All Research | EthicalEquities

Nanosonics (ASX:NAN) FY 2019 Results Analysis: Shortsellers Ruthlessly Owned

Claude Walker — Tue, 27 Aug 2019 22:41:56 +0000

Nanosonics (ASX:ASX) FY 2019 Full Year Results Analysis

We joined the Nanosonics (ASX:NAN) journey at Ethical Equities when we published this report predicting a short squeeze last year, when the price was around $2.60. Yesterday, the company, which sells the Trophon device and associated consumables, has delivered a record full year result for FY 2019. That saw its share price spike 32% to close at $6.50. You can hear me outline the (old) short squeeze thesis at around 18min 30s in this podcast.

For the full FY 2019 year increased 39% to $84.3 million, with installed base of the Trophon grew across all regions. As you can see below, the company is continuing to grow revenue strongly, albeit not smoothly, due to changes in selling model and the release of the Trophon 2. It just so happens the second half was an improvement on the first half, in terms of revenue, but not in terms of profit, as you can see below.

Note: This post was supported and assisted by Strawman founder, Andrew Page. I recommend Strawman as the best ASX stock forum available.

As you can see below, the number of Trophon units installed in North America continued its long term climb to reach 18570, with the growth rate steady at about 1500 per half.

Nanosonics has 75% market penetration in Australia and NZ, and is finding much growth there anymore, but on the conference call the CEO said that he sees no reason that the company cannot reach a similar market share in the USA. At current (absolute) growth rates, that implies around 10 years of growth in the US (albeit with a declining rate in percentage terms). So, a long runway remains.

Looking to Japan, the CEO reminded listeners that they do not have guidelines for adoption there (which are required to compel purchasing of high level infection control devices like Trophon.) However, he said, "things should start kicking in very positively from 2021”, which implies he thinks that "the fundamentals for adoption", as he calls them, are falling into place.

On top of that, the company has taken over the distribution of its consumable products in the US from July 2019. That means that instead of selling its consumables through GE for some of its customers, it will sell consumables directly to customers and get a better margin. The impact of this margin uplift is expected to be fully felt in the second half of FY 2020.

Importantly, however, operating expenses grew by around 15% in 2019 due largely to a 27% lift in headcount and an increasing R&D spend. The company said costs would increase significantly in the current year, forecasting $67 million in operating expenses (a 36% increase) for FY2020 as the business readied itself for its “strategic growth agenda”. That includes new products, sales & marketing and business development. We now expect the second product to be announced in the 2020 financial year, and note that this is expected to weigh heavily on profit in the short term.

While the company did achieve record profit before tax and revenue in FY 2019, we note the (significant) exchange rate benefit in these results. Without that, revenue growth would have been 29% instead of 39%. This benefit is unlikely to be repeated and may in fact reverse in future periods, so it would be unwise to build a model based on sustained growth at those levels.

On the call the CEO said that the impact of upgrades to Trophon 2 was “quite minimal during the year… probably sub-100” in the US. That means the capital sales in the US were new installed growth and what they sold to GE into their inventory. This bodes well for the company's prediction that growth in capital sales remains at constant absolute levels. Over 30% of the current installed base is due for renewal in the next two years, and that replacement cycle, even if not well conformed to, should help.

Buy, Hold, or Sell?

Nanosonics is a profitable business with over $72 million in cash on hand. However, after the share price pop yesterday it has a market capitalisation of $1.95 billion, giving it an enterprise value of $1.88 billion. Against that, it produced free cash flow of $2.6 million in FY 2019, putting it on an astronomical EV / FCF ratio of 722. The company is now trading on 22 times revenue, which is pretty phenomenal given it is a medical device maker, rather than the sexiest software stock you've seen.

For contrast, Resmed (ASX:RMD) the sleep apnoeia device maker, trades on around 8 times sales and Cochlear (ASX:COH), the hearing implant company on around 8.5 times sales. For Nanosonics, even if we bullishly assumed 30% revenue growth for five next five years, and some margin improvement, returns from here would arguably be lacklustre.

As I have previously disclosed, I had already begun selling my Nanosonics shares, at lower levels. For the last year or more, I have been holding on to Nanosonics stock because I believed, correctly as it turns out, that the people who had short sold 13% of the company when the share price was under $3 would receive a severe lesson and be forced to cover at higher levels. With short interest now sitting at about 3%, that thesis has largely played out.

