In this note, I review what happened in Modern Dental since I published my write-up in April last year. I then address the main concerns that investors considering investing in the stock have.

I went to a new dentist last week, and as usual, I tried to chat about everything dental investment-related with my dentist. The comments from my dentist nicely tie into other discussions I had with investors interested in Modern Dental Group (MDG) the past months. One of those was a 45 min call with a European based fund manager that wanted to discuss the threats to MDG’s business model, so I thought I’d also share these thoughts here.

But first, a quick recap what happened company-wise since I published my write-up on the company back in April last year.

Revenue numbers

As Hong Kong has semi-annual reporting, not all numbers are available on a quarterly basis, but MDG does, on a voluntary basis, release some quarterly data. After the volatile Covid period, MDG has come out as a stronger company with a nice upward trend in revenue:

Below is my favorite chart to keep track of MDG:

As we can see the European region is really on fire, whereas North America continues to disappoint, and Great China (with a lot of Hong Kong exposure) is even declining. From a low level, AU/NZ is growing nicely and Others growth is related to the acquisition of Thai dental lab Hexa ceram, more on that later.

Concluding, revenue growth looks solid, but under the hood, it’s created quite unequally. How about profits? One of my main arguments in April 2024 was that the increased usage of digital intraoral scanners would lift margins. Has this happened? Yes but perhaps not only due to intraoral scanners.

Profit

As we can see, the lift-off did not come immediately in 2024 when I did my write-up, but we had to wait until the first half 2025 profits for lift-off. The red bar is based on Bloomberg estimates for the second half profits, my own estimates are even higher.

And the stock price?

With Hang Seng ripping in Sep 2024, ironically Modern Dental did the opposite and visited the lows around HK$3.5. Then proceeded to tread water until the recent blow-out results were released. But overall, Modern Dental is still far behind the Hang Send Index since April 2024. I would argue though, that HSI is not a good benchmark for MDG, which is mostly a European business by now. I initially presented this stock idea on my old blog in Dec 2018. The stock chart looks slightly better when we zoom out a 22% 7 year CAGR:

Hexa Ceram purchase

Finally, to catch up to the present time, one has to mention the Hexa Ceram Thai dental lab purchase. To me this was big news as it had a solid impact on revenue growth and profits for 2025. Again ironically, the HK market is sometimes very inefficient, the acquisition was announced in Nov 2024 and the stock barely traded up on the news. For me this was extremely positive, why?

So many HK micro/small-cap run way too conservative balance sheets, MDG is a well-diversified business with low cyclicality in earnings. That means a more optimal balance sheet structure would be to run with some debt. And they did, they levered up after acquisitions in the US and Europe around the time of IPO. But since then, as MDG is such a cash-generative business, the debt has been paid off at a fast clip. So, for me as an investor, I was very keen to see the company “leverage up” again with further acquisitions.

Net Debt pre acquisition

As the purchase of Hexa Ceram was funded with available cash and minimal bank borrowings, with zero dilution for shareholders, this is very accretive to returns. I’m not sure if MDG will be able to find more bolts on like this, but it would be very positive if they could, preferably at reasonable multiples. Herein lies one of the problems: as MDG has such a low valuation, it gets harder to do slam-dunk acquisitions. They paid 8.25x EBITDA for Hexa Ceram. I would assume Hexa is of lower quality than the average of MDG, which is trading at 5-6x EBITDA. But in my view, if they integrate Hexa Ceram well and can find further acquisitions, at some point the market has to reward MDG with a higher multiple. Well, it’s listed in Hong Kong, so perhaps I should be careful with words as “has to”, forever shitco and all that.. :(

So what are my thoughts?

With the basics out of the way. Let’s start to address comments and discussions I had in the past:

New CEO

Mr Ngai has stepped down as CEO end of 2024, as the leadership has been shifting to the next generation of the family. A “bear argument” I heard from investors was that the top management was a bit too stacked, and too much money was spent on having them all on the payroll, so this is a small positive.

US market disappointing

The dental industry has been touted as a nice growth industry with boomers retiring and needing more dental services. Numbers like 5% CAGR have been thrown around for a long time. That might be true in some parts of the world like Europe. This has not materialized in the US in the past years, it’s rather been Covid hangover, which has been surprising to me and many others. Somehow, the US economy is running hot and stocks are taking all time highs, but the general broader consumer is hurting and can’t afford dental bills. Looking at data for the US, some tiny light can be seen in the tunnel with an uptick very recently:

One of the explanations I have been able to find for the weak US market, except the general economic situation of higher rates etc, is that dental policies are falling behind to cover the sharp inflation seen in the US:

The wonderful Euro strength

The EUR appreciation is really a huge part of the good results and tailwind MDG is experiencing right now. It’s pretty simple, Europe is the largest region, items in Europe are priced in EUR, but MDG costs are in CNY and to some degree USD. This has meant that MDG for its European business has partly been at the mercy of the exchange rates. The FX has moved more than they have dared to re-price their products in EUR. This currency effect is larger on bottom-line margins than on top-line revenue. On different Y-axis scale in the chart below, is the MDG share price vs USDEUR and EURCNY:

After the significant USD strengthening in 2021-2022 and the collapse of the MDG stock, the currency movements have been a great predictor of future MDG share price. As we can see, the market is very bad at picking this up and only fully believes it when the actual numbers are released by MDG.

The recent EUR currency appreciation only happened in April 2025, which means the first half of 2025 results only include one quarter of the boost from currency. The next results will include the full boost from currency as long as the USD doesn’t significantly strengthen now in Q4 2025. That’s why I earlier said that I think the Bloomberg estimates for the second half of 2025 profits are very conservative. H1-2025 Net Income grew 33% YoY, and the Bloomberg estimate is for H2-2025 Net Income to grow the same 33% YoY. But as we can see from the currency graph, H2-2024 actually had a headwind from temporary USD strengthening.

So, adding up the two components, H2-2025 is the first half year with full EUR strengthening, instead of just one quarter, and the comparable in 2024 had weaker EUR in H2 than H1. For me this means that the 33% increase in Net Income YoY should not be enough in H2 2025. At the current share price of HK$5.75 that puts MDG on about 9.4x P/E multiple for 2025, I find that incredibly low.

So why is the valuation so low?

This brings me over to the final part, discussing threats and sharing that discussion I was referring to earlier, plus some comments from my dentist. Which ties into perhaps why the valuation is so low.

Before we jump into this, I do believe I overcomplicated things with the below discussions. I think the simple explanation is probably the best one. Modern Dental is undervalued as it’s a “strange” dental company listed on an exchange nobody cares about. It's fairly tightly held and semi-illiquid, so it’s not easy for funds to buy; no blocks are ever offered. It’s not included in HK Stock Connect either, so mainlanders can’t buy the shares; they have been the main buyers pushing up Hang Seng the past year. It’s a classical undiscovered stock with a large illiquidity premium.

In a nutshell, what are investors worried about?

Mostly one thing, technology, in terms of 3D printers and milling equipment, that can cut MDG out of the equation. Since day one, investing in MDG 7 years ago, I have heard this argument. It was also what the European investor wanted to have a call about and discuss. It was a valid concern 7 years, ago and it’s valid now, but MDG keeps performing. I try to constantly keep on top of this topic, but so far, I do not see any major shifts in this area, and that is why I’m bullish MDG. It’s still worthwhile to explain this worry in a bit more detail. Below is a fuller explanation. First, we have to take a step back to set the scene.

What role does a dental lab like MDG really fulfill?

MDG line of business is to produce different types of tooth replacements, some permanent, others removable. Examples would be crowns that go as a permanent cap on what is left of a tooth or an implant, others are removable, like “grandma’s fake teeth" she puts in a glass of water overnight, these are called dentures. There are also other products like bridges, which are a permanent cap over multiple teeth. There are different processes to create these products, with different pros & cons in terms of price, durability, comfort, and looks.

The process of creating these products has gone through quite a lot of innovation over the years, but there has always been some piece of artistry and expertise needed to get that final product to hit all of those requirements, especially comfort and looks. That’s why dental labs and dental lab technicians as a profession became a thing in the first place. It was such a separate and complex process to produce these custom-made products that no dentist wanted to deal with this inside their own clinic. It was better and more efficient for it to be handled by a separate technician who spent his whole career perfecting the production of such products. MDG, as the world’s largest dental lab, has perfected this process at scale to deliver high-quality products at a very competitive price point. But not everyone values a low price; some are willing to pay up for a better experience.

The dream of chairside instant products

The threat to MDG is based on a dream scenario for the dentist, that a customer at the dentist can have his crown, denture, or bridge immediately installed in the mouth in the same sitting as first-time visiting the dentist. Large and small start-up 3D printer companies are trying to solve for this dream scenario.

Do such machines exist that can offer such a service?

As I said, I have tried to keep my ear to the ground in terms of these types of products. There are multiple fairly well-funded early-stage 3D-printing companies that are trying to crack this nut and produce a machine that can do all the steps of what a dental technician does to produce, for example, dentures.

My friend (thanks Brandon) pointed me to one such start-up called: https://zylo3d.com/

This company claims to have solved what was long an argument for me around 3D-printing machines, that the finishing, curing, and color touches still needed to be done by a technician. Meaning previously 3D-printed products did 80-90% of the product, but the finishing touches still needed to be done by someone. That someone most often does not exist within a dental clinic, so buying such a machine, although not useless, often meant that the products were seen as temporaries for the dentists. For example, I have seen dentists on dental forums explain that they do use 3D-printers to print crowns, but as the quality is so sub-par that the printed crown would be used for that 1-2 week waiting time until the real crown, perhaps produced by MDG, would arrive.

This leads me to my largest personal skepticism around new products, the question of durability. A machine like Zylo3d is an unproven product; the product might look good and even feel good in the mouth, but the actual durability of everything we put in our mouth is still probably the most important point. Nobody wants to buy new dentures or a crown and be back in 1-2 years, with the product cracked, stained, color changes, or whatever other durability issue you can imagine. Perhaps Zylo3D has created the perfect product, but based on what I have seen from 3D printing technology, it is not so easy to make something so durable in a single machine process. That is why the main way to produce crowns is by milling out the crown from a solid block.

What do the dentists say?

Dentists acknowledge that chairside immediate access to the product would be great, but they see many hurdles to this. Some of them are from quality as discussed, but most point to the economic point of view, or personal preference on how to operate a dental clinic.

I haven’t been able to find any dentist I met in person who actually tried a Zylo3D machine or any other up-and-coming machine. This is actually the starting point of my argument, dentists in general are not interested in experimenting with new things, most of them want the tried and tested solutions they were trained on.

The dentist I met confirmed another aspect of MDG “moat” and that is the volume of crowns/dentures his clinic does per month is too low to warrant any such investment. He runs his own clinic, a single dentist. This is very typical around the world that dental clinics have 1-3 dentists. This is a key point for understanding where MDG can be most successful; they thrive in a fragmented market. Germany, a large market for MDG, has 99% small clinics (1-3 dentists). I think this also explains why MDG is struggling more in the US, as there has been much more VC-infused consolidation of the dental market. At large dental chains, it makes sense to go in-house and create your own dental lab.

Another good data point on how conservative and/or hesitant to spend money on equipment dentist are, would be how many of MDG cases/orders are received in digital format. The rest are mailed as physical clay molds to MDG in China. About 35-40% of cases are received with digital CAD scans from intraoral scanners. Using intraoral scanners instead of molds undoubtedly gives a better experience and results for the patients, still less than half of MDG customers use it, why? I put it down to several things:

1. Dentists’ habits and unwillingness to adopt new technology.

2. Cost, intra-oral scanners up until recently have been quite expensive; not all dental clinics operate with the latest shiny equipment, in fact, most don’t.

3. As mentioned, smaller clinics can’t share equipment costs in the same way, so small clinics will, in general, be late adopters of the latest tech.

Intraoral scanners have been around for a long time now, and MDG is strongly promoting their clients to switch to it, as the turnaround time, error rates will all be better. Still, more than half resist. It is not likely that these types of customers, that had many years to adopt intraoral scanners, will suddenly jump up and invest in a shiny new Zylo3D printing machine. For all the explanations above it doesn’t make sense.

I see the threat to MDG mainly is from the medium-sized dental clinics, which are currently MDG customers. They have the scale and probably the money to invest. Perhaps there is a middle segment like this where MDG long-term will lose a customer group they have today. Most people in the developed world are not worried about waiting 10 days for their crown; they are worried about the costs and that the outcome is good, and by sheer size and utilization of their machines, a mid-sized dental clinic can never match MDG cost efficiency. But probably for some clinics, the faster turnaround time will be more important, and the in-house-made products are “good enough”.

My conclusion

MDG does not need to win every dental clinic in the world to be successful; they only need to win the fragmented ones without the interest, resources, or volume of clients to make it rational to buy their own in-house machinery. So far, at least for the European and AU/NZ market, that seems to be the case. The US market it’s harder to tell how much it’s the bad Macro environment and how much it is that MDG struggles versus other lab alternatives, I’m guessing it’s a bit of both.

In the short term, the EUR strengthening is creating a massive tailwind to revenue and especially profit. Just like the Hexa Ceram acquisition, these are one-off improvements, but beneath that, MDG also keeps winning. The EUR is back trading in the same range as when I first invested in 2018, it’s a staggering difference in profit, up from below HK$100m to above HK$500m. Currently, I don’t see any reason why MDG should not keep winning in the long term also. Yes, a huge technological innovation or massive increase in consolidation of the dental industry are the two things that could reduce growth. This will not happen overnight, but it will be a slow-moving change.

I leave you with a graph of Modern Dental’s 12-month trailing P/E ratio. Except for the hype period in 2021, the market has never believed in this company, pricing it as a business with huge risks of profits starting to fall. We now have the results for these 7 years, a 5x increase in profits. Where will we be in, say, another 3 years?

I hope these thoughts gave more clarity on MDG as an investment case, what the concerns are, and how I still see a bull case. Cheerio!

Disclaimer: Healthy Stock Picks uses information sources believed to be reliable, but their accuracy cannot be guaranteed. The information contained in this publication is not intended to constitute individual investment advice and is not designed to meet your personal financial situation. The opinions expressed in such publications are those of the publisher and are subject to change without notice. You are advised to discuss your investment options with your financial advisers and to understand whether any investment is suitable for your specific needs. From time to time, I may have positions in the securities covered in the articles on this website.

I would look back on that summer as the last year being childish, so spoiled by mommy that I didn’t even make my own bed. It was time for me to get ready for my 8 months of military service. I was 19 years old and nervous to enter my conscription service within the Swedish military. Only thing left to do was of course to shave off my blondish hair and have that buzz cut one expects when in the military. Very unused to my new short hairstyle I peered in the mirror and when the light hit right on my scalp, I realized to my horror, that you could hint a thinning of the hair in a pattern all too well known to me. Got damnit, I’m getting dads baldness and it showing already when I’m 19! I haven’t even left my teens yet, I’m not ready to get bald! I put my feelings about the topic aside for the time being, nothing I could do about it anyway. Machinegun shooter here we come!

A few years later in Uni that brewing baldness did really bother me though, I had never really been a vain person but I realized my hair was important to me, it was somehow a big part of my identity. I went online and decided to find a solution, that solution for me was Rogaine, which I kept using for over 15 years - and it really worked. It had some side effects, which is another story but all in all it was worth it. I could spend my 20’s and most of my 30’s with a nice blonde set of hair and only now in my 40’s am I sporting the bald look, everything has it’s time and place and 40’s is OK to be bald. That’s how I felt at least.

This investment thesis hinges upon the very same feelings I felt but in a different context. This is about how you feel about losing your hair when you are already down and going through something incredible hard - cancer. Most ladies dread this and it’s only when the hair starts coming off after 2 - 3 chemotherapy sessions that many really feel sick. You feel sick when you look sick. Paxman has pioneered a solution which gives the patient a high chance of retaining much of your hair through chemo treatments. Quite a few patients can go through their full chemo treatment with only minor hair loss. This product is obviously not needed to fight the cancer but it’s still darn important because how you feel going through one of your worst periods in your life, it matters, it really does.

When I started to learn more about Paxman and what they have been doing these past 25 years, I’m actually very surprised that offering this service at least to all female cancer patients should be standard of care in all developed markets at least, but it really isn’t. In a few places like the UK it is common (Paxman is listed in Sweden but is a UK company and penetrated their home market well). Paxman is on a journey to make it a standard option offered to all.

Working with cancer treatment centers to offer scalp cooling and insurance companies to cover it, has been a very long journey. So long that Paxman’s largest competitor didn’t make it and was in 2025 purchased on the cheap by Paxman. This has created an interesting situation where things are finally falling in place in the US from regulatory perspective (to improve reimbursement of scalp cooling), at the same time Paxman just gobbled up its only significant competitor and is effectively running a near monopoly, especially in some markets. The TAM is large for Paxman, if they can pull off to scale this product further, the rewards could be massive. Scaling in Paxman’s case mostly means how much the already installed machines are used, so in my write-up below I will focus quite a bit on that utilization bit.

Hope you like this investment idea as I think it’s one of the absolutely most interesting microcap ideas out there, as there is both a short term catalyst for revaluation, but investment story also holds as a very long term compounder, if they just keep executing as they done in the past. As usual I leave you with a slide deck with all thoughts about the company for you to flip through at your perusal.

Paxman Healthystockpicks

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I launched this Substack in the spring of 2024 and had quite high ambitions in terms of the ideas I would post. Since then, I have only posted four company write-ups, so what happened?

Well, first of all, I realized my circle of competence within Healthcare wasn’t so great. I have 20 years of investing experience, but it’s a different thing to really know a sector well, especially Healthcare. My conclusion - I needed to read more books. With a full-time job and an attention span like a goldfish (smartphone addicted), that was easier said than done.

Second, if I am converting to being a full-time Healthcare investor, what should my portfolio look like? Should I only pick stocks within Healthcare, or do Healthcare + index investing? I spent the autumn scratching my head on these topics while I was finding what books to read.

On the topic of reading, I managed to put my phone away, at least sometimes, to finish some great books. In total, I have finished four great books, and I’m halfway through a fifth this year. Most of these books were focused on Pharma and Biotech, the areas I definitely know least about.

On how to manage my portfolio, I decided to allocate 50% of my money to Healthcare investments, 40% to other sectors, and 10% to swing trades. So, I'm still doing stock picking outside Healthcare. The idea was to run a 10-14 stock portfolio of Healthcare ideas, the problem? Well, I didn’t have 14 good or even decent ideas. This was the main reason for my radio silence on the Substack. Silently, I have been lurking in the shadows, digging through healthcare-related ideas and building a portfolio of now 12 holdings, which I’m quite happy with. As I like to track things, with the inception beginning of 2025, I have also created a weekly NAV series of how the portfolio is doing.

The portfolio is off to a flying start, up +28% at the half-year end. I have decided to only share the full portfolio if/when I reach 2000 followers, currently I’m at 1000, but I will give some hints from time to time (for example at @HealthStockPick on X).

Given the strong returns above, something I’m less happy about is that the ideas I have shared, at least recently, have been among my worst performers.

If we evaluate the four ideas I published:

• Modern Dental - Price when published 5.1 HKD, price today 4.26 HKD

• Agfa Gevaert - Price when published 1.15 EUR, price today 1.06 EUR

• AngelAlign - Price when published 58 HKD, price today 56.5 HKD

• Envista - Price when published 16.7 USD, price today 19.54 USD

That doesn’t look like a list of stocks that generated a 28% return during 2025 and that’s correct, in my current 12-stock portfolio, both Agfa and AngelAlign have left the portfolio during 2024. Modern Dental is still there and is actually the largest detractor to returns, as it’s my largest position, and the stock is only up some 3% YTD, including dividends. Envista, which I picked up around the lows this spring, has contributed nicely to returns. To not be too hard on myself, the previous Healthcare ideas copied from GlobalStockPicking have killed it this year, OssDsign, which I was one of the very first to write-up, is up around 50% this year, RaySearch is +56% this year, as two examples.

Lastly, starting this Substack, I had planned to turn into a full-time investor and monetize this at some point, just like many other Substack writers worth their salt are doing today. Some good and bad news on that front. Healthy Stock Picks will, for the foreseeable future, remain a free Substack with no paywall. As I decided to continue my day job for a few more years. The bad news? A full-time job takes up a lot of my time, so the pace of writing will be slower. I will increase it from the current pace of one idea per quarter for sure, but perhaps lower the bar a bit in terms of how comprehensive the write-ups are. I hope I will be able to deliver ideas with better returns going forward and not just have them hiding in my portfolio, as has been the case this year.

Inspired by the books I read, I want to end this post with a story about how chemotherapy came to be and its link to mustard gas.

From The Emperor of All Maladies by Siddhartha Mukherjee:

“On December 2, 1943, .. a fleet of Luftwaffe planes flew by a group of American ships huddled in a harbor just outside Bari in southern Italy and released a volley of shells. The ships were instantly on fire. Unbeknown even to its own crew, one of the ships in the fleet, the John Harvey, was stockpiled with seventy tons of mustard gas stowed away for possible use. As the Harvey blew up, so did its toxic payload. The Allies had, in effect, bombed themselves.

The German raid was unexpected and a terrifying success. Fishermen and residents around the Bari harbor began to complain of the whiff of burnt garlic and horseradishes in the breeze. Grimy, oil-soaked men, mostly young American sailors, were dragged out from the water seizing with pain and terror, their eyes swollen shut. They were given tea and wrapped in blankets, which only trapped the gas closer to their bodies. Of the 617 men rescued, 83 died within the first week. The gas spread quickly over the Bari harbor, leaving an arc of devastation. Nearly a thousand men and women died of complications over the next months.

.. The injured soldiers and sailors were swiftly relocated to the States, and medical examiners were secretly flown in to perform autopsies on the dead civilians. The autopsies revealed what the Krumbhaars had noted earlier. In the men and women who had initially survived the bombing but succumbed later to injuries, white blood cells had virtually vanished in their blood, and the bone marrow was scorched and depleted. The gas had specifically targeted bone marrow cells

.. Could this effect, or some etiolated cousin of it, be harnessed in a controlled setting, in a hospital, in tiny, monitored doses, to target malignant white cells?

In 1942, they persuaded a thoracic surgeon, Gustaf Lindskog, to treat a forty-eight-year-old New York silversmith with lymphoma with ten continuous doses of intravenous mustard. It was a one-off experiment but it worked. In men, as in mice, the drug produced miraculous remissions. The swollen glands disappeared. Clinicians described the phenomenon as an eerie “softening” of the cancer, as if the hard carapace of cancer that Galen had so vividly described nearly two thousand years ago had melted away.

But the responses were followed, inevitably, by relapses. The softened tumors would harden again and recur—just as Farber’s leukemias had vanished then reappeared violently. ..there was only a fleeting glimpse of a cure.”

Disclaimer: Healthy Stock Picks uses information sources believed to be reliable, but their accuracy cannot be guaranteed. The information contained in this publication is not intended to constitute individual investment advice and is not designed to meet your personal financial situation. The opinions expressed in such publications are those of the publisher and are subject to change without notice. You are advised to discuss your investment options with your financial advisers and to understand whether any investment is suitable for your specific needs. From time to time, I may have positions in the securities covered in the articles on this website.

The dental sector did for many years see strong performance and high interest from investors globally. It’s such a compelling long term investment story. An aging population and teeth that doesn’t last longer than they used to (rather the opposite due to our eating habits). Add to that the whole beauty aspect of dental which is just growing. I have been pitching different dental companies to small groups of investors over the past years and I came to use this picture to drive home that point:

So with all of this positive backdrop maybe it’s somewhat surprising that a lot of dental stocks have been dropping like stones the past few years. Some people call it Covid hangover, a lot of demand for dentistry was pulled forward when stimulus checks gave people money to improve their teeth. Others point to the high interest rates and inflation where the average Joe has been squeezed financially and can no longer afford as much dental care as in the past. No matter the explanations the dental sector is going through a real soft patch, especially in the US, and stocks have corrected accordingly. For the long term investor this creates opportunities.

