Investment Thesis

We believe Surmodics Inc. (NASDAQ:SRDX) is in the early stages of an extended sales growth period, with high conversion potential from the pipeline, as evidenced this year. We expect accelerated sales growth from their portfolio from 2020 onwards, having approached a number of significant catalyst milestones recently. We are slightly more bullish on revenue estimates above consensus. Consequently, we view tailwinds from distribution for the Pounce Thrombus Retrieval system, expansion of the Sublime Radial Access Platform segment, alongside SurVeil uptake from 2022 throughout Europe. SRDX also has key differentiators within its medical devices and IVD segments that have potential to generate long-tailed returns via the business model in manufacturing and distribution. Therefore, our long-term outlook is bullish on the company, and we encourage investors to consider the factors outlined in this analysis for their own investment reasoning.

ChartData by YCharts

Catalysts For Long-Term Price Change

Long-term investors have seen +72.3% upside over the last 5 years, which is relevant as we view SRDX as a candidate for those enjoying a longer investment horizon. In our view, SRDX has further upside potential, especially from FY2021. Here, we feel the market will realise key drivers from 510(k) products that have been launched this year, alongside SurVeil adoption throughout Europe from FY2021. COVID-19 has been a tailwind for the IVD segment, where management explained up to 50% of IVD sales have seen heightened demand from coronavirus exposure this year. This is offset by headwinds in royalty and licensing fees yield, as key client accounts have suffered from reduced elective procedure utilisation this year. Procedure deferrals have been a large impact for the entire sector, and management priced the company’s impact at ~$2 million. However, with ongoing COVID-19 uncertainty in the US, the IVD segment will likely build further upside into the flywheel.

In late September, the Pounce Thrombus Retrieval System (PRDS) received 510(k) clearance for arterial use in peripheral vascular disease. The immediate application of PRDS is for peripheral thrombi and emboli extraction. We anticipate commercial scale to begin around 12 months from now at minimum, where top-line earnings will benefit greatly from end-patient uptake thereafter. Management have guided a $400 million peripheral vascular market for PRDS, which the company will look to capture early on. We see additional market size of ~$900 million with extension into the diabetes segment, and additional applications to deep vein thrombosis, ischemic stroke and pulmonary embolus extraction, to support this market size. In line with previous conversions from the pipeline, SRDX will likely realise a distribution agreement for PRDS. Therefore, diversifying PRDS application from the single skewed peripheral vascular market sees greater marketability for distributors.

Additionally, 510(k) clearance was granted for the company’s “Sublime Radial Access Rapid Exchange Percutaneous Transluminal Angioplasty Dilation Catheter” in August. Key differentiators of the device are on its 250cm extensibility, the greatest length on the market that allows below-knee access. This product joins the Sublime Radial Guide Sheath within the company’s Sublime Radial Access Platform segment. The platform is indicated to allow radial access for treatment of the superior and inferior knee arterial network. In peripheral artery treatments, radial access to the artery in question is becoming the new gold standard over femoral access, via bleeding reduction and earlier return to function. Therefore, the above 510(k) approvals give weight to our thesis that SRDX has high conversion potential from its pipeline, to capture market share and expand total sales volume.

SRDX also leveraged its expertise in peripheral arterial disease treatment by obtaining CE Mark certification of SurVeil back in June. SurVeil is a drug-coated balloon that has proprietary applications in treating peripheral vascular disease. Although not yet available in the US, the certification enables a $10.8 million milestone payment from the exclusive licensee, Abbott Laboratories (NYSE:ABT). SRDX covers supply manufacturing under the agreement. We anticipate European sales of the device to be limited in early phases due to absence of RCT data. However, this is offset by the company’s upcoming pivotal trial, where data release is likely for next year. Should the trial demonstrate efficacy and safety standards to expectations, FDA approval is likely from 2021. Like other SRDX licensing arrangements, company revenues will rely on ABT sales volume of the product. On this basis, we foresee around $8 million in revenues in 2022 in this segment for SRDX, with growth in line with ABT sales estimates.

