How to Play the Invest-for-Tomorrow Game in Medtech: Alan Brochstein


Alan Brochstein Alan Brochstein of AB Analytical Services blogs, publishes and creates model portfolios for retail investors and consults with institutional investors. He leans heavily toward medical technology because he sees the industry's devices, instrumentation and molecular diagnostics as huge efficiency creators and money savers for hospitals. He never pulls the trigger on a stock unless it has adequate insider ownership and superb management葉wo ingredients that almost always lead to success. In this interview with The Life Sciences Report, Brochstein highlights several turnaround stories that he believes can create real shareholder value and make money for investors.

The Life Sciences Report: Alan, you hold a multitude of advisory positions both internally and externally. Please connect all those dots for me and explain your business model.

Alan Brochstein: I was working at Piedra Capital Ltd., then a $500 million ($500M) assets-under-management equity firm, and left in 2006 to start my own firm, AB Analytical Services. The original plan was to work almost exclusively with small investment advisers, and I continue to do that to this day. But the business has evolved along the way. I currently work with a few registered investment advisers, and I sit on the investment committee at Friedberg Investment Management Inc.

I've stuck with those original parts of my business model, but in early 2007, I started blogging for Seeking Alpha. I really enjoy connecting with the public through that interaction. I started a model portfolio service in 2008, and have three different models. One of the stock models is called Top 20. It's very eclectic and represents my best ideas. My Conservative Growth/Balanced portfolio is more disciplined, and contains 60% stocks and 40% bonds. The goal of the latter is income and capital growth, and also capital preservation. I just hit the five-year anniversary of Top 20; it has returned approximately 133%.

Yet another part of my business has had a huge impact on everything I do. For four years I've been working with Bethesda, Maryland-based Management CV. This independent research firm provides an analytical framework for evaluating management teams, and I've contributed hundreds of due diligence reports on management teams to the business.

TLSR: Management CV helps investors determine the quality of management. Is this a proprietary product that's offered to institutional investors?

AB: Yes. It's an institutionally oriented service focused on larger, publicly traded companies.

TLSR: You're a chartered financial analyst (CFA). Do you create discounted cash flow (DCF) models on companies you follow?

AB: I do some modeling, but my approach is mainly to review other people's models instead of building my own. Building models is not the best use of my time. It's more important to me to understand what's driving the numbers in a model.

TLSR: I know you follow medtech, which is what we are going to talk about today. What other industries do you follow?

AB: I'm a generalist, but a lot of my companies are in healthcare. I have a disproportionate number of stocks in medtech, which is an area that has fascinated me for years, and I've been able to find a lot of interesting names in that space. I tend to be focused, but not exclusively, on smaller companies. Some of them might even be considered micro-cap.

I have a watch list of 100 stocks that I follow. These 100 stocks aren't the same every week; they are rather a living, breathing group of companies. If a company on my list is acquired, I have to find a replacement. Though I focus on 100 stocks at any one time, I like to think that I focus on more.

TLSR: My understanding is that you have been exploring the idea that insurance companies like medical technology companies because they save money on drugs. Would you expand on that idea for me?

AB: One specific example of this phenomenon is a new technology called renal denervation (RDN). It's a device-based technology for treating hypertension that has been resistant or unresponsive to conventional or first-line therapies. The therapy represents a huge opportunity, and it's not going to be a monopoly. Medtronic Inc. (MDT:NYSE) will be first to market, and St. Jude Medical Inc. (STJ:NYSE) will be a fast follower. Medtronic's Symplicity, available in some markets already, could be available in the U.S. later this year, while St. Jude's EnligHTN received the CE mark in Europe a year ago and could be available in 2014. A lot of smaller companies involved in this technology have been acquired, but there are still several other players. Patients can go in for a quick, minimally invasive procedure, and then they may not have to take blood pressure medications for years. The benefit goes beyond comparing the cost of the medicine to the procedure; it is also about patient compliance issues and the side effects of the medications, as well as mitigating complications that may arise from unmanaged hypertension.