I have tried my best to understand the dental sector globally, turned a lot of stones, looked at most of the listed companies and for me Envista is the most compelling de-risked case. As previously was the case with my investment in ZimVie (link to write-up) this idea is also from a spin-off from a larger company. ZimVie was spun-out from Zimmer Biomet and Envista is spun-out from the quite famous Danaher group. Just the fact that Envista has been part of Danaher should be some type of quality mark.

As usual for my deep-dives I have written a comprehensive deck for you to flip through. I hope you enjoy it!

Envista Healthystockpicks

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There was heavy rain in the air as my wife and I rushed into the building from the bustling street of Mongkok. Every time I venture away form Hong Kong Island to the “dark side” I realize how a different of a world it is over here. The people, the bustle, the vibe - not bad, just different. My eyes looked over the board listing all the businesses in the building. It was like looking at a page in the yellow pages, I gave up to try and confirm we were at the right spot. Wasn’t it eight floor honey? Ok up we go.

A big lift brought us up to the dental clinic where we had an appointment. The first thing that the clinic show-cases on the wall entering the reception is a mix of the doctors degrees and their awards for being a Platinum Invisalign clinic.

I thought for myself that its amazing, how out of all products in a dental clinic, Invisalign has created this brand awareness that customers ask for. “I want Invisalign” is something many dentists explained that their customers say. For something else like an implant, nobody would insist on getting a Noble implant, you just go with what the dentists says is good, don’t you?

I walk up to the reception counter and a take a look at the price list. Not updated since 2022 July, is this really their latest list? Anyhow let’s take a look together:

And surely enough, somewhere two-thirds down on the list is one of the most expensive treatments you can do in a dental clinic, braces for HK$36-40k or Invisalign for HK$46-50k. I also quickly note the mark-up for a crown, which in HK with a high degree of certainty comes from my other holding Modern Dental, the ASP for those are HK$1500 from Modern Dental but this fairly low priced clinic is charging HK$7000. Interesting..

Since this is not one of the luxury clinics in Princes Building central we get asked to sit and wait for a while. When it’s our turn I of course (as always) take the opportunity to ask the dentists about the products she uses.

- Do you have any alternatives to Invisalign to offer at this clinic?

- Yes we do have one other brand called Angel aligner.

- Interesting, what do you think of the product?

- Well in-fact I happen to be trying out the product currently myself.

- Ok I guess that says quite a lot about the product that you as a dentist is using it yourself, so overall you are happy then so far? And how about price?

- Yes so far so good, they have a different approach than Invisalign, they have two different sets of clear aligners which you alternate, that gives a little bit more comfortable experience using them. Price-wise we offer these about HK$10,000 cheaper than Invisalign.

- Thanks that very interesting!

AngelAlign (6699 HK)

AngelAlign, listed on the HK exchange has emerged as the only other substantial stand-alone clear aligner brand worldwide. With a 3% global market share, AngelAlign is on par with the other big dental companies who all try land grab within the clear aligner space. Many dentists want to at least have an option to Invisalign to both offer different price points but also to not be at the mercy of Align Technology’s pricing.

By studying the whole dental space I have identified a business acquisition that would make a lot of sense, involving AngelAlign and Private Equity group MBK. This is to be clear pure speculation on my part, I have no sources which verifies this thesis. It’s just putting the puzzle pieces together and seeing that this really makes sense.

I have as usual created a pitch book for my idea, which spells out the thesis for why this acquisition would make sense, what the clear aligner market looks like and what AngelAlign looks like as a stand-alone investment.

Press below to download the deck, hope you enjoy it!

Angelalign Healthystockpicks

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Agfa Gevaert is a 150 year old Belgian conglomerate which has been world leading in film and photo related business. Today it’s a micro cap valued at €210m but you get brand recognition and reach like a mid/large cap.

Active Ownership Capital (a friendly activist) took 7.5% of shares and a board seat in 2018 and has since increased its stake to 19%. It’s clear they push to bit by bit dismantle the “old empire building”, installing new management & creating a smaller leaner company.

Agfa has struggled with too many legacy businesses and a large pension burden. By selling down assets and paying off chunks of the pension debt the company is emerging as “investable” again. But market is focusing on a deteriorating Radiology business.

Cash flow stability can be found in medical imaging software and long term upside in green hydrogen membrane production called Zirfon. Zirfon has been pointed out by independent parties as market leading. ThyssenKrupp a leader in installing hydrogen plants has signed to install Zirfon in their plants.

Stock price and much of fundamental history looks awful. But with an activist investor, new management team who divested underperforming assets and kept some market leading ones, the stock has discounted too much negatives and none of the positives.

Agfa-Gevaert is as said an old conglomerate which acquired and spun off various entities over its very long existence. Today the company is mainly active in Healthcare and Industrial Printing + Chemicals. The majority of the cash generation comes from the Healthcare side and hence I found it worthy of being covered by Healthy Stock Picks.

The Healthcare business is split into two part:

1. Image management software, Agfa is a decently sized player in this fragmented market.

2. Radiology, X-ray machines of different types and the consumables that comes with it, for example printed X-ray films.

The Printing + Chemicals business can also be further split:

1. Printing solutions are industrial. This means huge machines to print for example signs, displays and even fabrics. Within printing hides many niche businesses, for example phototooling (a step in creating circuit boards), where Agfa is global market leader.

2. Chemicals is for example the after-sales ink to printers but also a new interesting business in Green Hydrogen production.

A very important factor, in this historically troubled company, is the activist investor who has been involved for the past 5 years and is pushing necessary change.

The next quarterly report is already out tomorrow, which should be exciting (as the previous quarterly was some early signs of turn-around)

Overall there is a lot to unpack in this company, which also means there could be quite a lot of value to find, if one looks closely enough. So we will look closely in the slide deck attached below. I hope you enjoy the idea!

Agfa Gevaert (Healthy Stock Picks)

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Modern Dental Group (MDG) is a low cost dental laboratory company. In a very fragmented market the company is the largest global player in terms of labs and distribution network.

Riding on the tailwind of a larger elderly population in need of dental care, MDG has grown revenue with a 15% CAGR the past 10 years. Due to the HK bear market this non-cyclical high quality small cap can be bought at 2025 expected EV/EBITDA below 6x and P/E below 10x including an expected forward dividend above 3.5%.

With improving margins, reinvestment of it’s strong cash-flow and bolt on acquisitions MDG is likely to outgrow the market as a strong compounder stock. The past years the stock has very significantly outperformed the Hang Seng Index.

A new clear aligner product which can be pushed in its distribution network is a free call option on the upside. This is a huge market opportunity with global market valued at 6bn USD and growing fast. Production line is now fully automated to support larger volumes and 510k FDA received already in 2021.

Read the full company write up in the slide deck below.

Modern Dental Group (Healthy Stock Picks)

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Full slide deck on company

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Introduction

Neck and spine problems will be on the rise in the future. We stare down into our smartphones all day and spend too many hours sitting (with bad posture) in front of our computers (old post for more on this link). OssDsign has a very interesting product, in a small but important niche of this market. The product has high gross margins and is used in spinal fusions.

In short:

Market Cap: 630 MSEK / US$60m

Explosive Growth: Newly launched bone graft product (My estimate 100 MSEK run-rate in sales)

High margin: Gross margins should be 80%+

Large total market: Total market estimated above 1.25bn USD for USA only.

In this same spine space, I have taken a position in Zimmer Biomet spinoff ZimVie, which is targeting the newer technology of disc replacement. OssDsign is trying to bring innovation to the old and current gold standard of care, spinal fusion. OssDsign believe so much in their newly launched product that they are willing to close their previous main business line and fully focus on the new. At the same time, in a poor market environment for micro caps, the company managed to raise a substantial amount of cash from investors. Even more impressive was that this direct share issue was done around the current share price, so dilution happened at quite "fair" levels for existing investors. The product has 80-90% gross margins and has potential to be used in a large number of surgeries. All-in-all this is a high risk, high reward case where the odds of bringing this product to market is much higher than for Pharmaceutical products as there is no need for Phase 1/2/3 studies to launch the product.

Spinal fusion

Spinal fusion patients are usually in tremendous pain and have often suffered for many years before a surgery is decided as the last option. Fortunately like many medical procedures, spinal fusions success rates have increased tremendously over the past 30-40 years and evolved from one of few bad options to the gold standard of care. Due to poor results of this procedure in the (far) past, it still has a quite bad reputation. The Spinal fusion procedure can simplisticly be explained as to remove the disc between two bone segments and then trigger the two bone segments to grow together (fuse) into one solid segment. Except the surgeons expertise in performing the steps of surgery, the most crucial component for the success of a fusion is to get as high confidence as possible that the full fusion will happen. Although outcomes have improved a lot over the years, that the fusions does not happen or partially happens, is still the weakest link of this surgery.

This is what OssDsign is trying to solve with their Catalyst bone graft material, where the idea is that the graft fills the void of the disc and triggers bone growth. The product sells at an ASP of about 2500 USD and depending on surgery different volumes of the product is needed. Together with two main competitors OssDsign have a bit of a first mover advantage here in a new generation of products coming to market increasing the interest from doctors to move to a synthetic solution instead of the other options available to them.

Although hard to exactly estimate, around 500 000 spinal fusion surgeries (lumbar and cervical) are done each year in the US. So with some quick math's of 2500 USD of OssDsign product per surgery the market size OssDsign is competing for is about 1.25bn USD. With an aging, obese population the number of surgeries just keeps growing. Given the rapid increase of spinal fusions, a both efficient and cost effective solution for creating stable fusions of the bone is highly desired by surgeons. As a small company out of Sweden, it might seem far fetched that they would win the US market. But together with 2 other players (where one is also a small company) they are the only ones seeing FDA approvals and all indications so far seems positive towards a chance to win a decent market share in this segment. The upside for OssDsign even at 5-10% market share is very substantial as this is a high margin product. Let's try to dive deeper into this topic.

History

OssDsign listed in 2019 for 27.5 SEK per share and today it trades around 6 SEK per share, not a great outcome. What the company has done historically is unusually irrelevant though. The company you are purchasing as of today, is vastly different to what was listed in 2019. How come the company has changed it strategy so drastically and quickly? OssDsign listed as a 3d printed cranium implant company with a titanium-reinforced calcium phosphate plate. I don't think the company necessarily done anything wrong in launching this product into the market, the problem, I believe, is that its just too niche. Yearly sales have roughly doubled since pre-IPO from some 20 to 40 MSEK. Although it could probably scale further, there is not enough patients in need of these type of cranium implants to really deliver shareholder value from this one product. In the hot "free money" era, OssDsign then decided to expand its produce range by an acquisition. OssDsign recently announced that they will abandon (in best case find a buyer) the cranium business and fully focus on their spinal fusion product Catalyst (which was the acquisition they made). Below is a timeline of the Catalyst product. Press read more..

Timeline of OssDsign Catalyst

2020: In the "free-money" era OssDsign purchased a British company (SIRAKOSS) for 8.4m GBP in Nov 2020. In the purchase price is also a low single digit royalty fee to the original founders. Given that this is a very high margin product I don't see an issue with the royalty. SIRAKOSS was basically only setup to launch their invention called Osteo3 ZP Putty which OssDsign later has relabeled as OssDsign Catalyst. As already described in the intro, this type of product has a much larger addressable market. The SIRAKOSS team was the two gentlemen below, working at University of Aberdeen in Scotland. Already at OssDsign's purchase SIRAKOSS had received FDA approval of the type 510(k) to use the putty in certain indications: ZP Putty FDA approval.

Source: https://abdn.ac.uk/stories/pioneering-new-bone-graft-material-to-improve-patient-outcomes/

"The culmination of the team’s research was the development of a brand new silicate-containing calcium phosphate material with properties much closer to the mineral crystals found in real bone than had been previously achieved in any other synthetic bone graft material. By processing the material to have smaller crystal dimensions and notably smaller pores than other synthetic solutions, the material achieves a much higher surface area, with the result that the surface supports bone repair more effectively and is more readily remodeled than traditional ‘ceramic’ substitutes."

2021: As a small company OssDsign decided to try to focus on the US market and have worked together with a smaller number of spine surgeons to evaluate the product through the trials they kicked off. The product was initially launched in late 2021 in the US. In late 2021 the first small scale study, called "TOP FUSION" was also launched, this study was only recruiting 17 patients and was run out of Budapest.

2022: Early 2022 they got an approval for their first "real" US based study called PROPEL, they started to recruit patients and reached a 100 participating patients earlier than expected before year end 2022.

2023: Early 2023 the first results from the "TOP FUSION" study was published, which showed a good outcome. The PROPEL study was successfully fully recruited with over 200 patients. After this things started to move very fast. Although the study had only about 200 patients a few weeks later the company announced that 2000 patients had been treated with OssDsign Catalyst. So the product has been used quite extensively outside the study by a smaller group of surgeons.

To illustrate the growth of total procedures in 2023, it's better to show a graph:

The company is pointing to IDN contracts (network of healthcare centers) as the reason for the recent strong growth. But there is more to the story here in my opinion. My own interpretation of what has happened is that spine surgeons that were early users of the product saw good results (although these are to large extent not published yet) and started to use it more widely. It raises in my view the probability of successful results in the PROPEL study. Doctors would not keep using it in surgery 3-4-5 if the outcomes were not good. This is basically the bottom line why I invested in the company. The week after announcing strong sales growth the company received another clearance from FDA for usage of Catalyst in a new indication (interbody cages).

Drastic strategy shift

So with all this happening and sales from the Catalyst product has gone from zero to twice the cranium business within the span of literally two years the company decided to make a drastic shift. OssDsign then made the "brave" announcement to fully focus on the US market and becoming a pure play orthobiologics company, which for now means betting all on the Catalyst. With this announcement they also attracted 150 MSEK (13m USD) in new funding through a direct share issuances. The Swedish micro/small cap space is in a proper bear market currently and to get this issuances done roughly at the current market price of the stock was in my view very impressive. Money will be used for costs of launching the product more widely in the US, as well as finalizing the very important PROPEL study with over 200 participants. This was the second factor which made me invest in this company, funding secured is important in this environment.

US spine market

As OssDsign is fully focusing on the US market for their Catalyst its interesting to look at how that spine surgery market developed over the years and what the outlook is forward. As mentioned an estimated 500k spinal fusions is done each year in the US. Some other quote this as high as 650k fusions (Source) I found the below journals confirming not only that 500k is a decent estimate (given 440k in 2014) but also showing how extremely rapid the growth in number of surgeries has been during early 2000's.

Source: https://www.ncbi.nlm.nih.gov/pmc/articles/PMC7797794/

I would expect the growth in fusion surgeries to decrease quite significantly and rather stabilize, as some segments like cervical fusions will over time now be replaced with artificial disc replacements. Like explained in previous post about ZimVie, there is still something like 8 times as many fusions compared to ADRs done in the US. That the market does not massively grow from here is less of a problem for OssDsign as the big question is what kind of market share could they get. Nevertheless the US spinal fusion market is still expected to grow with a CAGR of 4.6% per year until 2032 which is a further nice tailwind to the case (Spinal Fusion Devices Market Expected to Grow at 4.6% CAGR).

Existing technologies

Although the early evidence and especially uptake from some doctors tells a story that OssDsign struck gold with their purchase of the Scottish University company, they are of course not the only company globally that has tried to solve the problem of improving fusion outcomes.

Gold standard is your own bone

The current gold standard to trigger bone-growth so that the bones fuse, is to use your own bone, grinded down into smaller pieces. The problem with this is obviously that where do you take this bone from without causing harm? Sometimes the surgeon can take a little bit of bone from the surgery location, a bit of the bone can be sacrificed there as the segments anyway will be fused. Most often this is not enough and then there are a few options how to create the bone graft:

1. Take bone from the anterior iliac crest, this is deemed the safest place on the body to harvest bone. Although it's the safest place, its still not without it's problems, its a surgery so there is always an added risk of complications (infection etc). A quite high number of patients have short term and some even long term pain or sensory disturbance from the donor area. This type of procedure is also called an autograft - Further reading on problems with harvesting bone.

2. Take bone from a cadaver (i.e. a dead person), this bone needs to be properly cleaned and processed through different processes. This is sometimes sold in the form of Demineralized Bone Matrix (DBM). Again there are some tail risks with this and also that this bone is after the cleaning process is not as effective to trigger bone growth as your own bone. This type of procedure is also called allograft. This is often also mixed with own bone, so a combination of iliac crest bone and DBM which is again sold by a number of companies and is among the cheapest options, around $1500 for a DBM for a fusion.

3. Use only synthetic products like the product OssDsign is providing, there are multiple other materials on the market (I will mention some of them below).

4. And lastly what in my view seems to start to emerge as the new gold standard, mixing your own bone with a synthetics like OssDsign Catalyst. This gives the confidence of triggering fusion from using your own bone and mixing it with something that even on it's own would be a decent material to trigger bone growth. Mixed together say 50/50 it has in the early studies not only for OssDsign but also other brands products shown promising outcomes. The benefit here is that if you are lucky you can skip the harvesting from the iliac crest or remove a much smaller amount of bone from the iliac crest.

OssDsign Catalyst

Looking at the outcome data for OssDsign Catalyst from a pure scientific results perspective is hard. Initially I thought these products would need to proven with scientific data to by cleared by FDA. I learned that the 510(k) clearance is much easier to achieve than a phase 1/2/3 full FDA approval process. Essentially the Catalyst and previous products like Attrax are all approved based on a predicated product, meaning an earlier product which they claim equivalence against. From my understanding no further evidence is needed that proving that the product is close enough to a previously approved product to get the 510(k) clearance. OssDsign CEO is in certain interviews mentioning how they done something very special to get the FDA approval, how they belong in an exclusive group of products which have the FDA clearance. I'm sure it's still hard work to get the clearance but not nearly as hard work as passing FDA Phase 1-2-3 studies to get clearance. Due to FDAs treatment of these type of products its possible for a very small company with limited means to bring the product to market. Perhaps that is FDAs intention.

Rabbits

The existing published studies of Catalyst is first in a rabbit study published early 2021 in the Spine Journal. The study shows that the rabbits have successfully fused with the Catalyst substance. Even if it was a rabbit study the number of rabbits used was low and I personally put quite low significance on this study.

Safety Study

A safety study was performed on the roughly 500 first use cases of Catalyst in humans. The outcome of this study was very good with all complications seemed to be unrelated to Catalyst itself: Safety study.

First fully studied case

Out of the small PROPEL study the first (human) case results was published, showing a good outcome at first use: Link to study.

Conclusion on product quality

All of the above is necessary basics steps to launch the product and build up the credibility that the product works. But given that 2000 patients have been fused with Catalyst, there are clearly many doctors out there with much more information on the Catalyst than what has been published in studies. I tend to trust the 2000 procedures more as a stamp of approval that outcomes seems to be good/satisfactory. Another important aspect is that handling of the bone-graft is easy. Not all products are as easy to use (stay in the right place etc). Small things like this might in the end mean a lot for adoption rates of a product.

Competing products

So trying to understand this landscape of products is quite complex. But basically all products are shooting for in the best case #3 above, to fully replace your own bone with a perfect synthetic product. That's the dream scenario, create a synthetic product which in 100% of cases always triggers bone fusion in the patient without need of anything else. Realistically most products shoots for being a filler, to mix out with own bone but hoping to convince surgeons to use it without mixing.

Three different type of synthetics are competing for the future of bone graft materials:

1. New generation materials with nano-structures that imitate how are own bone looks like at nano scale - OssDsign Catalyst belongs to this category, also Attrax and MagnetOS which I will mention below.

2. rhBMP-2 (recombinant Human Bone Morphogenetic Protein-2) - Phew that's a complicated word! This is a highly potent protein which is expensive to produce. The large medical players produce this for a cost of around US$3500 per fusion. This has been the go to product when surgeon suspects that patient will struggle to fuse (due to age, obesity, smoking, etc). The problem with the product is that it can also trigger bone-growth where you don't want it, creating bone-spurs which creates new problems of nerve impingement etc. The product is for sure still used quite extensively, but listening to conferences among surgeons, I can feel they would prefer a better option with safer outcomes.

3. P-15 peptide enhanced graft - P-15 is a synthetic, 15-amino-acid residue found in type I collagen, containing the potent cell-binding domain of collagen. This can be adsorbed onto a calcium phosphate substrate and will enhance cell attachment and extracellular matrix and factor production, resulting in the formation of bone. Although no product is fully launched on the market, recent studies show superior outcomes of P-15 versus rhBMP (see study) The leading company in this area is Cerapedics, which is going to trials to prove the outcomes of it's iFACTOR P-15 peptide.

It is hard to define what is a competitor, as there different fusion techniques which give different synthetic materials with different properties an advantage. As a basic example a lumbar spine fusion can both be done from the back or go in through the front (stomach). Two different approaches with their drawbacks and benefits. Further the fusion can be done with screws and fusion material placed on the sides, or a cage can be placed between the bones and the cage is stuffed with bone graft. The cage can be fixed, or even expandable, which again gives different textures of bone graft advantages. To summarize, it's complex to create one bone graft product that wins in all situations. But a good product which fuses as well as your own bone, will probably be a strong candidate in many surgeries. As long as the surgeon can work with the texture (so it for example does not float away like a tooth paste) and fusion rates are high, it is already a strong candidate in the market. OssDsign Catalyst has the right texture, this is an important point of the quality of their product.

Looking in more detail at competitors

• OssDsign is currently charging in the range of 2000-2500 USD per 10 ml and from what I can find Attrax Putty costs about $1200 USD for 10 ml (quite normal amount used)

• Estimates vary but rhBMP costs around $3500 per level of fusion done.

• P-15 peptide cost is more un-clear but should be in the same range as rhBMP.

The competitors that stand out to me are (both belong to listed companies):

1. Nuvasive/Globus -  Attrax Putty

2. Kuros Bioscience - MagnetOS

Nuvasive's pitch for Attrax below:

Since Attrax is sold by a larger company, they have had the financial muscle to do multiple studies in different type of procedures. Although as described above the FDA 510(k) clearance does not require randomized trials with A/B cohorts, this is of course a clear positive to have when trying to convince a surgeon to use your product. So Attrax has a number of these type of studies which have been released over the past years. This is clearly a big benefit to Attrax vs all competition that does not have such scientific data to lean on. The negative is that I do believe Attrax is less advanced in its micro-structure compared to MagnetOS and OssDsign Catalyst, I don't have any solid evidence to back this up except the below:

There is an interesting history with Nuvasive and Attrax, as it was created by the lead man of Kuros Bioscience Joost de Bruijn. Joost has been one of the true pioneers in the field of new generation synthetic materials. Already in 2009 he sold his company and the Attrax product to Nuvasive in a 80m USD contract: Link to source. It took Nuvasive a number of years to launch the product they got FDA clearance and launched the product in early 2016: NuVasive Launches AttraX Putty.

MagnetOS

How come Joost de Bruijn is linked to both of OssDsign's competitors? Kuros Biosciences is the only true small cap competitor to OssDsign in my view. In 2000, it spun out from ETHZ. In January 2016, Cytos Biotechnology and Kuros Biosurgery Holding AG (“Kuros”) merged to create Kuros Biosciences. In early 2017, Kuros acquired Xpand Biotechnology to improve its orthobiologics portfolio through the addition of the MagnetOs product. The same Joost de Bruijn was the man behind Xpand and this was his second time to sell his product to a larger player, and from what I can see they were handsomely paid as Kuros paid some 2 million shares with Kuros at the time trading at 16 CHF per share (source).

If one just looks at the above history, Joost de Bruijn seems to have been the mastermind milking the market twice on this product. I do believe he tried to improve and differentiate the MagnetOS product from the Attrax product he previously created (after all he had many more years of experience when creating MagnetOS). Joost is also still active in Kuros and seems to have kept many of the shares he was given in Kuros when selling his company (1.1 million shares held). He could have taken his money and ran but he is trying to make MagnetOS successful. So my conclusion from this is that Attrax is the competition in the lower price segment, with the large Nuvasive/Globus spine company behind it. But from a technical and surgery outcome quality point of view, MagnetOS is the real latest generation competitor. MagnetOS has also come further in the adoption of the product, according to Kuros it has been used in 15 000 spinal fusions so far, already in Aug 2022 they reached 10 000 fusions, so the adoption rate of OssDsign Catalyst is not far behind MagnetOS.

