Risky Sunshine Heart Looks Very Interesting

| About: CHF Solutions, (CHFS)
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I spent close to a decade following small-cap med-tech companies, and in that time I learned to be very skeptical whenever a company talked about having a potential treatment for congestive heart failure. While there are indeed many heart failure patients in the U.S. and EU and there are depressingly few treatment options (particularly for the more serious patients), companies, devices, and technologies have often proved long on hype and hope and short on real-world efficacy and cost benefit.

Maybe, just maybe, Sunshine Heart (SSH) will be different. The dearth of clinical data creates substantial risk here, as does the long timeline to pivotal trial completion and potential FDA approval. Even still, in a med-tech world with few highly promising companies trading at reasonable values, Sunshine is at least worth a look from aggressive risk-tolerant investors.

A Fairly Simple Approach Using Proven Technologies

Perhaps one of the best aspects of the Sunshine Heart story is that the company is not trying to tackle the significant technological and biological challenges of an artificial heart or the ventricular assist devices of Abiomed (NASDAQ:ABMD), HeartWare (NASDAQ:HTWR), or Thoratec (NASDAQ:THOR). Instead, Sunshine's C-Pulse system is based upon balloon counterpulsation, technology that was developed almost 50 years ago with intra-aortic balloon pumps and is still used today.

The C-Pulse works by putting a cuff (vaguely similar to a blood pressure cuff) around the patient's ascending aorta through a minimally invasive procedure. In synchronicity with the patient's heart beat, the cuff inflates and deflates, helping to push blood through the coronary arteries. In essence, the system improves blood flow while actually reducing the workload on the heart. As I said above, this approach is proven and accepted; intra-aortic balloon pumps are still used today to deal with cardiogenic shock and to wean patients off bypass machines.

Unlike approaches like ventricular assist, the device does not contact the patient's blood flow (the cuff goes around the outside of the aorta, with leads going out of the body and to a control/battery pack. That effectively eliminates the risk of clots forming on/around the device and eventually breaking loose. That said, connecting to outside instrumentation creates its own set of problems - patients have to a wear a Darth Vader-style "utility belt," and there has been a relatively high incidence of infections at the exit site.

The Data Have Been Good So Far...

What we know so far about the C-Pulse comes largely from a 20-patient feasibility study. This study enrolled 18 class III heart failure patients and 2 class IV patients. Of those, there were three deaths, two drop-outs, and a total of eight non-responders. All in all, though, the data were quite strong. The patients saw an improvement in NYHA class from 3.1 to 2.2 at six months (and to 1.9 at 12 months), an improvement in left ventricular ejection fraction from 28 to 31, and improvement in 6-minute walk distance from 20-25 meters to 46 meters.

I think those last data points are particularly important. Quality of life metrics can be squishy ("Do you feel better? How much better?"), but ejection fraction (the amount of blood pumped out of the heart) and walking distance are pretty cut-and-dried. What's more, it's worth noting that two patients responded well enough that they were gradually weaned off the therapy.

There were some negative data points as well. Because the device can be turned off by the patient (to shower, for instance), patient compliance is an issue, and it looks like a large percentage of the non-responders were non-compliant (leaving the device off for too long a time). Nearly half (9 of 20) of the patients had major infections, with eight of those related to the exit site. It's also worth noting that an average New York Heart Association (OTC:NYHA) functional classification score of 3.1 suggests that the patient group wasn't very ill (more on this in a bit).

But The Big Trial Is Just Beginning

Sunshine announced in November of 2012 that it had received FDA approval to begin its pivotal study of the C-Pulse System. This study will enroll 388 patients (likely at 30 to 40 sites), half of which will get the C-Pulse with the other half getting optimal medical therapy. As of a January 2013 update, the company was in discussions with seven U.S. sites and management expected to have its first implants by the end of Q1 2013 (likely March).

There will be a lot in this study for investors to chew on. For starters, management has talked about a two and a half year timeline to fully enroll the study - that strikes me as a little conservative, but I'm glad that they're not over-promising. Along the way, though, the company will be able to charge for the devices used in the study. It's also worth noting that the C-Pulse has been designated a CMS category B3 device - meaning it's considered "non-experimental" but with technological advances.

The primary endpoint for the study will be a reduction in heart failure-related hospitalizations, advanced HF treatments, and HF-related mortality. The study will be powered to show a 30% reduction at 12 months, and investors should note that class III heart failure patients generally have a 50% re-hospitalization rate by six months. What's more, patients must have the device on at least 80% of the time to be deemed compliant.

Now for some concerns and risks. First, I have not seen any detailed information on the ratio of class III and class IV patients to be enrolled - if the trial sites enroll significantly more sicker patients (class IV), that could throw off the data relative to the feasibility study. Second, control group patients will be eligible to get VADs, and that too could introduce some noise into the data. Last and not least is the patient compliance issue - if too many patients have their C-Pulses turned off too much, it will interfere with the resulting data.

Significant Opportunities Here … But Challenges Too

In principle, Sunshine is targeting a very attractive market. There are roughly 1.1 million patients in the U.S. and EU that fit into the target class III/class IVa zone for this treatment. What's more, these are sick patients. Class III heart failure basically means that any sort of normal physical activity (including just walking to the mailbox) causes fatigue and shortness of breath.

