The Life Sciences Report: As the very first person interviewed in 2014 for The Life Sciences Report, your coverage looks to be very timely.
Jason Mills: It's an honor to be first in 2014. I'm hopeful that it's going to be a great year.
TLSR: You focus on the cardiovascular industry. What distinguishes cardiovascular from other industries inside medtech?
JM: In cardiovascular medtech, you are primarily dealing with the gold standard of randomized, controlled clinical studies, which offer the best clinical evidence that a medical device company can attain. Cardiovascular devices are also reimbursed at a higher rate because of the cost of the chronic conditions that they target. In addition, the U.S. Food and Drug Administration (FDA), by and large, requires premarket approval (PMA) applications because the products are often unique. In other areas of medtech, devices may be approved under a 510(k) premarket notification pathway or a supplementary approval pathway, which require less time and less clinical study. I should say that not every cardiovascular device requires a PMA, but the biggest market opportunities do, in most cases.
TLSR: Can you elaborate on the approval process in your coverage universe? If a company has, for example, a left ventricular assist device (LVAD) that it is marketing for infants, and it is miniaturizing that device, would that require a PMA, or could it go through a shorter 510(k) pathway?
JM: If a company is miniaturizing an LVAD, it is essentially changing that device. That's happened quite a bit in this industry, where innovation has been fast and furious over the last seven to 10 years. Both Thoratec Corp. (THOR:NASDAQ) and HeartWare Inc. (HTWR:NASDAQ) are coming out with some fantastic medical technology in mechanical circulatory support. These companies are looking to make their pumps smaller, less invasive to implant and more durable over time, with fewer adverse events.
Whether in infants or adults, miniaturization of pumps is a trend. Miniaturization is not only moving forward in the cardiovascular sector—it's the trend throughout medtech in general, because the surgery required to implant smaller devices is less invasive. Minimally invasive surgery is a major trend as well, and will continue to be. Both trends are certainly apropos to LVADs.
On the other hand, if a company is seeking approval for a device that's already on the market and is being used in a specific patient population, the FDA may not require a full-blown investigational device exemption (IDE) clinical trial and PMA for a different patient population. But the agency may require some sort of clinical data.
"The overriding theme in medtech over the next five years will be merger and acquisition."
Pathways to approval for miniature devices are similar to those for any medical device designed to be implanted in the body. If an LVAD is significantly or materially different in the way that it is configured, or the way it moves blood, it will probably require an IDE and randomized clinical studies.
TLSR: Small-cap cardiovascular medtechs have significantly outperformed large-cap cardiovascular medtechs over the past year. Can the risks of the smaller caps be justified to attain these higher returns?
JM: Yes. I believe the risk—if we call it risk—in the small-cap cardiovascular medtech group is justified. I have a greater affinity for growth companies, and the group I focus on is composed of small- and mid-cap medical device stocks. Growth, by and large, resides within the small- and mid-cap sector. That's true across the board, in cardiovascular medtech as well as in diabetic or orthopedic medtech, which my Canaccord partner, Bill Plovanic, covers very well. I believe the risk is justified, and that appreciation is going to continue.
TLSR: How do growth rates compare between the small- and mid-caps and the large caps?
JM: The median topline growth rate among large-cap companies—those that have a $7 billion ($7B) market cap or more—is at 4%. The median growth rate in mid-cap companies, those at $1–7B in market cap, is about 7%. The median growth rate in all the small caps—those under $1.5B—is more than 10%. When you look at a sample of the best in small-cap medtech, you're looking at 40% growth—and there are only about 10 companies in medtech in general, including in diagnostics, growing the topline more than 20%. Revenue growth and gross margin expansion are key factors to consider when valuing a medical device company and, especially, a small- to mid-cap medical device company.
TLSR: Why do you believe that growth and share-price appreciation are going to continue in the small- and mid-cap space?
