Atricure, Inc.'s (NASDAQ:ATRC) expertise in novel atrial fibrillation ("AF") therapies differentiates itself as a pure play, focused with minimal competition and a defensible moat from its Convergent procedure. The Hybrid AF Convergent procedure is the only proven therapy to treat patients who have been in AF for more than one year, per ATRC. The position is fortified through its Isolator Synergy device. Now with the Converge overhang settled, ATRC is at a turning point. However, it needs to extend its tentacles outside of ablation and diversify its top line with continued performance in its AtriClip platform, and recently, minimally invasive surgical instruments ("MIS") segment. Moreover, data from its operating performance suggests it has to overcome numerous idiosyncratic headwinds. Investors must ask themselves if they are willing to pay 5x forward sales for a period of impeding losses at or below the bottom line. With that in mind, we are trigger shy with this name and rate neutral.
Exhibit 1. ATRC 12-month price action
Turning to its latest earnings, Q1FY'22 revenue came in at ~$75 million, a ~27% YoY growth schedule that came in ahead of consensus. Down the P&L, it printed gross profit of $55.6 million on a margin of 74.5%, Dow ~60bps sequentially. Gross margins have normalised at 73.7% for the last 3 years, above the GICS Industry median of ~59%. The above-average gross margin raises questions if it's a bullish or bearish sign. Bullish in the sense, ATRC has more headroom to absorb cost inflation down the P&L; bearish in its ability to raise margins further should costs surge too high. Adding further weight to the bearish camp is ATRC's sustained losses over the past few years to date. Not just on an annual basis either – a series of quarterly losses in cash terms (CFO, FCF) and at the earnings level. Net margins normalise to -18% for the last 3-years, whereas 3-year normalised FCF margins come in at -11%, out to -18.3% when extending back to Q1 FY'19. It's also averaged a $5 million loss over this period to date on a quarterly and annualised basis. However, operating losses have been realised since Q1FY'19 with an average -60bps YoY growth schedule in the last 3 years. As such, 3-year normalised operating margins are weak at -17%, well behind the GICS industry median's 4.6%.
Hence, whilst top-line growth has been expansive for ATRC on a rolling basis, the loss on these revenues has been equally as consistent. The loss extends down below the bottom line to CFO and FCF and ultimately hurts the company's credit metrics, seeing its loss on operating income.
The question then becomes if this loss is sustainable. Profitability is difficult to examine from the sustained period of losses, however, surprisingly, has turned positive in recent periods. ROE has crept up from a loss of 14% in Q2FY'21 to 12.16% in the last print. Trends were continued in ROA, jumping from -8% to +8% YoY and ROIC from -11.5% to +11.3% in the 12 months to Q1FY'22. Operating and earnings leverage are, therefore, paramount for ATRC in order to sustain this loss into the future, particularly with a period of macro-challenges on the horizon.
Here, we measure how sensitive ATRC's operating income is to each unit increase in revenue. Ideally, it produces a high spike in operating margin as revenue gains. On examination, it's not so much the case. Operating leverage has normalised at 5.6% on a quarterly basis since Q1 FY'19, and -0.07% annually since FY2015, suggesting low sensitivity to changes in revenue. That's also important moving forward, potentially indicating that a drop in sales might not materially hurt operating margins. But it's equally as troubling for its earnings outlook when veering ahead. Our modelling shows ATRC to print continuing losses into FY'26 at the earnings and FCF level. We question its ability to turn into the black after this as well, considering the low sensitivity to upticks in revenue. We've modelled CAGR 11.5% top-line growth into FY'23 after diminishing from 18% YoY growth in FY'22 and 16.5% growth into FY'23.
We are trigger light on the company's qualitative metrics given the above analysis. It needs to grow revenues by more than 16% YoY into FY'26 in order to command the FCF conversion we are seeking in our core portfolios. However, it does present with commendable growth schedules within its operating segments. The latest quarter's results give inferences on this momentum and potential inflection points looking ahead. Q1 growth was underscored by both performance in both appendage and pain management. The former posted $31 million to the top, with a 30% YoY growth schedule. Open heart ablation turnover stretched up by ~18% to $25 million, whereas minimally invasive ablation sales secured $10 million to the top. Pain management was the star performer by growing 109% to $8 million, in line with industry trends in moving away from opioid-based interventions. Importantly, turnover from its cryoSPHERE probe almost doubled YoY, whereas AtriClip came in 30% higher a well.
