Outset Medical Looks Like A Good Short Ahead Of IPO Unlock

Summary

• Outset Medical's IPO unlock happens on 3/15, where 27.3 million more shares become available for sale, roughly twice the current float.
• Revenue expectations for the Q4 quarter may be too high and could show negative sequential growth.
• Despite a reasonable $35 million/year run rate, gross margin is still deeply in the red at -41%.
• Snowflake and Affirm have been weak since their unlock dates, and the same may happen to Outset.

Outset Medical (NASDAQ:OM) is a medical device maker that produces a novel dialysis machine called the Tablo Hemodialysis System.

Tablo is more compact than many other dialysis machines and includes water purification integration. It's not a new product; it was approved back in 2015 as a 510k device. In March 2020, the FDA approved its use for in-home dialysis, which has generated a lot of excitement around the stock.

Bull Case

As straightforward as it gets - treating Chronic Kidney Disease (CKD) and End Stage Renal Disease (ESRD) is a massive market. According to U. of Michigan total spending exceeded $120 billion in 2017 alone. Creating a compelling technology and grabbing even a small share of the market could be extremely lucrative.

Bear Case

Aside from the usual concerns around profitability and valuation which I'll cover below, they're not the only player in the space, and many of the competitors are larger and better capitalized.

For example, CVS launched a clinical trial for Hemocare, an at home dialysis machine in July 2019. Meanwhile, Fresenius Medical Care (FMS) purchased NxStage Medical for $2 billion in cash several years ago for their home dialysis device.

Another piece of the bear case is that Outset is selling Tablo at a negative gross margin. I believe the current $35-40 million/year run rate should be sufficient scale to generate some gross profit, but they're not even close, losing 41% on each sale. I wonder if they're only growing because the price is unsustainably low.

IPO Valuation and Pricing

Outset Medical had a lot of interest in their IPO. Originally slated to sell 7.6 million shares at $22-24, it sold an upsized offering of 10.3 million shares for $27/share.

From the Q3 10-Q

On September 15th, the first day of trading, shares opened above $50 and finished above $60. Currently trading around $49, shares are still far higher than the IPO price.

Follow on Offering

There's an old Wall St expression "When the ducks are quacking, feed them."

Shares hit a high of $64 on November 30th and some existing holders wanted to sell before the 180 day lockup ended. They did so through a secondary offering. Since it was announced and the secondary closed, shares dropped 18% and the secondary priced at $53/share.

Note that this is not like the IPO. The company receives no proceeds from this. It's just some of the existing shareholders not wanting to wait the full 180 days to sell. That sure doesn't look bullish to me.

Date and Size of Unlock

180 days from the IPO date of September 15th, 2020 is March 14, 2021, a Sunday. So the locked up shares will be eligible to be sold on Monday, March 15.

On this date, the full 42.7 million shares will become eligible for sale, compared to the current float of around 15 million shares.

The current ownership structure is above. Considering how far above the IPO price shares trade at, I think it's likely that a significant amount of existing holders will look to ring the cash register on at least a part of their stake.

Financials

Outset's results are less than confidence inspiring, and they seem many years away from turning profit. They've quadrupled revenue from last year, but the product itself is still significantly negative gross margin. They are burning significant cash currently.

Q4 Expectations and COVID

On the first conference call as a public company, CEO Leslie Trigg was cautious about providing explicit guidance and careful about not over promising future expectations.

It appears that a significant portion of the current growth was driven by a large one time COVID related order

Over the summer, we talked about $7 million associated with that Q2 order, and we recognize just around $3 million of that in the second quarter. You should think about the vast majority of the delta being recognized in the third quarter ... we would encourage you to not, again, extrapolate the COVID-related trends from the second and third quarter and think about it more from the base business

...

third quarter to fourth, effectively, as we shared with you all over the summer, console units are expected to be down sequentially in total -- across the total console unit placement number. That being said, if you do strip out this large order that we received in the second quarter, that trend is much less -- is not the same. Effectively, the trend will be flat to slightly up in terms of console unit placements on a sequential basis.

They sold $9 million in consoles in Q3, so $4 million of this was a single, COVID related, non-recurring order.

Revenue last quarter came in at $13.75 million. This quarter estimates are exactly the same, despite the benefit from that large order being removed.

It's possible that this is priced in. It's also possible they are sandbagging and will come in far ahead of expectations, or announce a major new customer order. If there is ever a quarter in a company's history where they want to announce bullish results or news, it is right before the IPO unlock.

That said, it's possible that investors just missed this and could be disappointed if sequential revenue growth in Q4 decelerates or goes negative. Shares could also sell down after the announcement if traders add short positions ahead of the unlock, with the uncertainty of the earnings release out of the way.

Average Volume and Short Interest

As of 3/8, average trading volume is under 300,000 shares/day. An additional 27.3 million shares become available for sale on 3/15.

The latest short interest as reported is just 3.7% of the float. Take this number with a grain of salt since this data lags, but it does not seem like a crowded trade. Fidelity has plenty of availability to short and there no borrow cost.

Conclusion

There's enough here that I like it as a small short heading into the unlock date.

• Significantly above where the IPO priced
• Losing money, no profitability in sight
• Potential negative revenue surprise in Q4
• Low volume, low short interest - not a crowded trade

Data by YCharts

Performance from recent IPO unlocks for Affirm (AFRM) on 3/3 and Snowflake (SNOW) on 3/5, as well as upcoming DoorDash (DASH) on 3/9 have not performed well recently.

I'd be more bearish if the secondary offering had not occurred, since some of the existing shareholders that were looking to cash out already have. But I believe the direction will be down over the next few weeks.

Analyst’s Disclosure: I am/we are short OM. 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.