I have finally rebuilt my valuation of $PNV. The reason for the challenge in doing it, is that the change in sales & marketing strategy since Swami came onboard as CEO. This has driven the need to create an entirely different way at looking at both sales growth and contribution margin - the dual push on developed and developing markets means that modelling performance by averaging key metrics means you lose sight of what is going on. So the model needed a total rebuild.

Estimated Value $2.00 Range [$1.63 - $3.30]

Based on 9 scenarios, I arrive at an expected value/share of $2.00, and an estimated p10%-p90% range around this of [$1.62 – $3.30].

This is a significant downgrade from my prior valuation $2.46 [$1.63 - $3.28] from September 2022. However, what is interesting is that the upside and downside ranges are largely unchanged (albeit also reduced about 10% given the passing of a year.)

Revenue Growth

Revenue growth is modelled driven by sales force expansions aggregated into separate Developed Markets and Developing Markets buckets.

• Developed market performance starts with average sales per rep of $0.811m p.a.
• In Developing markets, realised prices are modelled at 25%, 30% and 35% of developed market prices (see “Commentary” at end of this Straw). At this stage we don’t really know what the net sales values will be in these markets.
• Costs and Revenues are subject to constant annual inflation (2.5% developed markets and 5.0% in developing markets.)
• Like-for-Like growth: As more and more indications for Novosorb become accepted and applied, the value of each account is expected to increase, and each saleperson become more productive by accessing more clinician-customers at each hospital visit. Research publications indicate that we are still very early in this process of adoption. On average, an annual “Learning” growth factor is applied to each Sales Rep across a range from a minimum of 3% to as high as 7% across different scenarios. This is one of the most important value drivers. (Hence DW is actually getting investor to focus on the right information in emailing around clinical review studies showing the increasing breadth of clinical applications.) In truth, I have no idea what the appropriate learning rate is. However, as an indication at the expected valuation, a 1% increase in annual learning at the mid-range leads to a $0.30/share increase in valuation. Wow! The best way of tracking this metric is by continuing to focus on the number of sales reps in the USA and the value of US sales. (Swami has said from day 1 that $PNV has to stay close to the physican customers to understand how they are innovating in their use of the product. That's why.)
• Sales and Marketing costs have been estimated by calculating: benchmarks market rates, adding allowances for super, health insurance, seniority mix, incentives and applying a a ratio of one marketing FTE per 7 sales FTEs. A non-FTE sales and marketing expenses factor of 12% revenue has been applied (this covers everything from advertisements, free sales, to conferences and flying opinion leaders around the world.) This is likely to be on the high side, but I have modelled a range of expense growth scenarios to accommodate this uncertainty.
• In developing markets, a 2023 cost for a sales rep. has been estimated at $40k p.a.. This is probably on the high side for current costs in India (as quoted by DW), but over the 10 years the model assumes expansion to all major cities in middle income countries across Asia, Central and South America and the Middle East. The valuation is not hugely sensitive to this assumption.

The output from the Revenue Growth and Sales and Marketing modules is shown in Figure 1 for one scenario, below.

Figure 1: Revenue and Sales and Marketing Headcount for one Scenario

It is worth commenting that I have followed a cautious approach to the build-out of developing markets that may not stand the test of time. For example, in 2023 a team of 22 people has been established in India within months of market entry, with as yet no material sales. By contrast, the combined UKI and ANZ sales teams number only around 13, with combined annual sales of around $7-8m.

As a result, I follow a more cautious build-up in the developing market sales force over time. These reach a total workforce of between 160 to 320 by 2033, with a contribution of 13% of total 2033 revenues in the most conservative to an upper case of 26% in the most aggressive case, with 20% shown in Figure 1 above. This is somewhat at odds with the rhetoric we’ve been hearing from Swami and David over the last 12 months. However, I want to see proof that developing markets can make a meaningful margin contribution before setting too much of my investment thesis against that.

It is getting to grips with the new prominence of India (in particular) and developing markets in general that has given me the most pause for thought in modelling the updated strategy.

In my earlier September 2022 valuation, I assumed a more aggressive approach to Europe and other high value markets like Japan, South Korea, and Taiwan. So, as far as my valuation is concerned, the change of strategy has lopped $0.40-0.50 off my valuation. That is the price of me NOT sharing Swami and David’s conviction. I may well be wrong and will be happy to be so proven!

