshine Heart in the league of corporations like Medtronic. There will not be many opportunities for JNJ to acquire any business that addresses a large unmet need, is potentially able to grow profits at high rates over a long period and is not up against one or more similar competing devices.
In my article, "Johnson & Johnson: At The Crossroads - Part II", I discussed how JNJ could leverage acquisitions through its greater ability to exploit an opportunity due to brand name and sales and marketing infrastructure. I have allowed in my assumptions and projections in Tables 3.1 and 3.2 for Sunshine Heart to expend $6bn to build an organization that would have the capability to fully exploit the C-Pulse opportunity. JNJ already has that capability and more, so JNJ could take $6bn out of my projections, and that is not where the leveraging ends. With greater execution capabilities JNJ would be unlikely to arbitrarily reduce its estimated valuation by a further 30% as I have done.
Warning and explanation: It should be clearly understood that projections in this article, some going out 14 years, are not in the nature of what is generally described as a "forecast" or "outlook" but merely a very limited "what if?" analysis.
The nature of the C-Pulse opportunity means there will be many years before the opportunity can be fully exploited and profits reach a level that might justify the investment. Any projection going out 14 years will be inherently unreliable as a "forecast," for the reasons that company "outlooks" can be unreliable for just one year, but magnified many times over, and with little or no basis like detailed forecasts for explaining why outcomes might be different from projections.
But that does not mean one should not make a financial projection, on the basis of the very limited information available. Many absolutely brilliant ideas and inventions proceed to attempted commercialization and fail, when a simple projection on the basis of limited information available would have indicated the opportunity could never be profitable.
The projections in this article have been made on the basis of certain assumptions described in the article with no account whatsoever of the many and varied risks that might arise nor of the fact that the company itself might have no intention to exploit the C-Pulse opportunity along the lines of that projected. I take no responsibility for any of the assumptions or the projections.
Additional cautions: As always, please do your own research before any buy or sell decisions. Use of information and research in the article above is at your own risk.
Investing in micro cap companies is not suitable for all investors and can be risky. It's important that investors thoroughly perform their own due diligence and analyze the potential risks. Due to illiquidity, share prices can fall despite strong fundamentals and possible inability to raise sufficient additional cash to continue to fund ongoing operations is always a serious concern. Fuller details of risks associated with Sunshine Heart as identified by the company may be found with their form 10-12B/A registration filing with the SEC and their other SEC filings.