Living La LivaNova Once More: Shakeup Pays In Capital Gains

Summary

• LivaNova Plc continues its excellent turnaround story that commenced in October 2020, since 2.2% owner Prime Capital LLP's scathing letter.
• Shareholders have enjoyed +65% upside from this point until today, and the technical picture corroborates more upside on the charts.
• We are looking for a pullback to key support zones identified in our studies as Covid-19 headwinds remain, evidenced in Q12021 earnings.
• The company reported mixed results across the quarter, although saw sequential gains in market cap and EV.
• Normalised P/E of 65x FY2021 EPS estimates and normalised EV/EBITDA of 29x FY2021 EBITDA forecasts sees a price target of $105.

Photo by Bart Tyszka/iStock via Getty Images

Investment Thesis

LivaNova Plc (NASDAQ:LIVN) looks well-positioned to deliver on revenue growth and continued share appreciation in FY2021, as elective procedures begin to rebound and COVID-19 effects on patient turnover begins to diminish. However, to push back on this point, LIVN continues to dedicate a high factor of capital resources to its pipeline, which may be unfairly compressing margins for shareholders. Moreover, there is a backlog of clinical data from the company's pipeline up until FY2022.

Exhibit 1. LIVN Single-year performance

Data: Author's Bloomberg Terminal

Nonetheless, the company has made a significant turnaround since the year prior, following the scathing letter from Prime Stone Capital LLP, which owns 2.2% of LIVN, back in October 2020. Management have embarked on a significant effort to expand value proposition for shareholders, rightly correcting sloppy covenant and balance sheet management, and divesting the underperforming heart valves business in FY2020. Consequently, we remain constructive on LIVN shares, and believe that further upside is quite visible in the medium to long term, with a contrarian flavour to one's thinking. Here, we cover all of the moving parts in the investment debate, linking fundamental and technical factors to future expectations and valuation.

Q1 Performance Illustrates Covid-19 Headwinds Remain In The Short Term

Q1 sales came in behind Q4 2020 Q revenues of ~$270 million, with a total of $247.6 million posted at the top across the quarter, $5.08 revenue per share. This signifies a 2.1% YoY growth pattern on a reported basis, but actually is a 0.4% decline in constant-currency terms. Additionally, gross profit, operating income, and the bottom line all came in behind 4th quarter postings, as did CFFO, translating to a ~600bps headwind to operating leverage. An additional focus point in the picture here is a ~100 basis points decompression of gross margins across on a sequential basis to 67.9%, whilst market cap and enterprise value continue to expand, from $3.2 billion to $3.58 billion, and $3.6 billion $4 billion, respectively. As such, we see margin expansion of ~400bps over the coming 2-year period, at the gross level, gaining ~200bps in operating leverage and an additional ~200bps of leverage at the bottom line.

Exhibit 2. Market Cap & Enterprise Value Summary Q32019A-TTM

Data: Author

Segmentally, there was a mixed performance across the portfolio. In the cardiovascular segment, sales were $143 million or $2.90 per share, which is a 9.4% YoY decrease. Cardiopulmonary products within this segment this amounted to $108 million (~$2.21/share), which was a 10% decline YoY for instance. Much of the decline here was underscored by COVID-19 impacts on elective and essential cardiac surgery procedure volumes (including patient turnover), particularly throughout Europe, where cases continue to plague patient turnover volumes. Partially offsetting this weakness was cash flows on capital equipment purchases, which helped to bring the spread of loss YoY back to more respectable values.

Moreover, ACS revenues came in at $13 million on the nose, or $0.26/share, which was a ~24% YoY increase, and much of the upside he was underlined by the life SPARC segment's adoption throughout the US, which will continue to see the upside as procedure volumes continue to normalise towards pre-pandemic levels throughout this year. With respect to neuromodulation, sales came in at ~$104 million for the quarter, or $2.10 per share, which is a 14% increase YoY. Market strengths are a structural growth driver for the company here, and we see evidence of the same geographically, given the strengths in the US and Asia for this segment observed across the quarter.