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We view double-digit sales growth at a CAGR of 12.72% by 2023, alongside EBITDA level growth at CAGR of 33% over this period, by leveraging operating income. We see EBITDA margin expansion at a CAGR of 12.21% over this same term, with added gross margin pressure from manufacturing costs tied to PRDS and SurVeil. Free cash flow has remained positive over recent years, which has allowed high conversion of the pipeline and contributed to sales growth. Further, we see FCF pressure over the coming years, as the company has guided an increase to manufacturing costs volume by 2023, where additional cash will be required. Straight line expenditure is set to increase during this time as well, which has further implications on FCF and balance sheet positioning.

Key Financials & Forecasts (Annual), Base Case:

Data Source: SRDX SEC Filings; Author’s calculations

Data Source: SRDX SEC Filings; Author’s calculations

On the charts, we’ve seen a longer-term uptrend since the selloff in March. Shares quickly gained momentum and set on the journey north, where support was clearly defined, and the stock bounced away from the support line 6 times until early August (seen in red on the chart below). From there, there was a gradual pullback where shares breached the support floor, and continued in this direction with a dive at the beginning of September. The cause of the downtick is uncertain in our view, but could be a large influx of stop-loss orders from trading rules, usually set at 7%-10% below the level of support. Further, there was news of COVID-19 vaccine progression around that time, so speculators may have reallocated capital towards COVID-19 exposure in order to reap short-term profits. The stock consolidated in a U-shaped recovery, before taking another downtick to today’s trading of $36.75, around -24% off the July/August high. We can see evidence of this activity YTD on the chart below, where prices have corrected to the longer-term trend line, seen in purple. Longer-term investors will benefit from observing the longer-term support level, and the stocks direction from it in the coming months.

Data Source: Author’s Bloomberg Terminal

Since the downtick in September, shares have struggled to find range and have trended sideways in an all-out war between bulls and bears. We’ve seen the stock hold within the range shown on the chart below, veering away from support, but failing to break resistance at the green upper trend line. These next periods are crucial for SRDX shares, where the stock must find its range and make its next moves. Longer-term investors should watch closely, as entry may be favourable within the range shown below, if shares begin an uptick from the lower level of support. We feel that long-term investors would benefit from this range of entry, considering our belief on the future trajectory of pricing. Additionally, those holding SRDX in portfolios should look at the stock’s movement within this range closely over the coming periods, to assist with tactical allocation and rebalancing procedures. We can see evidence of this war between the bulls and bears on the chart below, where the stock currently sits on the flat lower trend line.

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Data Source: Author’s Bloomberg Terminal.

Of good news to investors in the current period is that shares have recently exited out of oversold territory at the end of September. This indicates to us a turnaround in investor sentiment, and shares have just recently touched the RSI 30 line again, seen on the chart below. Considering the correlation in price direction and the RSI line over the recent periods, we view that any breach of the RSI 30 line will exhibit an exciting entry point for longer-term investors to consider, to capture upside in the near term. Investors can observe the correlation in RSI and price returns on the chart below, and the recent RSI ranges.

Data Source: Author’s Calculations

Momentum has also been volatile YTD and in line with price direction. In light of the points raised about on RSI ranges, we can see this correlation in momentum and price returns YTD on the chart below. We encourage long-term investors and those holding SRDX in portfolios, to keep a close eye on momentum over the coming periods. The aim is to guide in decision making on entry, reallocation, and to lower one’s dollar-cost average. Should momentum see a large uptick, correlation shows the likelihood of a corresponding capital gain. Therefore, investors can benefit from entry at the lower end of the momentum line. Moreover, it seems momentum is set for a turnaround, based on the movement of momentum YTD. Investors can observe this correlation on the chart below.

Data Source: Author’s Bloomberg Terminal

Valuation

On a multiples front, we’ve seen valuation dislocate from price over the coming periods. Furthermore, we view the recent downtick in price towards today’s trading as a positive correction to valuation. At EV/EBITDA of 35-37x, we see this as expensive and see gradual expansion in this multiple over the coming period. The company currently trades at 24x free cash and has $1.53 FCF per share on an FCF yield of 3.55%. These represent decent value on today’s trading, in our view. At 3.8x book value, we see this as excellent value creation for shareholders, whilst remaining below or in line with peers. The market has high expectations of the company also, on a P/E of ~65x, which is in the upper quadrant of peers.