Which one is better MagnetOS or OssDsign Catalyst? I don't know and probably nobody else either. We need to see more data, more adoption of the product to deduct a clear winner. And probably since there are so many surgeons operating in different ways and different procedures done there is no magic bullet that will always be best. I find the story about Joost compelling enough that I might (if you are lucky) write that up some day also. Until that day here is an initiation report of Kuros: Kuros Bio

Management / Ownership

CEO is Morten Henneveld with a background in sales and restructuring. Most relevant experience was as VP at Zimmer Biomet Spine division until 2017, meaning he is an old colleague to the team I'm today invested in through ZimVie. Although he worked in fairly US centric Zimmer Bio his area of focus was EMEA, so his knowledge about how to penetrate the US market is possibly limited. This is the first time for Morten to step up into the CEO role as in his latest position he was a SVP for Danish hearing aid company GN Group which is a mid/large cap company.

An interview with Morten here: Link

Other interesting names on the management team is Tom Buckland who seems to have joined through the SIRAKOSS acquisition. Tom has previous experience from bone graft companies as co-founder of ApaTech which was purchased by Baxter for 330m (Baxter - Apatech). In the same deal the VP of Sales US - Eric Patermo also comes with a background at Apatech. This is a bit similar like the Kuros Bio situation where the same names again come up in the sector. To have these two experienced gentlemen onboard I see as a positive for OssDsign's likelihood of success.

The shareholding from the management is very modest in outright shares, the CEO only has 200 000 shares but all of management are incentives through subscription options which is more substantial, for example 2.3m shares for Morten. It would have been nice to see a bit more skin in the game and perhaps some insider purchases either through or after the recent share placement.

In the recent direct share issue TAMT AB, Karolinska Development, Adrigo Asset Management, Lancelot Asset Management and Linc AB were the takers.

Valuation

Due to the explained competitive landscape it's in my view not realistic to believe OssDsign Catalyst can win whole or close to the whole US market. A slam dunk outcome would probably more be in the range on 20-25% of all spinal fusions. More than this is not needed for the case valuation wise. Already at 10% market share we are talking about 50k procedures with US$2500 in sales, that translates to 1.3bn SEK in sales with 90% gross margin and probably 20%+ net income margin vs current MCAP of 630m SEK.

I like to draw up scenarios in a DCF analysis for more mature stocks but find such an analysis pointless at this stage of the company. I draw comfort from the capital raise, but would still expect another capital raise before the company can reach a cash flow positive stage. This depends if they team up with a larger company in their distribution or not (currently no plans for that). Again here noting that Kuros Bio with MagnetOS has teamed up with a larger player. Another way to look at this are the numerous purchases from larger firms in this field. It's not unlikely if OssDsign Catalyst continues to sell well in the US market that a larger player just puts in a bid for their product.

Market share model

Another way to play with valuation is to look at what kind of market share of the 500 000 yearly spine fusions that Catalyst can win. If one does the "silly" exercise of modeling current growth to the non-linear function it's currently exhibits, the extrapolated growth would mean a 5% market share (25000 use cases) already by end of 2024.

If one rather looks at MagnetOS and their growth rate, it seems plausible that OssDsign (with continued good clinical outcomes) would sell some 5000 Catalyst during 2024, meaning 1% market share (if one catalyst is used per surgery). Making some quite conservative assumptions about further growth from that point on yields the following values.

This numbers are of course highly dependent on successful outcomes for the studies that OssDsign plans to present. Talking about that, since if something negative comes up along the way, the company is basically a zero. So this can in my view unfortunately not be sized as a larger position, but will stay a small speculative position until they are a more proven company.  I also did not pen in the 4.6% CAGR of number of fusions done, at the moment this tailwind is of less importance compared to the market penetration by OssDsign.

Conclusion

To conclude this somewhat technical post. My take on this is that the previous generation of synthetic bone graft materials were not great substitutes for using own bone (autograft) or cadaver bone (allograft). But with the latest generation this is shifting and this is changing the landscape quite fast in favor of these few products like the Attrax, MagnetOS and Catalyst to win market share from previously used products. I can see a trend of these latest generation products mixed with own bone 50/50 as the new gold standard of usage. In complicated cases with obesity, smoking etc bone fusion is difficult at best. To have better options like these latest generation products will hopefully make a significant difference for patients and hopefully also save money where more complicated and more expensive solutions previously was needed (rH-BMP2 etc).

It is still up to OssDsign to play their cards right and pivotal will be results from their fully recruited PROPEL study. This will be an exciting case to follow during 2024 and Kuros Bioscience who is perhaps one year ahead of OssDsign is rallying strongly on the Swiss exchange in the past months. If that is any guidance for OssDsign's 2024 is yet to be seen.

Hope you enjoyed the reading and agree it's an interesting high risk small cap case to take into the portfolio at a small weight. As always do your own due diligence and let me know what you think!

Background

ZimVie completed it's spinoff from 29bn USD MCAP Zimmer Biomet (ZBH) in March 2022 and traded around a 800-700m MCAP + some 600m USD of debt after spinoff. The MCAP has since then shrunk to around below 150m USD and lately rebounded to 350m USD. The company is active in two segments: Dental (main product teeth implants) and Spine (main products spinal fusion and disc replacement).

Zimmer Biomet comes from a long history of spinoffs, mergers and acquisitions. Zimmer was spun off from Bristol-Myers Squibb in early 2000's. Including in the spinoff was the dental business which back then was a main segment within Zimmer (now part of ZimVie). In 2016 Zimmer Bio acquires LDR Holding for about 1bn USD, with the flagship product being Mobi-C artificial disc, which now belongs to ZimVie (current EV of ZimVie less than the Mobi-C purchase).

For industry background I made two post about the dental sector back in 2018: Dental Industry Part 1, Dental Industry Part 2 and one post in 2020 about how our spine health has worsened due to smartphone usage, strengthening the case for young people needing neck surgery: Smartphone usage – ticking time bomb.

ZimVie is a small company holding unique assets and in a unique position. To establish products on a global scale like ZimVie's has you need a massive sales network, this is something normally only large companies have the muscles to do. ZimVie coming from large Zimmer Bio has the benefit of being a small company but with that reach pre-established by a large company. Now the question is they can right size their business and leverage the advantaged they have. Press More to read the full story

Spinoff - Selling pressure gone

The spinoff was achieved through the distribution of 80.3% of the shares of ZimVie to holders of Zimmer Biomet common stock on March 1, 2022. The rest was initially held by Zimmer Bio. It's quite common that spinoffs perform poorly in its first year/years as a public company, firstly a big group of shareholders who usually only hold large caps are given a small cap position that they don't really want. This creates a huge selling pressure as they divest the spinoff they have been given. Secondly the company internally needs to find its feet, that can naturally take some time and in the meantime create some turbulence (this has clearly been the case with ZimVie). According to the 2023 proxy Zimmer Bio has disposed of its almost 20% position, most likely in blocks to some larger funds, like Camber Capital, a L/S hedge fund which now holds 10% of ZimVie's shares. This obviously also created significant selling pressure, which now seems to be done.

Why did Zimmer Biomet spin out its dental and spine segments? I have not come across any very clear explanation, but its clear that dental was a bit of an oddball in Zimmer Bio's large portfolio (totally different sales channels). Why then the motion preserving spine products was matched together with this is quite unclear. Spinning out the dental segment clearly made sense and given how bullish I am on the spine products ZimVie owns I am happy they paired these together, even though it doesn't fully make sense as the synergies is non-existing.

Management

Vafa Jamali a former Medtronic exec who oversaw the Zimmer competitor’s respiratory, gastrointestinal and informatics divisions, was selected to lead ZimVie in early 2021 (joined Zimmer Bio shortly after the spinoff plans were announced). He then worked roughly one year in Zimmer Bio before ZimVie was separated. His most recent role was as chief commercial officer of device maker Rockley Photonics and has not previously held the role of CEO elsewhere. Also the CFO was an external recruitment, there is continuity at the business segment level though, where Zimmer Biomet dental and spine business managers comes from Zimmer Bio and have joined ZimVie.

Glassdoor shows quite mixed reviews, some people are very positive whereas others are very bitter and says management is shit, hiring their buddies from outside etc. Trying to draw a balanced conclusion out of these comments, there seems to have been plenty of turbulence and pains trying to decouple from Zimmer Biomet and become a well oiled smaller separate company. This has also been confirmed to some degree by senior managers through various channels (conf calls, podcast etc).

Overall I rank management as one the areas of worry investing in ZimVie, unproven management that are steering a company with high debt and a tanking share price. Clearly they are off to a rough start.

Products / Market outlook

As previously introduced ZimVie is active in two segments: Dental and Spine. Below I will go a bit deeper into these two products and the outlook for the two segments.

Dental

The dental implant market is expected to have healthy growth over the foreseeable future. The global dental implants market reached a value of US$ 5.89 Billion in 2021. One market forecast expects this to reach US$ 7.64 Billion by 2027, a CAGR of 4.2%. Another forecast comments: "The globally rising senior population, which is especially prone to dental problems, is predicted to considerably contribute to market expansion" and predicted a 6.5% CAGR between 2023 and 2032.

Although implants for teeth is a very mature business with high competition among a number of players it has partly hit a new wave of growth thanks to digital technologies. Especially the usage of digital dental (intraoral) scanners has exploded and is becoming market standard. This together with 3d-printing has taken the dental prosthetics business into a new level of convenience and quality of outcomes. This is also seen in one of my other dental holdings, HK listed Modern Dental Group (3600.HK).  ZimVie's dental business is global, with 50% in the US and 50% in Rest of the World (RoW).

To be a successful seller of dental implants it has become essential to combine strong hardware with a strong digital product suite. My impression is that ZimVie (or previously Zimmer Bio) has been behind on the software side, with a quite outdated offering. This is evidenced by the acquisition done recently before the ZimVie spinoff of Italian company 3Diemme for about 30-40m USD (exact price tag not known). The company had developed a Cloud-based dental surgery workflow management solution for dentists. This acquisition seems to have translated into these new launches one year ago: ZimVie Announces Launch of the RealGUIDE™ CAD and FULL SUITE Software Modules. That said, I have not evaluated the difference software head-to-head, just based on my guess this specialist company are delivering a product in-line with competition (or perhaps even better than some, given its newly released). One can also think of this development as both a moat and a problem for a smaller company like ZimVie, previously you only had to provide solid "hardware", but now you need to also develop software to stay in the game, which is costly.

ZimVie key dental products

The T3-Pro which was launched one year ago is built on the previous T3 implant which has been used in more than 2 million implant procedures. So in the past year both the implant and the digital dentistry software has been improved upon, surely there has been major costs taken to get these across the finish-line. Given the tougher situation ZimVie is in given high debt etc (we will come back to this) it's good to note some large costs have already been taken to launch new generation products.

ZimVie dental market position

Since these are medical advanced products and procedures, margins are normally still very high. For a market leader like Swiss listed Straumann, they run around 25% operating margins and almost 20% Net Income margins. ZimVie is not there at all in terms of margins currently but this is sticky business and with a good product offering as ZimVie seems to have I don't see any major reason why this should majorly deteriorate going forward. Listening to interviews with dentist who choose ZimVie's products it's clear that you get used to a set of tools you work with and the barrier to change to a competitor is high.

Spine

The global spinal implants and surgery devices market will witness a robust growth to 2030 with a CAGR of 4-6% depending on which research you choose to believe. Current market size is around $12 billion and there are a number of larger players in this field. Lately two large players Globus and Nuvasive have decided to merge and create the absolute giant in this field (combined MCAP almost 10bn USD). ZimVie's spine business is very USA concentrated, and as ZimVie has been for example moving out of the Chinese market, it is getting even more US centric.

The spine surgery market products can be divided into two main categories:

1. Fusion - The gold standard for decades where surgery outcomes have gone from terrible to acceptable over the last 2-3 decades. Fusion means fusing the bones in and making a segment entirely without movement.  This is the majority (75%) of the $12 billion spine market with roughly $9 billion spent here.

2. Motion preservation - The new technology which for many years have been touted that it should take over from fusion. But for many reasons, including insurance coverage, doctors reluctance to rely on new unproven technology and actual issues and failures of surgeries using the new techniques have hampered the growth foreseen only 5-10 years ago. Another issue is to find suitable candidates, many older patients are not candidates for this new technology. Here my previous analysis on spine problems (us looking down in our phones all day) explains how a new group of younger people will need neck and back surgery. To conclude months of reading, ADR is superior to fusion for long term outcomes with lower re-surgery rates, especially for younger (below 60 years old). Currently Artificial Disc Replacement (ADR) is only 5-6% of the overall spine surgery market. ADR is expected to out-grow the overall market with a CAGR of about 12%.

I should also mention there are also other spine surgery procedures that make up the rest of the market, where ZimVie is also providing products.

Motion preservation leader

ZimVie owns one of the most used ADRs on the market - the Mobi-C. It has one of the longest track records and one of the most studied disc replacements that are still modern enough to be sold. It also is one of few ADRs to be fully FDA approved and approved for two level surgery. It is no longer the latest generation of ADR, as there are newer more advanced ADRs by now but the track record and FDA approvals puts in a strong position. It's easy to get lost here and think, well there are newer better ADRs on the market, Mobi-C is not attractive anymore, well yes and no. Because the competition is not really the other discs which share the 5% market share of the overall market. The big deal here is ZimVie manages to upsell a doctor who today does fusion and move him to do ADR on the patients. So to move the 75% of the market from fusion to ADR is where the big money is. This is happening but at a fairly slow pace, hence the 12% CAGR instead of the market overall of roughly 5% CAGR.

Like I mentioned in the intro, in 2016 Zimmer Bio acquired LDR Holding for about 1bn USD, with the flagship product being Mobi-C artificial disc. In 2016 the hopes were still high for a much higher growth than 12% for ADR, so valuation for owning these products have perhaps come down a bit, but it's worth to put into perspective that ZimVie's current Enterprise Value (EV) is less than what was paid for LDR Holding.

"Fun fact" - Elon chose Mobi-C. I just want to make clear for the reader (on Elon's twitter comment below) who is not into the details of neck surgery. That the first surgery failed for Elon has nothing to do with Mobi-C. He most likely had a bone spur in an area which is very close to arteries and his spinal cord, so to remove to spur has a small risk of creating serious damage or death. Obviously if the bone is not removed it doesn't matter how good the disc is, the spur has to go before you can recover from pain.

https://twitter.com/elonmusk/status/1317274309186838529?s=20

One should also mention the Tether device, which is targeting a smaller market but oh so important, as it is for kids with severe scoliosis in their spine. Again the current gold standard is fusion and tether is not a perfect alternative but it gives the kids a chance to keep their mobility in their spine. Given that we talk about kids and making their spine immobile at such a young age, even just investments aside, that ZimVie takes this product to market is major kudos to them. Hopefully ZimVie will also make good money on this in the future. Talking to a spine surgeon again he was not convinced that Tether gives better outcomes than Fusion, but doctors are strange creatures, they define outcomes differently than we do. They think more in pain scores and less in quality of life, many parents push hard for that their kids should keep their spine mobility and get the Tether device. Actually the story is similar with the ADR, it's very much patient driven, with patients seeking up the few doctors that does disc replacement instead of fusion.

Spin-off troubles, turn-around and potential offer?

Spin-off

Anyone picking up ZimVie's stock graph and looking at it from listing will be wondering, what kind of shit-show happened here. The short answer is that Zimmer Bio loaded ZimVie with a bit too much debt, just when FED decided to start a massive rate hike cycle. When I started to write this post, ZimVie stock had just experienced a -40% day after it's Q1 report and I saw a bargain trading at 7-8 USD per share. Since then the stock rallied which further lowered my interest to finalize my post (as there is less margin of safety).

To fully explain the pressure the share came under it was multiple factors:

1. The mentioned debt load worried investors, although the rate ZimVie pays is actually very attractive, only 1.5-1.75% above SOFR benchmark.

2. Bad results for ZimVie who still were struggling to form its own company and detach from Zimmer Bio, we have still not seen a fully clean result in my view. Q1 was promising and Q2 coming soon will be very important.

3. Mostly in my opinion it was the strange structure where Zimmer Bio left a 20% ownership which they intended to sell in chunks as ZimVie was listed. This seems to have happened through forward contracts to different funds and hedge funds and there was no end to how much the stock could fall while Zimmer Bio was still on the sell side. This created an insane double pressure on the stock, from both Zimmer Bio themselves and all the other Zimmer Bio shareholders who now got a small cap holding that does not fit their investment mandate (this is more the classical selling pressure from spin-offs which many try to take advantage off). As mentioned from what I can see from filings the 20% owned by Zimmer Bio is now sold and ZimVie has been listed long enough so those large caps funds have reasonably also sold now.

All in all this created an extreme opportunity in a slightly bruised company with a bit too much debt to plummet down to almost below 150m USD MCAP at it's worst. Incredible given the two quality business it owns. I unfortunately bought my first shares before the -40% day, but at least picked up enough guts to add and double my position in the 6 USD range.

Turn-around?

So is ZimVie turning around financially now? Well a bit early to tell, but Q1 was the first report that showed some type of possibility to move in that direction. Basically it stopped becoming worse and together with a quite bullish guidance for the rest of the year. The company needs to continue to show sequential improvement over Q2 to Q4 for the guidance story to be believable. The positive is that the dental business has stabilized and is not decreasing anymore. The spine business is still struggling, but mostly this is a one off effect of exiting China. Even if international sales continues to decline for Spine, this is so small now so it won't hurt the company as much anymore. Spine is really a US story.

Potential offer?

Lately the stock is up a lot off rumors' off a potential bid for whole or parts of the company. This makes sense to me for multiple reasons:

1. Buying the whole company because it's just undervalued, in the right hands this company is worth around or even more than when ZimVie listed, meaning 30-40 USD per share.

2. Selling either the Spine or the dental business makes sense to ZimVie, because the synergies between the two is almost zero. The only reason they were bunched together was because Zimmer bio wanted to get rid of two divisions that became oddballs in their company. It did not make sense to bunch them together. Now when ZimVie is struggling under a quite high debt load, selling one half and perhaps become debt free, with the other half left would make sense. As a shareholder I strongly prefer that the Spine business was sold as the dental business in my opinion is of much higher quality. The spine business has great long long term potential but it needs the stamina and right company to go through the growing pains until a product like Mobi-C is part of the new gold standard, we might be 10-15 years away from that happening. If the dental business was sold and ZimVie just left with the Spine business I would potentially sell my shares as I'm more interested to hold the dental part of this business.

The question then is who could the buyer be? Well we have seen a lot of shuffling around especially on the spine side. It could be anything from a Private Equity company to one of the other players who sees an opportunity to grab very strong products at a bargain price. Developing something like Mobi-C and getting it FDA approved costs hundreds of millions of USD. On top of that to build a track record of hundreds of thousands of implanted devices, with over 10 years of data, this is not something you can replicate. ZimVie is sitting on a gold mine with Mobi-C waiting for the US market to wake up to disc replacement surgery. The main reason US is behind the rest of the developed world in this area is due to insurance. This is coming around lately so now its a question of the doctors acquiring the skills to do these procedures. I expect strong movement in the US market over the coming 5 years. Some clever buyers might see the same thing. Zimmer Bio paid 1bn USD for the spine segment, if a buyer can get it for 5-600m USD and wipe out ZimVie's debt, that is a bargain price. Another way to value the Spine segment would be to look at listed Orthofix, which has also struggled although they have a good FDA approved alternative. Their EV is about 800m USD and I don't think ZimVie's spine segment should be worth much less than Orthofix (very similar total revenue, product portfolio etc).

Conclusion

Normally I would add some DCF here, thinking through valuation more properly, but as the stock now has a potential bid on it, I felt that it was more important to get this out, then wait another few weeks. There are many ways to value this company but this might be a rare case for me where DCF adds little value. I do see the stock being worth around 15-20 USD conservatively with a DCF, with blue sky around 30 USD. This becomes less relevant if ZimVie sells all or parts of its business. The bigger story here is that this company has great assets which are impossible to replicate, others in the industry must know that. Shareholders seems not really have understood that yet, that's why I'm very long ZimVie here, its my second largest position and after that gut wrenching -40% day and me adding at the bottom I'm in a very good position at the moment.

I'm holding on to my shares, hoping for a good outcome from the bid and especially a Q2 report which should continue to show an improving trend. Let me know what you think, happy to discuss in comments or on twitter. This was not one of my more well written posts as it was a bit rushed, I hope you can see past the spelling mistakes and poor sentences. But I can promise you this is one of my most well researched cases, especially Spine, but also dental.

In the early days of my blog I talked a lot about my investment process, how I tried to combine top-down analysis of long term trends with bottom-up stock picking. I still think the best ideas comes from this approach, you identify something the market has not fully appreciated yet and then you find the best company in that something area and you buy that. Hopefully you both got a discount because the company is trading cheap and you get exposure to an area/theme which in general is trading at a discount because the market has not priced in the outcome you see. As both these things re-price you get a double re-pricing effect, which can be very powerful. In this case this trend is not news, but I think I found a pocket of this trend which is not appreciated how much it will grow. Also unfortunately the company is not cheap on trailing multiples, but it is at an infliction point where growth is pulling up margins quickly, so a few years out it does not look too expensive.

Now that I have been doing this for quite a while, I can start to evaluate my track record also on my top-down analysis. Maybe somewhat surprising I feel have got the long term trends more correct than my actual stock picking. Expressed a different way, even if I figured out where the world is going, betting on the right companies that benefit from that has often been far from easy. So what I have tried to become better at is the stock picking part and not get too excited about the top-down analysis. If no good enough company presents itself at the time, I will keep my world view in mind and keep my eye out for a suitable investment, but I won't force it. For this top-down analysis I have definitely taken my time and it has taken me an incredible 2.5 years to find two investments to express the very long term tailwind I see from the theme of (excessive) smartphone usage. That I found both stocks almost at the same time was partly by coincidence and partly that the growth sell-off has given me opportunities to buy stocks which otherwise were too expensive (not enough margin of safety).

This post is really the part 2 of the investment theme idea started 2.5 years ago, so it's essential to read what I wrote back then first.

http://www.globalstockpicking.com/2020/09/30/smartphone-usage-ticking-time-bomb-part-1/

The Part 1 goes into detail of problems for the neck (cervical spine) I will below expand on the issues related to myopia (not being able to see objects far away). After that I will do two separate posts to present the investments I made in two US companies to benefit on these strong tailwinds. One of the investments I already revealed and invested in ZimVie, which is related to neck issues. The other will be revealed towards the end of this post and is then obviously myopia related. So let's get going on the Myopia background (press to read more)

Myopia - an epidemic barely talked about

For decades, researchers had thought myopia (or short-sightedness) was mostly genetic. There were early hints, though, that this could not be the whole story. A study of Inuit in Alaska, published in 1969, found that myopia was virtually unknown in those middle-aged or older, but that rates were above 50% in older children and young adults. Such a change is much too fast to be purely genetic, and it had happened just as the study participants had begun to adopt a westernized way of life. The dominant hypothesis now is that exposure to daylight is the main variable/culprit to myopia. A study of Californian children, published in 2007, found that time spent outdoors was strongly associated with a lower risk of myopia. It explains why rates are high in Asia in particular, since private tutoring and after-school classes mean schoolchildren there routinely work longer days than their Western counterparts. So I'm simplifying this a bit saying it's due to only the smartphone, but the smartphone (or other tablets and gaming devices) are a large reason why kids are not playing outdoors anymore. Below one can see the clear trend of myopia growth world-wide and how it is expected to grow in the future:

World myopia development

Affluent Asian countries were already in the 1990's at the current global levels and looking at the graph of myopia among 20 year old's in Asia that is a hint of where the world is going and why the 2050 figure in the graph above is so extremely high.

Researchers have also been working on ways to slow myopia’s progression once it has started. One is to use low doses of atropine, the juice of which was once used by women to dilate their pupils, in order to make themselves look more attractive. Another is specially designed “ortho-k” contact lenses, which are intended to reshape the cornea while sleeping. Even so Myopia is unfortunately just getting worse, and especially in Asia the numbers are increasing at an alarming rate. In Asia is no longer a question of having myopia, the focus is shifting to how severe your myopia is, because all kids have myopia.