Exhibit 3. P&L Summary with key financials FY2017A-FY2022E

Data: LIVN SEC Filings; Author's Calculations

Headwinds realised at the P&L level carried through to the cash flow statement, with a decline in cash from operating activities to ~$20 million, a significant down-step from $37 million one year prior, as the company absorbed COVID-19 headwinds as cases resurged at the back of FY2020. The company ended the quarter flat in cash from Q4, with $252 million in cash on the balance sheet, ~$5.17 in cash per share. The total amount of working capital did decrease by ~ 5% YoY, which was reflected largely in a reduction in marketable securities.

Although the company did realise these headwinds to the top line and margin performance on a sequential and YoY and sequential basis, guidance has remained firm, and management anticipate FY2021 sales growth of ~8-13% or a constant currency basis. This calls for revenues of $1.012 billion-$1.062 billion for the full year, and could carry through to operating income of ~$170 million and FCF of $184 million at a higher forward FCF conversion rate, which seems likely by our estimation. Granted, this figure in FCF would be a significant up-step from historical averages, particularly as the company has been in the red for free cash flow over the prior two year period, nonetheless FY2021 is a period of opening for LIVN. To illustrate, from the quarter, the company realised $11.3 million in free cash conversion, ~$0.23 FCF/share, going from $31 million on a sequential basis, but up from negative values across the aggregate of FY2019-2020. This should come through to the bottom line for earnings of $1.90 at the upper bound, and management remain firm on these figures, which doesn’t give some confidence in the forward estimates moving forward.

Operating Efficiency Has Been One Key Driver to Success and Helps Justify the Valuation

Operating efficiency has exhibited significant improvements over the single-year period to date, and even more so on an annual basis over the last 5-years. Analysing the previous 6 quarters to date (Q1 2021), we can observe that accounts receivable turnover has increased from 4.22X to 4.63X, whilst days sales outstanding has reduced by eight days to 78 days. Inventory turnover has also widened slightly to 2.2X, which is a 1.45% sequential growth pattern from Q4, and also showed a 24% growth pattern from 3rd-quarter to 4th-quarter in FY2020. Additionally, accounts payable turnover has remained quite flat over this time period, and the summation of these inputs has led to the cash conversion cycle reducing from 172 days to 144 days whilst inventory to cash days has reduced from 257 days to 244 days across this short time period.

Exhibit 4. Financial Statement Forensics- Activity Analysis

Data: LIVN SEC Filings; Author's Calculations

Comparing this or an annual basis, from FY2015-FY2020, accounts receivable turnover reduced from 5.76X to 4.3X, whilst days sales outstanding increase from 63 days to 86 days. Inventory turnover has increased from 1.31X 2.17X, whilst the days of inventory outstanding has reduced significantly from 207 days to 168 days. Again, the summation of these factors has led to a significant reduction in the cash conversion cycle on annual basis, from 260 days to 150 days. Consequently, the inventory to cash days figure has reduced equally as vast from 244 days to 255 days over the same time frame. These improvements in operating efficiency have been realised at the net and gross levels for the company, as there is less working capital tied up in operations, and the company is realising a greater level of profit from each level of cash that is invested into the operating cycle. Furthermore, company is selling more product and at a faster rate, and this should continue to deliver at the shareholder level over the years to come should these trends continue. Given that the company has made significant improvements at this level, we would anticipate factors of liquidity to improve alongside this also.

On this basis, short-term liabilities are covered only 0.8 X from cash, and 2.3 X from working capital on the balance sheet. Additionally, long-term debt as a function of equity is 61%, whilst long-term debt financing ~37% of total capital. To offset these points, the debt ratio is only at 29% for the company, and total capital is under 40% as well. A risk that must be factored in here, is the fact of the Altman's Z-score is at 1.0, which signifies the cash figure may not be significant or may not have enough runway to last over the next 2-year period. This must be factored into the investment debate also, and ties into the credit summary.