As such, I intend to take more profits from Nanosonics after publishing this report. Because I believe Nanosonics is a great quality company, I will almost certainly be retaining a small holding, so that I remain engaged with the business and capable of understanding it properly. I would very much like to participate in another short squeeze of such epic proportions in the future. I'll take an 100%+ gain in about a year whenever I can.

However, I strongly believe that the company is very generously priced at current levels. While the business could continue to perform very well over the long term, and the stock could become even more richly valued, to quote Andrew Page, "should growth not materialise as expected, the downside could be severe." He too, has taken some profits.

Nanosonics is a high quality business that is making the world a better place by reducing the transmission of the HPV virus, among others. That in turn reduces the number of people who get cervical cancer. That is very considerable pain and suffering alleviated. At current share prices, I will be doing some selling for sure, but am unlikely to sell out completely. I will likely sell in only small increments, as I am enjoying the sport of watching to see how ridiculous the price can get, and basking in the glow of what has to be one of the most satisfying short squeezes I have ever seen.

Thanks again to Andrew Page for helping with this article. We recommend you continue the conversation over at the Strawman forum for Nanosonics.

For occasional exclusive content, join the FREE Ethical Equities Newsletter.

Disclosure: Claude Walker owns shares as disclosed and will not buy any for at least 2 days after publication (but does intend to sell a few as disclosed).

This article does not take into account your individual circumstances and contains general investment advice only (under AFSL 501223). Authorised by Claude Walker.

If, somehow, you are not already using Sharesight, please consider signing up for a free trial on this link, and we will get a small contribution if you do decide to use the service (which in turn should save you money with your accountant, or time if you do your own tax.)

"The Ethical Equities website contains general financial advice and information only. That means the advice and information does not take into account your objectives, financial situation or needs. Because of that, you should consider if the information is appropriate to you and your needs, before acting on it. In addition, you should obtain and read the product disclosure statement (PDS) of the financial product before making a decision to acquire the financial product. We cannot guarantee the accuracy of the information on this website, including financial, taxation and legal information. Remember, past performance is not a reliable indicator of future performance."

Three Wise Monkeys Podcast: MNF Group (ASX:MNF), Pro Medicus (ASX:PME), Appen (ASX:APX), Nanosonics (ASX:NAN), A2 Milk (ASX:A2M) and Webjet (ASX:WEB)

Claude Walker — Fri, 01 Mar 2019 02:37:40 +0000

The latest episode of the Three Wise Monkeys Podcast is out now. The pint-size chimps cover MNF Group (ASX:MNF), Pro Medicus (ASX:PME), Appen (ASX:APX), Nanosonics (ASX:NAN), A2 Milk (ASX:A2M) and Webjet (ASX:WEB) in an action packed earnings season episode.

Listen to episode 15 on Soundcloud here.

Or, if you prefer, subscribe to the feed on iTunes by clicking here.

Please feel free to sign up to the forums and let us know what you think!

For early access to our content, join the Ethical Equities Newsletter.

Disclosure: The Author, Claude Walker, owns shares in all the above-mentioned companies, at the time of publication. This article contains general investment advice only (under AFSL 501223). Authorised by Claude Walker.

Nanosonics (ASX:NAN) Grows Profit: 1H 2019 Half Year Results

Andrew Page — Tue, 26 Feb 2019 03:25:24 +0000

Nanosonics (ASX:NAN) Grows Profit: 1H 2019 Half Year Results

Disinfection specialist Nanosonics (ASX:NAN) has posted another record set of numbers for the first half of 2019, with revenue climbing 36% higher to $40.7m. Pre-tax profit was 195% higher at $11m. You can see in the chart below that the company has quite lumpy profits, but there’s no denying the revenue was good this half.

Driving the gain was a 20% boost to the installed base of the groups main product (Trophon), which now sits at 19,310 units, as well as a 59% rise in the level of consumables/service revenue. Indeed, the latter is an especially encouraging result as it is here that Nanosonics derive the majority of revenue (~60%), has the best margins, is recurring in nature, and for which there remains significant pricing power.