In countries who further locked down their population during Covid or parents trying to protect their children by keeping them indoors, this has just further aggravated an already bad situation, creating even more myopia cases. The conclusion of this recent Chinese study was: "The prevalence of myopia among students increased during the COVID-19 pandemic, especially in primary school Grades 2–5." This latest study suggest Chinese myopia levels are so high now that it's rare for anyone in their early 20s to not have myopia - that is over 250 million people in China alone, all with myopia - mind boggling.

China myopia prevalence in recent study

Source: https://www.frontiersin.org/articles/10.3389/fpubh.2022.859285/full

Diving deeper into Myopia

As can be seen from all the data, kids already have severe myopia and they growing up in the coming 10 years being blind to objects further away, this is a phenomena at a totally new level compared to when you who are reading this probably grew up. To better understand Myopia from an investing perspective one needs to understand what products and procedures for myopia drive revenue for companies. Let's look a bit deeper what is happening under the surface of these myopia figures which seems to almost go towards 100% among children in Asia.

This is what you see if you are in the high moderate or high myopia category (which now majority of Chinese kids are in).

The gold standard solution to permanently solve the myopia problem is LASIK surgery. The picture above basically explains at least to me why so people today do LASIK surgery. What a liberation to go from picture 2 or 3, to picture 1. if you add in the beauty aspects to not need to wear glasses combined with the freedom to actually see clearly again and throw it to not need to spend money on contact lenses in the future, it's almost a no brainer for anyone who is eligible for the procedure. LASIK today which is a multi billion dollar industry has been refined both in terms of quality of outcomes as well as the volume has brought down the price. It is now basically a mass market product available to most that want to get rid of their glasses or contact lenses. LASIK became so popular that after an initial boom in the 2000's the number of procedures actually dropped (everyone interested who was older already got it). With myopia now growing so significantly in prevalence the industry is now on a growth path again.

Another important area, like already mentioned are products that try to stop myopia from progressing and getting worse in the first place. One big reason why that is important is that high/severe myopia is dangerous on a different level than more mild cases. Your retina could detach and you have increased risk of a number of other eye problems as you grow older. Basically up to moderate myopia is quite risk free, after that it's getting worse complications. So the incentive to stop myopia should be there for parents, but as the figures show, it's not easy to stop. Also high myopia means that you are basically blind to objects further away (you can see contours but no details on objects a few meters away). So you are very dependent on your glasses, contact lenses or whatever you are using, it really turns into a real handicap. In my view, due to the increase in more severe/high myopia cases the investment opportunities from myopia grows a lot, as it is much more urgent and important for the person to do something about it.

Weifang study - High Myopia (> -6 D)

Weifang is a smallish Chinese city with a population of about 10 million. This is not the most affluent area where all parents are buying night tutoring to their kids, probably it is a decent average of what China in large looks like today. A huge study was done on basically all school children in Weifang, over 1 million children. The results are similar like the color full graphs shown above, but actually even worse:

High myopia (> −6.00 D) prevalence was 20.12% for high school students. As myopia progresses into the early 20s the figure for adults are therefor even higher, probably around 25-30% (my guess). That means in the future 25% of the Chinese adults have eye sight which is like the third picture above or worse and there are no signs that we are reversing this trend. Like the Covid study done in China mentioned earlier, these numbers of high myopia is unfortunately just getting worse.

Source: https://www.ncbi.nlm.nih.gov/pmc/articles/PMC9358211/

Myopia as an investment

So what would you then guess I say is the investment case to make here? Well like I said I tried for 2.5 years to figure this out. Instead of jumping on the first or second good company I found I looked at different categories and held off (until now)

Companies that slow progression or produce glasses / lenses

First a looked at Cooper Vision part of (Cooper Companies ticker COO). A really good company who have come out with a good contact lense (MiSight) to slow down myopia progression in kids. Unfortunately this company is so huge, so even if MiSight product grows big, it's almost not going to move the needle in COO total sales and profit. Most of Cooper's profits is rather from regular contact lenses and a big surgical segment (related to fertility etc). But all in all, Cooper is a great company, they will benefit from more people needing help with their vision for sure. If it ever trades down 50% or even 35-40% I'm buying it straight away - but it's not the ideal way to get exposure to this mega-trend. There are also other lens companies like recently listed giant Alcon, twice the size of Cooper its the market leader globally on contact lenses. But neither here are they at the forefront of a solution to myopia (and especially high myopia) than just their existing range of contacts.

Eye surgery clinics

Another way would be to invest in eye-clinics, there are especially in China a few listed ones. A Hong Kong listed company is called C-MER (3309 HK) but the valuation is so lofty that it has never interested me, perhaps one day the market will give an opportunity here.

Producers of LASIK machines

So how about LASIK? The LASIK area has good growth and can restore eye sight for myopia. Yes this area has nice growth but competition is fierce, these machines although refined are by now old tech, there are many different companies producing the machines and selling machines. A bit like Cooper, these companies are not but, rather high quality more mature companies.  One example here would be Carl Zeiss Meditec AG (AFX), again quality company, but valuation too high for me for such a mature company. There is also one big issue with LASIK, it's not really suitable for people with high myopia. LASIK stops being the treatment of choice somewhere around larger than -8 D, some clinics go further, but its no longer the gold standard past this point. It's around these levels of -7 to -9 D that, although some people can still do LASIK, many are not eligible because in their specific case there is not enough material to shave off with the laser to re-shape the eye back to good eyesight.

The latest choice for high myopia

There are good solutions in place for mild to moderate myopia already, basically up to moderate myopia are fine with just glasses (it's more beauty/convenience related to use LASIK). For high myopia and especially those that go several levels past the definition of high myopia as there are few choices. Basically the choice stands between wearing glasses or contact lenses, a surgery which removes your own lenses (unusual to do) or the product which is my investment case . We know from above mentioned studies more and more people are falling into the high myopia category, The product is meeting a quickly growing unmet need and that's why the product is growing so fast in China where high/severe myopia is so high. The company is called STAAR Surgical and their product is called EVO ICL which is the only existing Implantable Collamer Lenses (ICL) and it solves the problem if myopia all the way up to -15 D, and the patient can get perfect or near perfect vision back, with results just as good as with LASIK. In fact for patients in the -8D range, close to the maximum of where LASIK is recommended, the EVO ICL lenses produces better outcomes than LASIK. The best part of the procedure is that it is fully reversible, it does not remove anything from the eye, so a patient can fully reverse the whole procedure and do for example LASIK after, or just go back to wearing glasses. Not that many patients want to do that, given how extremely well the product seems to work. This is my latest investment case and I will go into much more detail in a full write-up later. But it is very important to understand this backdrop of how myopia is getting worse globally, it really is an epidemic and many companies like Cooper etc will have good growth from this. But I do believe the highest growth pocket will be for a small company like STAAR which has a unique product which meets a growing need which no other product in a satisfactory (and safe) way can do. Just running number like 25% of all Chinese in the future would have high myopia and be potential EVO ICL users and you understand that the potential is mind boggling.

I leave with a doctors comment here on EVO ICL:

https://www.healio.com/news/optometry/20221207/innovative-implantable-collamer-lens-expands-options-for-higher-myopes

In the future I will refer to this two part series (which took almost 2.5 years to finalize) when I talk about investments either within the spine or myopia space. As always, hope you enjoyed it as good food for thought and perhaps gives you confidence in the strong tailwind for companies in the eye-care industry.

Disclaimer: This post is for general information purposes only and does not constitute investment advice. Always do your own due diligence.

Elevator pitch

• Only independent software company in radiotherapy for cancer treatment with very strong product offering, never lost a customer.

• Founder led company which spent more on software R&D than the current market cap of the company.

• Although their product is good, a strong R&D push which reduced profits + previous aggressive accounting and now Covid-19 has hammered the stock from 260 to 45 SEK.

• New CFO in place and CEO/CFO has promised focus on cost control (for the first time).

• With a stronger software offering, hospitals are going back to business as usual, latest report confirmed early signs of turn-around.

• RaySearch has 70% market share in proton therapy, which has a very strong outlook the coming ten years.

• With very conservative estimates more than 60% upside and a weighted valuation pricing gives 85% upside.

Background

RaySearch is a Swedish medical technology company that develops software to improve cancer treatments. RaySearch software is today used by over 2,600 clinics in more than 65 countries. The company was founded in 2000 by Johan Löf as he was working on his PhD in radiation treatment. Johan is still the majority shareholder and CEO and has proudly stated that RaySearch has never lost a customer, that's a pretty strong statement. In the early days RaySearch delivered functionality to the leading treatment system vendor Philips. In 2003 RaySearch listed on the Stockholm exchange. RaySearch is developing highly complicated software in a very specialized field. The cancer treatment facilities are among the most complex areas in a hospital and requires both very advanced machines and software. Radiotherapy kills the cancer cells by various kind of high energy beams, like x-ray or protons. The core of RaySearch products and what Johan worked on already in his PhD is a more clever dosing of the dangerous radiotherapy. Basically "burn" away the cancer with higher precision, meaning minimizing damage to healthy tissue. After the early cooperation with Philips, RaySearch tied more and more partners to its development. Companies like IBA Dosimetry and Varian as well as certain large University hospitals worked together with RaySearch. Over the past two decades RaySearch grew from a small niche player with some smart algorithms into the only major stand-alone software company in this field. All this was done without any share dilution, RaySearch has funded all growth by being profitable from a very early stage. This R&D has coincidentally costed RaySearch just in line with the current Market Cap of the company (1.55bn SEK). Let's look at the history and the products RaySearch developed in greater detail (press read more).

History and software

A key to understand RaySearch and its products is to understand what is going on in the radiotherapy department of a hospital. The picture is a bit dated, taken from an old RaySearch annual report but its a good introduction for the ones that need it (click to enlarge).

RayStation (treatment planning)

From 2008 RaySearch decided to create its own stand alone treatment planning system (RayStation) and sell it directly to clinics. This was obviously a large step as previously RaySearch improved someone else's product offering, now they came in as a challenger with an alternative standalone software. Late 2010 RaySearch kicks off its sales in Europe/USA and in 2012 in China. In 2013-2014 the RayStation software gets more mature with new versions released, sales picked up at an impressive rate (around 30% YoY growth). With benefit of hindsight these really became the golden years for RaySearch, sales boom off a fairly small cost base.

RayCare (Information System)

Scroll forward to 2017 and RaySearch decides recycle a lot of these profits, taking their products to the next level. RaySearch establish a Machine Learning department, which now in present time start to bear fruit (more on that later). An even more important introduction was the new software, RayCare. RayCare is a so called Oncology Information System (OIS). In more simple terms this means an information system to file data about the patients (prescriptions, side effects, delivered dose and much more). This takes RaySearch further away from its niche of just providing a very specific system (RayStation). This system has the potential to be the cancer departments main tool used to track all activities related to the patient.

In 2018 the impressive growth levels slows somewhat but the company still grows a healthy 10-15% YoY. In 2018 Anderson Regional Cancer Center in USA becomes the first customer to order the RayCare platform. RaySearch continues during 2019 to expand its staff and prepares an even stronger sales push. Unfortunately that sales push barely gets off the ground as 2020 Covid halts all activity. Covid hampers sales opportunities with large hospitals which switches focus to Covid rather cancer care improvements. For the first time in over ten years RaySearch sales drops.

RayIntelligence (Big data analytics)

Even if sales suffer, the now larger development team continues to upgrade their software and launch new ones. In 2020 RayIntelligence is released, to understand it one can break it down into 3 products: Ray-Data, RayAnalytics and RayMachine. Ray-Data - extracting all data from everything that happens within RayStation and RayCare. Everything that is related to the treatment planning of the patient, all the diagnostic data, and from RayCare, everything that's been done to the patient in terms of workflow, administering of drugs, radiotherapy follow-up etc. All of this data is a big repository in Ray-Data. RayAnalytics - is a way to provides means to visualize the Ray-data, to see connections and look at population data. RayStation deals with 1 patient at a time, RayAnalytics looks at aggregates. RayMachine - based on all of that structured data one can create machine learning models that are used to drive machine learning algorithms within RayStation and RayCare. Basically to unleash the full power of both RayStation and RayCare.

Machine Learning (part of RayStation/RayCare)

Another example of ML that I found was what their new ML algorithms can do within RayStation: The deep learning contouring feature in RayStation uses machine learning models that have been trained and evaluated on previous clinical cases to create contours of the patient’s organs automatically and quickly. “We used deep learning to contour the first patient on May 26 and the treatment was performed on June 9. From taking 45-60 minutes per patient, the contouring now only takes 10-15 minutes, which means a huge time saving.” This press release is from June 2020. It's in my view impressive how RaySearch gone from starting a ML department in 2017 to three years later having product which improves processes so much for a client.

RayCommand

2021 also became a lost year from growth/profit perspective. Since RaySearch is an independent company their software has to work with different hardware, RayCommand was released early 2021 to bridge such differences and simplify treatment processes with different hardware.

That is a short summary of the history and also an overview of what RaySearch software does. What is clear from this history is that a lot has happened in the past 3 years. RaySearch basically goes from a one product software, RayStation, two having a suite of options. Both RayCare and RayIntelligence are highly ambitions software to launch and they never really got off the ground before Covid hit. We are now entering 2022 and seeing clear signs of a turn-around in terms of order backlog. The jury is still out how successful the new software will be, but its clear RaySearch has put considerable effort and money into developing these.

Market Outlook

There is a lot of talk in the cancer industry that the coming years could be very bad cancer patient years. People have been holding off getting a check-up, due to Covid and hospitals have also been overwhelmed. Reports are already coming in from doctors that they see later stage cancers than they normally would, truly sad. There is a strong case that hospitals will have to quickly refocus on cancer care. Doing as much as possible with the resources available means that efficient software becomes key, here RaySearch for sure can play a part. Various studies will give different estimates of future growth of radiotherapy, ranging between 4-6% yearly CAGR. Much of that growth will come where the need is the largest, in Asia. As the below picture describes the "number of radiotherapy units per capita" various significantly between regions, with North America at 12, Europe at 5 and Asia at 1. So the case for increased usage of radiotherapy is very strong.

Source: Elekta Annual report A subset of this market proton therapy is set to grow at an even higher pace. Estimates seems less predictable but most are above 10% yearly CAGR, although I found one study that estimated it as low as 2%. If we look back historically we can see that growth has accelerated over the last few years. Overall the growth prospects for the industry looks to have good tailwinds. Why is proton therapy so interesting? Because RaySearch is the gold standard software in this niche.

Proton Therapy - the new gold standard

What USA does matter a lot for setting a standard of care, especially when we are talking about expensive new health tech. Healthcare professionals have for a long time agreed that proton therapy is superior (to x-ray) for some types of cancer. For example the most common male cancer in the prostate is a strong candidate for proton use. Even so the growth of proton therapy has been extremely slow. The reasons for these are numerous, for example even if the X-ray technology does not have the same potential, it has been refined to a higher degree than the proton therapy. A bit like an EV being superior to a Petrol Car on paper, but for a long time the EV tech was not mature enough (For the interest reader see this Debate). The tech side is changing rapidly though, partly thanks to RaySearch software and proton therapy seems to clearly be the future from a pure technical perspective. Proton systems are also more expensive, so although they are sometimes better cost is also weighed into the equation. This I see partly as the same issue as with EVs again, volume will drive down price. One important economical aspect of this has also been that insurance companies in the US have denied a lot of people to use proton therapy. Naturally a hospital wont invest in a super expensive proton system if their customers gets denied its usage by their insurance companies. This seems to have changed significantly over the past years, especially through this judging in 2019: Judge rips insurance company for 'immoral, barbaric' cancer denials. As the article states UnitedHealthcare the largest insurance provider in the US changed its policy in 2019 around proton therapy, so that hurdle is now cleared, proton therapy will be approved. It's very important that the US can lead the way for bringing down proton therapy cost, since the public healthcare systems in the rest of the world weighs in cost effectiveness for what they will purchase. With a lower price and a larger gap in outcomes between proton and photon therapy the public health systems will also shift.

Understanding the customers

RaySearch has a very impressive list of customers, including Princess Margaret Cancer Center, MD Anderson Multi-cancer Center, University of Washington Medical Center and Massachusetts General Hospital. The later one has decided to gradually replace all existing treatment planning systems and use RayStation alone. Obviously this is the dream situation for RaySearch and ultimately what the company wants to achieve with all customers. So far, this approach seems to work better at the bigger and more complex hospitals. My take on this is that the hardware is so extremely expensive, so for top of the line hospitals, if they can squeeze out a bit more performance out of these machines with better software, that is worth a lot.

Smaller centers are key to growth

Smaller centers with with perhaps only one or two simple linear accelerators (the more standard type of radiotherapy) is not in the same need of such a sophisticated platform as RaySearch offer. RaySearch has created a simplified pre-configured version of RayStation that they call RayPlan for the less sophisticated customers. RaySearch has admitted in the past that this is the area they would like to get better traction in sales. So far that has not gone according to plan but is a key factor for how much growth the company could see in the future. Johan in a recent conference call gave a very strong example of how their new suite of software could create a very strong sales pitch to smaller less sophisticated clinics. We have a collaboration with MD Anderson in Houston. So we'll take their treatment protocols and their entire workflows for all cancers, head and neck, breast, prostate, lung, et cetera. It will result in complete workflows that are viable options for both RayCare and RayStation. So a clinic in India can mimic the MD Anderson way of treating any cancer. It's so much information in such a protocol. It's exactly how you define the tumor, how you define the margins, which structures to include in the treatment plan. How much dose should be given to various areas? What was the maximum dose to other areas? And what's the quality assurance procedure, et cetera. All of that is embedded in a complete workflow. And this is extremely powerful, that we can spread the highest standards of care that are developed in these most advanced centers in the world, and they can be easily applied to a much smaller clinic with much less resources anywhere in the world. And RayCare, RayStation will be the vehicle of that and combined with RayIntelligence. I found this comment from Johan to be one of the things that made me the most bullish on RaySearch in the long term. For a small clinic in an Emerging Market to say they work with the same process flow as the worlds leading cancer clinics is a pretty strong selling point from the clinic towards its patients.

Particle/Proton therapy

Customers/hospitals have a number of hardware and software providers. Many hardware solutions are bundled with software from the same vendor, perhaps the hardware is great but the software could be better? RaySearch is trying to get a foothold at these hospitals and basically take over as much as possible on the software side. There are many different types of cancer treatments as explained one niche is called particle/proton therapy. RaySearch has a very strong foothold here, basically being the market standard software system. There are roughly 100 particle centers world-wide and RaySearch is selected at some 70 of these. Growth of particle therapy is hence good news for RaySearch who often wins these contracts and gets a foothold in more centers.

Press releases

Reading through RaySearch press releases one can get a deeper understanding of how large hospitals work and think. "Charles-Le Moyne hospital has been a RayStation®* customer since 2018. With the planned expansion, the cancer clinic will now fully replace their former treatment planning system with RayStation for all of their radiation oncology services, which today includes eight linear accelerators. Further, the clinic has added new and advanced technology to the order, including multi-criteria optimization, dose tracking, adaptive planning and TomoTherapy planning." "Carbon ion therapy is a highly advanced radiation therapy technique that can be effective for complex tumors which are difficult to treat with conventional methods. The market for carbon ion therapy is gaining momentum in China with several facilities either under construction, or in a planning phase. Lanzhou Ion Therapy Co, LTD (LANITH), located in the city of Lanzhou, specializes in the development and installation of medical devices using carbon ions and other heavy ions. LANITH has now chosen RayStation to ensure maximum dose precision and workflow efficiency" "RaySearch Laboratories AB (publ) announces that La Clinique Générale-Beaulieu, a part of Swiss Medical Network in Switzerland, is the first center in the world to treat a patient using the Accuray Radixact® radiation treatment delivery system with RaySearch treatment planning system RayStation®* and oncology information system RayCare®. Johan Löf, Founder and CEO, RaySearch, says: “We are very pleased to hear that the first treatment with Radixact and RayCare has been successfully carried out at this world-class center. It is an important proof of concept that RayCare can be used as the sole oncology information system together with Accuray machines." "National Cancer Centre Singapore (NCCS) has placed an order for RayStation®* as the treatment planning system for its new proton therapy center currently under construction and scheduled for completion by 2022. The Goh Cheng Liang Proton Therapy Centre at NCCS will be equipped with the state-of-the-art PROBEAT treatment delivery system from Hitachi. The setup will include four treatment gantries capable of 360° rotation and a fixed-beam room. Hitachi’s treatment delivery system includes dose driven continuous scanning (DDCS) functionality –an innovative technique aimed at improving proton dose delivery accuracy. RayStation is currently the only treatment planning system to support DDCS."

The founder/CEO

Johan is a highly intelligent physicist who has proven he does not only have the engineering smarts but also the business acumen to build a company. Johan's mom passed away in lung cancer when Johan was a young boy. Reading up on Johan's and RaySearch's achievements, its clear that improving survival rates from cancer is a real passion project for Johan. He is a highly involved CEO, looking at Glassdoor comments he seems so highly involved that the most common negative comment mentioned is how top-down driven the decision making is in the company. At the same time he seems to have created a company with a very family like culture and overall Glassdoor scores are quite good. Johan built the company from scratch and I have a lot of respect for CEOs who 20 years later still are at the helm, involved in details and improving their product. Johan describes in interviews how he often visit the cancer clinics waiting rooms when he travels the world. There he gets inspiration and ideas how to better develop his software to help cancer patients. Maybe this was one of the reasons for RaySearch to take the big step of developing their own Oncology Information system, RayCare. Perhaps this passion for growing RaySearch into a better/bigger company has also created the situation the company is in currently (loss making and looking at cost savings), more on this later.

Compensation and shareholding

Compensation as in almost all Swedish companies is very modest, Johan's bonus is capped at 1 year salary, with a salary of roughly ½ million USD. Johan holds about 19% of the overall share capital and with a dual voting share structure he holds some 57% of the votes, his old time professor holds some 10% of the votes as well. It's obviously a big positive to see Johan have such a substantial holding in the company. The dual voting structure is unfortunate though in my view. With all the IP the company has, its strong market position and current low valuation, there is a clear case for someone bidding on the company. But with this structure in place, it's up to Johan if he wants to sell or not. Johan has been selling some of his shares lately. He has done this a few times in the past, always stating personal reasons. I don't really see any issue with this, he still has such a significant holding. With almost all of his wealth (presumably) tied up in the company its natural to diversify at least a little bit. I'm a bit curious with the timing though since the share has been under a lot of pressure lately and last year end he sells his shares at a multi-year low. Hopefully it really was some urgent expenses that he had (I guess he would have sold more if he really is giving up on the company).

The competition

RaySearch has three competitors for RayStation:

• Philips' Pinnacle

• Varian's Eclipse (now part of Siemens Health)

• Elekta's Monaco

The later two are packing their software with their hardware. Basically RayStation has to be significantly better than their included software for a hospital to consider changing from something that comes with the hardware. RaySearch has had success to convert centers with both photon and proton therapy to RayStation, as they are the best choice on the proton therapy side. It's hard for me as a layman to judge which software is better at what. What I can see is that for example Philips Pinnacle system does not seem to inhouse be able to create that ML contouring as earlier described. They partnered with an external firm to bring that functionality into their software (not sure if its even a launched product for them yet). Since the other two only produce software for their own hardware, the risk here lies with that these hardware players take over the whole market. It would be better for RaySearch if the market got more fragmented with other players taking market share in terms of hardware sales (for example Accuray). Varian and Elekta are the two giants in the industry though. RayStation is today installed in over 700 clinics, which is roughly 10% of the worlds clinics. The fact that RayStation has been sold in so many clinics says something to me about the quality of the product compared to the products Varian and Elekta include with their hardware. In some sense this makes sense, RaySearch pioneered the industry and lives and dies with the quality of its software. Elekta and Varian are foremost researching and producing the hardware and software is important too but not as important as the hardware. On the RayCare side there are two competitors:

• Varian's ARIA

• Elekta's MOSAIQ

Given how new RayCare is, it's hard to judge in what kind of shape RaySearch is to get clinics to switch from ARIA/MOSAIQ to RayCare. What seems clear at least is that its harder for RaySearch to win such contracts when Varian and/or Elekta is not co-operating with RaySearch. So far, ironically enough the company who has refused any coop with RaySearch is the Swedish company Elekta. Wheras for Varian, RaySearch in 2020 signed and interoperability agreement that will allow the RayCare oncology information system to connect to Varian TrueBeam linear accelerators. See press release: link. This agreement basically enables the use of RayCare for clinics who use Varian's TrueBeam accelerators, it's a big step since the TrueBeam accelerators are one of the most common ones in the market. Varian has been dragging their feet in the validation steps for interoperability, in the latest conference call Johan commented that it will be done for sure later this year. If this somehow would fall through (maybe because Siemens now acquired Varian) that would be a pretty big negative for RaySearch. That Varian are dragging their feet to finalize what they agreed does not sounds great but I'm still cautiously optimistic given Johan's comment. There are only some 20 clinics worldwide that so far switched to RayCare, a very small number compared to RayStation. There is some risk here if the Varian deal falls through.

