Thoratec Corporation (NASDAQ:THOR) is a world leader in the development, manufacture and marketing of medical devices used in the mechanical circulatory support (MCS) industry. Its product portfolio is used to treat the full range of clinical needs for advanced heart failure patients.
Heart failure and the MCS industry
When functioning properly, the four chambers of the heart (two upper atria and two lower ventricles) beat in an organized fashion. Typically, oxygen-rich blood travels from the lungs to the left atrium, then to the left ventricle, which pumps oxygenated blood to the rest of the body via the aorta. After the blood is circulated throughout the body, it returns to the right atrium and then to the right ventricle which pumps the blood back out to the lungs to be re-oxygenated.
Heart failure is a chronic disease that occurs when degeneration of the heart muscle reduces the pumping power of the heart, causing the heart to become too weak to pump blood at a level sufficient to meet the body's demands.
Heart failure is ranked as one of the leading causes of death in the developed world, with 50% of people diagnosed with heart failure dying within four years during which period quality of life is negatively affected. There are four categories of heart failure: 1. class I (mild), 2. class II (mild-moderate), 3. class III (moderate), and 4. class IV (severe). MCS products are primarily targeted to patients in class III and class IV categories.
MCS devices supplement the pumping function of the heart in patients with heart failure. In most cases, a cannula connects the left ventricle of the heart to a blood pump. Blood flows from the left ventricle to the pump chamber via the cannula, powered by an electric or air driven mechanism that drives the blood through another cannula into the aorta. From the aorta, the blood then circulates throughout the body. Mechanical or tissue valves enable unidirectional flow in some devices. Currently, the power source remains outside the body for all FDA-approved MCS devices. Some of THOR's devices can also provide support for the right side of the heart.
Other treatment options for heart failure patients are pharmaceuticals, pacemakers and heart transplants. Pharmaceuticals and pacemakers are not as effective for patients with class III or IV heart failure. Although heart transplant is widely considered an effective and accepted surgical procedure allowing for end-stage heart failure patients to resume relatively normal lives for periods of ten years or longer, the shortage of donor hearts and the fact that many patients are ineligible for transplantation because of the presence of their age or existence of other diseases significantly constraints this option. MCS devices are used either as a temporary solution while the patient waits for a heart transplant (Bridge to Transplant; BTT) or as a solution for patients who cannot get a heart transplant due to their age or medical complications (Destination Therapy; DT).
MCS devices have a critical role in treating patients with heart failure, in light of other options and its benefits. MCS devices have been shown to help move a patient from class III or IV to class I or II, reducing mortality rates and improving the quality of life. In a post-approval BTT study of 169 patients, HeartMate II, THOR's current left ventricular assist device (LVAD), resulted in a 91% survival rate at six months and 85% survival rate at one year. For late-stage heart failure patients who are unable to undergo a heart transplant, drug therapy is currently the only other treatment available. With drug therapy, the two-year survival rate for these patients is approximately 8%.
MCS devices have strong insurance support in the US. In addition to attractive Centers for Medicare & Medicaid Services reimbursement (~$147,310 per procedure on average), several private insurance providers have coverage for MCS devices.
Market size: long term growth in number of eligible patients and wider adoption of MCS devices
According to estimates by the American Heart Association, 6.6 million people suffer from heart failure in the U.S. and approximately 600,000 new cases are diagnosed each year.
The National Institute for Health estimated that the DT application represents a market opportunity of 50,000 to 100,000 patients in the U.S.
Approximately 40% to 50% of patients on the waiting list for a heart transplant in the U.S. receive a vascular assist device (VAD). This percentage is likely to increase over time, due to the benefits and more widespread acceptance of VADs.
In 2013, a total of 6,320 VADs were sold. As such, the growth opportunity for industry sales is very large.
While the VAD market grew only 1% n 2Q14, the market has a history of lumpy growth. US VAD growth in 2013 was about 15%, but Y/Y growth by quarter varied widely (from -7% to +25%).