Remember, too, that from July this year management have indicated they expect a “material” increase in both volume and margin for consumables, as the new distribution agreement with GE comes into effect.

Looking across the various operating geographies, Nanosonics reported strong, double-digit gains in all areas, with the US (easily the largest at over 90% of revenues) reporting the strongest increase with revenues there up 37% on the previous corresponding period, and consumables sales up 64%.

Encouragingly, for the full year, management expect the North American installed base to expand by a similar amount to FY2018. That implies a fleet of over 18,500 by July 1, 2019. Given my estimate of annual consumables sales per device, that would indicate a full year revenue run rate of over $50m for the US alone at year’s end.

As you can see below, the installed base is still growing, but the rate of growth is decreasing, with just 1400 added in the last half, down from 1520 the half before.

When you consider that Nanosonics has only 43% of the potential market opportunity in North America, and has barely entered into other key geographies, you can begin to see why the market has been prepared to give shares in Nanosonics such a hefty premium. For example, the business estimates it has only 2% of the total addressable market in Europe and 4% of the Asia Pacific market.

Then we have the launch of new products (the first of which is expected in another 16 months or so), the replacement cycle for older units, and increased pricing and margins. Oh, and the business remains debt free with an increasingly large mountain of cash -- about $71m as of the latest half.

All that being said, there are some things to be mindful of.

The growth in revenue was exacerbated by the fact that the previous corresponding half was depressed due to the then imminent release of the next generation Trophon product. Resellers were running down inventory and customers delayed orders in anticipation of the newer device, which saw HY2018 revenues slump ~17% from a year earlier.

In comparison to first half 2017, revenues for the latest 6-month period were a more modest 12.7% higher. That’s an annualised growth of ~6%.

Further, although the installed base is still expanding strongly, the pace of growth continues to slow. At the end of FY2018, the annual growth in the Trophon fleet was 25%, or 11% over the preceding 6 months. That compares to 20% and 9%, respectively, for the latest half.

Of course, that’s nothing to sneeze at, but we must be mindful that the lower hanging fruit is typically picked first, and that growth rates always moderate as businesses penetrate further into maturing markets.

The real concern for me, however, has nothing to do with the business. Following a warm response by the market to the latest results, I fear shares are priced for perfection -- and then some.

Now, it’s usually a mistake to get too fussy with high quality, fast growing companies that enjoy very large and untapped addressable markets. Especially for those that can grow the top-line without a corresponding boost to operating costs.

That being said, on a pro-rata basis, shares in Nanosonics are trading at ~15x sales. Based on full year guidance for operating costs, and making some reasonable assumptions around margins and sales growth, the company is on an EV/EBIT multiple of over 100.

Let’s cut it another way. Assume that the installed base continues to grow at 20% per annum for the next three years, and the company lifts its average consumables sales per device to $3000 per annum. We’ll add in $20m in capital sales, apply a operating margin of 75% and keep the cost base unchanged at $50m per annum.

Even with these (very) ambitious assumptions, we’d need Nanosonics to attract an EBIT multiple of at least 30x in 2022 for the current market price to represent reasonable value.

That’s not impossible. Indeed if Europe or Asia experience the same kind of traction as we’ve seen in the US, or new products enjoy a similar success to the Trophon device, we might be under-baking things. But the fact is that a lot of things need to go right for investors at today’s price to get an adequate return on investment. And although new products and geographies hold great promise, they invariably bring added costs and risks, too.

I’m also mindful that nothing attracts competition like high margins and staggering growth. Despite a solid competitive lead and various patent protections, it’s difficult to imagine that Nanosonics will have this market all to itself indefinitely. In the long run, everything is a toaster.

As much as I’m a fan of the business, and it remains a major holding, the risk/reward proposition is becoming far less compelling. So while there’s a real danger in being too fussy with these things, it’s equally reckless to ignore all valuation considerations entirely. It's certainly nice to see the share price action given the stock has proved popular with Strawman users, ranking on the market-beating Strawman Index, even prior to these results.

For more detail, and alternate perspectives, visit Strawman.com

Disclosure: Andrew Page and Claude Walker own shares in Nanosonics at the time of publication. Neither Claude nor Andrew will trade NAN shares within 2 days of publication of this article. This article contains general investment advice only (under AFSL 501223). Authorised by Claude Walker.

