A Recall-Driven Slowdown Only A Minor Setback For Penumbra

Summary

• Penumbra has been impacted by the pandemic and the recall of its leading-edge neurovascular aspiration catheter, but those only look like bumps in the growth story.
• With the JET 7 Flex Xtra off the market, management is seeing robust demand for older models and is currently capacity-constrained; a new neuro catheter may appear in 2021.
• Peripheral thrombectomy remains a very strong growth opportunity for Penumbra.
• Penumbra remains a premier med-tech growth story, but at over 12x '22 revenue, the valuation is not low.

Mechanical thrombectomy continues to take share in both neurovascular and peripheral vascular procedures, and Penumbra (NYSE:PEN) is continuing to leverage that strong physician interest to build this franchise. The recall of the JET 7 Xtra Flex catheter was definitely a setback for the company, but given the specifics of the product failure, I do not believe it will damage the franchise on a long-term basis.

I'm far more concerned today with Penumbra's valuation than any potential long-term overhang from the recall or competition from the likes of Medtronic (MDT) and Stryker (SYK). Growth med-tech, particularly growth med-tech with fast-growing underlying markets, can often sport double-digit multiples to forward revenue, but at around 12.5x my 2022 revenue estimate (which is a bit above the highest published sell-side estimate), it's hard to say that Penumbra isn't getting appreciated for its well above-average potential.

Stronger Than Expected Results

Penumbra had given investors an early look at its revenue performance back in January, but the final results were still quite strong relative to the expectations before that early look. The company's growth in peripheral thrombectomy remains excellent, and I think it's well worth noting that many doctors have chosen to continue on with Penumbra products for neuro cases - switching back to older catheters.

Revenue rose 14% in the quarter to $167M, beating expectations by around 20%. Neuro revenue was down about 7% in constant currency (down 1% on a recall-adjusted basis) to $80M, and the company reported that physicians are switching back to older ACE 68 and JET 7 catheters at a pace that has the company capacity-constrained for the time being. Vascular revenue was up 45% to $87M, with 73% growth in the peripheral thrombectomy business driven by the Lightning 12 product.

Recall costs pushed GAAP gross margin down about 11 points to 56.5%, while adjusted gross margin declined 240bp to 65.2%, beating by over seven points. I'm not usually a fan of "if you exclude…" math when it comes to earnings, and the costs of the JET 7 Xtra Flex recall are very real, but I do believe this is a legitimate example of a "one-time" event, and I think considering both reported and adjusted numbers is a legitimate exercise.

On an adjusted basis, operating income increased 57% to a little under $17M.

Strong Guidance

Although neuro thrombectomy is not typically elective, Penumbra's business nevertheless did see a meaningful impact from the pandemic, and I expect business to pick up as procedure counts normalize, particularly on the peripheral thrombectomy side (where there is typically less urgency to procedures).

Management's guidance for 2021 revenue was about 5% above prior expectations and calls for 21% growth at the midpoint - a number that I think the company will likely beat, though ramping up alternatives to the JET 7 Xtra Flex could be a near-term challenge. Management also reiterated its target of $1 billion or more in 2023 revenue, a number about 10% above the average sell-side estimate prior to the earnings report (I'm modeling $1.03B for now).

Management's growth guidance is in large part based on the strength of the peripheral business, where the Lightning 12 is seeing excellent interest/usage, and the Lightning 7 (which has a smaller access size) is launching this month. I'd also note that the Lightning 12 should get a boost from expanded labeling for pulmonary embolisms.

Penumbra management was more guarded about the REAL VR product for stroke rehab. The company will be ramping up commercialization activity in 2021, and I've previously noted a total market opportunity of over $1.5B, but management is taking its time with this product and acute rehab facilities are still under a lot of strain from the pandemic, so launching new treatment paradigms is not exactly top-of-list right now.

A Setback In Neuro

After a warning notice in July of 2020, and in consultation with the FDA, the company formally recalled the JET 7 Xtra Flex aspiration catheter in mid-December of 2020. Around the time of recall, the product accounted for 7.5% of sales, but it was expected to be the near-term driver for neurovascular sales.

The catheter was pulled from the market because it was liable to distal tip damage (the end of the catheter could break and/or break off) when contrast was injected through the catheter under pressure. The end result was patient injury (0.056% cases) and some deaths (0.046%).

This was an off-label use of the catheter - company bench testing showed that the aspiration catheter couldn't handle that pressure and the company's instructions were to use the guide catheter for contrast - but a lot of physicians prefer to use aspiration catheters for contrast and they went ahead anyway. With no way for the company to prevent that off-label use, the recall became necessary.

Recalls never look good for med-tech companies, but it's tough to find an established company that hasn't had them. I'm sure there will be doctors who won't use Penumbra products again, or who will use Medtronic and/or Stryker products in the interim and decide they like them better. Given the performance of the neuro business in Q4, though, and management's guidance, I believe Penumbra will ultimately keep a meaningful percentage of its neuro business, with doctors using older catheter designs in the meantime.

Penumbra will also be introducing a new product for neuro in the near future. As is typical for the company, there was little specificity on timing, and management would only talk about it in nebulous terms like "new technology" and a "paradigm shift". At a minimum, though, it would seem reasonable to assume this isn't just a new iteration on the basic JET 7 design.

The Outlook

Capacity constraints in neuro will pinch, but again I do not believe that Penumbra will lose significant long-term share; if the product were defective when used as intended, that could be a bigger issue. In the meantime, I expect peripheral to be a major growth driver.

I would also note that the company's business in China could benefit from having a stronger distribution partner as of December 2020. Penumbra will be working with Genesis Medtech (which is acquiring Hua Medtech), and part of the distribution agreement includes a license from Penumbra allowing Genesis to manufacture some products locally (almost certainly not the highest-end products, though).

I'm expecting Penumbra to get to $1B in revenue in '23, $1.5B sometime in '26, and $2B in 2028, with long-term revenue growth in the mid-teens. Competition from Medtronic, Stryker, and other players will always be a risk, but one I believe Penumbra can handle.

As the business scales, I expect meaningful profitability improvement, with double-digit EBITDA margin in 2022 and FCF margins eventually reaching the 20%'s.

The Bottom Line

Penumbra does not look undervalued on discounted cash flow, and I wouldn't expect it to (that's rare for growth med-tech). Unfortunately, the stock also doesn't look that cheap even by the different standards I use for growth med-tech. A multiple of 10x to 12x revenue over the next 12 months is nothing unusual for premier med-tech growth names, but Penumbra is trading at around 12.5x my '22 revenue estimate. That's more than I want to pay, even though I do think this is remains a great med-tech growth name.

Analyst’s Disclosure: I/we 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.