The partnerships

RaySearch has many partnerships, here are four of the main ones mentioned.

IBA RaySearch has a very strong relationship with Belgium both with IBA and the Iridium Network. IBA is listed on Brussels exchange with a MCAP of 500m EUR. In particular these press releases shows how they work together with selected customers and basically build the next generation of their software together. In this case the RayCare platform: Iridium Network invests in RayCare to become their primary oncology information system. And here with IBA for proton therapy: RaySearch and IBA expand their partnership in proton therapy. Mevion Medical Systems A privately held company which is a market leader in compact proton therapy systems. This is a pretty well funded company and from valuation rounds the estimated valuation of Mevion seems to close to 1bn USD. RaySearch and Mevion have collaborates since 2014 and new functionality on the hardwire side is developed together with RaySearch software. This is one of the clear partners for RaySearch to ride the proton therapy boom. Accuray Accuray a 340m USD MCAP company (still twice RaySearch's current MCAP) makes radiotherapy hardware and has not really been a winner in this space. The stock is trading close to all time lows and sales have been flat in the past 10 years. Although Accuray has their own treatment planning software, the co-operation with RaySearch seems very tight and RaySearch supports their whole platform of hardware products. Even at trade shows Accuray and RaySearch do joint previews of their products. Strong sales of Accuray hardware would clearly benefit RaySearch.

United Imaging Healthcare (China)

Founded in 2011, UIH has developed the world’s first medical linear accelerator with fully integrated diagnostic-quality CT imaging to support adaptive therapy planning. RaySearch will adapt RayStation and RayCare to UIH’s CT and standard linacs. They will be the first conventional linacs to be integrated with RayCare.

Financials

As previously mentioned RaySearch has an impressive track-record of growing in a profitable way. The Covid situation has clearly both stopped both the nice revenue growth and profitability. A rebound seems very likely as the world is opening up.

Revenue is split in the below categories. The past two quarters are showing early signs of a turn-around. It's also important to note that as RaySearch install base grows larger, the more sticky support revenue is growing to a very decent size. The market should trade this revenue at a higher multiple than volatile licensing revenue. Hardware is related to physical computers etc which are delivered with the RayStation installation.

Unsurprisingly the distribution of sales is nicely spread across the world, RaySearch is a true global business.

Explaining the share price drop

As you have seen the share price performance has been awful over the past years. I think its worthwhile spending a bit of time asking why is that? First of all obviously profitability has dropped significantly over the past years. The big picture for that is that RaySearch has decided to increase (development/R&D) cost quicker than they had profits coming in the door. Given that RaySearch is a software company that costs basically mostly comes in the form of headcount. Below you can see that FTE and R&D basically goes hand in hand and increased quickly from 2015 onwards.

This disregard from growing profitably is pretty much in-line with the growth mantra the stock markets have been rewarding (until recently). Don't show us profits, just maximize growth and RaySearch seems to have joined in on that. The next item that would explain the weak stock performance would be related accounting. RaySearch has got criticism for its accounting practices. We need to figure out what is going on there.

Accounting

I usually don't dive into accounting details in my write-ups. If I see red flags I usually avoid the companies and there won't be any write-up. Most cases I write up the accounting is pretty straight forward. In RaySearch case there is a history of the company getting criticized for it's accounting treatment, so we need dig a bit deeper than usual here. The criticism is that the cash that the company generates is much smaller than the net profits, see comparison below. This has been true and relates mainly to two accounting treatments, more on that below. To make it even more complicated the accounting standards where changed in 2018, when IFRS15 was introduced. This reduced the revenue that RaySearch could recognize in 2018 (a good thing if you want RaySearch to be more conservative). Below is an important graph where I defined what I see as the true cash flow generations, removing any new debt issuances or repayments.

As you can see RaySearch during its big growth years, showed very nice growth in Net Income, whereas the company generated very little cash. This large timing difference is a head scratcher and could be one of the reasons why RaySearch is trading at such a low valuation today. People got cold feet from the cash never showing up and was one of the reasons for the weak stock performance. As Net Income dropped this reversed in 2019/2020. Let's look at how this happened: R&D costs are capitalized and then amortized

The first row present the actual development costs (in cash terms), whereas the last row is what is deducted from revenue to end up with a Net Income figure. This explains the majority part of the gap between Net Income and cash generation. Below is a graph of the difference of the first and last row of the table:

For 2011 - 2022 this summarizes to 355m SEK in R&D expenses that are capitalized, which has "inflated" Net Income vs actual cash flows. But this is not all that goes on unfortunately. In my view this is fairly straight forward. The next effect is more "hairy" Recognition of revenue vs receiving the cash In turns out hospitals are both great and awful customers. Great because they are secure credits who rarely default on their obligations. Awful because the payment terms are sometimes very very long and the hospitals are even sometimes late to pay. This means that since RaySearch recognizes the income when the software starts to be used but does not receive an actual cash payment from the hospital, some of that net income is therefore building up as accounts receivables. Given that the capital cost of software is free (no physical object costing money) the negative aspects of having to wait to get paid are in my view not so bad. As long as the companies actually do pay, its basically shifting all payments in time. The result though for a growing business with growing profits, means you are always one step behind in your actual cash-flow (if you are early to recognize the revenue). RaySearch has in my view been to quick to recognize revenue. Perhaps IFRS15 in some way forces RaySearch hand in this, but I do believe there is still a choice to define the performance obligations differently, which would delay the recognition of revenue. The receivables are split into billed and unbilled receivables in the accounting notes. Billed receivables I don't really have a problem with, it's pretty standard, you sell a software and send the bill, with some payment terms on the bill (like 90 days). Unbilled is where it gets a bit murky in my view. This is where you recognize the revenue but the bill has not even been sent yet, so obviously payment terms will be longer here. Some of the reasons for this (as I understand it) is that some new customer need a long time to get fully up and running on the new software. So they won't pay before this is met, and this could be up to a year later + the bill terms after that. The receivables historically have been split like 50/50 between billed and unbilled.

Note the word expected date of payment above, its unbilled so this is some type of best estimate. I would have preferred that RaySearch would have just not recognized this revenue at all, until its billed. But then RaySearch would have been much later in showing it's very significant growth, perhaps shifting the whole Revenue and Income distribution 1 year later. Also looking at competitors like Varian, they also have unbilled revenue, so it seems to be the market praxis. As you can see the unbilled amount decreases 2020 vs 2019, with some 41m. Also the billed amount decreases with 38m SEK. This explains the strong cash-flow in 2020 where these receivables are released as they land as cash on RaySearch account. Actual credit loss levels have been fairly low, although 2020 did see a larger jump (-12m SEK in actual losses), so the recognized revenue should show up as cash when the receivables are released (minus higher than expected credit loss levels).

Summary of accounting deep dive

Two effects have in the past been hindering cash flow although RaySearch reported strong Net Income growth:

1. To capitalize more R&D cost than you amortize, which is indirectly is an effect of R&D spend increasing.

2. Revenue recognition with complex payment terms for delivering software and continuous support of that support. As with R&D this has overstated Net Income vs cash flow due to increasing sales.

To summarize this is not great accounting practices, but is not a show stopper for me. All software companies have some type of model for revenue recognition, especially in the new SaaS world it get complicated. RaySearch model has perhaps been a bit aggressive, but now cash is coming in. As my picture above shows 2019 and 2020 had higher cash generation than Net Income. A lot of people seems to have sold the stock due to poor cash generation and now forgot about the stock when the cash generation is strong (due to Covid issues taking focus instead). Now the CFO has stated they will not expand R&D further either from this level, so Net Income and Cash flow should be more aligned going forward with a more stable R&D spend base. And even if it wasn't stable I would be OK with this effect, as long as I understand it. What matters in the end is that the product sells and customers pay.

Looking ahead

It's clear that RaySearch has ambitions goals to go further on the software side than any competitor has. A statement I found on long term plans: “Ultimately the goal is co-planning of radiotherapy, medical oncology and surgery within the same software platform". RaySearch has in the past years doubled the number of staff, significantly increased R&D spend (significantly sacrificing profitability). Just when this development push was supposed to bear fruit, Covid happened. It doesn't matter how good software you developed when the hospitals are busy with something else. Obviously the competition has not been standing still either but relatively they have not more than doubled their R&D budgets like RaySearch has. The most likely outcome in my view is an initial sales bump from hospitals catching up with spending that had to wait for the past 2 years. After that the "cancer debt" will continue to take its toll which to me seems like a strong argument for hospitals to continue to invest heavily in this field for the coming 3-4 years. In the very latest report we could see the early signs of this bump.

Early signs of turnaround

With the install base being larger, although order intake is far from record levels, the support backlog is large enough to bring total backlog to all time highs. The markets rewarded RaySearch which a +15% stock price increase when this report was released but due to the generally weak market the stock is now trading below that initial price bump. Waiting for the turn-around to show up in the figures you will usually have to pay a higher price, but in this case it seems to me you can buy at rock bottom although the turnaround is already here. Another large growth area is something we did not touch upon in this write-up. That is that RayStation now since recently supports brachytherapy planning. A lot of radiotherapy clinics also offers this type of treatments. As is the case with proton therapy, its attractive for a client who already uses RayStation to get one common system for all treatments and the wider RaySearch offering is the higher the likelihood is for that jump. With all in this write-up in mind, lets move to valuation.

Valuation

All my scenarios are starting with that the first years revenue will see a recovery from the Covid depressed levels. So the starting point is a slight increase on the 2019 revenue levels. After that I draw the usual three scenarios.

The bear scenario is in my view unlikely, it assumes basically a total failure in increasing future sales. This would mean all the R&D and doubling in staff would have been partly lost investments (or investments made to just keep up with competition). The base scenario takes an conservative turn-around approach. Sales will grow but at a moderate rate, more importantly Operating Margins will only slowly recover and never fully recover to levels seen in 2016-2017. The bull scenario sees 4-5 years of very strong sales growth which later slows than in YoY growth terms, more towards industry predicted growth levels. The Operating margin also recovers much quicker and reaches higher levels as the company reaches scale benefits in its operations. To this I use a 10% discount rate

Probability Target Price Bear 15% 27.6 Base 45% 75.2 Bull 40% 117.0 Weighted TP: 84.7

This gives me a weighted target price of 85 SEK, which is roughly 85% upside to the latest traded price. I have taken a position in RaySearch over the past months with an average buying price in line with todays price. A lot of work went into this research (1.5 month) and I learned a lot myself about radiotherapy. For the ones that made it through this whole long read-up I hope you enjoyed it too! As always comments are more than welcome.

Key Metrics to ongoingly follow

• Revenue growth back on track

• Cost control and return to profitability (in actual cash flow)

• No increase in credit losses

Recently some of you readers have contacted me either through the blog or on twitter to discuss Essex Biotechnology. Since I also recently increased this to a high conviction position, I thought I would share my thoughts on why I did so and some very recent development.

This post will not make sense if you are not familiar with the company, so please check out my full write-up from last April: Essex Biotechnology (1061 HK) – Core products fund investment portfolio.

Terrible investment

To start with I want to say so far Essex has been a terrible investment, I allocated significant capital to Essex on 5th of April, very close to the market bottom. And the stock is trading flat since then, whereas my portfolio is up 54%, a pretty remarkable underperformance. Why am I then adding to this holding which obviously the market doesn't really see any value in? Well the (maybe obvious) answer is that I believe that the market is wrong and that there is significant upside in Essex to hopefully be unlocked. The most exiting trigger is that Essex today posted what I have been waiting for for some time now.

The Board is pleased to announce that, as informed by Mitotech, the topline data of VISTA-2 will be released and presented on 24 February 2021 after trading hours, and an announcement will be made by the Company accordingly

This post won't be very structured but I would just comment on different aspects of the company. Let's jump in

SKQ1

Let's start with the exciting news that we finally tomorrow might have a trigger to take us away from value trap land. If you need a refresher on what this is about, this article is good: Mitotech: a Dry Eye treatment aimed at mitochondria. Essex has so far spent ~37m USD to fund this research and Essex MCAP is 300m USD so this is really significant for the company.

Just as the article mentions it is very hard to get a product approved for dry eyes by FDA. I can imagine partly because dry eyes is not a very clearly defined symptom/disease. That said, if we allow ourselves to dream away a bit here, the potential is really good if the VISTA-2 results are promising enough. Restasis is best seller of three FDA approved eye-drops for dry eyes and has annual sales of 1.2bn USD, Xiidra second has 400m USD and newly launched Cequa from an Sun Pharma does not seem to have taken off in a major way yet. The sales potential is in other words mind-boggling if they can take some 10-20% market share over time. Obviously Essex/Mitotech would need a partner to distribute the product (outside of China) but if the results are good enough I can't see any larger problem with securing a good deal for this. Essex would potentially have very good sales of this product in China (and the sales network they already have).

If we try to land on the ground again, we should not forget that the VISTA-1 study was not a home-run: "not meeting co-primary endpoints (Central Corneal Fluorescein Staining and Grittiness)". I think what was very positive from the VISTA-1 study was how well tolerated the SKQ1 formula was for the patients. "Drug tolerability comparable to that of an artificial tear", the reason why this is so important is that the three above named FDA approved drugs all come with quite common side-effects. Potentially Essex's product doesn't need to be better, just a very good alternative for the once that can't tolerate the Restasis drug. We should also not forget that this product is already approved in Russia and sold over 1 million eye drops. Anyway, there is no point for me to speculate too much, by tomorrow we will know much more.

Henlius

Next big one is the co-operation announced with Henlius, this is not something that will create value short term but has good potential long term. Again Essex is putting up some big bucks, up to 49m USD for getting Henlius help to develop a drug for wet-AMD from their biosimilar portfolio. Essex will get about 85% (deducting royalties and milestones) of future revenue on the products if launched successfully. Mind you here that Essex a 300m USD MCAP company is funding one of the developments for 2.8bn USD MCAP Henlius.

As a good comparison how the market values a biosimilar that replicates a existing wet-AMD product is Swedish listed Xbrane. They are in a phase 3 awaiting the patent to expire on the product they are creating a biosimilar off. Xbrane has a market cap of 250m USD today and they have given away more of the sales due to not having a sales network themselves to push out their product (they also needed the funding). In my view Xbrane is a weaker company financially launching one single promising product, whereas for Essex this is just one of many products they can fund off their cash flow from their already highly profitable products. But the market does not put much value on Essex cooperation but highly values Xbrane, again I don't agree with how the market currently values Essex assets.

Essex core products

Two questions I got here on the blog:

1) Why don’t they sell some of their products outside of China? even if the drugs are less good than their more expensive counterparts (Regranex vs Beifuji) when you described them as “advanced generics” wouldn’t some other countries also be potentially interested? 2) What did you mean by advanced generic? was it that they developed a drug that does the same thing as another, but just charge significantly less for it?

Clearly when I wrote my Essex write-up I did not in detail understand this myself, so allow me to correct myself to the level of knowledge I have now. Recombinant Bovine Fibroblast Growth Factor, or rb-FGF as Essex calls it is the key ingredient for both their eye drops and wound care product. What is this rb-FGF then, some magic product? In some ways, yes. As I understand it FGF was discovered a very long time ago (1973) initially from cow brain extract. the "rb" part in the name is basically saying that its a synthesist version of the bovine (or in my plain English cattle) brain extract. Ok great, so we have a lab version of cow brain extract? What is the deal here? Without making too much of a funny story out of it, the deal is that it's hard if not impossible to patent something that comes from a cow brain - except that it what Essex managed, in China. From my discussion with the company It seems Essex was lucky to be able to patent it's rb-FGF products in China back in the late 90s. I understand that such a patent would probably not have been given in more modern days. So by a somewhat lucky stroke or call it mistake by China's patent office this enabled Essex to invest in a sales network to sell their rb-FGF products without fear that someone would just copy their products. Over the years now they have established themselves with a strong presence in the market and even if the patent expires it will be hard for a competitor to just swoop in and take over the market. Perhaps somebody will try, but Essex is already selling their products fairly cheap. So the answer to why this product barely exists abroad and why Essex would struggle to launch it abroad is at least partly because you can't patent the rb-FGF product elsewhere. From what I understand you can order some rb-FGF online: rb-FGF from webshop, so it's not a unique product in that sense.

Something else I thought about was, what is the competition for Essex core products? Well there are some as mentioned earlier, depending on use case. But as I also was explained, in many cases the competition is to not use anything. Your skin will heal even without Essex products, perhaps slightly less nicely and less quick but still the product is a nice to have, not need to have in many cases. Again this then explains why Essex has spent so much of its money to build up the sales network. They just needed to educate doctors all around China to push the product and also ensure that the products are safe. Safety might be an area which explains why these products are not sold elsewhere in the world but this is something I haven't got a clear answer to. Studies are being done on use cases of FGF. Two examples here:

Efficacy and safety of basic fibroblast growth factor in the treatment of burns

Effect of recombinant bovine basic fibroblast growth factor gel on repair of rosacea skin lesions: A randomized, single-blind and vehicle-controlled study

If you read the studies above it does seem to be a powerful product with strong use cases. So the company has a strong set of products, which just keeps growing on back of China's growth. I confirmed that Essex products are not affected by the Central Procurement initiatives.

Finally I just want to end with this now quite old update on how the company is fairing in these Covid times:

The board of directors of the Company (the “Board”) wishes to update its shareholders and potential investors that as clinical operations of hospitals in the PRC have been largely resumed to normalcy, the Group’s revenue in the third quarter of 2020 has also been largely recovered to nearing the pre COVID-19 level

It should mean that looking forward the company on 2019 earnings should be back to generating 300m HKD net profit in 2021, not too bad when it has the above presented pipeline and trading at a Market Cap of 2.4bn HKD.

This summarizes why I felt it was time to make this a high conviction position: Strong rebound in results to be presented in the annual report within a months time. SKQ1 announced tomorrow and Henlius R&D will progress over the coming years.

Summary

+ Strong core business of radiopharmaceuticals, natural moat where products can only be produced locally.

+ Added an extremely successful leg as exclusive Polish distributor of Da Vinci surgical systems. Sales have exploded on back of pent up demand for these systems.

+ Product for heart disease in pipeline, finalized Phase 2 trials, seeking Phase 3 partner. Similar product by US listed Lantheus brought 60m USD in milestone payments. Synektik MCAP is ~60m USD.

+ Strong Polish Macro backdrop with Europe's strongest GDP growth as tailwind for Poland to catch-up in terms of medical advancements.

- Covid-19 is as for most Pharmaceuticals hampering sales.

- There has already been some delays in finding a partner for the Phase 3 study.

Company Background

Synektik Group was established back in 2001 and started off servicing different types of medical equipment mainly for Siemens. Fairly early some IT solutions were also developed for archiving and distributing images as well as patient data admin. In 2004 a laboratory was established for medical imagine diagnostics. In 2010 the company acquired IASON and entered the field of radiopharmaceuticals. On this heritage of servicing equipment for large medical equipment companies and radiopharmaceuticals the company has grown together with the Polish economy and delivered strong revenue growth and product innovation.

Today, Synektik is a leading Polish supplier of services and IT solutions for surgery, diagnostic imaging and nuclear medicine. Synektik operates a research laboratory for diagnostics imaging systems and a service center for medical equipment. The company is also the first commercial manufacturer of radiopharmaceuticals used in diagnostics for oncology (PET) in Poland. The Synektik Group operates three radiopharmaceutical manufacturing plants. Moreover, Synektik operates its own Research and Development Centre working on radioactive tracers for oncology, cardiology and neurology.

Management

The two largest shareholders are Mariusz Wojciech Książek, a Polish businessman (26%) who acquired his stake in the company late 2017 and the company CEO Cezary Kozanecki (25%).

Business Segments

The company is standing on two main legs in terms of cash flow generation:

1. Radiopharmaceuticals

2. Distribution and service of medical equipment

The third important leg is the cardiotracer product where they are looking for a Phase 3 partner.

1. Nuclear medicine / Radiopharmaceuticals

Nuclear medicine is a medical speciality that uses targeted radioactive compounds, called radiopharmaceuticals, to diagnose, stage, treat and monitor diseases. Nuclear medicine can be divided into two categories: diagnostic nuclear medicine (or molecular imaging) and therapeutic nuclear medicine (or theranostics). The nuclear medicine market is predicted to reach $30 billion by 2030 worldwide.

Positron-emission tomography (PET) is a special form of medical imaging which enables doctors to visualize specific function inside the body in 3D. This is done with the use of a radiopharmaceutical, which is a special molecule combined with very small amount of radioactivity, and a special scanner. The images obtained can provide physicians with information to help them to diagnose, monitor and treat disease. The most frequently used PET imaging radiotracer is fluorodeoxyglucose (¹⁸F) (FDG), a compound made from a simple sugar and a small amount of radioactive fluorine (¹⁸F). This radiotracer accumulates in the body’s tissues and organs where there are increased levels of activity, such as in tumors. FDG is used in cancer imaging to search for tumors, metastases or to monitor response to certain therapies. However, it does not work well in some anatomical areas such as the prostate and the brain.

Synektik group produces a number of these basic radiopharmaceuticals and some special radiotracers. One example of a special radiotracer is produced under an agreement with Blue Earth Diagnostics. Fluciclovine (18F), a compound that is formed from a synthetic amino acid and includes a small amount of the radioisotope fluorine (18F). Fluciclovine (18F) accumulates in the body’s tissues and organs where there is an increased uptake of amino acids, as can occur in certain tumors. A PET/CT scanner is used to detect the distribution of the fluciclovine (18F). The images obtained from the fluciclovine (18F) PET scan give doctors information which can assist in the management of the patient. Fluciclovine (18F) is approved in the USA and Europe for PET imaging of biochemically recurrent prostate cancer.

The key point to understand with radiotracers are that they have to be produced locally. The whole idea of the compound is to have a very short half-life or radioactivity, to harm the patient as little as possible. So the product is made in a nearby cyclotrone the same morning. This creates a wide moat for the product, since a production facility in another country is too far away. There are 4 public cyclotrons, but they don’t have the license, they can only produce for their own hospitals. On top of that, Synektik is the only Polish company that can produce special radiopharmaceuticals, which translates to a 30-35% EBITDA margin. From this base of stable cashflow Synektik has been able to build up and scale its operations, organically and through acquisitions.

PET Tracer sector is hot

In recent years larges players have been snapping up assets in this space. Blue Earth Diagnostics that Synektik co-operates with was acquired by Bracco for 475m USD: Link

Novartis invested $6 billion to acquire Endocyte to expand expertise in radiopharmaceuticals: Link

This is from a global perspective, as interesting to Synektik is how the market has developed locally in Poland. As you can see below there is plenty of room for growth.

This is also translated into stable sales for Synektik with very stable EBIT margins:

Cardiotracer - the gamechanger

What is most hot in this sector is of course not old technology that has been around for years, but new innovative tracers. Synektik has for a number of years been working on an improved tracer formula for heart disease. This project has been sponsored by EU Getting to the heart of diagnosis for imminent coronary artery disease.

The benefits of this new type of tracer is summarized by the following points:

• high quality of image, strong sensitivity and adaptivity of the scan.

• the same image quality for small and large patients, people with breast implants and those unable to lift up their hands.

• four times less radiation (of significance to children and people with chronic coronary heart disease).