TLSR: These are large companies. St. Jude has a $12 billion ($12B) market cap, and Medtronic is more than four times that size, with a $52B market valuation. Can RDN technology actually move shares of these companies?

AB: St. Jude called out the market as a $25B opportunity a little over a year ago. I don't know if that's true or not, but optimism rules when you're talking about the future. I have seen estimates that 25% of hypertensives fail to respond to conventional drug therapy, and St. Jude suggests that 4% penetration of the 250M global patients that fall into this category would yield a ($25B) market opportunity. I have also seen estimates that the market could be $2-3B per year within the next decade. According to government data, we spend more than $20B per year on prescription medicine to treat hypertension in the U.S. alone. Unfortunately for these companies, trying to get a lot of growth when so much of the business is exposed to the cardiac rhythm management market (CRM) market is challenging. I don't follow Medtronic, but given that it's larger, I would imagine it will be more difficult for RDN to affect share price. On St. Jude, I think RDN can definitely move the needle. But, is it enough to double the value of the company? No.

TLSR: Alan, I'm thinking that even as a minimally invasive therapy, RDN is going to be a difficult sale when there are alternatives. Nevertheless, it's certainly going to be a valuable service for many patients.

AB: You are right. It's not a first-line treatment; that's for sure. But perhaps it could become first-line once safety and efficacy are better proven.

TLSR: You follow some surgical robotics names. Hasn't hospital consolidation been a problem for this industry? Can you address this?

AB: I'm not sure we've reached the point where hospital consolidation is an issue with surgical robotics. I don't think that's been a problem for Intuitive Surgical Inc. (ISRG:NASDAQ) and its da Vinci Surgical Systems, which are used for prostatectomy, hysterectomy and many other procedures.

"Building models is not the best use of my time. It's more important to me to understand what's driving the numbers in a model."

The other surgical play I'm following closely is MAKO Surgical Corp. (MAKO:NAS). Its challenge hasn't been a macro issue with consolidation or other big-picture issues, but rather one of getting early adopters to its system, the RIO Robotic Arm Interactive Orthopedic System, which is used to perform minimally invasive MAKOplasty procedures for partial knee resurfacing and hip replacements. The company has been able to get surgeons to use the system, but it has tapped out that pool of single users and has had to move up to the executive or CFO levels at hospitals to get sales. Hospitals are saying the system is good, but they must get more surgeons to use it to achieve economies of scale. The selling process takes time, and that has been the problem with MAKO. It's not as far along on the adoption curve as it would like to be.

TLSR: Could you address some other names and their value propositions?

AB: I have mentioned St. Jude Medical. The value proposition there is the great franchise. St. Jude does a lot of research and development (R&D), but it's never the one that invents a new product or procedure. Instead, the company comes up with a better version, a better mousetrap.

Management is a very important consideration for me. Chairman and CEO Dan Starks is very passionate about cardiac health, which is most of St. Jude's business. Dan and his former CFO John Heinmiller, who now serves as executive vice president, own tons of stock in the company. St. Jude's is very well run. For years, it stood out from Medtronic and Boston Scientific Corp. (BSX:NYSE) for its quality, but then ran into quality issues with the Riata Silicone Defibrillation Leads for its CRM devices. The company voluntarily stopped selling the Riata leads in December 2010. That was a disaster, but it's mostly behind the company now. There were residual questions about the Riata replacement technology, the Durata lead system, which has come under attack. But data released by Population Health Research Institute at Heart Rhythm 2013 seemed to refute the reported problems.

CRM has been a tough area for all the players because of changes in the market. Defibrillation products may have been overused. Cardiologists, like all physicians, want to do procedures葉hat's what they do. People were getting CRM devices when they might not have needed them. In any event, that market has been very sluggish recently. We're starting to see it come back now, just like the hip and knee market. Especially with recent information about Durata not having the feared flaws, St. Jude can get its premium valuation back.