Exhibit 6. Liquidity & Credit Summary FY2017A-FY2020A

Data: LIVN SEC Filings; Author's Calculations

FY2021 interest expense is poorly covered from operating income, with a figure of -6.61X coverage from FY2020, and this represents additional factors for consideration in the investment debate. Common equity to total assets is at 46%, therefore the capital structure remains that focused. Management must therefore continue to demonstrate excellent debt and balance sheet management, in order to skew the balance sheet more towards equity holders.

The Value Proposition for Investors

One aspect where LIVN has been extremely attractive over peers, has been share price performance since October of last year. Since this period, shareholders have realised over 65% upside on the charts, and the technical picture is directly backed by the fundamental underlying. Shares have traded in a narrow ascending channel since October 2020, bouncing to and from resistance and support respectively over this time. Shares have bounced from support 5 times over this period to date, and support is well defined at the $80-$82 mark at the current standings, as seen on the chart below. Given the mean reversion activity observed on the charts since October to date, it is not unreasonable to anticipate a pull-back away from the resistance level of ~$90 over the coming few periods.

Shares are trading well above the ichimoku cloud and above all 50D, 100D and 200D MA's, each of which are acting as clearly defined support floors. Therefore, any consolidation back to the support level would be welcomed from an entry and/or allocation perspective, as shares would likely recapture its gains back to the upside in a move away from this level.

Exhibit 7. Ascending price action since Oct 2020; narrow channel, testing resistance + support

Data: Author's Bloomberg Terminal

Given the longer-term price action demonstrating a reversal on a longer-term downtrend, I see the current momentum continuing net-positive over the coming quarters, given the degree of confluence between the technical and fundamental picture for this name. Analysis of the technicals demonstrates there is clear upside to be observed on the charts, and we are confident that shares will converge to our price target discussed below. Right now, prices are testing December 2017 2018 and 2019 resistance points, which have failed to breach each of these times, albeit in 2017 where she is eventually retraced back to this level anyway. Prices have also broken out from the previous high in January 2019, and have passed the 50% level on the Fibonacci retracement from the AHT, well on the way to the 61.8% or $94 marks on the Fibonacci tabs. This technical momentum gives a short-term price target of $94, and given the strong support level the speed of this move, could reach this mark by around May or June this year, should the current trend continue.

Exhibit 8. Long-term price trend reversal, past 38.1% + 50% on Fib. level, testing Dec 2017, 2018 + 2019 resistance

Data: Author's Bloomberg Terminal

Exhibit 9. Price distribution outcomes; Technical Price target = $94 (short-term)

Data: Author's Bloomberg Terminal

On a shorter time frame, we see a high degree of confluence with the 76% levels and 80% levels on the Fibonacci retracement and the upper lead lines on the ichimoku cloud. Therefore, in the near term, there is a higher propensity of shares to pull back towards this level, which would conveniently serve towards the level of support anyway. Investors can observe this zone via the blue circle indicated on the chart below, where there is a high degree of confluence between several of these factors, indicating where prices are being called to. As such, we believe an attractive entry point and/or re-allocation point for this name would be around the $83-$82 mark if shares were to pull back towards this level. Given the pattern we’ve observed over the past 6-months to today, it’s not an unreasonable expectation to believe shares would retreat towards this level in the short-term, before making another move back to the upside. In the near-term, should shares continue north towards the resistance ceiling, this also calls for a near-term price target of $94, corroborating with additional time frame calculations.

Valuation

Given negative earnings and significant COVID-19 headwinds that have disrupted the entire sector's supply chain to end-markets, LIVN is best analysed on a normalised basis relative to peers. To illustrate, on current terms, shares are trading at a mammoth 360X FCF and 3.9X book value. Shares are also currently trading at 46X Q1 EBITDA, and each of these figures represents a net-discount to the peer group. Keep in mind the group contains significantly defensive holdings such as Smith & Nephew (SNN), who do not offer the growth potential on the charts, but do you lend a more respective valuation relative to the peer median.