Three Wise Monkeys Podcast #4: Nanosonics Limited (ASX:NAN) and Afterpay Touch Group Ltd (ASX:APT)

Claude Walker — Wed, 28 Nov 2018 21:06:54 +0000

With brand new microphones we sound out Nanosonics Limited (ASX:NAN), and discuss our reservations -- but also what we like -- about Afterpay Touch Group Ltd (ASX:APT).

Andrew draws on his own experience with infection control (sweet pick up line) to inform his view of Nanosonics, and I recall my early experiences with Afterpay. For the record, the first time people pay with Afterpay, repayment is over 6 weeks, but the second time it's over 8 weeks (because the timing of the first payment varies). So don't tell him, but Matt was at least half right on that one. And finally, I can confirm that Batch Brewing Co still makes good beer.

You can listen to this episode on Soundcloud by clicking here.

Or, if you prefer, subscribe to the feed on iTunes by clicking here.

Claude

Please feel free to sign up to the forums and let us know what you think!

For early access to our content, join the Ethical Equities Newsletter.

Disclosure: The Author, Claude Walker, owns shares in Nanosonics at the time of publication. This article contains general investment advice only (under AFSL 501223). Authorised by Claude Walker.

EDIT

Sticking With Nanosonics (ASX:NAN): FY 2018 Results

Claude Walker — Wed, 22 Aug 2018 12:38:40 +0000

Disinfection specialist Nanosonics (ASX:NAN) has delivered an 11% drop in sales and a 60% decline in pre-tax profit for the full year ending June 30, 2018. That’s a big decline, but these headline numbers mask what’s really going on.

In the first half, Nanosonics sales were down 17%, a result that was attributed to a particularly strong prior period in which a major distributor undertook a large restocking. The previous corresponding half also benefited from a one-off tax benefit to the tune of $10m.

So it was always going to be tough besting 2017’s full year results. That challenge was made more difficult as distributors and customers delayed orders in anticipation of the Trophon 2 unit, which is being launched this month (earlier than originally anticipated). That left sales growth flat, half on half.

While I’m generally sceptical of excuses for lacklustre sales growth, this issue was flagged back in April when the company first received FDA approval for the second generation Trophon device. Very clearly, in fact.

Another factor is that an increasing number of units are being sold under a Managed Equipment Services (MES) or Rental basis. This greatly reduces the upfront revenue received, but is offset by much greater recurring consumables costs over the term of the agreement (it also lowers the barriers to purchase).

As for the much larger drop in profit, that’s explained by a significant ramp up in costs. For the full year, operating expenses were 15% higher, with the 4th quarter costs almost 44% higher than those expensed in the first. In the current year, management expects costs to come in at $53m, a further 24% jump on last year’s level. Around $13m of this is slated for R&D.

The rationale for the increased operating costs is that they are expanding their headcount to accelerate sales and product development, as well as funding the move into new regions -- a perfectly sensible thing to do as an investment in future growth, but one that doesn’t always work out. Plenty of fast growing hopefuls have misstepped with poor cost control (e.g. catapult).

Given the demonstrated efficacy of the Trophon product, it’s rapid adoption in leading markets, regulatory tailwinds and the advantages of being a first mover, this seems a justifiable move by Nanosonics. But it's something to watch.

What’s core to the bull case on Nanosonics is that the installed base of Trophon devices continues to grow at a sufficient rate. Each machine creates a very high margin recurring revenue stream (I estimate at least 75%) -- one that can be expected to last around five to seven years, with a high rate of retention at the end of the period.

To that end, we saw a 25% boost to the installed base, with a commensurate increase in revenues from consumables. There were 3580 new Trophons in use at the end of June 2018, 90% of which came from the US. That’s down on the 4030 adds in 2017 and the 3880 added the year before that (again explained by deferrals relating to Trophon 2).

With expanded sales resources, new regions and plenty of runway ahead in existing markets, it's not hard to imagine the installed base to grow by at least 4,000 units per year for the next few years. That’ll be supported as the replacement cycle ramps up; at present around 20% of the fleet is five years or more old.

Nanosonics has previously said that each unit generates around $3000 in consumable sales per year. On the numbers provided in the latest results, that number now looks closer to $2200 (that’s a rough estimate; different sales models, a shifting maturity profile, and different regional pricing make it difficult to know exactly).