TLSR: You mentioned MAKO before.

AB: People who have been successful in the past are more likely to be successful in the future. I knew about MAKO because Management CV had done a profile on the company and its CEO, Maurice Ferre, who has a history of building and selling companies. I was very familiar with MAKO as a good management story.

"The cardiac rhythm management market has been a tough area for all the players because of changes in the market. . .We're starting to see it come back now, just like the hip and knee market."

Well, that kind of fell apart last year. By the time I looked more closely at it, MAKO had missed two straight quarters, and went on to miss another. I think MAKO is a high-growth story where people's expectations were probably too high. The stock was decimated after the company had to reduce RIO placement guidance in Q2/12 and Q3/12 and then its procedure expectations in Q4/12. The company's procedure growth has slowed from about 50% to 30%. But it seems like the management team has now figured out what the challenges are.

TLSR: MAKO is up 14% over the past four weeks, but is down 48% from a year ago. Do you like it now? Do you see it as a value play?

AB: I do, but value is a tough word to use for this company. I have it in my Top 20 model portfolio. It has high gross margins, but it is not profitable right now. I think the stock could double to $23 per share or so, but the company has to hit its numbers. That's been the problem.

TLSR: No company is going to continue to grow revenues at 50%.

AB: That's probably true, but I think the decline happened a little quicker than people thought.

TLSR: Go to your next idea, please.

AB: Masimo Corporation (MASI:NASDAQ), based in Irvine, is interesting. I was charged by my clients to find a replacement for one of my stocks, Synovis Life Technologies, which was acquired by Baxter International Inc. (BAX:NYSE) at the end of 2011. I needed to find another Synovis. That meant I was looking for a rapidly growing company that investors didn't appreciate for whatever reason.

Masimo struck me as a similar opportunity. It was hurt by declining earnings after it settled with Covidien Ltd. (COV:NYSE) and accepted lower royalties for its pulse oximetry technology. The idea was that as Masimo progressed, investors would realize the core underlying growth was pretty high and that vanishing royalties from Covidien were a one-time hit. Again to management: The company's CEO, Joe Kiani, is an entrepreneur and a brilliant guy who invests for the future. A lot of investors like that, but other investors want to see earnings today, right now. Kiani has done some dilutive acquisitions葉echnology buys葉hat have chipped away at earnings. However, he has a better appreciation now for the balance between investing for the future and letting some drop to the bottom line today. He has made some large open-market purchases, too, at great prices, including a purchase of 50K shares near the lows at $18.47 a year ago.

TLSR: What's the growth driver at Masimo?

AB: The main opportunity that I see for this company is its ability revolutionize the way hemoglobin is monitored. Right now, it is guesswork, meaning early transfusions on a preemptive basis. The current standard is to draw blood, run it to the lab and then wait for an answer, which is time-consuming. Masimo can monitor hemoglobin in real time, allowing surgeons to avoid early transfusions. Transfusions are dangerous and expensive, but Masimo's noninvasive Total Hemoglobin monitoring system, based on its Rainbow technology, has been clinically proven. If cost-benefit analyses are performed, hospitals see that a lot of money is saved by using the system. In fact, Masimo guarantees it.

TLSR: I note that you have a small cardiovascular play in coverage where investors may be able to get a significant bump.

AB: I have followed Volcano Corp. (VOLC:NASDAQ) for years, and the stock has always been pretty expensive. The company has alliances with many companies, except for Boston Scientific, which is its competitor in intravascular ultrasound (IVUS), and St. Jude, which competes in fractional flow reserve (FFR). Volcano is focused on percutaneous coronary intervention (PCI), which is a minimally invasive or nonsurgical method of dilating narrowed coronary arteries to place stents.

"People who have been successful in the past are more likely to be successful in the future."