Cost Growth – R&D and G&A

In all scenarios I assume a moderation in the % rate of cost growth of the company, which over recent years has really been in a start-up mode. David and Swami should demonstrate this disciplined as they are now under pressure to breakeven this year and show a meaningful profit in FY25.

While expenditure on R&D and G&A both grow strongly throughout the 10 years modelled, I assume $PNV remains a highly focused company selling only variants of the Novosorb product (BTM, MTX, etc.). This allows for a highly-focused organisation and cost structure which achieves exceptional net margins.

Figure 2 shows the projected evolution of expenses as a % of Revenue. In Scenario 6 (shown), the 2033 Net Margin is 32%. The range of modelled scenarios yield net margins are 30-36%. This compares with a Net Margin in 2022 for competitor $IART of 12%. Good net margins in medical devices are more typically in the range of 10-20%. So how can this possibly be?

The answer lies in the high gross margin (93% in FY2023 for %PNV). Medical device companies more typically achieve gross margins in the range of 50% to 65%, with $IART achieving 64% in FY22. Thus, $PNV has a very material Gross Margin advantage, providing headroom over the competition of a full 25-30%! That's massive.

This positions it well to respond to competition, as other synthetics will inevitably emerge over time. (To be fair, David has been banging on about this for the 5 years+ I've been following the company, and it was only over the last weeks when I did some detailed industry benchmarking, that I realised how important this is.)

Figure 2: Evolution of Expenses (Scenario 6: $2.16/share)

Looking at the % expense/revenue structure modelled in the above scenario in 2033 and comparing it with $IART in FY22:

• R&D of 8% at $PNV compares with 6% at $IART
• SG&A of 36% at $PNV compares with 40% at $IART (with the latter a much more complex business)

Of course, $IART is a much larger company with a much more diverse product portfolio, so the comparison is limited. However, what $PNV lacks for in economies of scale, it can be argued to recover in its narrow product focus.

(*As a "post-production note": I've probably been a bit aggressive on $PNVs G&A, so will address this next time. In the case illustrated above, if 2033 G&A/Revenue is more like 12%, then value is reduced to $2.04.share)

Total R&D spend over the 10-year modelled period amounts to over $200m (nominal), however, no new products are assumed beyond new variants of Novosorb, such as MTX. It is assumed that significant funds should be spent in supporting studies to broaden the range of product indications, and providing tailor variants, like MTX.

New products for applications in breast, hernia, other internal procedures, and drug elution are all still assumed to be “blue sky” upsides, even though this is where the lion's share of the R&D spend will do. So, there are significant potential upsides for the business that have not been contemplated in these valuations.

This level of R&D investment without an explicit revenue stream justifies the continuing value annual cashflow growth beyond 2033 of 5% p.a. (However, this might be conservative if $PNV is successful in positioning itself in developing markets. Here, although revenues are low by comparison to developed markets, growth rates are very high.)

Gross Margin (GM) Evolution

Historically, $PNV has achieved %GM ranging from 91% to 95%. With the proliferation of product variants and lower price realisations in emerging markets, I assume 93% represents a cap on future gross margins. As the new facilities come onstream in 2025, lifting sales capacity to $500m, I assume %GM falls to 91% as the existing sales bear the fixed costs of the larger production facilities, before returning to higher values as plant utilisation ramps up.

Capex

Capex has two drivers: "base PPE" capex and investment in new production facilities.

Base PPE capex is assumed to grow proportionately with sales.

Expansion of new production facilities occurs in two tranches: $30m capex to scale up to $500m total sales (current reported cost is $25m), and I've assumed a further $40m to scale up to $1000m total sales.

Timing of expansion capex is driven by revenue growth assumptions.

Common Assumptions

WACC = 11%

Inflation = 2.5% (5% in developing markets)

Effective Tax Rate = 30%

Shares On Issue = 1% growth p.a.

Capital Leases grow proportionately with G&A

Working Capital grows proportionately with Revenues

All R&D expensed

Cash Flow Growth in Continuing Value Period = 5% p.a.

Valuation has been performed on a 100% Equity basis - no debt. As the business scales it will make sense to put in some long term debt. $IART by comparison has Net debt/EBITDA of about 2.4x. However, at this stage in its evolution, I prefer to consider the business as 100% equity funded.