JM: Money goes where growth is in medical devices. The primary reason large-cap medtech companies don't have small-cap-type growth is that, over the last 20 years, the larger caps have acquired or developed devices in sectors that have been penetrated at significantly higher rates than newer sectors. The newer growth sectors include transcatheter aortic valves, mechanical circulatory support, renal denervation and transcatheter mitral valves, which are coming down the pike. Other growth sectors include abdominal aortic aneurysm (AAA), fluorescent imaging and atrial fibrillation (AF). Innovation in these areas is in small-cap companies. What you have is a dichotomy between large players that need growth and small companies that have it.
TLSR: With such low growth in the large-cap medtechs, they surely must be thinking about acquiring growth. Is that where you're going with your theme?
JM: The overriding theme in medtech over the next five years will be merger and acquisition (M&A). Medtechs will consolidate. The large-cap guys need growth, and I don't think they will develop it quickly enough internally. Large caps are going to look more and more to external sources, acquiring the growth that they need to drive share price appreciation over time via acquisition.
TLSR: You and I last spoke in April 2012. You said there was deep value in medtech for investors. You were right, and congratulations on that. Have we already seen the bulk of that move in small- and mid-cap cardiovascular medtech in 2013, or is more left?
JM: There are still good stocks to buy, which will appreciate over time, but it's going to be less of a group move. That said, investors should look at companies with the best growth profiles, coupled with the best gross margin profiles. If you're seeing consistently strong or accelerating topline growth, and consistently strong or expanding gross margins, those stocks have the best chance of appreciating from today's levels, which are up quite nicely over the last two to three years. We're still not at the peak medtech valuations we saw prior to the financial crisis. I'm not suggesting we'll get back there, but it's entirely possible that multiple expansion in medtech will continue. And if we do see consolidation in this space, valuable assets will become fewer and farther between.
TLSR: Cardiovascular medicine has been very successful, both on the drug side and the medtech side, and it has been an excellent model of how to employ preventive medicine, including diet, exercise and the use of statins and antihypertensives. Interventional therapies and the new advancements in electrophysiology have helped patients greatly, and they are living longer. What should investors be looking at in this growing market?
JM: Heart patients and older patients are living in an age of significant transformation and advancement in medical devices. Many will use these devices and technologies over the course of the next 10–20 years. A case in point is transcatheter aortic valves. As patients age, their aortic valves calcify and don't work very well. That is a leading indicator on the heart failure continuum: If the heart valves aren't working and the heart is not pumping blood efficiently, that's essentially the definition of heart failure. The advent of transcatheter aortic valves, used when patients are either too frail, too sick or too old to have a full-blown sternotomy and open-heart surgery, means these patients can now derive benefit from a new aortic valve via a minimally invasive catheter-based technology.
TLSR: Jason, would you address minimally invasive, transcatheter mitral valve technology?
JM: That's coming down the pike. Edwards Lifesciences Corp. (EW:NYSE) and Medtronic Inc. (MDT:NYSE) are spending millions of dollars over the next five years on development of a transcatheter mitral valve. I believe it will be developed—and it will be a dramatic paradigm change in the treatment of mitral valve disease, which is one of the most frequently diagnosed heart problems in the world and more prevalent than aortic valve disease.
"Revenue growth and gross margin expansion are key factors to consider when valuing a medical device company."
Transcatheter device technology has gotten more durable, and the devices are less invasive to implant. You must have both of those features to accommodate older patient populations. I believe that, going forward, we shall see transformational, paradigm-changing medical devices achieve good success in big markets.
TLSR: Jason, talk to me about further innovation and where we are seeing it. What about mechanical circulatory support, for instance?
JM: We shall continue to see improvements in circulatory support, as well as penetration into the end-stage heart-failure patient market for mechanical circulatory support. In my estimation, less than 10% of the patient population can benefit from those devices. On the heart-failure continuum, there is more development and innovation in treatment of class III heart failure using pumps or medical devices.
One example is the non-blood contacting device called the C-Pulse Heart Assist System, from Sunshine Heart Inc. (SSH:NASDAQ). HeartWare just acquired a company, CircuLite Inc., which has a miniaturized pump for class III heart failure patients. Many class III patients have aortic valve and mitral valve disease, with transcatheter valve technologies available or in development for both of those conditions.