Exhibit 7. Multiples analysis with comps

Data: Author

On a normalised basis, shares a trading at 63X earnings, over 100 X FCF, and just under 30X EBITDA. Normalised FCF yield of $0.29 is also below the peer median, whilst the normalised ROIC figure of -11% certainly does not help way in the premium to valuations here. Shares are trading above normalised figures, consequently, this detracts from valuation as a significant weigh-in to the long case, as LIVN must be valued on a normalised basis to smooth the effect of the pandemic, by my estimation, Valuations on a fundamental basis are consequently unattractive at this point. Should the market begin to discount LIVN shares on the basis of the most recent earnings, or due to factors valuation factors and back to such as these valuation factors, this confirms the thesis that shares are set for a pull back towards the support level in the coming periods.

Exhibit 7. Normalised Valuation metrics

Data: Author

Where the valuation situation becomes more attractive for this name, is when discounting future expectations and another analysing market the market expectations in today's terms. Consensus views earnings of $1.68 for FY2021 and $2.24 for FY2022 and this is certainly a reasonable expectation. On normalised P/E figures of 63X FY2021 estimates of $1.68, this drives a price target of $105.84. Applying the same 63X normalised earnings multiple to FY2022 earnings estimates of $2.24, and discounting this figure to the present at a discount rate of 15% that reflects the opportunity cost of holding his name over more secure cash flows, this yields a price target $122, and the future value of this figure in 2-years time at those stipulations is $141.

On a normalised 29X EBITDA this yields a price target of $105 also, when applied to FY2021 EBITDA estimate of $177 million, and using the same multiple to FY2022 EBITDA estimate of $205 million, and discounting this figure using the same stipulations outlined earlier, this drives a price target of $106. The future value of this figure in 2-years time is $122. Therefore, we can confidently say that our assigned price target is $105, as there has been a high degree of confidence across several forward multiple calculations that help to corroborate this figure. We believe that shares have a high propensity to converge towards this upside price target, given the turnaround since October last year. The technical picture supporting the fundamental outlook serves as a recipe for shareholder upside, by my view.

In Short

LIVN shares continue to look attractive given the recent upside observed on the charts. Fundamental momentum is beginning to convert to shareholder value as management embark on their new growth vision. Now that debt management has improved, shareholders may look forward to greater access to the balance sheet as time progresses. Recent activity on the charts corroborates the story here, and valuation metrics trade below peers but above normalised averages. This must be factored into the investment debate, however, given the state of equities markets at the moment in that there is a high percentage of individual names who are considered a value anyway, this may not be a significant deterrent given the current appetite for risk in the market.

Furthermore, the company looks well positioned to capitalise on the early stages of a turnaround in sales recovery, and this should translate directly to earnings for shareholders over the years to come. We are confident in growth at the top and bottom lines for shareholders over the coming 2-year period at least, and foresee free cash flow of $35 million in FY2021 leading to a mammoth $245 million in free cash flow for FY2022, as the company converts on margin expansion, in addition to how this carries through the P&L.

Downside risks to our price target of $105 outlined in this analysis includes significant pushback on the charts, unfavourable reaction to recent earnings by the market, litigation, competitive forces capturing additional market share from the company due to lack in sales growth over the last 3-year period, and the fact that the company may fail to execute its new growth strategy over the coming periods. Partially offsetting these points at the recent activity on the charts, and the fact that management are confident on a strong year in sales growth, as indicated by guidance. We are aligned with management's view, and believe one must continue to possess a contrarian flavour to their thinking in order to play this name. We look forward to providing additional coverage as time goes on.

As such, we see Margie and expansion of around 400 basis points over the coming two year period, at the Grace level, with a with the company going around to her place a point of leverage at the operating and the operating level and an additional 200 basis points of leverage at the bottom line. We also see gross profits whitening significantly in line with the growth of these margins, and much of this will be should be driven by an increase in revenue volumes and carry through to free cash flow over time.

Analyst’s Disclosure: I am/we are long LIVN. 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.