• faster imaging protocols, leading to shorter test times

This cardiotracer product is Synektik's major research pipeline item and is a potential gamechanger for the company. The company has finalized Phase 1/2 studies and is now seeking a partner to take the product through stage 3 and to the market. Synektik have been dragging their feet a bit on finding a partner which has disappointed some investors.

Some comments around this topic from a recent investor chat with Synektik management:

We assume that 2021 will be the optimal time for concluding a contract with a partner. Of course, we DO NOT judge that it will happen. Why the frequent changes in schedules and delays in this area. I would like to ask for a more detailed explanation of this problem, as you have already failed to meet your declared deadline several times. You are talking about 2021 now, but you DON'T SEE it. So it may be later or not at all. This is very disturbing Dariusz Korecki: We would like to emphasize - we believe that concluding a contract next year would be optimal. But we are not going to make a deal at any cost under time pressure. Kardiagnnik is a one-of-a-kind project, and we will conclude a partnering contract for it only once. I assume that we all want this to be the best possible deal that will allow Synektik to become a global player. The game is at stake for our company. It would also be irresponsible on our part to ignore the impact of COVID on the course of the project in our plans.

The market speculates that the partner with whom the company will complete the third phase of clinical trials of the cardiac marker will be Astra Zeneca or Blue Earth. Can the company relate to these speculations? Dariusz Korecki: We cannot, by nature, comment on such speculations. In terms of direction, our partners may include drug manufacturers, manufacturers of medical equipment, who are also the largest producers of radiopharmaceuticals in the world. At this stage, we can reveal that we are in dialogue with the leading players in the global medical industry.

Do you have knowledge of the work on competitive markers for the tested cardiac marker? Cezary Kozanecki: We monitor the market, we have the fullest possible and current knowledge about it. The potential sales market is very large and competition is invariably limited.

Dariusz in the investor chat also points to Lantheus Medical one of few listed players in this space which made a deal with GE Healtcare, which provided for an upfront fee and success fee of approximately USD 60 million. This payment with potential good royalties for Lantheus was for more or less the same type of product: Phase III development and worldwide commercialization of flurpiridaz F 18, an investigational positron emission tomography (PET) myocardial perfusion imaging (MPI) agent that may improve the diagnosis of coronary artery disease (CAD), the most common form of heart disease. Link to press release.

Just to be clear, up-front and milestone payment during Phase 3 to Lantheus is 60m USD, which translates into 223m PLN and current MCAP of Synektik is 232m PLN. This 60m USD does not include future royalties if the product is launched. Synektik does not even need to land a deal half as good as Lantheus and this would still be massively accreditive to share price of Synektik.

2. Distribution and service of medical equipment

Synektik has a number of products they distribute and do maintenance on in Poland. But the main driver of this sales is from the Da Vinci surgical machines.

Synektik is the exclusive distributor of da Vinci robotic systems in Poland. Under the agreement concluded with Intuitive Surgical, Synektik is responsible, for the sale and service of robots, instruments and equipment accessories, as well as training of operator doctors. Selling these machines gives firstly a nice one off cashflow (profit sharing with IS) but long term more importantly it builds up a base of service income of the surgery systems. Although Covid-19 has been very bad in Poland, Synektik has still managed to land a few sales during 2020:

• November 2, 2020 the Company concluded an agreement with Międzyleski Szpital Specjalistyczny in Warsaw (Hospital). The contract was concluded as a result of the public procurement procedure conducted under the open tender procedure for the total net value of PLN 9,050,885. The system will be delivered by November 30, 2020.

• April 21, 2020 the Company signed an agreement between the Company and the Independent Public Clinical Hospital No. 2 PUM in Szczecin. The contract was concluded as a result of the public procurement procedure conducted under the open tender procedure. Its value is PLN 12,496,500 net.

As you can see the agreement with Intuitive Surgical in July 2018 has been a game changer for this segment. My expectation is that sales of Da Vinci systems will increase further again after the pandemic. Synektik has made the estimate that approximately 40 Da Vinci systems will deployed in Poland until 2025. And very importantly create a new steady stream of service income. Synektik estimates by 2025 that service revenue will be more than yearly sales of Da Vinci systems (4 in past year and 5 estimated for 2021).

Other products

There are also other products where Synektik co-operates with various companies to access the Polish market. For example ZAP-X a new innovative system for stereotactic radiosurgery (SRS). The company has also continued to develop its IT platform for storing images. Called Zbadani.pl the company has ambitions to expand the platform to more centers with a wider set of functionality.

Another example is that Synektik obtained exclusivity in Poland for the distribution of Genomtec's two-gene tests (Genomtec® SARS-CoV-2 EvaGreen® RT-LAMP CE-IVD Duo Kit) for the diagnosis of SARS-CoV-2 infection.

Valuation

Although some larger Da Vinci sales in past years makes the EBIT quarterly data a bit lumpy, it's clear from the above picture that Synektik has established a new higher level of EBIT. And this is during Covid-19 when hospitals and the country is in partial lockdown. With Covid (hopefully) gone in 2022, I see possibilities for a very bullish growth scenario.

With a discount rate of 9% (Stable industry in Emerging Market) this gives me the following range of valuations:

Bull Case: 49 PLN per share - Assigned 30% probability

Bear Case: 14.6 PLN per share - Assigned 10% probability

Base Case: 35.5 PLN per share - Assigned 60% probability

Gives a weighted target price of 37.5 PLN per share versus its current price of 27.3 PLN. A decent 37% upside, but perhaps nothing to write home about. For the ones of you who read my post from top to bottom you know what I will say know. This does not account for the value for the cardio tracer product. Given that the company seems to have struggled somewhat to find the right partner I will be conservative and assign a third of the value of what Lantheus would get from only milestone payments. That is another 20m USD in pipeline value which translates into 8.8 PLN per share.

So my target price for Synektik with a conservatives pipeline valuation is 46 PLN per share or 68% upside to current share price. 

If the company continues to execute as well as the past years and with a partner found in 2021 on good terms, I see much more upside than this over the coming 2-3 years.

Key metrics to follow in the future

• Margin development - Valuation is fairly sensitive to changes in margin

• Continued sales of Da Vinci machines and that nothing happens to the sales agreement (which currently lasts to 2022)

• Further growth of radiopharmaceuticals expected, confirm that trajectory is intact

• Partnering for Phase 3 of cardiotracer.

Intro

A time bomb is currently ticking in most of our bodies, maybe you are aware of it. But very few of us do anything about it, especially for our kids. This post is the backdrop to a series of post which will involve investment ideas related to this theme. But even if you are not interested at all to listen to my investment ideas, you should probably read this post just for your own well being.

Since modern computer technology entered our lives a lot has changed in terms of how we use our bodies. We can see the effects of this in increased cases of back pain, carpal tunnel pain in the hand and much more. But something has happened in the past 10 years which is currently having much more drastic effects on our bodies. I'm talking about how smartphones quickly entered our lives and become the number one tool we spend our time on. This series of posts will explore how heavy smartphone usage damages our bodies, particularly young people, what this means for the future and what companies are positioned to leverage this rather bleak outlook.

How much do we use our phones?

Let's start with setting the backdrop. We all know that we spend a lot of time on our phones but how much? The below pictures puts this into perspective.

As we can see there is first of all a large group (47%) which are very heavy smartphone users (more than 5 hours per day). And the second picture gives some insight into that this is mainly concentrated for the people below 30 years of age. Keep in mind that this is 2017 data, since then smartphone usage has worldwide become even more widespread and latest data suggests average time spent has increased even further.

How is the body damaged?

There are many issues with heavy smartphone usage, everything from damaging the hands and fingers from excessive pressing, strange angles of holding the phone etc. But from the research I have done, two main issues of heavy smartphone usage emerge.

• Bad posture damaging the cervical spine (neck) and drastically accelerating spine degeneration.

• From a young age staring at close objects causing myopia (nearsightedness).

Both these two areas are turning into such a widespread issues that its very concerning that we do not hear more about it. Especially myopia is already a global epidemic among kids. In 2010, an estimated 1.9 billion people (27% of the world’s population) were myopic, and 70 million of them (2.8%) had high myopia. These numbers are projected to rise to 52% and 10%, respectively, by 2050. This is especially an issue in East Asian countries, where the condition affects 80% to 90% of high school graduates. Of these individuals, 10% to 20% have sight-threatening pathologic myopia.

Neck damages has so far not seen such alarming figures but in my view this is a ticking time bomb to be unleash over the coming 10-20 years. There are of course very strong powers in the world with vested interest to keep our bent necks staring down at our phones as many hours as possible. More and more addicting apps are created each day to keep us entertained through our small screens, TikTok being the latest example among young people.

In this part 1 we will dive deeper into understanding the damages we set up for our neck by bad posture. Future posts will dive deeper into Myopia.

How we stress our necks

An academic study presented results on how much stress we put on our neck depending on the angle we are looking down at (see below picture). This is at the core of the problem, many smartphone users stay in the 30-45-60 degree angle for very long periods of time. Day after day the effects of such extreme pressures on the neck will compound and create damage. Since looking down at the smartphone is such a new habit, we of course do not fully understand the long term effects of this habit. I tried with the latest academic research combined with talking to spine surgeons paint a picture of what is going on in the world.

Nerve pain is the end-game

My understanding of this topic is a combination of talking to chiropractors, spine surgeons and academic research. I'm not a medical professional myself so some parts of this might not be explained properly.

When our head tilts down, our muscles in our upper back, connecting to the neck will do their best to pull back on that forward bent head. The muscles will over time get very tired and tight. A spasmed upper back with general stiffness and muscle pain are going to be common early onsets of heavy smartphone usage. Probably something most of you readers have yourself experienced at least once or twice. This type of pain is still manageable and not anything that needs more than a bit of rest, a warm pillow on your neck and perhaps some massage. Long term what is much more damaging (and irreversible) is the damage we do the cervical spine in our back. With age everyone's cervical spine will degenerate, the key component being the soft nucleus disc which sits between each bone segment. These discs will naturally over time decrease in height, from classical wear and tear. But obviously how much wear and tear we experience depends on our habits. Looking down at a smartphone for 5 hours per day, year in and year out is not doing wonders to the discs.

The symptoms from damaging the cervical spine will at early onsets still be mostly muscular, with similar muscle spasm and cramps that just occurs more frequently than before. The body is so to say warning us. The next stage of damage is when one starts to experience nerve pain. This can be caused from a multitude of issues, the below pictures try to depict some of the reasons for nerve pain. The nucleus of the disc can become compromised and start to either push on the main spinal cord or one of the spinal nerves going out to one of the arms. Bone spurs will normally also start to build up with age and poor posture. These spurs can also over time pinch the nerve. Nerve pain is a state which is much more acute and if not resolved the person will be on heavy medication to reduce the experienced pain and inflammation on the nerve. The very depressing news with the state of bone spurs or intervertebral disc height is that best case is status quo. A disc will never grow thicker and healthier again, a bone spur will never go away. We can compensate by building our muscles stronger around the area, but it will only help to a point. A so called slipped or bulging disc where the nucleus has been compromised can also heal. The body recognizes that the liquid has leaked out to where it should not be and in most cases a slipped or bulging disc heals with time. But with poor posture the risk of later in life have a bulging or slipped disc increases and even if many heal, some do not.

To summarize, this intricate system of muscle, bones and nerves degenerate over time, just as everything else in our body. What studies now are showing is that with our extremely poor posture, created by a new habit - our smartphones, we accelerate this degeneration drastically. Nerve pain which one would expect in people who are 60-70 years old are starting to be more common among much younger people. We are only 10 years into using smartphones, most of us have not been heavy users for that long. What will happen in the future when we have been using phones with a front tilted head for another 10 years? This is the ticking time bomb I started this post with. Why are not more people talking about this? In my view it is because it is still early days. But go and talk to a neck surgeon and he will tell you that he now sees patients that are 20-30 years old which have necks that degenerated to such a degree that one would think they are 60-70 years old.

What does academia say?

Almost all older studies are studying correlation between perceived neck pain/issues versus smartphone usage. The most interesting study is less than a year old, where scientist in China confirm versus MRI scans the state of the neck and link it to smartphone usage. Below are brief summaries of some of the studies I read:

China study in 2019 on young smartphone use and cervical disc degeneration through MRI checks

All patients in study had neck pain. The study invented a measure to scale how much "degeneration" was seen along the spine. This was as classified per disc segment from the MRI scans. The scale was called Cervical Discs Degeneration Scale (CDDS) from a scale of 5 to 25. CDDS of all patients was 15.80 ± 2.68 (range from 9 to 21). Another scale was then created to rank users in terms of smartphone usage: Smartphone Addiction Scale (SAS) 33-item self-rating scale. Score from 33 to 198. average SAS score was 76.67 ± 22.58 median 70. Above 70 were classified as excessive users and below as non-excessive.

Example of questions: My life would be empty without my smartphone, Feeling impatient and fretful when I am not holding my smartphone. 1= strongly disagree, 6= strongly agree.

As a side not the study confirmed previous data that patients in excessive smartphone use group were younger than those in non-excessive smartphone use group (p < 0.001).

Conclusion of study: This current study presents evidence linking excessive smartphone use to cervical disc degeneration. The results of this study indicated that excessive smartphone use might accelerate cervical disc degeneration. In other words, excessive smartphone use is a risk factor for cervical disc degeneration

Swedish study - 7000 participants with a 1 year and 5 year follow-up.

There were clear associations between the highest category of text messaging and pain in the neck/upper back. In the group with symptoms, almost all individuals had the neck flexed forward and did not support their arms. This causes static muscular load in the neck and shoulders. Furthermore, they held the phone with one hand and used only one thumb, implying increased repetitive movements in hand and fingers. This distinguished them from the group without symptoms, in which it was more common to sit with a straight neck, to support the forearm, to hold the phone with two hands and to use both thumbs.

Meta-study of 12 studies between 2012 and 2016:

The findings of this review suggest that using smartphone may induce musculoskeletal symptoms in the neck. This systematic review revealed that the use of smartphones may contribute to the occurrence of clinical and subclinical musculoskeletal changes as well as associated factors in the head–neck, shoulder– arm, and hand–thumb areas.

Academic articles referenced:

• Journal of Orthopaedic Science - Association between excessive smartphone use and cervical disc degeneration in young patients suffering from chronic neck pain

• Applied Ergonomics - Texting on mobile phones and musculoskeletal disorders in young adults: A five-year cohort study

• Hong Kong Physiotherapy Journal - Musculoskeletal disorder and pain associated with smartphone use: A systematic review of biomechanical evidence

End part 1

This was a pretty bleak but I think important post. The good news is that medical neck surgery has moved forward tremendously in the past 20 years. The recovery rates after surgery are very good nowadays, it's just a very costly procedure which unfortunately not everyone has access to.

This investment theme is something that I will keep with me for many years. My expectation is that this topic will just grow in importance for at least the coming 10 years. As I identified earlier investment themes, half of the job is understanding how the world is going to change, the other half is how to express that through investments and make money from it. It's particularly cruel being correct on a theme (early) but losing out by betting on the wrong horses. In 2016 I was convinced that EVs would take over the car market (most people at the time were not convinced of this). I then wrote this post contemplating on how to best invest: Investments in EV value chain. It's easy now to say that I should just have put all my money in Tesla, but I took a different approach which was quite successful but not of course nearly as good as betting on the "winning horse". In coming post we will explore some ways to invest for a future with many more people requiring neck surgery.

+ Silly low valuation at P/E 8 (net cash) given the companies track record of profitable growth.

+ A number of own developed patented products in the market selling at good margins, with large market share in China.

+ Founder led for 20+ years, building this company from scratch.

+/- Using much of it's cash flow for investments in products from other research teams instead of dividends or share buybacks, which to me is still a negative. On the other hand the products are related to the companies own core business so the investments makes sense.

- The founders are running a real estate company listed in Singapore as well. It does not seem to be doing very well lately (hotels in Japan).

- A fair chunk of revenue is dependent on a distribution contract with Pfizer, which is expiring in 2021. It has been rolled multiple times since 2014, but its still an unknown.

Background

In the early 1990s, most Chinese pharmaceutical companies were focused on manufacturing generics. Essex instead pioneered the use of recombinant DNA technology (a process that involves molecular cloning of DNA from any species) to develop their own unique series of biologics. The company has obtained seven patents for drugs developed using recombinant DNA technology in China. The company enjoys more almost 60 percent market share in its niche areas (eye products). The high market share is largely explained by their very competitive pricing. For example, its Beifuji spray for treating burns and skin ulcers sells for $5 per 15ml bottle. By comparison, a 2.5ml bottle of Regranex, a widely-used spray for treating wounds and ulcers, sells for $74. The company’s products are used in more than 4,500 hospitals across China. Although Essex never explains it as such, my interpretation is that these products are like an advanced form of generics, which enjoys higher margins than simple generic pills.

The company listed all way back in 2001 and for many years grew revenue slowly of a very low base. The company disposed of an agriculture related business in 2009 and has since then developed in it's current form. I therefore focus on the history of the company since 2010.

Some of the background story is taken from this article: Essex Bio — Bringing Pharmaceutical Innovation to China

Core products

Essex core products Beifushu series of drops and gels to treat eye injuries, dry eyes, refractive and cataract surgery, and the Beifuji series of sprays and powders to treat surface wounds, including burns, ulcers, and cosmetic plastic surgery. They also make Beifuxin, a gel that repairs and regenerates cells damaged by bruises, burns, contusions, cuts, surgery incisions, skin grafts, skin resurfacing, laser therapy wounds, bedsores, fistulas, and cervical erosions. The products are patent protected until 2030 in China. Essex also undertakes exclusive distribution in China of third party products that complement its area of focuses. Major third party products distributed are Pfizer's eye products Xalatan and Xalacom, Iodized Lecithin Capsules for treating various eye diseases and Yi Xue An Granules for treating bleeding or spotting of uterus after induced abortion. Below is a picture of the products:

Third party products

The company has built up a fairly large sales network throughout China, which helps the company in penetrating the Chinese market with its products. On back of this network the company has managed to tie some third party products to them, the big one being Pfizer's eye drop related drugs. This has been rolling contracts that has been extended multiple times since 2014, the current contract expires in 2021. The other two larger distribution agreements are for Iodized Lecithin Capsules and Yi Xue An Granules. The two last agreements have been won by Essex by investing in the companies that owns the products. In total these products are some 15-20% of Essex's revenue, but less of its profits. Obviously there is some downside risk if Pfizer would abandon this agreement in 2021. Other smaller distribution contracts have also been negotiated, for example with Elektron Technology UK Limited (“Elektron”), where Essex is its exclusive distributor of Henson 9000 until 2024. The Henson 9000 is a machine to detect eye diseases.

Enrichment Programme

In 2015 Essex initiated an “Enrichment Programme” for "enhancing its research and development pipeline and expanding its products portfolio for boosting its competitiveness and maintaining a sustainable growth". In plain English this means taking some of the cash generated from the core products and investing it in other companies which Essex can co-operate with. When I started to look into this I feared the company is throwing away money in silly projects and perhaps even investing with friends in some type of related party transactions. After having looking into this as deeply I have been able to, this is not the case. It's rather a portfolio of very interesting assets, many with linkage to Essex core product of eye diseases. Another way to look at this is that company has decided to build it's research pipeline more on investing with research teams around the world, instead of pouring all cash into a stronger in-house research team. That said, Essex still maintains a decent in-house research team as well. As Essex makes more and more investment the value of the company shifts towards the portfolio of call option like investments in pharmaceutical products in development stage. Essex has by end of 2019 invested some HK$430 million into this programme and has announced further large investments in early 2020. Given that the Market Cap of Essex is HK$2430 million this is already a significant portfolio for the company.

Management & Ownership

Essex is a founder led company, which I tend to see as a big benefit, as long as there is no history of abusing the position or running the company not in the best interest of all shareholders. Patrick Ngiam and his brother Benjamin founded the company some 23 years ago and to this day holds just above 25% each of the shares in the company. The brothers have also founded a Singapore listed real estate company which mainly runs hotels in Japan (IPC Corporation). This company has not done very well over the some 27 years it has been listed, although lately all hotel related companies are getting hammered. This is a bit worrying also from the perspective that Patrick's time seems to be split between Essex and IPC. Although from what I can see, his brother Benjamin is listed as Managing Director, so I think the brother is more involved in IPC (but nothing that I can confirm).

Business Outlook & Segments

The company has an impressive track record of revenue growth and cash flow generation from it's core products and third party distribution.

Breaking this down into the three segments available, eye care, wound care and third party product sales we can see that the growth driver over the past few years has been the wound segment. The eye care segment has also been growing, but in the past 5 years at a much slower trajectory. Given how long the eye care products been in the Chinese market, without new product launches and looking at a slowing growth trend I would draw the conclusion that the product is fairly mature in the market and would rather grow by underlying factors as a large population needing the product, rather than growth from market penetration. But listening to sell side research First Shanghai, they claim that penetration in the market is still only 11.5%. This is nothing I have been able to verify elsewhere, but I'm a bit surprised that they estimate the penetration as so low.

Some volatility lately in sales, probably due to the two invoice policy implemented in China. Still trend is increasing sales, especially for the wound care products:

One should also mention that the company seem to see further growth in it's own developed products. The company is currently expanding its factory in Zhuhai China. The plan is to construct the Group’s second factory with a gross floor area (GFA) of about 58,000 square metres to house the Group’s R&D centre, additional manufacturing facility, administrative office and staff hostel. Construction work has started on 1 January 2020 and is expected to be completed by mid 2023.

Pipeline of products

The main pipeline of products are from the so called enrichment programme, although some new releases of own products has also been made lately. Late last year it was for example announced that: "the company has obtained approval from National Medical Products Administration (NMPA) for the registration and commercialisation of the preservative-free single-dose rb-bFGF Eye Drops (Single-Dose Beifushu Eye Drops) in the People’s Republic of China (“PRC”)."

It's important to point out that the company has done all of these investments by the cash flow generated from it's own products (one convertible loan has also been issues). The main investments which could bring future income to Essex are the following:

Company Amount Invested Timeframe

Abpro Corporation 3.5m USD 2016-2026

AC Immune SA (“ACI”) 5m USD + 0.75m CHF per year Listed company ACI

MeiraGTx Limited 5m USD (1.76% of listed entity) - half sold in 2019. Listed company

Mitotech S.A. (“Mitotech”) 16.5m USD + 20m USD Phase 3 trial. The product if succesful, is expected to be listed in the United States in 2023, the company will enjoy 60-65% of global equity. Ongoing trials

DB Therapeutics, Inc. (“DBT”), 4.5m USD +0.6m Subscription fee (45% of company if converted) Ongoing

Chengdu Shanggong Medical Technology 20m CNY (8% equity) rolled to 15m CNY Ongoing

Mitotech co-operation is the investment that stands out

The largest amount invested and the by far most interesting product is Mitotech's drug for dry eyes based on it's SKQ1 ingredient. The product is already approved for sales in Russia under the name Visomitin. Essex together with Mitotech now wants to bring the product to USA. Here is some info about the SKQ1 ingredient: Mitotech SKQ1. And this is the paper which explains the trial process for getting the drug approved in Russia: Results of a Multicenter, Randomized, Double-Masked, Placebo-Controlled Clinical Study of the Efficacy and Safety of Visomitin Eye Drops in Patients with Dry Eye Syndrome. As you can see the products Essex invests in, is very much in line with the companies strategy. Although Essex is a small company, in this niche it acts like a larger player, funding a small research team to get a product through the trial stages. Given that this product is already listed in Russia, I'm pretty bullish on the phase 3 trials being approved, but you never know. This would by my understanding be the first product where Essex would launch something which is a world class product with the margins that comes with it. It's current products sell well in China, because they are competing on price with equal or better products sold by the big Pharma companies. The Visomitin product would be different story.

The second most near term interesting investments in my view is the Chengdu Shanggong Medical Technology.  The company uses medical data analytics (AI Algorithm) in the medical service industry in China. Using 700,000 retinal images of diabetic patents in China. The AI Algorithm can screen retinal images of patients and detect diabetic retinopathy, which affects almost a third of diabetes patients that would otherwise be examined by highly trained ophthalmologists.