Volcano's original technology is IVUS, which aids the interventional cardiologist in placement of a stent. The company grew market share in that area; it was a big growth business. All of a sudden the company's PCI business hasn't been quite as good. Medicare and insurance companies have questioned potentially excessive stenting, which has been a problem for Volcano as procedures have actually declined. On the other hand, the company has developed its FFR technology, which helps determine if the PCI should even be done. The company has both angles covered. The company also has been very heavily focused on Japan, and recently that's been a problem because of the currency moves between Japan and the U.S.

Volcano seems to compete very well with the giants in the field. The bottom line is that Volcano is a company that saves the healthcare system money, which addresses a theme of mine. FFR can prevent unnecessary surgeries.

TLSR: The medtech category also includes a lot of diagnostics and prognostics technology. Can you mention something in this realm?

AB: That gets me to the final company I want to talk about, Luminex Corporation (LMNX:NASDAQ), which is based in Austin, Texas. One of the things that attracted me to Luminex is its CEO, Patrick Balthrop, who has been running the company for nine years. He spent 20 years at Abbott Laboratories (ABT:NYSE), mostly in its diagnostics division. This guy really knows how a molecular diagnostic company should work. I can't tell you I understand all the technology, but what I can tell you is it has a lot of royalty revenue coming from a total of 40 paying partners.

The company is known for its respiratory test panel, and has recently introduced a gastrointestinal pathogen panel that allows rapid diagnosis of bacteria, viruses and parasites. Molecular diagnostics allow for quicker diagnosis, which is a money saver and potentially saves lives as well.

TLSR: Diagnostics seem to have a short shelf life. They lose market share rapidly when another test appears on the market. What about the future?

AB: Luminex is investing 20% of its revenue in R&D, and that goes to the problem of obsolescence. Like Masimo, this is a company with a vision for the future. I imagine it could show more profit now, but it is investing for 510 years out, not next year. Unlike a biotech company, which needs U.S. Food and Drug Administration (FDA) approval擁f it doesn't get it, lights out有uminex has revenue and is growing that revenue at 1520% per year.

Unfortunately, from an earnings standpoint, Luminex is reinvesting everything it makes, so it ends up with a sky-high price/earnings ratio, and that scares off investors. But I'm very happy with what it's doing. I feel like it's a great story.

TLSR: The invest-for-tomorrow game is very difficult for most smaller companies. Are investors just afraid that they can't pull it off?

AB: Investors are often focused on the short term, unfortunately. In this market, investors are focused on mature, dividend-paying companies, not growth and not speculation. There's just not a lot of interest in small-cap medical device companies in general. The other issue for these companies is the 2.3% medical device tax. Because it's an excise tax, it hurts a small company more than a big company.

TLSR: Thank you for these insights, Alan.

AB: I really appreciate it, George.

Alan Brochstein, CFA, has worked in the securities industry since 1986. He managed investments in institutional environments until he founded AB Analytical Services in 2007, and now provides independent research and consulting services to registered investment advisors. In addition to advising several hedge funds and investment managers, including Friedberg Investment Management, where he participates as a member of the investment management committee, Brochstein is also a senior analyst for the independent research firm Management CV. Brochstein also offers the Analytical Trader service at Marketfy, where he uses fundamental and technical analysis to offer specific trade ideas geared toward swing traders.

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1) George S. Mack conducted this interview for The Life Sciences Report and provides services to The Life Sciences Report as an independent contractor. He or his family own shares of the following companies mentioned in this interview: None.
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3) Alan Brochstein: I or my family own shares of the following companies mentioned in this interview:None. I personally am or my family is paid by the following companies mentioned in this interview: None. My company has a financial relationship with the following companies mentioned in this interview: None. I was not paid by Streetwise Reports for participating in this interview. Comments and opinions expressed are my own comments and opinions. I had the opportunity to review the interview for accuracy as of the date of the interview and am responsible for the content of the interview.
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