But as newer units ramp up and as the sales mix shifts towards MES and rental models, we can expect consumables sales per unit to rise. That’s especially true next year when the new agreement with GE kicks in -- one that will see a “material increase in both consumable sales and margin in North America as of and beyond July 2019”.

Altogether, Nanosonics could be churning out at least $75m per year in high margin recurring revenue by 2021. Likely another $30-40m or so in capital sales (when accounting for FX rates), and still with a lot of potential for expansion. That’s before you assume revenues for any new product releases (they are hoping to have one or two new products by the end of FY2020).

Importantly, Nanosonics remains debt free, is cash flow positive and has $69 million in cash. It seems extremely unlikely that they will need to raise capital to pursue their growth plans, and should get a high return on retained equity.

I’d go as far to say that the business is as close to recession proof as you can get, at least for the consumables sales. Moreover, it has very little exposure to the domestic economy.

So I’m not too concerned at all by the latest results. In fact, the business’ prospects remain as attractive as ever.

That being said, adjusting both operating costs and unit economic assumptions have led me to lower my fair value estimate.

I reckon Nanosonics is worth around $2.80 per share (down from $3), though that could prove too conservative if sales growth accelerates (and visa versa!). Check out my forecast on Strawman.com for more.

Despite the very high quality nature of earnings and exciting growth potential, shares in Nanosonics are trading on more than 17 times sales. The PE is 183. Growth needs to be extremely strong to justify these multiples. And, if there are any speed bumps along the way -- as there often is -- we could see some pretty significant swings in market price.

I’ve learnt the hard way that you shouldn’t be too fussy on valuation when it comes to high quality businesses, and I’m very much in Nanosonics for the long term. So despite my view that shares are now above fair value, I’m not tempted to sell just yet.

We could easily see shares jump much higher in the short term given current market conditions (who knows?!). But I wouldn’t be tipping any new money into the business at these levels.

A patient investor will likely get a better buying opportunity in the future. If and when that occurs, and assuming the installed base continues to grow as expected, it’s an opportunity to be pursued with gusto.

I will not trade shares within 5 days of publication of this report.

A note from Claude: I’m very glad to have this fine coverage of Nanosonics from Andrew. I note he has made detailed forecasts available. While I may make slightly different assumptions around the numbers, I think his is a high quality and thoughtful analysis. Andrew bought Nanosonics well before I did, but we both bought more at around $2.50. Like Andrew, I am not buying at current prices. And like Andrew I plan to hold my shares at current prices. I will not trade shares in Nanosonics within 5 days of publication of this report.

For early access to our content, join the Ethical Equities Newsletter.

Disclosure: Andrew Page and Claude Walker own shares in Nanosonics at the time of publication. This article contains general investment advice only (under AFSL 501223). Authorised by Claude Walker.

Nanosonics (ASX:NAN) Share Price Popping On Short Squeeze

Claude Walker — Wed, 15 Aug 2018 00:00:15 +0000

A major reason to study short-sellers is that a weak short thesis can create opportunities to buy underpriced equity.

Case in point is Nanosonics Ltd (ASX:NAN), the maker of the Trophon EPR, a mechanical unit that uses nanonebulant disinfectant to more effectively and efficiently sterilise ultrasound probes.

The company recently saw its share price sold down to about $2.30, as you can see below (click to enlarge).

(Think this graph looks cool? Try Simply Wall St)

While markets are said to be a weighing machine in the long term, they are a voting machine in the short term. Short sellers can temporarily depress a share price because they borrow stock and then sell it, creating artificial supply. Unless existing buyers buy more shares -- or new buyers emerge -- the share price will therefore drop, all else equal. Notably, the market ‘voting machine’ allocates votes not according to skill or intelligence but simply according to the amount of capital ‘voters’ are willing to sink into an investment thesis (whether long or short)

So when market participants with plenty of capital get the wrong idea about a company, and decide to short-sell it, there is the potential to predict a short squeeze. Here’s how I think you can spot a short squeeze.

The Start Of A Squeeze

Throughout 2018 I observed the short interest in Nanosonics gradually build. The chart below shows that as the short position was built at a time when the share price ranged from about $2.40 - $2.90, with most volume trading at around $2.50 - $2.70. By April, some 14% of the company was sold short at around that price.