New England Journal of Medicine Article
In November 2013, the New England Journal of Medicine (NEJM) published an article concluding that thrombosis rates with THOR's HeartMate II pump was 8.4% between March 2011 and April 2013, compared to a 2.2% rate between Jan 2004 and March 2011.
While the NEJM article has had a negative impact on industry sales, the longer term impact is likely to be muted. While thrombosis is an issue, without a LVAD device, 70% of patients in need of an LVAD die in one year. Further, since the NEJM article, there have been a number of publications and presentations showing a better safety and efficacy profile when certain steps are taken.
Within the LVAD space, for years, THOR had the only FDA-approved product in the market. In 2013, HeartWare International (NASDAQ:HTWR) got FDA approval for use of its device for BTT. Since then, it has become a formidable competitor given that its device is smaller and eliminates the need for an additional incision in the abdomen. HTWR has been taking market share from THOR in the US and in the EU, where the growing trend towards less invasive procedures gives HTWR's product an advantage.
THOR's first mover advantage will enable it to continue to have a large share of the market over time. Further, the market will grow at a double digit rate over time due to demographics, health trends, clinical benefits of VADs and advantages over other heart disease treatment options (detailed earlier). Strong growth in the market will result in attractive long term growth for both companies, even if market shares shift back and forth due to differing product upgrade cycles.
THOR's HeartMate II product is the most widely used and extensively studied LVAD (left ventricular assist device). It has gone through over 1,300 patient clinical trial (BTT & DT) and extensive post market study experience with highly challenging patient populations. Over 18,000 patients have been implanted; over 7,000 patients are on ongoing support and over 3,000 patients at on ongoing support for over 2 years. There have been over 400 published, peer-reviewed articles on HeartMate II. Doctors are likely to be slow to adopt newer technologies, which will have a relative disadvantage on leangth of clinical data and personal doctor experience, both of which are very important for a critical life-saving procedure.
Thoratec: products and sales
While the company has many products, its HeartMate product line accounts for ~88% of sales. The company sells its products worldwide and ~78% of its sales are in the US. Pumps account for ~63% of total sales and the company sold 3,846 pumps in 2013.
I. For chronic circulatory support, its primary product lines are its ventricular assist devices
HeartMate product line (accounts for ~88% of sales)
- HeartMate Left Ventricular Assist System (HeartMate XVE), HeartMate II Left Ventricular Assist System (HeartMate II)
- HeartMate II is an implantable, electrically powered, continuous flow, left ventricular assist device consisting of a rotary blood pump designed to provide intermediate and long-term MCS. HeartMate II is designed to improve survival and quality of life for a broad range of advanced heart failure patients. Significantly smaller than HeartMate XVE and with only one moving part, HeartMate II is simpler and designed to operate more quietly than pulsatile devices.
- HeartMate II received FDA approval in April 2008 for BTT and received FDA approval for DT in January 2010. It is the only product currently approved for DT in the US.
- HeartMate XVE is an implantable, pulsatile, left ventricular assist device for intermediate and longer-term MCS. HeartMate XVE received FDA approval for BTT in December 2001 and for DT in April 2003.
- Pipeline: HeartMate II evolution, next generation pumps (HeartMate III expected to be commercialized in the EU in 2015 and HeartMate PHP), and cross-platform breakthrough technology (surgical tools etc).
Thoratec product line
- Thoratec Paracorporeal Ventricular Assist Device (PVAD), and Thoratec Implantable Ventricular Assist Device (IVAD)
- PVAD is an external, pulsatile, ventricular assist device, FDA-approved for BTT
- IVAD is an implantable, pulsatile, ventricular assist device, FDA-approved for BTT.
II. For acute circulatory support
CentriMag Acute Circulatory System (CentriMag)
- CentriMag is an extracorporeal full-flow acute surgical support platform incorporating a polycarbonate pump, based on magnetically levitated bearingless motor technology. CentriMag is cleared by the FDA for use up to six hours in patients requiring short-term extracorporeal circulatory support during cardiac surgery. Additionally, CentriMag is approved under an FDA humanitarian device exemption to be used as a right ventricular assist device for periods of support up to thirty days in patients in cardiogenic shock due to acute right ventricular failure.