Valuation

As has been prestend above the revenue and profit growth of the company has been very strong. The share price had done nothing the past 5 years though. This can be explained by again, like many Hong Kong companies a serious multiple contraction. This used to trade like a US/Europe medical company at P/E between 15-30, but is now instead down at P/E 8. Partly this can be explain by the changes in China's invoicing system for purchases of drugs. This has in general contracted the multiple for these type of listed companies. But the fact is that Essex has had very limited damage done to it's revenue and profit margins due to this. In fact the operating income margin has increased over the past years, from stable around 20% upwards to 26% for 2019. One would think that would warrant a higher multiple but so far no.

The company has as presented two parts:

1. The cash flow generating core business, which can easily be valued by a DCF

2. The enrichment programme which is much harder to value, but where we know that the company has invested some 430 million HKD. Parts of those investments are done to drive revenue to the core business.

Assumptions - Essex Core

IFC has a 150 million HKD convertible loan with conversion price 5.9 HKD per share (maturity July 2021). Given that the share price is so far away from 5.9 I will give less weight to the share dilution of such a conversion and just count it as debt.

Discount rate = 10%

Revenue growth rate = 0% growth this year due to Corona and 5% for 9 years, 2% in perpetuity (last years growth was 8% and year before that was 30% growth).

Operating Margin: Decreasing from 25% back to long term average of 20% over 5 years.

Investments = 40 million yearly, for factory increase etc.

Net Cash = 300 million HKD

Valuation = 7.4 HKD per share an 80% upside from the current level.

Conclusions

This above valuation is with very conservative assumptions on growth and even decreasing margins. This is also not accounting for the investment portfolio and the value add the Mitotech co-operation could have in a few years time. It's pretty easy painting a bull scenario with an extremely high valuation. Say growth continues at a historically more average pace of some 15% per year, with 2019 margins. The valuation is such a bull scenario comes out at some 12-13 HKD per share. A more simple way to phrase it would be that if the company trades at a 24x P/E multiple, the share is trading in that range.

I think this company is a really hidden gem on the Hong Kong exchange, a bit more risky than some of my other holdings. It's not easy to judge the competitive landscape in China for it's drugs, so there lies the major risk. To be honest I have not been able to figure out if there is any other product being developed by a competitor that could threaten Essex sales. This would obviously be a huge risk, at the same time such a product would need to either be better and/or much cheaper. Given how long time it taken Essex to reach the penetration it has in the market, I think that says something about the moat of this niche product segment. In my view it's well worth taking that risk which such a strong track record of profitable growth over such a very long time period. I deploy my 5% cash to this holding as of latest available close (Friday). I hope you enjoyed yet another HK "growth at a reasonable price" case! There are a lot of those on the HK exchange and I think this is among the very strongest ones I have been able to find.

Valneva

+ Two strong cash generating assets, with the prime asset being Ixiaro, the only FDA approved vaccine for Japenese encephalitis

+ The only company attempting a Lyme disease vaccine, with a potential huge untapped market.

+ Strong family owner, which is the largest shareholder with 15%.

+ Interest from US investors who have taken a stake in the company above current market price.

- Not the best track record of successfully launching vaccines, several failures lately.

- In the hands of the big players to partner in development of vaccines, it is too costly to do by themselves.

- Small development pipeline means a lot hangs in the balance on very few trials and there is some doubts around the Lyme vaccine.

I already briefly introduced the company in a previous post, if you have not read that post, I urge you to start with the shorter pitch written there: See Valneva headline in this post

Below follows a bit deeper dive into the company (press Read More):

Company Overview

In May 2013 Intercell AG (listed in Austria) and Vivalis SA (listed in France) merged into a the new entity Valneva. Although it was a merger Vivalis was the controlling part which offered a premium to Intercell shareholders to accept the merger. Intercell was formed as a spin-off from Research Institute of Molecular Pathology (IMP) in Vienna. Intercell was the company which developed the vaccine for Japanese encephalitis, which now has grown into Valneva's cash cow. Vivalis had at the time developed a cell line they call EB66, which can effectively scale different type of vaccines in duck eggs. In Jan 2015 the new entity Valneva acquired Crucell Sweden AB which owned the license to Dukoral, a vaccine against cholera and traveler’s diarrhea caused by ETEC, as well as a Nordics vaccine distribution business. Valneva paid 45m EUR for this acquisition. Dukoral is today Valneva's second income generating asset, so none of Valneva's significantly income generating assets comes from the Vivalis group. Even so the company is controlled by Vavalis largest shareholder, the Grimaud family, which today holds some 15% of the outstanding shares of Valneva. Which leads us over to management

Management

President & CEO Thomas Lingelbach - CEO of Intercell since 2011, before that MD for Novartis Vaccine & Diagnostics Germany. Holds some 130 000 shares outright and also options.

President & Chief Business Officer Franck Grimaud - Found of Vivalis and also involved in the family business Groupe Grimaud, which is the largest Valneva shareholder of 15% of shares outstanding. In general I see it as a big positive to have a strong family owner. In this case the large owner also has some financial muscle since Valneva is only a smaller part of Groupe Grimaud, which is large animal breeding group and specializing in genetic selection.

Chief Medical Officer Wolfang Bender - Senior international positions at various large life science companies including Novartis, Takeda, Pfizer and Hoechst, experiences in scientific-medical affairs, drug development and general management of vaccines and pharmaceuticals, more than 30 years of experience in life sciences.

The company also has a strong group of board members, with long careers with Pharma companies. The board is led by Frederic Grimaud who represents the family group.

Ownership Structure

There are also a some 17m preference shares trading, which are a heritage from the company merger. This shares would under certain conditions be converted to ordinary shares. From what I have found those conditions have not been met and hence the preference shares should not be accounted into the diluted shares. Also from what I have been able to find out this preference shares will at the latest be converted in June 2020, so after this the company would be in a better position if it wants to pay an dividend (although unlikely).

Compensation

Given that this is a very small company with historically has been burning cash, I think its extra important to look at compensation. Here I feel the company is paying out fairly high amounts, given that this a French company. In USA this would have been very normal, but Europeans are usually a bit more moderate in paying top euros. Let's look at the bonuses paid in 2018 and 2017, this is after two years where the stock price more or less ended flat for the period

Total Compensation (including long term shares/options) 2018 2017 Thomas Lingelbach €644,400.34 €1,208,098.02 Franck Grimaud €408,759.85 €879,805.50 Wolfgang Bender €470,923.43 €934,274.21

About half of the 2018 amounts are fixed salary, but bonus seems to be given out on fairly easy grounds. The high 2017 amounts is due to a long term shares incentive program. Personally I think share/option incentives programs are the best way to align shareholders and management so I'm all for that. But it hurts a little bit to see staff picking up so significant salaries, for such a small cap company.

Business History

Looking a bit deeper at Valneva's history in terms of vaccine development, it has actually been a number of disappointments along the road. The company had two main vaccine candidates in the pipeline some 5 years ago:

1. Pseudomonas aeruginosa (VLA 43) - This was really the big one, where a big enrollment of 800 patients was done (co-finance by GSK). It ended really poorly with the following result: Valneva´s Pseudomonas Aeruginosa Candidate (VLA43) Did Not Confirm Positive Vaccine Effect in Phase II/III trial. This was obviously a big set-back for the company, it's like with all medicine development, just because Phase II looks good does not mean that one will pass Phase III. Although the rates passing through Phase III is higher than for conventional medicine (this is one of few benefits with vaccine development compared to other medicine). This failure also created a write-down of assets.

2. Clostridium difficile (C. diff) (VLA84) - Here we find another set of issues for a small player like Valneva, they have a positive Phase II result, but they need a partner to go ahead with the large scale Phase III. Since Pfizer has already launched a 16 000 patient Phase III trial, which should be finalized by this year, Valneva struggled to find anyone that wanted to pick the fight with Pfizer. So the candidate has been put on hold, by my guess until the results of the Pfizer study is out. If that study fails, maybe they can then find a partner, being the only other option still in the game. But this highlights a major risk for Valneva, they can have a fantastic product, but if they can't find a partner, they will not be able to launch a new vaccine to the market anyway. Article on the competition for C.diff: Pfizer, Valneva stand to gain from Sanofi's C. diff vaccine flop.

3. There was also a short lived project to produce a Zika vaccine, which has been shut down for now.

Another type of service which Valneva has tried to scale is what they call their EB66 platform. This is Valneva's platform for large scale vaccine production through embryonic stem cell (duck eggs). Valneva claims efficient low cost production through their platform. A number of agreements has been signed with various Pharmaceutical companies. For example GSK supposedly would produce their pandemic and seasonal flu vaccines on this platform (I have not been able to verify the current status of this). Here is the link to the announcement from 2016: GSK EB66. As you understand this platform becomes highly interesting given the Corona virus which is currently spreading over the world. But after 2017, when they signed an agrement with Bavarian Nordic, it has been very silent both in terms of announcement and from Valneva itself about the EB66 cell line. As we also can see from the below revenue split, very minor revenue comes from this cell line. Valneva has previously claimed potential milestones of up to 80m EUR from the platform, but very little of that has materialized.

So far the history looks fairly negative, with multiple failures. What has been more positive is the way Valneva managed to scale its existing approved products, Ixiaro and Dukoral.

Current Business outlook

The largest driver for Ixiaro has been the US military, which alone stands for some 50% of Ixiaro sales worldwide. Economies of scale is very much part of driving the cash flow generation here. All US Military and their families going to the Asian region receives the vaccine. So partly I guess this sales will be driven by how active the US military is in the region. I think we have seen a boost in sales due to Trump allocating more money to the military overall. Valneva guides for continued growth of the vaccine. Here the strength is really in that Ixiaro is the only FDA approved vaccine, which gives a long runway for continued growth just from the general population.

Dukoral is an interesting case as well. It has a somewhat lopsided sales geographically, with 59% of sales from Canada. We will go a bit deeper into this in the competition section, but its all down the availability and what the doctors in those countries recommend. Dukoral is available over the counter in Canada, without prescription. In most other markets there are either competitors selling Cholera vaccine, and/or it is a prescription medicine. Dukoral mainly is a vaccine against Cholera, but it is some markets it is recommended as a general precaution for "tourist stomach". Since it's freely available OTC, it has become common for Canadians that travel to for example Asia to take this vaccine as a precaution: Traveller’s Diarrhea Vaccination (Dukoral Vaccination).  Another aspect of Dukoral that I came across which I never seen mentioned by the company is this study, linking prostate cancer death reduction rates by use of Dukoral: Association between post-diagnostic use of cholera vaccine and risk of death in prostate cancer patients. In my view this could be a huge growth driver for Dukoral, given the number of prostate cancer cases in the world.

Some speculation from my side would be that the EB66 cell line might be used more in the future by Nordic Bavarian. They have recently bought two vaccine assets from GSK and has an agreement with Valneva on the cell line.

New Vaccine development

Looking ahead the company has now two vaccine candidates, one which has been in Valneva's road map for a long time, against Lyme disease and the other one thanks to CEPI awards which wants to fast-track the development of Chikungunya vaccine. Let's talk about Lyme first

Lyme disease

For the once that doesn't know what this tick looks like, they are tiny creatures, which will jump onto you and start to suck your blood. As they do that, they will spread the Lyme disease (also called Borrelia) to you. The case for a vaccine for this disease is very strong and climate change seems to make the tick borne disease more and more prevalent.

This is Valneva's timeline so far for development of the vaccine.

So things look good, there are no competitors developing vaccines against Lyme, Phase I has shown that the vaccine is safe. If this vaccine comes to market there is multi-bagger potential for the stock, since it could add revenue potentially larger than current Ixiaro sales. After this summer when the Phase 2 interim data is expected, the company again comes to this crucial phase of needing to find a partner to move on to a large scale Phase III study. Failure to quickly find a partner would at least delay the launch of a vaccine, given that testing of the vaccine can only be done during "tick season" once per year. However, It is not a given that such a partner could be found. And the reason for that is due to that this particular disease has an especially thorny history with a previously launched vaccine against Lyme. Instead of summarizing everything here, because it is a lengthy story, I instead found an excellent article written on the subject: Can a new Lyme disease vaccine overcome a history of distrust and failure?

As you can see from the article, that getting a vaccine approved does not only have upside, but potential downside, from lawsuits. Vaccines will always be a controversial product, since you give it to healthy people. Just my personal view is that vaccines in general is also a fantastic product, which for very little money removes some serious tail risks from your life.

Estimates given by the company for Phase III development of Lyme vaccine is about $360 million, which includes clinical, nonclinical and so on. So basically, if you take the 50% of that, you deduct a bit that Valneva can generate through own cash generation. They will need to raise some  EUR 100 million, there has been indication by the company that such a raise would happen through a new listing of the company in the USA. In general the US market has much more experience with funding this type of companies in clinical trials and probably Valneva will be able to more easily raise this there. A first step which made this even more probable was the US investor base that was taken in during the previous Capital Raise in 2018.

Chikungunya

This project is more driven (and funded) by CEPI (Coalition for Epidemic Preparedness Innovations). It is the same CEPI that in the last few days given large contributions for the development of a treatment/vaccine against the Corona virus (2019-nCov), not to Valneva though, but some of it's competitors in the vaccine space. Naturally CEPI don't want to put all their bets on one horse in this kind of case, so there will always be competition for the production of these vaccines. I don't think Valneva has any edge here against the competition, perhaps rather the opposite, given how much smaller Valneva is than its competitors. Valneva claims to have the only solution that potentially would be a single shot dosage, whereas competitors is a 2 shot solution (2nd shot a month after the first). But from what I can find from the competitor Emergent Biosolutions they say the following:

Seroconversion occurred in 74% to 98% of subjects within seven days after one dose, and in all subjects by 28 days after the last dose. Looking specifically at the single-dose regimen, 96% of the single dose volunteers had detectable antibodies within seven days of the vaccination. At the one-year visit, 98% of subjects receiving the single-dose regimen remained sero-positive.

Quite frankly I think the potential upside here is limited, one would almost need to see that the competitors vaccines fail, for this to be a proper success for Valneva. The likelihood that both competitors fail and Valneva succeeds, seems low. This topic kind of already lead is into the general competitive landscape.

Competition

For the Dukoral and Ixiaro it comes down to which markets the vaccines are approved in. The big issue for Dukoral is that the company never went through the process of getting FDA approval and now a competitor launched a similar product which got FDA approval. Dukoral is strong in some markets and has the benefit of being a well recognized name. Some people might have taken it many times over the years, when they travel to places like Africa, India, etc. Ixiaro has a much stronger position, since it is the only FDA approved JE vaccine. In other markets there are competitors to Ixiaro, but I think a big growth driver here is sales to the US public. The problem is that Americans travel so little to the regions where JE is most prevalent. Still I think there is potential to grow this product a lot and being the recommended product by the US FDA pulls a lot of weight in many other markets as well (which is equally much the issue for Dukoral).

In general the competition is three fold in terms of companies, the major Pharmaceuticals which have their own lines of vaccine production and sales. But these companies are also partners to Valneva and needed to share the risk/cost and potential income of developing a new vaccine. Then there are local players in emerging markets, here unfortunately it seems patents for the vaccines do not hold up. Perhaps it because it is in the developing countries interest to have cheap vaccines produced. So very little sales seems to come from this region since vaccines mainly seem to be copied at a fraction of the cost. This is an important point and unfortunately this takes away a lot of the strong growth that could be seen by sales in emerging markets. A lot of the most dangerous diseases exist closer to the equator, like Japanese encephalitis which is mostly prevalent in Asia's jungles. The vaccine market for Valneva, is very much a developed market business. Thirdly there are the more pure play vaccine companies. I will focus on the two pureplays which also have a Chikungunya candidate in the pipeline:

Emergent Biosolutions

This is the company that is most similar to Valneva, listed in USA with a market cap around 9x as large as Valneva and also current revenue of about 9x Valneva's. The main difference is then of course of the launched pipeline of drugs/vaccines, where Emergent has a big lead. Even so the pipeline of upcoming products is very similar to Valneva's. Both have been working on the Chikungunya as mentioned above. Both have also worked on a Zika vaccine. The Vaxchora is now launched in USA, which is a direct competitor to Dukoral (which is not licensed in USA) in some markets. The Vaxchora launch is in particular worrisome, since this might threaten further growth of Dukoral, or even detract future sales.

Moderna

This is an even larger company with a Market Cap of 7.4bn USD, with a large development pipeline. In the pipeline is both Zika and Chikungunya.

It is interesting (and worrying) that none of these two companies sees potential to go after a vaccine for the Lyme disease. One has to again question the likelihood that Valneva will find a partner for it.

Capital Allocation

There is not that much to say about capital allocation. The company is now cash flow positive on it's two products, and Valneva plows down some 30 million EUR of that cash into R&D and development of their current pipeline. If the company can further grow it sales, it will most likely increase that R&D spend further, to some 35-40m EUR annually. Basically it comes down to if one values that 30-40 million spent on R&D as long term adding value to the company, or if it's just burning the cash and never manage to get a successful product launch to the market. This bring is to the valuation.

Valuation

There are many ways to look at the valuation of a Pharma company with cash generating assets + a pipeline of vaccine candidates. One can play around with the probability rates for success of the vaccines. It is equally unclear how large sales would become once the vaccine is launched. Although unlikely, but some countries might recommend all citizens to take the vaccine, like the Lyme disease vaccine, that would mean huge sales. Or there could be backlash from anti-vaccine groups, scaring people from taking the vaccine (rightfully or not). It's almost impossible to put a narrow range of the value of a small vaccine pipeline like Valneva's. If you have a diversified pipeline like Moderna, you can use averages which will make more sense.

Let's start with the easier part, what is Ixiaro, Dukoral and the EB66 platform worth?

Assumptions:

I assume these assets will generate some 35 million EUR of free cash flow

Growth: 5% per year (which is conservative, given Valneva's own guidance)

Discount rate: 10%

Adding Net debt of: 16m EUR

This gives me a value of 5.15 EUR per share for this cash flow. 

Another way to prove that these assets are worth quite a lot is to look at recent M&A. Nordic Bavarian recently bought two similar assets like Valneva's. One is for TBE (Tick Borne Encephalitis), which highly relates to the Lyme disease (since this the other disease this tick spreads). It also relates to Ixiaro, since the symptoms of the disease is very similar like the Japanese Encephalitis which Ixiaro protects from. The other is a Rabies vaccine. The combines sales of these two assets is 175m EUR (compared to Valneva's 125m). For these two assets Nordic Bavarian paid 301m EUR upfront and a up to 495m EUR more in further milestone payments (some parts of this milestone was to pay for inventory). Just the upfront payment is more than Valneva's current MCAP.

So what the market is telling us now is that since this cash is used for R&D, the pipeline Valneva currently has, has a negative effect on that cash flow. The market would increase the valuation of Valneva if it ceased its R&D efforts and just milked the cash out of the assets it already has. Is this a reasonable assumption then? Well yes perhaps, given what I have stated above, the Chikungunya does not look very promising. Although Valneva has received cash to produce this vaccine, it probably still takes away effort from other products that could have been developed. The Lyme diseases then, which is the big one has a very troubled history. There must be good reasons why the other companies are staying away from this vaccine.

So this puts one as an investor in a bit of hair scratching moment, the companies assets are worth quite a lot, but the company is burning the cash on not so promising products. If the market is wrong on this and either Chikungunya or Lyme becomes a cash generating product, we have quite a lot of upside from here. Taking a position in Valneva basically comes down to a few key questions:

1. Will Ixiaro continue its nice sales growth for the long term?

2. Will Dukoral at least hold up its current sales level, or perhaps the indication that it reduced prostate cancer deadliness can ramp up sales?

3. If the Lyme disease candidate can find a partner for it's Phase 3, even if this means some share dilution, the upside is many times more than the share dilution of some 30-35%.

4. Can the EB66 platform create a new revenue leg, for example we have the Corona virus now, the platform should be able to produce a vaccine here. The previous co-operation with Nordic Bavarian also sounds promising, given that they bought the GSK assets.

I have to say I'm a bit split myself here, I bought into the company around 2.5 EUR per share, but at the time of writing, the stock is already at 3.18 EUR per share, still far away from some "fair value" of about 5 EUR per share. But I'm not all convinced of the pipeline and the previous execution of the other vaccine candidates does leave some extra worry in how it will develop.

Usually it really helps to do a proper write-up, the case becomes more clear, you get more conviction. I have done a tone of reading this time, honestly I barely summarized a third of what I read in this post (I thought it got long enough anyway). I have to say in this case I got more confused if I should own Valneva or not. Any input from you readers would be most welcome!

+ Strong core business of dental prosthetic production with good cash flow generation. Possible margin improvement after factory move in 2019/2020.

+ Although listed in HK, this company mostly has stable revenue from developed markets - Europe/USA/Australia.

+ A kicker is the growth opportunity in China where the need for dental care is huge as well as the high fragmentation in the market.

+ Debt tenor recently extended, which shows prudence of liquidity management.

+ Low valuation with good potential for turn-around and multiple expansion if management can integrate acquisitions successfully.

- So far acquisitions has just grown top line, nothing has feed through to the bottom line. Markets are currently in doubt of management execution on the investments.

- Strange history of running core operations on land where the lessor did not have the right to lease out the land (might have been hard to understand beforehand though).

- Recently started a share buy-back program (about 1% of float so far), although this is general is an acceptable way to shift out earnings to shareholders, it more looks like a way to prop up the share. The management should concentrate their efforts and cash in improving the businesses they bought.

Background

Modern Dental Group (hence forth called MDG) is the only listed company in the previously described segment of prosthetic producers and distributors. The company floated on the Hong Kong exchange in December 2015, offering 175m new shares and 75m secondary shares at 4.2 HKD. This brought in about 660m HKD cash to the company. The current market cap of MDG is 1.2bn HKD.

The company started growing significantly during the early 2000's with centralized production facilities in Shenzhen, China, for dental prosthetics production. The company used third-party distributors to sell their low prices dental prosthetics. This co-operation grew over the years to a large number of distributors world-wide, selling their products to local dentists. The offshoring of prosthetic production to China has seen strong growth (as discussed in Part 2) and created good cash flow for MDG. This enabled the company to bit by bit acquire it's distributors and smaller local labs. MDG has through acquiring these companies become a direct distributors to the dental clinics with the purpose to control the whole mid-stream segment. The goal as I interpret it, is to be able to provide a full-service offering, both low cost options from China and the higher quality products from the local labs.

As we learned in previous posts, the development of CAD/CAM technology enables the local labs (who can afford it) to fight off the low cost production in China. With machines doing most of the work, low labor cost is not as big of an advantage as in the past. This is probably the main reason MDG has been on a spending spree over the last 5 years. My guess is that MDG see the next leg of growth as consolidating the small local dental labs into bigger units where economies of scale works better with CAD/CAM. In fact MDG has already created such labs of larger scale in Hong Kong, Melbourne and Emmerich (close to the border of Netherlands). By consolidating the market MDG might be able to out-compete smaller local players.

Ownership structure

47.4% of the company is held by the Chan family

16.1% of the company is held by the Ngai family

The rest 36.5% is free float.

A family majority owner is very common in HK listed company. This is both a blessing and a curse, if it's the right family leading the company, it could be very good with a strong owner to lead company. HK also has many cases where this has gone totally wrong and money is more or less embezzled into other non listed entities which are family controlled. Given the nature of the business in this case and that two separate families are large owners, I see this risk as minimal. It's rather the risk of incompetent leadership which would be the largest risk. At the same time, the families have all the motivation in the world to not mis-manage their company, since they are more heavily invested than anyone else. On balance in this case I see it as a positive that this company has a strong family owner.

Fundamentals Overview

The core of this company has been the large production facilities in Shenzhen China, they have delivered solid cash-flow (some 150m HKD per year back in 2014) and continues to do so. Although exactly how much is not fully visible anymore, since income is now mixed together with all the acquisitions done (more on that later). The company has some 780m HKD in debt, which recently has been refinanced (at a cost) at a longer tenor (5 years). Being prudent and taking up longer term financing, even if it costs more, I see as a positive and responsible management. I would not want to see debt levels escalate, now at 2.45x EBITDA.

As we can see above, Europe is the largest market, followed by the U.S. Unfortunately profit contribution and margins per region is not available, but from my readings Europe together with Hong Kong (included in Greater China) are the two regions which contributes most to the bottom line.