By the time patients reach class III, the efficacy of pharmaceutical treatment declines significantly, and patients are on a slow road to worsening symptoms, a more limited/restricted life, and eventual death. While VADs are an option, they are generally only indicated for the sickest patients (class IV). On the other side, the cardiac rhythm management companies - Boston Scientific (NYSE:BSX), Medtronic (NYSE:MDT), St. Jude Medical (NYSE:STJ) - have aggressively pushed expanded labeling and usage of pacemakers and combo pacemaker-ICD devices for less severe cases.

While cardiac resynchronization therapy (CRT) has shown some efficacy, only about one-quarter of class III patients are good candidates, and about 30% of them fail to respond. What's more, there's something unsettling about the approach - shocking a damaged/diseased heart into performing better doesn't do anything to reverse the disease, and there is evidence that it can make it worse and accelerate the deterioration of the patient.

What this means is that Sunshine has a sizable "sweet spot" where the C-Pulse could conceivably add real value. Moreover, I believe the system can at least theoretically be used with CRT, which may give some expanded usage options far down the line.

With an approximately $50,000 selling price, it doesn't take very much penetration of that 1-million patient pool to generate large revenue numbers. Keep in mind, though, that no heart failure therapy yet has come close to its full potential. Some doctors may have issues with the therapy and some patients may refuse a wearable device (though experience with early insulin pumps and ZOLL Medical's (NASDAQ:ZOLL) LifeVest) suggests otherwise). In addition, issues like atherosclerosis, a-fib, and aortic regurgitation could shrink that addressable patient population pending clinical results and labeling discussions with the FDA.

Still, I'm optimistic that 10% or so of that 1 million-person market could be in play. That could be particularly true with new reimbursement rules that punish hospitals with re-admissions/re-hospitalizations above a certain threshold. If the pivotal study of the C-Pulse shows that this device really does keep the doctor away, reimbursement won't be a problem.

Still A Long Way To Go

That doesn't mean that Sunshine doesn't have multiple other issues and problems to surmount. Cost-effective/efficient manufacturing is often more challenging than companies expect, and small med-techs almost always have to spend more on SG&A than they think they will. In the near term, Sunshine will need to keep a close eye on its cash and attempt to raise more at shareholder-friendly terms, particularly if the company wishes to continue with the development of a fully implantable version of the system (that eliminates the Darth Vader belt).

Valuation is more art than science now, with wide margins of error. Other similar companies (VADs) have carried $200 million valuations at similar points in their development (suggesting 3x potential for Sunshine), but that was a different time in the market, and few med-techs carry that sort of valuation anymore.

Using Sunshine's estimated two-and-a-half-year trial enrollment timeline, I believe that the device could get approved in 2017. While the company will be selling the C-Pulse Systems used in the trial and in Europe, the U.S. launch will be the key factor in generating revenue. Three years post-launch, in 2020, I'm looking for the company to have less than 1% share of its adjusted addressable market.

In 2020, I project that Sunshine could sell 3,000 C-Pulse Systems at an average price of $50,000, totaling $150 million in revenue. A long-term revenue multiple-based approach suggests a fair value of around $12 based on $150 million revenue in 2020 (with each $50 million +/- worth about $4/share). In this case, I'm using a multiple of 6x trailing revenue – a multiple that basically matches the trailing multiple that investors are willing to pay on a blended index of high-growth med-tech companies that includes names like Edwards Lifesciences (NYSE:EW), Thoratec, HeartWare, and Intuitive Surgical (NASDAQ:ISRG).

Using a discounted cash flow analysis is tricky here, as the positive cash flows are so far distant in the future. Nevertheless, I am assuming that same $150 million in Year Three post-U.S. approval with adjusted market share growing and free cash flow margin both growing thereafter. Ultimately, the inputs suggest a fair value of $14.

With multiple metrics pointing to a valuation in the teens (and two in the low teens), I feel that's a relatively fair starting point for the discussion. That said, if the launch proves to be more sluggish than projected and/or the operating/launch expenses are higher, the valuation drops into the high single digits pretty quickly.

The Bottom Line

Any company with an effective treatment for congestive heart failure is a candidate to be bought by Medtronic, St. Jude, or Boston Scientific (as well, perhaps, as Covidien (COV), Abbott Labs (NYSE:ABT), or Johnson & Johnson (NYSE:JNJ)), but there's long been much more smoke than fire there. Said differently, I wouldn't ignore the possibility that good data from C-Pulse earns Sunshine a bid, but I wouldn't bank on it.

All in all, this is an intriguing company. I see little risk that a new drug or improved ICD will significantly alter Sunshine's potential market. Likewise, I see only modest risk that VAD makers or other potential rivals (including Circulite and CardioKinetix) will bring forth a mousetrap that is so much better as to meaningfully cut into Sunshine's target market. That said, investors need to appreciate the risk of development-stage med-tech companies and understand that the odds do not favor success. On balance, I think Sunshine is worth the risk and could be a very interesting story to watch, but this is by no means a "bet the retirement fund" sort of stock.

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.