III. For pediatric patients
- PediMag/PediVAS Acute Circulatory System (PediMag/PediVAS)
- PediMag and PediVAS are identical, extracorporeal full-flow acute surgical support platforms incorporating a polycarbonate pump, based on magnetically levitated bearingless motor technology, designed to provide acute surgical support to pediatric patients. The brand names differ according to indication for use, duration of support, and regulatory approval.
Valuation: Upside $40.02 (68%); Downside $14.91 (-38%)
Since this is a long term growth situation with multiple critical variables, a DCF valuation has been used to arrive at the upside and downside.
- Current stock price: $23.85
- Number of shares: 57.20 million
- Total cash (no debt): $291 million
Upside ($40.02; +68%) assumptions:
- Global market grows at 14% pa. for the next 5 years
- THOR's market share falls from 63% in 2013 to 53% in 2018
- THOR's adjusted operating margins increase from 22% in 2013 to 32% in 2018 (the company's operating margins were 28% in 2012)
- Terminal PE 18x
- Discount rate 9% pa.
There is further upside if the market grows faster than 14% pa., which will not be surprising given the growth potential detailed earlier.
Downside ($14.91; -38%) assumptions:
- Global market grows at 9% pa. for the next 5 years
- THOR's market share falls from 63% in 2013 to 38% in 2018
- THOR's gross margin falls from 70% in 2013 to 65% in 2018
- THOR's operating income after stock based compensation falls from 22% in 2013 to 19% in 2018. Assumed that the company will be able to reduce operating expenses in light of the loss of market share.
- Terminal PE 12
- Discount rate 11% pa.
Alternative valuation related data:
I. Analyst targets (there are 17 analysts covering the stock)
- 8 buys (47%), 9 holds (53%) and 0 sells
- Average and median targets are $31.27 (+31%) and $30.00 (+26%) respectively
- The high target is $40 (+68%)
- The low target is $25, which is 5% higher than the current stock price of $23.85
II. The stock is trading at a forward price-earnings ratio of 15.23x, compared to its 3 and 5 year average of 20x. At 20x the recently reduced earnings-per-share, the stock would trade at $31.32 (+31%).
III. The stock is trading at an enterprise value-sales ratio of 2.2x, compared to its 3 and 5 year average of ~3.7x and the median of 9 comparable companies of 5.1x. At 3.7x the recently reduced sales, the stock would trade at $35.82 (+50%).
IV. Short interest is 7.6% of equity float; put-call option open interest ratio is 0.21x.
Peers for valuation: HeartWare International, Abiomed (NASDAQ:ABMD), Align Techology (NASDAQ:ALGN), Cyberonics (NASDAQ:CYBX), Edwards Lifesciences (NYSE:EW), Endologix (NASDAQ:ELGX), Intutive Surgical (NASDAQ:ISRG), Insulet (NASDAQ:PODD), Dexcom (NASDAQ:DXCM).
Competition: If THOR is unable to commercialize a competing product in a reasonable period of time, its market share loss will be worse than expected.
Negative articles: If there are other negative articles, like the November 2013 article in the NEJM, the Company and the industry may grow slower than expected.
Reimbursement: If reimbursement rates for LVAD therapy are reduced, sales and margins for THOR will be negatively affected.
Risks (competition and industry growth) are material; however the stock valuation is compelling. Investors often find opportunity when fear and confusion are high. The stock is down 45% in 9 months and is trading lower than the lowest analyst target. The company is the significantly larger player in a two player market that is likely to grow at double digit rates for an extended period. The company has a debt free balance sheet and its cash balance is ~21% of the market capitalization. The company continues to have high margins and healthy free cash flow. Significant (68%+) upside.
Disclosure: The author is long THOR.
The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it. The author has no business relationship with any company whose stock is mentioned in this article.
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