TLSR: Sunshine Heart's C-Pulse is approved in Europe, but is in pivotal clinical trials in the U.S. You obviously like the company, because you have a $14.75 price target on it. What's the value proposition?
JM: At the end of the day, if C-Pulse proves to be an efficacious therapy for class III heart failure patients, the value proposition would be tremendous. The company's risk profile is higher than that of other medical device companies because we haven't seen as much data for this device, as we have for other potentially paradigm-changing medical devices. But the risk-reward, in my view, is favorable. If this device, in the clinical trial that Sunshine Heart is running here in the U.S., meets its endpoint, the market opportunity for the C-Pulse will be three or four times bigger than the market opportunity for class IV-targeted LVAD technology.
"Miniaturization is not only moving forward in the cardiovascular sector—it's the trend throughout medtech in general."
One of the reasons HeartWare bought CircuLite is that CircuLite essentially targeted the same patient population as Sunshine Heart. That acquisition validated the Sunshine Heart's market opportunity. Sunshine Heart has a long way to go, and must prove that its device has a definitive impact on cardiac output. Early feasibility data suggests that it might, but the data isn't definitive. However, if the device proves efficacious, the opportunity for this company, with only a $167 million ($167M) market cap, is tremendous.
TLSR: Another area?
JM: I think there will be more innovation on the atrial fibrillation (AF) side. Atrial fibrillation—both persistent and paroxysmal AF—is one of the most undertreated chronic conditions in the world. I cover a company, AtriCure Inc. (ATRC:NASDAQ), that's doing a lot of training, education and product development in AF, which is a huge market.
TLSR: AtriCure reached your target price of $16 in a hurry. Could you address the value proposition there?
JM: The AF market is significantly underpenetrated. AtriCure is the only medical device company with an FDA approval to treat AF surgically, which has been proven to be the best treatment for chronic AF, otherwise known as longstanding persistent atrial fibrillation.
The market is a multibillion-dollar opportunity. With the only FDA approval in that indication, AtriCure has been able to go out and train physicians to do this procedure the same way across the board, which is resulting in better clinical outcomes. The company also has a product to treat concomitant left atrial appendage (LAA) condition, which dovetails nicely with its surgical ablation platform for AF. LAA is a culprit in stroke, and there are a lot of links between AF and stroke.
AtriCure is also spending money on clinical trials to address other patient populations. I think the company has a significantly strong value proposition. If I had to rank companies that have the highest probability of being acquired, AtriCure would be at the top of the list.
TLSR: Is there another area you'd like to mention?
JM: Investors should pay attention to developments in the treatment of peripheral artery disease (PAD). We are seeing a number of interventions to treat blockages in the legs, growing at or just below 10%. PAD is a chronic problem that affects patients' quality of life, and is related to amputations. For patients who have an amputation, the five-year survival rate is very poor. I cover Spectranetics (SPNC:NASDAQ), which is developing innovative technologies there.
TLSR: Can you address developments in the aneurysm sector?
JM: There is a lot of room for device improvement and continued expansion of devices to treat both thoracic and abdominal aortic aneurysms. That market is growing and should benefit from demographics, as aneurysms are more prevalent in older age groups. Endologix Inc. (ELGX:NASDAQ) and some private companies are doing great work in that field. It could be interesting for investors.
TLSR: Endologix has a $1.1B market cap. Could you address the value proposition there?
JM: The company's growth profile is among the best in medtech. Given aging demographics, AAA will continue to see growth, on the order of at least 5% a year in our estimation. Endologix has two potential paradigm-changing devices, and its gross margin profile is also among the best in medtech. Its management team is very strong as well. I think that Endologix has a bright future, whether as an independent company or as part of a larger organization.
TLSR: Back on Dec. 3, the company announced it was going to offer $75M in convertible senior notes plus an $11.25M greenshoe. It didn't want to leave any money on the table. There seemed to be no specific reason for raising the money. Can you comment on that?