Commentary on the Analysis

Developing Markets

With the current push on India and with China to follow the Hong Kong beachhead (3 out of the 4 major hospitals already signed up), $PNV is entering new territory, so all the developing markets analysis is a placeholder. I have, however, tried to err on the side of conservatism. At this stage we have no idea what contribution margins might be achieved.

So let me put this my reservations in context, because I suspect Swami and David would disagree with my analysis. The US medical devices market is c. $164bn p.a., around 3.4% of the US Healthcare Spend. The Indian medical devices market is around $6bn p.a. That’s less than 4% of the US market. In the US, average annual healthcare spend per person is c. $15,000. In India, it is $101.

I understand the clinical and humanitarian imperative to bring lifesaving and life-enhancing treatments to developing markets. And I support it. My point in writing here, is that I can’t at this stage model the economics for $PNV in developing markets with any confidence. The strategic shift in the priority of market rollout has chopped about $0.50 off my expected valuation. Only time will tell it that’s reasonable.

US

The US is a potential concern. With a salesforce now in the region of 80 in the US (up c. 50% on end FY22) to have seen only 34% constant currency sales growth in FY23 over FY22 raises a question mark. None of the analysts appear to have picked up on this, so far as I can tell. But it is the key result I'll be focused on in 1H FY24.

It is this question-mark which leads me to be cautious on the ultimate potential of the US market. (I max-out the US sales force at 150 reps. at about 2030. If US sales growth of >30% p.a. can be sustained for a few more years, then I will revise this upwards next year.) This upside possibility is not fully accounted for in my range of scenarios.

Europe

For me, Europe remains the untold story. UKI was a big surprise in FY23. Growth of +169% means this must be getting to total of around $3.50m-$4,0m in sales. (Of course, by comparison to ANZ, an equivalent penetration would be more like $12m at a comparable stage, so there is a lot further to go.) Germany grew +192%, but this is via a distributor, and off a very low base as to probably not be meaningful.

Still, UKI and the EU is a high value market of some 450 million people and, even though a smaller $ market in aggregate than the US for medical devices overall, it is still very significant and largely untapped by $PNV. In all my scenarios, I assume a direct sales model for Europe but a slower build-up over the 10-year period. So, there is the potential for upside to all scenarios, particularly if the latest UK experience leads to management getting more serious about Europe. (C’mon on Swami, you can do it!)

Ongoing Visibility

It looks like $PNV are going to disclose sales on a US and RoW basis only going forward, with scatterings of informal disclosures to highlight individual market milestones or successes. I don’t like that because RoW is going to be a blend of 1) long term developed markets (like ANZ and UKI), 2) new developed markets like (EU, Canada, and Japan) and 3) developing markets, primarily India and China. This is going to make it hard to track how things are going for us analysts. However, the good news is that the US will give good insights into clinical adoption, market penetration and competitive positioning … and for the rest, we’ll just have to extrapolate! Hopefully, we will soon be able to get intelligence on realised prices and volumes in India.

Range of Modelling Outcomes

Below in Figure 3 is a summary of the valuation outcomes. I’ve equal-weighted each of the 9 scenarios, and from the graph been able to read off p10, p50 and p90 estimates of value.

Table 1 summarises some of the key valuation metrics and multiples.

What I do know from all the modelling is that higher valuations can easily be achieved, and it is much harder to drive downsides much below the $1.40 - $1.50 range. This is the same conclusion I reached in 2022.

So, I am comfortable that today $PNV is significantly under-valued. It remains my largest SM position and at the top of my conviction list in my high risk holdings.

In RL, the great progress of $WTC, $ALU and $TNE (plus my doubling-down on $RMD against the shortselling-thesis), means it now only sits in 6^th position at 4%. It is tempting to add more at these prices; however, it remains a risky proposition with a lot of execution risk. Often the best investment strategy is to do nothing.

Figure 3: Outcome of Valuation Modelling Scenarios

Table 1: Summary of Key Valuation Metrics*

* Note that the High value of $3.62 is higher than my quoted upper limit of $3.30. This is because the valuation range is read off the above chart at the p10% and p90% levels, and ignores any extreme individual valuation results.

Disclaimer

The above analysis is not valuation or investment advice and is for my personal purposes only. It is provided for information and to stimulate debate. The analysis is not validated to be free from errors.

Disc: Held in RL and SM