Red-Hot Novadaq Shows There's Green In Being Green

| About: Novadaq Technologies (NVDQ)
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There aren't a lot of great med-tech growth stories these days, and many of those are already quite expensive. Novadaq Technologies (NASDAQ:NVDQ) is hardly cheap at almost 22 times sales, but this company is very early in its product launch life and could see revenue grow from about $25 million over the trailing 12 months to perhaps $1 billion down the road.

With an affordable, safe, easy-to-use diagnostic system that delivers very real benefits in terms of lower complication rates and costs, Novadaq has an impressive opportunity as well as strong partners like LifeCell and Intuitive Surgical (NASDAQ:ISRG) to help them realize those opportunities. I think it's relatively easy to argue that Novadaq is worth about $18 per share today, and seeing upside beyond $21 is not too challenging.

A Simple System To Improve Outcomes

One of the great things about what Novadaq does is that it's not terribly complicated. Novadaq sells the SPY imaging system, a system that uses indocyanine green (a fluorescent dye) and a laser to assess the perfusion (blood flow) through tissue. The ICG dye rapidly binds to certain plasma proteins in our blood and when hit by the laser, it glows a sort of Predator-ish green. Images of this can then be transmitted to a video screen on the system cart so that the surgeon can assess the perfusion in the targeted area.

This approach is simple, fast, safe, and effective. ICG dye binds quickly, stays within the vasculature, and metabolizes quickly (a half-life of two to three minutes). ICG is broken down in the liver and has a long history of use in medicine, with a moderate-and-severe side effect occurrence of one-quarter of one percent (0.25%).

In over 65 peer-reviewed articles, SPY imaging has been shown to be quite effective in lowering complication rates due to issues like necrosis (tissue death caused by lack of blood flow). Perfusion can be hard to assess with the eyes alone, but using SPY reduces complication by 50% to 65% in mastectomies, and a 2010 CMS study showed consistent cost reductions in coronary bypass procedures (due to lower side effects) between $2,000 and $4,600. What's more, the potential uses of this technology are extremely broad - from breast removal/reconstruction to colorectal surgery to gall bladder removal (cholecystectomy) to assessing diabetic ulcers.

The Money Is There

Many effective therapies and treatments run into reimbursement challenges, but Novadaq's SPY system is already in good shape in this regard. Hospitals can make $100 to $150 per imaging sequence when SPY is used intraoperatively (and two sequences per procedure would be typical) and likewise reimbursement is in place to generate upwards of $500 per procedure in out-patient wound care settings.

Between the efficacy, ease of use, and cost, Novadaq has seen solid uptake relatively quickly. There are about 850 systems in place at over 300 U.S. hospitals, and 45 of 50 top cancer centers use the system.

Up until now, Novadaq has largely sold its systems and kits through its partners. LifeCell, a reconstructive tissue products company owned by Kinetic Concepts (which itself is privately-held now) sells the SPY Elite to the plastic surgery and reconstruction market, where it already holds about 13% share of the market (including those leading cancer centers). Novadaq also sells through Intuitive Surgical where the system is called Firefly and the kits are sold under Intuitive's name. Firefly has been sold with/to over 500 daVinci robots to date, where it is an invaluable tool in safer robot-assisted nephrectomies.

More recently, the company has had to start contemplating a larger direct sales effort. While the company has an agreement with Kinetic Concepts to sell a system into the diabetic wound care market (under the name Luna), the two companies recently ended this agreement. This will be good for Novadaq's revenue and long-term profitability (since they don't have to share revenue), but it will come at the cost of near-term sales investments.

But that internal sales effort won't be going just toward Luna. Novadaq has been selling the Pinpoint system since its launch in December of 2012. Pinpoint is a rigid endoscope fluorescence imaging system that essentially allows for SPY imaging to be done in minimally invasive surgical procedures. There are at least 1 million minimally invasive procedures where Pinpoint would make sense, and two studies are currently underway to assess the usefulness of Pinpoint in anastomosis and gall bladder procedures.

Where's The Competition?

No good market goes without some fighting, and competition is relevant to Novadaq as well. The biggest competitor to Novadaq is the status quo - surgeons using their own eyes and their own judgment to assess perfusion. Surgeons (like physicians in general) can be a stubborn lot, resisting any techniques they didn't learn in medical school and/or any techniques that suggest their own skills and abilities aren't sufficient.

