Tactile Systems: Q2 Earnings Continue Value Erosion For Shareholders

Summary

• Tactile Systems reported Q2 earnings yesterday with upsides in revenue but a miss at the bottom line.
• Despite the top-line growth, it printed another quarterly operating loss, adding to a string of losses from bottom up since FY20.
• Investors have turned to rewarding bottom-line fundamentals in FY22, thus, TCMD displays loose affinity to this premia.
• We rate the stock a hold and price it at $6.47, expecting it to de-rate further to that range.

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Investment Summary

Portfolio construction in H2 FY22 has shifted away from systematic, index-like strategies to more discretionary mandates to harvest alpha. No longer can investors simply rely on the positive carry from capturing beta on the long side in equities. High-beta, low quality companies have been punished in FY22 and trends look to continue, despite a series of bear market relief rallies.

As such, we turn to Tactile Systems Technology, Inc. (NASDAQ:TCMD), specialist in pneumatic lymphedema management. Here we illustrate that Q2 FY22 earnings continue an unsavoury trend of operating and earnings losses, features that investors are punishing in FY22. The market has turned to bottom-line fundamentals and measures of 'quality' this year and TCMD displays a loose affinity to this kind of premia. Without the profitability to confidently predict the company's future cash flows, we rate it neutral with a price target of $6.47.

Exhibit 1. TCMD 6-month price action

Data: Refinitiv Eikon

Q2 earnings don't beat the macro-hurdle

Second quarter turnover came in strong with a 17% YoY growth at the top to ~$59.5 million. The result came in ahead of a guided 10-15% and saw upside versus the Street's estimates as well. At a supposed 241 sales reps, productivity was ~$246,900 in revenue per rep. Segmentally, the airway clearance business came in with strength and was underscored by upside in the durable medical equipment ("DME") channel. The AffoVest acquisition contributed ~13% to the top with an $8 million contribution, up 96% YoY. Management reports that its DME rep partners "appreciate the value and complementary nature" of the AffoVest option within the sales portfolio. It expects another ~$8 million from its airway clearance business in Q3 FY22 and hopes to add a second supplier by the end of this year.

A key conversion hurdle that TCMD must overcome is integrating its airway clearance products (such as AffoVest) within the indicated patient pool, i.e. those who require assistance with airway clearance. Note, in layman's terms, airway clearance refers to the capacity to maintain an open, functional and safe passage of air through the respiratory tract into the lungs. This is only achieved by maintaining an appropriate clearance of mucous and bronchial secretions from the airways. Normally it's not an issue, especially in ambulant populations. In less functional cohorts, however, the situation is different – airway clearance – especially from mucous – isn't a given. Mostly, these patients require a high level of care/intervention and thus may already be tied up to certain providers. Management report that its DME reps are seeing success in getting in front of these patients and this has converted to greater traction in the segment.

Meanwhile, its legacy lymphedema segment saw a ~100bps YoY gain to $51.6 million and clipped ~87% of total sales. This was broken down into a split of ~60% commercial, 13% DME distribution and 11% VA, with the remaining 17% to Medicare. Contrast to Q1 FY22 with 55%, 15%, 12% and 18% respectively. Gross margins lifted ~160bps YoY to 72.5% and TCMD reports a non-GAAP gross margin of 73%, +210bps YoY. It calculates non-GAAP gross margin by excluding the non-cash amortization on intangibles expense, which is a prudent measure by estimate.

Exhibit 2. TCMD quarterly operating income pushing lower on sequential basis whilst turnover, GP growth stall

Data: HB Insights, TCMD SEC Filings

Moving down the P&L, OPEX came in 30% higher YoY at $47.3 million, underpinned by a ~1,300bps increase in S&A expenses toward the AffoVest sales team, including headcount, travel expenses and new product introductions. As seen in Exhibit 2, operating income has narrowed on a sequential basis since Q2 FY20 for TCMD, whilst both turnover and gross profit growth have each stalled as well. As such, operating margin continues to narrow and compressed to -7% last quarter.

TCMD also recognized a ~280bps YoY gain non-cash earnout expenses related to the AffoVest transaction, specifically acquisition costs and intangible asset amortization. This is important to factor because Q2 FY21's results didn't include these expenses and/or weren't booked in this fashion. The company booked an operating loss of $4.1 million for the quarter vs. $76,000 the year prior. Non-GAAP operating loss was $1.8 million, however, and it brought the ~$60 million in revenue down to a net loss of $4.6 million or -$0.23 in earnings.

Exhibit 3. TCMD cash burn rate showing greater than 2 years of runway

Data: HB Insights, TMCD SEC Filings

Note: As of June 30, 2022, TCMD had ~$23 million in cash and cash equivalents and $50.5 million in outstanding borrowings; up from ~ $21 million in cash at March 31, 2022 and ~$28 million of cash at December 31, 2021.

Strength in the quarter prompted management to update FY22 full-year guidance by ~100bps, forecasting 14–16% YoY revenue growth, calling $238–$242 million at the top. It previously guided 13–15%. In particular, it expects substantial upside in the airway clearance business of $32 million, and a 3% YoY growth in the lymphedema segment. To arrive at the full-year number, it needs to deliver ~$1 million in revenue per rep for the 12 months, presuming no additional rep hires. This sits in-line with historical averages. TCMD forecasts gross margin of ~71–72% on these revenues and GAAP OPEX to stretch up a further ~24% at the top end. This stems from the increase in incremental OPEX tied to the AffoVest transaction that will ratchet up over the coming 12 months.

Valuation

Shares have de-rated heavily in recent months and now trade at a compressed 1.4x book value and ~1x TTM sales. Given its lack of profitability, it's difficult to assign a concrete valuation in the current investment landscape. Yet, we do see the stock trading at a deep discount across the multiples used in this analysis, as seen below. The question is, is the discount warranted, or do we have a situation of relative value here? In our estimate, it is justified, considering the comps in the list that offer substantial upside premium. Even still, there may be a case argued for deep value players seeking exposure to lymphedema – especially if wanting access to the pneumatics pocket of the lymphedema market.

Exhibit 4. Multiples and comps

Data: HB Insights

Unfortunately it doesn't seem TCMD represents much 'deep value' or mispricing on closer examination. If we are to pay 1.4x book value, we'd also be paying ~1.85x TCMD's enterprise value ("EV") relative to book value, and this translates to us paying $10.55 per share in relative value in order to enter a position. The value gap to the downside implies TCMD is overvalued by ~24%, and hence we price the stock at $6.47 apiece.

Exhibit 5. Deep value is not a compelling factor in the TCMD investment debate

Data: HB Insights Estimates

In short

TCMD's Q2 FY22 earnings – whilst resilient at the top – explain the value erosion investors have realised on the chart in FY22. Ongoing quarterly operating losses and a loss at EPS over the past 12 months to date leave investors with little to sink their teeth into. Market pundits are rewarding bottom-line fundamentals in FY22 and TCMD therefore displays a loose affinity to this kind of premia. Hence, we are trigger shy on the name.

Despite trading at a discount to peers, this seems justified, and on absolute terms, doesn't represent a deep value proposition. In that vein, we price the stock at $6.47 per share following its Q2 FY22 earnings and expect the market to price in further downside, despite the earnings downgrade. We rate the stock neutral on the culmination of these factors.

Analyst’s 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.