On Thursday 26, April, the share price spiked down to below $2.30, just as the short interest spiked up to its peak, on the chart above. This suggests that the short seller dumped shares in the hope of generating irrational selling.

On April 27, when the share price jumped back, it seemed likely that the jig was up, and the squeeze was beginning. And I wondered aloud whether it was on.

I wonder if the shorts are feeling the squeeze... #ASX $NAN

Disc: long pic.twitter.com/s789pFq2Ne
— Claude Walker (@claudedwalker) April 27, 2018

With short interest having dropped from 14% at $2.30, to 8% and $3.30, it’s clear that some of the share price rise is attributable to capitulation by short sellers who now have to buy back the stock at higher prices. Yesterday, the price popped to $3.44: new twelve month highs. In large part, the move has been driven by substantial holders JCP Investment partners, who were buyers at recent lows but have recently reduced their holding above $3. Their deep pockets frustrated the short sellers at the bottom. But it is almost certainly shortsellers capitulating that is driving the share price today.

Do Your Research

Of course, the key ingredient in a short squeeze is that there is no credible short thesis. A credible short thesis is required to convince shareholders that the stock is overvalued. Otherwise, the potential gains from short selling will be limited by buyers who see value.

When Nanosonics short interest started to grow I was confused. Typically good short sellers will target a company with severe weaknesses or rampant overvaluation. While Nanosonics doesn’t produce steady earnings, the company has over $60 million cash in the bank, has around $60 million in revenue per year, and could easily make a profit if it reduced investment in new products. It seems likely that -- at current highs -- the stock is somewhat overvalued. I wouldn’t be surprised if it drops on earnings, but I also think that it makes sense to buy this stock at around $2.50.

I put the feelers out to see if I could find the short thesis for Nanosonics. I had numerous helpful suggestions -- slowing revenue growth, over reliance on GE Health as a distributor, the fact that its patents will expire, and the likelihood of losses as the company launches the Trophon 2, and its (as yet unspecified) new product. I asked the CEO and CFO, but they were none the wiser. Importantly, however, they did not seem overly concerned about it. This is a crucial tell: those with serious skeletons in the closet are typically extremely worried to learn someone has a financial interest in shining a light on them.

As the trade started to move against the short sellers, one would expect that if there was a compelling short thesis, they would have published it. Instead, around half of the short positions have been covered, mostly at higher prices. Whatever happens when Nanosonics releases its full year results, it seems like a stretch that this will be a particularly profitable trade for the short sellers. This is particularly true because long term shareholders are unlikely to want to sell before the company reaps the benefit of taking over the direct sale of its consumable products, such as the disinfectant solution that the Trophon uses.

Nanosonics will be taking over the distribution of the consumable products from July 2019, and that will bring higher margins on the largely recurring ‘blade’ part of the ‘razor + blade’ business model. The uplift is likely to be very material, and recurring.

In the short term, Nanosonics could well disappoint. It has communicated well that a number of factors will mute revenue growth. It is increasingly moving to rental style agreements, which reduce capital sales, and the new version of the Trophon could cause a destocking event with GE Health. On top of that, unit sales have been slowing a little, as the low hanging fruit is already converted.

When I recommended it to members of Motley Fool Hidden Gems at around $2.55, there was minimal chatter about Nanosonics. Today, the herd has veritably arrived; twitter awash with tweets about Nanosonics. Sentiment is high, and the shorts won’t have to keep covering forever. But it could go higher still.

I’m an investor in Nanosonics for the long term. My position is not so large that I need to reduce it, and I am not inclined to try to trade around sentiment. This stock could certainly go higher from here -- and eventually, I think it will.

But whereas I would happily accumulate shares in the company (all else being equal) at around $2.60, I am certainly not buying at this price. But I’d consider Nanosonics to be worth holding. Now is the time for long term investors to sit back with the popcorn. Spare a thought for squirming short sellers -- we need them to have a healthy market.

For early access to our content, join the Ethical Equities Newsletter.

The Author of this piece, Claude Walker, owns shares in Nanosonics. This article contains general investment advice only (under AFSL 501223). Authorised by Claude Walker.