Beyond this, angiography is a pretty well-accepted standard and companies like General Electric (NYSE:GE), Siemens (SI), and Philips (NYSE:PHG) have been selling these systems for decades. While they're well-understood and every surgeon is trained on them, they can cause blood clots, kidney damage, and allergic reactions to the contrast agent (not to mention X-ray exposure to the patient).

In theory, Novadaq may face competition in its own wheelhouse. While Novadaq has numerous patents on the devices and the procedures, it doesn't seem unreasonable that a company could have a go at Novadaq with a knock-off system. Then again, Intuitive Surgical isn't stupid and I have to think they had their lawyers go over Novadaq's IP before signing on as a partner.

The Opportunities Could Add Up Quickly

In a relatively short period of time, Novadaq and LifeCell have garnered about 13% of the breast recon market - a market worth about $50 million to $60 million alone. In addition, this partnership should be able to capture meaningful share of markets like maxillofacial surgery, complex hernias, colorectal cancer surgeries, gall bladder procedures, and peripheral bypasses. All told, that's close to 1 million annual procedures or nearly $500 million to Novadaq.

Pinpoint and Luna are likewise significant opportunities. I believe Pinpoint could address over 1 million minimally invasive procedures, with upside to perhaps as many as 2 million. With a slightly higher ASP (because it's a direct sales effort), the addressable market here works out to another $500 million to perhaps $1 billion well down the line.

The wound care (LUNA) market is trickier. There are over 26 million Americans with diabetes, and about 15% to 20% of those are likely to be hospitalized at some point because of complications with their feet (including ulcers). Certainly not all of the patients will seek treatment, or live near a dedicated wound care clinic, but assessment with Luna can go a long way towards assessing the potential for wound healing and steer the patient to optimal treatment (and avoid amputation).

While transcutaneous oximetry (TCOM) is the current standard of care (and cheaper), the Luna approach is faster and provides more information (as well as covering a larger diagnostic area). If just 10% of the 15% of diabetics liable for serious ulcers would get examined with Luna in a year, that would mean almost $100 million in potential revenue (assuming an ASP 50% that of the Pinpoint/SPY kits).

The Intuitive Surgical situation comes last, as it may be the more challenging one for the company. I think Firefly could be exceptionally successful - I believe Intuitive will push this hard to encourage the use of the daVinci robot in colorectal, renal, urinary, gynecological, and gall bladder procedures, so as to keep complication rates down (use of Firefly significantly improves bile duct visualization, for instance). Unfortunately, the agreement with Intuitive gives Novadaq a relatively low ASP (about $125, but also larger one-time payments for placing a system), so Intuitive taking even more share in minimally invasive surgery could actually end up harming Novadaq's long-term opportunity. I think it will be a while before Intuitive procedures represent more than $50 million in revenue, but that could happen.

I also expect Novadaq to generate meaningful profitability. The next couple of years are likely going to see reasonable gross margins (in the 60% area), but breakeven on the operating income line would likely be the best probable outcome, given the need to invest in sales and marketing. Longer term, I think Novadaq can see a very significant revenue and profit ramp, with possibly $240 million in sales and a nearly 18% free cash flow margin in 2017. Longer term, I think the company's marketing agreements will cap free cash flow margins below 20%, but I believe revenue in the $750 million to $900 million range is possible long term.

The Bottom Line

Companies like GE and Philips in the diagnostics space and Stryker (NYSE:SYK), Covidien (COV), and Olympus in the minimally invasive space could view Novadaq as both an opportunity and a threat. Novadaq threatens their existing businesses in visualization and imaging, but could be an interesting growth-oriented acquisition.

My stand alone base-case fair value for Novadaq is $18 based on $750 million in long-term revenue, but the number jumps to $21 on the $900 million scenario. That's better than 40% upside for a company that already has strong partners and excellent clinical data - data that has led some reconstructive surgeons to call this system "essential" for procedures. While there absolutely will be bumps along the way (also known as "buying opportunities"), I'm bullish on the potential adoption curve of this system and, as a result, the stock of Novadaq as well.

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.