JM: Capital is very important in sustaining the growth of small-cap companies. Endologix has some very expensive clinical trials upcoming, so I don't think the financing was a bad move. It doesn't need the money right now, but I can't say that the environment for raising capital is going to get significantly better. If the company believes it's going to be independent for the next five years, we may look back two years from now and say it was a brilliant move.
TLSR: Can you discuss innovation in imaging?
JM: Interesting developments are occurring in the imaging market, whether it be cardiovascular imaging or general surgery imaging—giving the physician a better perspective prior to surgery, intraoperatively (during surgery), and postoperatively.
"Heart patients and older patients are living in an age of significant transformation and advancement in medical devices."
Advances in intraoperative imaging are changing the way surgeries are done, allowing them to be minimally invasive and completed more quickly. I cover a company called Novadaq Technologies Inc. (NVDQ:NASDAQ), which has technology in fluorescent imaging that demonstrates not only the ability to drive better clinical outcomes, but is also saving costs for hospitals because there are fewer complications after surgeries. The number of repeat operations is down where Novadaq's fluorescent technology is being utilized.
TLSR: I'm noting a company called Vascular Solutions Inc. (VASC:NASDAQ) in your coverage.
JM: Vascular Solutions is doing fantastic work, participating in niche markets in cardiovascular and radiological medical devices to help interventional cardiologists and radiologists do better interventional procedures.
TLSR: You made a note in a report on Vascular Solutions back on Dec. 9 indicating that the company had gotten an early Christmas present in an injunction to prohibit Boston Scientific Corp. (BSX:NYSE) from using its technology. Protecting intellectual property (IP) is a persistent problem in medtech. What is going to be the upshot of this?
JM: This IP issue is subject to a trial that is set to commence sometime in H1/15. But this injunction is very important and positive for Vascular Solutions—and, frankly, for the whole industry. When you have a patent on an innovation that has clearly augmented the ability of a physician to deliver care to a patient, and it's unique, it deserves patent protection. That's one of the critical pillars on which our country is built.
It is gratifying to see a court of law uphold IP that has traveled the appropriate pathway to patents. I say this because a lot of innovation in medtech happens at small, entrepreneurial companies. This injunction is an indication that the large players aren't going to be allowed to copy technologies developed by smaller companies, which happens all the time. If we continue to see this trend, it will dovetail nicely with my theme, which is that over the next five years you'll see massive M&A in medtech, to the extent we haven't seen in 30 years. If, in fact, large companies can't copy the innovation of smaller companies, their only option is to buy the smaller companies. That's the way our country and our sector should work.
TLSR: Jason, it's such a pleasure speaking with you. I wish you a happy new year.
JM: You too George, and thanks for spending time with me.
Jason Mills is managing director at Canaccord Genuity. He joined Canaccord from First Albany Capital, where he was managing director and senior analyst covering the medical devices sector, with a specific focus on the areas of cardiovascular disease, ophthalmology and sleep disorders. Mills previously served as a vice president and senior research analyst with Thomas Weisel Partners, where he covered companies in the ophthalmology and sports medicine/arthroscopy sectors. Mills holds a master's degree in sports administration from Ohio University and a bachelor's degree in economics from Yale University.
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DISCLOSURE:
1) George S. Mack conducted this interview for The Life Sciences Report and provides services to The Life Sciences Report as an independent contractor. He or his family own shares of the following companies mentioned in this interview: None.
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3) Jason Mills: I own, or my family owns, shares of the following companies mentioned in this interview: None. I personally am, or my family is, paid by the following companies mentioned in this interview: None. My company has a financial relationship with the following companies mentioned in this interview: Spectranetics, Sunshine Heart Inc., Vascular Solutions Inc. To view full disclosures, click here. I was not paid by Streetwise Reports for participating in this interview. Comments and opinions expressed are my own comments and opinions. I had the opportunity to review the interview for accuracy as of the date of the interview and am responsible for the content of the interview.
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