We then turn to its pipeline, and ATRC received FDA approval to proceed with its LEAPS trial. It's set to examine AtriClip device administered prophylactically in patients without a prior AF diagnosis. Given its nature, readouts are still a number of years away. Nevertheless, ATRC is targeting a cohort of 6,500 in the study population, diversifying its reach to over 250 trial sites across the globe. It also got FDA approval to go ahead with its HEAL-IST study that's examining the treatment of patients with inappropriate sinus tachycardia using hybrid ablation procedures. Site initiation has commenced and R&D continues around this segment.
Further, management raised its full-year guidance by ~16% off the base to $318 million to $330 million, given sales momentum last quarter. Patient turnover has more than normalised to pre-pandemic measures, with national hospital discharges increasing more than 19% YoY since FY'20. It projects a 9–10% growth for Q2, calling for $80 million at the top, implying a $4 million gain to operating leverage based on historical averages. These are inflection points that have headroom to build as further tailwinds into the coming periods.
ATRC has grown its book value per share by 16% geometrically over the past 5 years to date, ahead of the S&P 500's annualised return in the same time. It trades at 4x book value and ~5x forward sales. At 5x sales, for ATRC to give a '5-year payback', it needs to pay 100% of revenues for 5 years straight in dividends, assuming no additional costs below the bottom line. Whilst it's a hypothetical situation, it's relevant as it begs the question if one is prepared to pay 5x forward sales for an impeding period of losses at and below the bottom line. Moreover, with the company set to print a loss in FCF into the coming years in our modelling, this leaves a lacklustre volume of unrealised FCF/share for shareholders. Our DCF implies the same even with a 10% weighted shock to both upside and downside cases, adding that we only see another $10 in FCF per share to be realised in the coming decade, well below the current stock price.
Exhibit 5. FCF Summary
Applying the 5.1x forward sales to our FY'22 revenue estimates of $324 million implies a price objective of $36. Assigning the same mathematics to our FY'23 revenue forecasts of $378 million and discounting this back at 12.5% – reflecting the opportunity cost of holding the SPX + current yield on long-dated treasuries – suggests a price target of $37. Using an unambiguous method to understand where the stock might head adds another flavour to the valuation mix. Point and figure charts achieve this by cancelling out the noise of time. Our P&F charting suggests there are downside targets to be met at the $36 region, with the price action to date suggesting bearish sentiment and multiple downside targets. A composite of these measures on an equal weighted basis values ATRC at $36.30. Adding in our DCF forecasts in the same way prices the stock at $29.75. Hence, this confirms our neutral thesis, as there doesn't appear to be robust fundamental or technical support behind the stock at this point in time. It also appears as if the market may have correctly priced in the more systematic risks impacting the sector.
Exhibit 5. Multiple downside targets suggest bearish sentiment as well
It's also showing bearish activity on the charts by trading well below cloud support. Price action appears flat and there's tight activity between bears and bulls with potential for further downside in our view. On a directional basis, shares entered the trend with rapid downside activity, and the chart from April–date appears to be toppish after testing resistance levels 3x and failing, and now breaking below support. Net-net, price action and sentiment appear to be bearish at this point.
Exhibit 6. Trading below cloud support
ATRC presents with numerous inflection points that sit on the distant horizon. Point is, many are just that – on the distant horizon. Medium-term value has yet to be demonstrated, and investors are paying 5x forward sales for a blend of losses for historical and forward-looking earnings. Shares also appear to be fairly priced at their current levels, particularly amid the systematic risks infecting the broad sector. We've priced the stock at a range of $29.75–$36 suggesting there is little to no upside potential to be harvested at this point in time unless the company can demonstrate a more robust profitability profile. On that note, several profitability measures (ROA, ROIC, ROE) have in fact been strengthening in recent times, which could serve as a springboard for earnings momentum. Alas, we rate neutral.
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Disclosure: I/we have no stock, option or similar derivative position in any of the companies mentioned, and no plans to initiate any such 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.