Data Source: Author’s Calculations

Data Source: Author’s Bloomberg Terminal; Author’s Calculations

We see the stock trading in line with peers, not necessarily at a discount, certainly not at a premium. With future expectations, relative to companies who have exciting opportunities in the pipeline, such as Boston Scientific (BSX) and Edwards Lifesciences (EW), SRDX constitutes a value play in our view. With reasonable ROIC and ROA of 5.74% and 4.69%, respectively, the valuation is justified in our view. Applying a 3x premium to the median EV/EBITDA peer multiple of 26x, relative to our 2022 EPS estimate of $0.70, we assign a price target of $55.23 over the next 2 year period in our base case. We believe a 3x premium is reflective of SRDX’s future sales growth over this time period. Price ranges over the coming 2 quarters relative to the current long-term support line can be observed on the chart below, for the benefit of investors.

Data Source: Author’s Bloomberg Terminal

Assessing valuation from a perspective intrinsic value, we have provided investors with a snapshot of our DCF framework below. We have completed 2 cases for each scenario – base, blue-sky and grey-sky. First, we have calculated the company’s terminal growth rate using the PRAT model of DuPont. This gives us a clear indication of what growth rate the company can reasonably achieve in the distant future, into perpetuity. Second, we have applied a required rate of return that reflects the opportunity cost of holding a risk-free treasury security plus the S&P 500 index. This factors in the additional credit and market risks for holding a single equity over these instruments. Then, we have completed the same DCF framework using the company’s WACC as the required rate of return. This gives us a range for fair value and reduces the assumption risk with defining a single set of inputs for the fair value of the asset.

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Case 1: Opportunity Cost as required rate of return, Base Scenario:

Data Source: Author’s Calculations

Using the above inputs, we arrive at a fair value of $23.04, around -37% downside from today’s trading. The value gap to the downside is quite significant, and must be factored by investors in their reasoning. The above represents pricing risk for investors, which aligns the current narrative of the sizeable retracement that’s occurred over the last few months. To strengthen the valuation analysis, we have extended the scope of inputs as seen below.

Case 2: SRDX WACC as required rate of return, Base Scenario:

Data Source: Author’s Calculations

Using the company’s WACC estimates, then a divergence from the alternate calculations can be observed. Here, we arrive at a fair value of $39.70, a +8% value gap skewed to the upside. Taking the arithmetic mean of the 2 values gives a fair value of $31.37, around -14% skewed to the downside. We can see the effect of implied inputs on the valuation in a DCF analysis. As such, investors can observe our sensitivity matrix on a range of values below, where we see the effects of many assumptions on valuation. We would point investors’ attention to the outlined square in the middle of the matrix, which highlights the central and upper/outer ends of where we see the intrinsic value at this point. There are no outliers within that data set, so it is reasonable to take the arithmetic mean of the square. Within these ranges, taking the arithmetic mean, we see a fair value of $30.50. Interestingly, the mean of the whole square and the mean of the coloured squares are both about the same. Therefore, being scrupulous, we believe the fair value of SRDX at this point in time is around $30.50, around -17% downside from today’s trading.

SRDX Sensitivity Matrix:

Data Source: Author’s Calculations

Conclusion

For investors seeking exposure to arterial treatment and medical device distribution, SRDX is therefore a candidate for longer-term players. We believe that SRDX has potential to generate long-tailed returns from key conversions in their pipeline into the future. The market has yet to price in these developments in our view, and there is future upside potential in the longer-term once sales volume is realised from 2021. We would consider investors keep a close eye on the RSI and momentum ranges for the stock, to identify appropriate entry points and reallocation levels. In our base case, we see upside in revenue growth from 2021, with FCF growth over this period as well. From our calculations, we set a price target of $55.23 or around 50% upside, over the coming 2 years. We are confident the company can adhere to this trajectory in our base case. Based on the range of analyses on fair value, we believe in an intrinsic value of $30.50 for SRDX stock today, around -17% downside. In light of the tailwinds in view for the upcoming years, especially on the back of key relationships with large players like ABT, we hold a bullish outlook in the long-term for SRDX. We look forward to additional coverage for the end of FY2020.

Disclosure: I am/we are long SRDX. 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.



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