Revenue and Net Income

Top-line has increased significantly (mainly from acquisition) but so far small effect on bottom line. One reason is that a loss making US operations was added into 2017 figures. Maybe it will be famous last words, but my investment thesis here is that we are experiencing the worst right now. On the flip side there is a lot of potential for margin improvements, if management delivers in terms of synergies and operations of scale in general and for the U.S in particular. Another factor for margin improvements, will be few years down the line, when the move to the new factories in Dongguan are completed.

P/E contraction

Given the declining share price and flat Net Income, the P/E has just kept contracting, reaching as I see it, attractive levels.

Acquisitions Overview

Given the large number of acquisitions this becomes an important component to poke a bit deeper into. The below tables summarizes the acquisitions over the past 5 years.

Larger Acquisitions

Smaller acquisitions (dental labs)

In total since 2013 MDG has done acquisitions to the tune of 1.2bn HKD, the current market cap of MDG is 1.29bn HKD, adding on net debt of about 450m HKD, the Enterprise Value of MDG is 1.75bn HKD. For MDG to currently be fairly valued they must have grossly overpaid for the companies the bought. Or the market has miss-priced the company and its significantly undervalued.

Has MDG in general overpaid?

The short answer is, probably yes. The slightly longer answer is, the earlier acquisitions seems to be OK-ish. Its hard to judge exactly how improvements and synergies are moving along per region and contributing to the bottom line. The jury is still out on the execution of their strategy of lab purchase RTFP (MicroDental) being the main one. Just looking at the purchase prices of the larger acquisitions, the market price seems to be around 1x Revenue of the companies, which without any deeper insight, sounds fairly cheap. The problem child in my view is RTFP, which is bleeding pretty badly.

One case where the company was somewhat unlucky was the SCDL acquisition in Australia/New Zealand. Australia's government changed the contributions to dental healthcare, which has reduced the business significantly overall in Australia. The market is slowly recovering from this.

A look at RTFP Dental (MicroDental)

This acquisition in 2016 is quite different from the larger ones done in the past. First, this is the only large scale dental lab acquisition done. Second, this is the first significantly loss making operation bought. As you can see in the second table above, MDG has also started to selectively buy Dental Labs in other places of the world, but that has been small scale compared to this huge acquisition of 21 labs in one go. MDG acknowledged that RTFP was losing a lot of money, US$-9.3m which translates to -73m HKD (that is a lot for MDG which has a historical Net Income of about twice that).

These were their main rational why this still made sense to acquire:

Brand Name - MicroDental is a renowed brand in USA.

Customer network - Platform for MDG to further penetrate the USA market, mainly through the 21 labs around USA.

Laboratory EBITDA - at US$5.9m EBITDA on lab level shows there is actual value in the company. RTFP is burdened with high admin costs, an expensive facility in Dublin etc. MDG believed it could improve results through offshore product lines, elimination of unnecessary corporate expenses, reductions in rent and operating expenses for the facility in Dublin and streamlining measures.

Location of dental labs of RTFP Dental

Tax benefits - MDG can enjoy tax deductions through amortization of goodwill, to the tune of US$7-9m.

Finance cost - 2016 US$2.4m of the losses were due to Finance costs and MDG would be able to fund this more cheaply.

The Latest comment released last month on MicroDental business outlook:

"The North American market has experienced a slight drop in sales (of less than 2%) and a drop in sales Volume (less than 3%) due to (i) the management’s focus and attention on the ongoing restructuring and integration of MicroDental during the period as a result of the temporary distortions arose from closure of inefficient locations and relocation of production facilities during the period; and (ii) the management’s planned decision to focus on higher priced and margin products and gradually phase out the lower priced and margin products in MicroDental Group."

In the latest semi-annual report they disclose how the reshaping of the MicroDental business is progressing, in total it contributed -9m HKD in loss for the first half of the year. Still terrible, but much better than the 73m HKD loss before. This progress will be key to MDG's long term success and potential share price recovery. I think it will be hard to come out of this and create shareholder value, meaning turning this business highly profitable. So far the market agrees with me and I think this the main reasons why the stock is down -60% since the acquisition was announced. This of course give us that invest now, a good discount. So the damage done by this acquisition is in my view already reflected in the share price, now there is upside if they actually manage to turn it around properly. There are some early signs that they are making good progress.

The strange land story

Going through the IPO documents a very strange story emerges. The very short version is something like this: The factories MDG are running in China are rented by some type of local community in the suburbs of Shenzhen. This was all well for many years, until Shenzhen grew so much that the land became more valuable. The city has after that re-evaluated the claims different people or groups have to that land. It happens so that Shenzhen government has realized that this local community does not have the legal rights to this land and therefore MDG ends up in a very strange position. Basically MDG could at any point be evicted from the land (with a grace period for moving out). Since this local community of course strongly opposed the Shenzhen governments view on the matter, this has ended up in some type of legal conflict. Consequently MDG decided, it's time to start to look for a new factory in neighboring Dongguan. This also makes sense from a labor cost perspective, since Shenzhen starts to become a bit too developed and rich. Back in the IPO days, 2016, there was still a long runway until a new factory would be up and running. I can't understand how investors would be willing to bare this big risk of being thrown out of their factory, before the new one is finished. Now this issue is diminishing, the first phase of the constructions of the new factory is scheduled to finish end of this year. Even if MDG was told to start to prepare to move out by tomorrow, the impact would not be terrible. I would not have been comfortable to invest in MDG earlier than now, just by this fact. These kind of issues is not something I contemplated for my other investments, you always learn something new and the number of traps in emerging markets are so much greater.

Valuation

Being the only listed company in it's segment of course makes valuation from a peer perspective more challenging. What MDG themselves paid for the acquisitions is one guideline of the value of the business. Currently the Enterprise Value of MDG is about 1.75bn HKD with revenue of 2.28bn HKD for rolling last 12 months. On the very simple metric of paying 1x revenue, the stock is undervalued by some 30%. I don't suggest this to be a very good method though, I prefer to look at cash flows.

As we have seen in Part 1/2, the dental business is not very cyclical and has a nice growth trajectory in many parts of the world. These are important reasons, since it gives stability to revenues and income. The big question for the valuation is, what will be happen with the margins? The company has gone from stable 14% Net Income margins in 2012, down to around 6% in the past years. Will that improve, become even worse, or stay stable going forward? This all depends on how well the company manages all the acquisitions done over the past 5 years, since they brought down the margins.

Assumptions:

For revenues I do not assume further large acquisitions, just some minor labs being bought. Majority of revenue growth is assumed to be organic growth. China as we have seen is growing very quickly and that will also feed through in the companies revenue growth. The growth rates are 2%, 4% and 6% per year.

My base case assumptions is that some type of efficiencies of scale will start to take effect. Also that the bleeding stops in the U.S. dental labs turn into a profit, there is a few percentage points of margin improvement just from that. Making the base case in my view, fairly conservative.

WACC = 12%, given the stable nature of the business with revenue from developed markets I think a lower WACC is warranted. 12% maybe is not even low enough. I would go even lower, if it wasn't for that I wanted to keep some risk premium for the uncertainty around management execution.

This gives me my three valuations:

Base = 1.42 HKD per share (I give this a 60% weight)

Bull = 2.19 HKD per share (I give this a 30% weight, since I see it as more likely that margins will improve)

Bear = 0.53 HKD per share (I give this a 10% weight, I see it as unlikely that margins would further significantly deteriorate)

Which in turn gives me a weighted target price of 1.56 HKD per share and about 20% upside to the current share price.

Summary

I have been somewhat torn if this is a good enough case to invest in or not. I do love a good turn-around (maybe I like them a bit too much). It's not easy to catch the bottom and this stock is currently a slow falling knife. 20% upside at a WACC of 12% is not extremely good, but a DCF is also tricky. I'm not a slave to the DCF and there is a lot about this company not captured in my simple DCF. Just changing the assumptions a little bit moves the valuation up and down by quite a bit. For example a WACC of 10% instead of 12% gives a Base case valuation of 1.86 HKD per share.

I like that the family is so heavily invested in this company, they must have a great understanding of the dental industry. They are executing on a strategy they believe will be fruitful in the long run and there are some early signs that the losses in USA are coming to an end.

I think what made me finally decide is the defensive nature of this business. There is a reason this company initially traded at a P/E of 30 and most healthcare and dental related companies are trading at very high multiples. So buying this below a P/E of 10, is pretty darn good for a defensive business.

I initiate this at a 4% position as a Long Term Holding in my portfolio, I will not increase my position before I see proof of margin improvements. I'm willing to give the company about 1-1.5 year to prove that they can improve margins from here.

Source: 2016 Modern Dental Group Presentation.

Dental laboratories and distributors

The focus in Part 1 was on total industry level, revenue and all the different services provided by a dentist. There are a handful of listed dental clinic companies globally and some of them are listed in the picture above. Singapore listed Q&M has an interesting spin-off that I might come back to, but for now I find the other segments more interesting. The next layer in the supply chain are the laboratories and distributors. There is only one listed company in this layer of the supply chain, Modern Dental Group. It has been listed about 2 years now on the Hong Kong stock exchange.

How are dental prosthetics made

There are many different services at a dentist, the more simple ones being just a filling. But when you need a prosthetic of some kind, you enter into a more complex product supply chain, with companies supporting the dentist. This is what we will learn more about now.

Before we dig into more detail we non-dental experts need some more background info first. It's a pretty complex production flow to replace or repair teeth, I found videos like the ones I linked below very helpful to understand the process and turn-around time to produce any type of dental prosthetics. This is what makes it so fun to be an investor. On the journey to find new investments, you get to learn so many new things. I really had no idea about these processes a few months ago!

Press Read More for videos and further details:

The second video on crowns/veneers as well as modern 3D-methods for the same process in the first video:

Implant supply chain

We are working ourselves backwards in this supply chain. We have now discussed the dentist and their clinics. On the back of that sits a number of companies that work as Sales and distribution centers for the clinics. Although not as fragmented as the dental clinics, this is still again a fairly fragmented group of companies, with local champions in different countries.

Dental Labs - being taken over by China

Behind the Sales and distribution are companies that do what was shown in the videos above, so called dental labs. The dental labs are usually also small centers, with a few technicians that produce the dentures and other type of tooth replacements. The technicians use the machine and tools, produced by the Upstream suppliers and make a finished end product, either manually or through a more advanced CAD/CAM process. Very few dental clinics are big enough to have in-house capabilities of producing dentures with traditional or CAD/CAM technology. So either there is a local dental lab they turn to or a central bigger operation. The local dental lab has the benefit of providing a quick turn-around time, which is obviously important for the end-customer. The problem with local dental labs in for example western Europe is that the dental technicians are expensive. So what quite interestingly has happened is that, just like many other products we purchase, it has been outsourced. If the customer wants a low priced product, the production has been centralized to low cost countries. There are large pools of dental technicians trained to produce these products, mainly in China. I for one did not know that perhaps grandma's dentures were produced in a "factory" in Shenzhen China. The upside obviously is cost, the downside is the turn-around time, the close communication between dentist and technician. This means that in many cases the factory in China can not deliver the same top quality product. But as we have seen, dentist cost is major issue hindering more supply, with lower prices more people would want the services. Several reports claim that this outsourcing of services to low cost countries has hurt the local market and the number of local dental labs have been shrinking. For example in the U.S there seem to be growing shortage of local technicians US Study from 2012. Another example is Sweden where the local lab market declined from 5bn SEK to 2bn SEK between 2007 and 2011, after that it has been fairly stable.

Technology has help this shift of outsourcing production to larger centers. Before the co-op between the dentist and technician was very close. Today we have machines that create very good images/scans of the mouth/teeth/gum, which helps the technician to produce good products without much back and fort with the dentist. On the other hand technology reduced the manual labor cost, which has been the big advantage of producing in countries with high labor costs, acting as a counterweight to the outsourcing trend.

Industry Insight - Interviews from Master Thesis

A very good master thesis has been written on the topic of China challenging local labs, it describes many parts that I summarized above. For the interested reader I urge you to read the report here: Dental Laboratory Crisis: How is Chinese competition affecting the Swedish dental industry?

What I found the most interesting in the report, which I had a hard time to find elsewhere was the interviews with Swedish technicians, expert and dentist. Below I summarized some of the main points of those interviews. This gives the perspective from a more highly developed country, keep in mind that is not the case all around the world.

C1 ("half advanced dentist") is a dental technician and shares a lot of insights, for example:

• Beforehand, a dentist would stick to its supplier if the quality is good. No matter if the price is a little more expensive than the competition. Currently, the dentists realize that they have more opportunities and can choose their supplier with more ease, C1 states

• The concluding remarks were that they are aware of the Chinese competition but they think that the ‘stolen’ market share is currently at a top level and that the most important function within the collaboration of dentist and dental technician is still the close connection which is needed to clarify missing details and make perfect color matching possible.

Technician C2 ("old school method") shares:

• The treats from China still seem to be far away,” C2 states “a bigger threat are our neighbor countries like Poland because patients can go there and get a better price than in Sweden.” If patients need one crown they will go to a Swedish dentist and will moan about the price but they will do it. If they need 10 to 15 new teeth it is worth crossing the borders. In Poland, there are even service centers where one can go to, have the impressions made, stay in a spa for one day and on the next day they will get the prosthodontic. In the background, technicians work all day and night in shifts to complete the product within 24 hours.

Technican C3 ("aided by latest technology"):

• Since 2009 the Chinese competition is shrinking, C3 argues. They trace this to the good Swedish aesthetic quality, the product quality as well as the service quality. “You can’t compare local dental laboratories with the foreign competition when it comes to these parameters.” On the other hand, Chinese firms are producing their products more cheaply than C3’s company could ever do. When the company started, they had about 60 percent of their suppliers located in China. Today, after eight years, this percentage decreased to 4 percent. They shifted from importing the products to manufacturing them locally.

The Market Expert E1:

• The expert sees the foreign competition from south-east Asia as a stagnating threat in the past years. Since this competition also has the need of new manufacturing technologies the price advantage is not that big anymore. When talking about SMEs in the dental industry, Expert E1 sees the threat especially for the micro and small firms. These firms do not have the financial capabilities to make bigger investments for the upcoming technologies such as AM or intraoral dental scanners. “The biggest drawback here is, even if they afford such a technology they do not have the capabilities to outlast these machines.” When Expert E1 focuses on the collaboration between the technician and the dentist itself, a few changes in the future can be seen. The communication is still an important factor but it will be decreasing in the future. The expert argues that in the future dental technicians will work as a refining party in the process chain. Within the next years, the number of market players will decrease due to all these changes mentioned before.

Expert E2:

• The new technology of the intraoral scanner is too expensive for small dental laboratories. In the next years when the technology becomes affordable, this will transform the market again. The Expert states “This is the missing link in the digital workflow.” When facing the problems for the industry, Expert E2 says that the small laboratories will have a hard time staying in the market. This is not only because of the missing resources to invest but also if a small laboratory can afford a 3D printer they do not have the capabilities to run the printer at a reasonable capacity.

Dentist D1:

• As a consultant, dentist D1 thinks that the majority of Swedish dentists does not want to produce prosthodontics in-house due to the risk of the high investment and the low utilization level. A lot of participant D1’s clients tried out Chinese dental laboratories, some of them were satisfied and some were not. “Price doesn’t matter because I don’t pay it. As long as the patients is willing to pay a fair amount to sustain his health I will go for European products.”

• As a private dentist, D1 is aware of the technological changes: already 15 years ago, the dentist bought a CAD/CAM machine to produce crowns in-house as a chair side6 solution. Dentist D1 was very satisfied with the product but when it broke down, dentist D1 knew that an investment in a new one would not be a good idea. The first reason was that the machines are very expensive, a breakeven of the investment was never possible. Second, the dentist has so many patients that participant D1 wants to spend more time on the patient in person and not on the production of additional products.

Summary

This is the end of the industry dynamics description, there is still much more to say, but I want to move over the company specifics. So the rest of the dynamics of the industry will be included when certain companies are described. For example the first post discussed Invisalign and similar products, for treating misaligned teeth. These supply-chains are not as complex and can be brought into the analysis of for example Align Technology. Another big area is the implants and the different product choices for doctors in terms of titanium screws, abutments etc. This will also be brought into the analysis of such a company.

Why the dental sector?

I had several sector themes in the past and some of them are still in my portfolio (EV's, breweries, funeral). My most well covered theme has been Electric Vehicles. It's time to learn about a new niche segment of the market. Over the past year I have spent a lot of time looking in to many different Pharma/Biotech/Healthcare related companies. Unfortunately it has not yielded in anything I can confidently hold long term. I thought I had an investment case with Teva, which I spent a lot of time researching (Teva - The Perfect Storm in 2 parts) but at the later stages of my analysis I decided not to. The main reason why I in general have such a hard time pulling the trigger on a Health related investment, has been the research pipelines. These Phase I, II & III research pipelines often drives most of the value in these companies. I just feel I never have an edge, in understanding the probability, if a product is going to pass through these stages. In the search for something more understandable but still healthcare related, I ended up with dental care. Although still complex, I think this is a niche which is understandable and therefore for me - more investable.

Some segments and markets in the dental services industry has very attractive investment dynamics. First of all it's generally very defensive, especially in countries where dental care is government sponsored or part of a health insurance. Second, is demographics and economics, the world is getting older and we also live longer combined with increasing wealth. Old people need dentures and implants, and reaching a certain level of wealth, you start to take care of your teeth in another way. These two factors create a significant long term tailwind for these products. Third, it is a very fragmented market, with custom made products. This creates a very low price transparency for the end customer, it will take a long time before end consumers have proper price comparison, for dental services. In many cases it's also not needed, given government sponsorship or insurance covering the procedures.

This will be a multi part exploration in understanding the dental sector and the investable players in that space. If any of you readers happens to be a dentist or just have deep knowledge in the sector, please do help out over the coming posts to explain the dynamics of the industry.

The Big Picture

It is very hard to get a good global industry overview. First of all because of scarcity of data, secondly because different sources group different products and services in different ways. I have done my best to pull together a industry overview from a number of sources. Most of the industry data is from 2014-2015.

One can divide everything related to mouth health into two main segments, my focus will be on the first of these two:

1. Dental Services - All products and services when you visit the dentist (teeth check-up, tooth filling, dental implants, cosmetic changes, xray, etc).

2. Oral Care products  - All products and services outside the dental clinic (toothbrush, toothpaste, dental floss, mouthwash, etc). Although a large market, I will leave this segment for now, this series will focus on Dental Services.

Tooth decay (dental caries) is the most widespread chronic disease worldwide and constitutes a major global public health challenge. It is the most common childhood disease, but it affects people of all ages throughout their lifetime. Current data show that untreated decay of permanent teeth has a global prevalence of over 40 percent for all ages combined and is the most prevalent condition out of 291 diseases included in the Global Burden of Disease Study. Another very common disease is periodontitis, which means inflammation of the gums and supporting structure of the teeth. Periodontitis starts with gingivitis, where the first sign is bleeding from the gums. I think many of you have experienced early stages of this, when you are flossing your teeth and the gums start bleeding.

We can also see that teeth is a question of economic background, as people get richer they eat more sugary food and get more tooth decay. But as income rises, more of those teeth gets fixed:

Source: The challenge of oral disease

Dental Service market

The U.S. dental services is today a market of more than a 130bn USD. The European dental market is valued at above 80bn USD. The U.S. dental market is growing at an average growth rate of 5.8% per year since the 1990's. The European Dental market is a more mixed picture, but on average it is growing at a slower pace of 1-2%. For the Asian region the data is much more scarce. Large countries like China and India has not come nearly as far as the highly developed countries, but growing at significantly higher pace (from low levels).

U.S. Dental Services expenditure

Source: Harris Williams & Co

The below picture gives a feeling for when markets are saturated in terms of number of dentist per 1000 population. One can see a pattern of about 0.5-0.8 dentists in developed markets, whereas a country as China has significant growth ahead:

Dental Services explained

To explain the different parts of the industry I use this split from 2015 on the U.S. Dental Services:

Source: Brocair Partners

This gives a brief explanation of these different sub segments of dental services

Restorative - Dental fillings, dental crowns, procedures treating damaged or decaying teeth or gums.

Preventive - Routine dental exams, cleanings, fluoride and sealant applications.

Diagnostic - Digital radiography and x-rays, etc.

Orthodontics - Treating improper bites and misaligned teeth.

Prosthodontics - Artificial teeth, partial or full dentures, bridges and implants. This also includes veneers, a thin layer placed over a tooth and other types of tooth restoration.

Oral surgery - reconstructive surgery, jaw alignment, dental extraction. This segment also include cosmetic surgery to the jaw.

Endodontic - Root canal procedures and other treatments related to the pulp of the tooth.

Other - Includes services to dental practices, distributors, software solutions, HR, marketing, financial planning etc.

Within all these areas the are a number of large to medium sized companies providing different products and solutions to the dental clinics. In coming posts I will dive into some of these segments and see what kind of investment opportunities we can find.

Highly Fragmented Market

Dental centers do not normally belong to large chains or a company group. The dental service industry is in fact highly fragmented, with smaller dental shops run by one or a few dentists. The top four dental service firms in the US account for less than 2% of domestic market share, and over 88% of the US dental service companies operate with less than three dentists, according to a IBISWorld Dentist report. The same situation is seen globally in most countries. Some exceptions are: China, where some 350 dental practices control over 50% of the market. This is due to most current centers are government run, in a similar way as hospitals. But as could be seen in the above picture, China is a very under-served market in terms of number of dentists overall. The growth currently seen in China is coming from smaller groups of private centers. In Europe the situation is also mostly of a fragmented market (with Finland perhaps being the exception):

Source: KPMG - The dental chain opportunity

This fragmentation seems to have been something the Private Equity firm have picked up on. Obviously there are synergies to be had by running a larger operation. So from a very fragmented market we have seen the early days of some consolidation. This article (Pan-European dentistry is here, but at what price?) though argues that some players have been overpaying.

This fragmentation in dental clinics has also meant that the bargain power has been sitting with the dental suppliers. These companies are huge in comparison to the small dental clinics and supply the clinics with all the products they need, to run a modern dental clinic. Given this fragmentation on the dental clinics side, most of the investable universe is with these companies supplying the dentist with their products.

Your mouth is expensive

A strong motivational factor for spending on dental care is of course just pure looks. To change the appearance by moving misaligned teeth, using veeners, or just a simple whitening. This is a fast growing segment in the market, where products like Invisalign has grown tremendously. These procedures though are like cosmetic surgery, a luxury product, which will cost you a lot. The Invisalign procedure will cost you anything between US$4000 - Us$8000.

Very few people in the world can afford to out-of-pocket front the full bill for dental care when more advanced procedures are needed. Replacing a lost tooth with a single implant will cost you between US$2000-$6000 depending on where you are in the world. Since dental issues, like a lost tooth seldom is an emergency, we end up with a lot of untreated cases. Because of the high prices, the dental market is to a large extent driven by the level of government support. Few countries has totally free dental care to the whole population though. A rich country like Australia for example seems to have a very lively debate on this, where even young people go with untreated tooth decay: The dental divide – and the decay of public dental services.

Countries like northern Europe which are famous for their welfare states, have free dental care for kids up to around 18 years of age. Even in these countries adults have to pay, although there is still usually some type of back-stop coverage from the state. For example in Sweden 50% is covered between 3000-15 000 SEK and 85% of the amount above 15 000 SEK is covered by the state. This kind of coverage is similar to expensive health insurances in other countries which include dental. For example the health insurance I myself have (global coverage), covers 80% of my dental bills. Even if this sharing of cost helps, people still need to pay out of pocket fairly significant amounts when doing a larger change, like implants or dentures.

So the growth of dental care is very much up to governments willingness to pick up the bill. The other factor is is increasing overall wealth, like in China, where a rising middle-class is deciding to start to pay themselves, either out-of-pocket, or through better health insurances. To reach a larger part of the population, price is obviously an important factor, if companies are able to lower prices, volume will follow.

End of Part 1

I hope this set the stage for a series of posts on dental related companies. Do you have any investment favorites in this market segment and why? Anything you would like to add in terms of important industry trends? Please leave a comment!