Lowering Target Price
Q3 results: TSO3 supports a stumbling partner
TSO3 reported Q3 results that were generally in line. More importantly, the company provided an operational update, highlighting increased spending on the launch of
VP4 to supplement efforts by partner Getinge. We are concerned that the additional marketing investment is indicative of a lagging sales ramp, suggesting to us that a revenue inflection may not be imminent; this is supported by management commentary that Getinge was not meeting minimum order quantities. As a result, we are cutting our estimates for near-term sales of VP4, essentially pushing our forecasts out by one year. With these changes, we are lowering our target price to C$4.25 (from C$5.25) but maintaining our BUY rating. Moreover, we are removing TSO3 as our Focus List pick as the company struggles with the near-term revenue growth for VP4.
Investment Highlights
• Partner challenges trickle down to VP4 launch. Following a reorganization and leadership turnover, Getinge has not met all the conditions outlined in its partnership agreement. While both parties are working together to get the launch back on track, we expect these challenges are likely to impact near-term adoption of VP4.
• Installations show VP4 launch is progressing slowly. Management finally provided installation numbers, indicating that 50+ VP4 units have been installed to date and ~70 units could be in place by year-end. Despite challenges with Getinge, we believe this data should provide investors with comfort that the US launch is gaining traction.
• Catalyst likely pushed out to mid-2018. TSO3 is working with leading OEMs to
gain FDA approval for additional expanded claims for the sterilization of individual duodenoscopes. We expect an FDA decision by mid-2018 and continue to believe an approval could provide a significant potential catalyst for the stock.
• VP4 launch has been slow, but extended claims drive upside to our peak forecasts. Given the long-sales cycle for low-temperature sterilizers, we do not expect the impact of broad extended claims to be felt for several quarters. However, we continue to believe that the upside potential from this market opportunity is immense.
Estimate changes
Given the challenges with Getinge, we have pushed out our forecasts for the VP4 launch by one year, reflecting a slower sales ramp. While we have only nominally reduced our 2017 estimates from 176 to 167 units (VP4 shipments have been generally tracking our forecasts), we have lowered our 2018 and 2019 unit estimates to 230 (from 390) and 390 (from 530), respectively. As a result, our 2018 revenue declines from $57.0M to $36.0M, and adj. EBITDA from $12.0M to $1.1M. Our 2019 revenue and adj. EBITDA falls from $84.6M to $62.6M, and from $21.2M to $9.1M, respectively.
Valuation
We value TSO3 based on a DCF model, using an unchanged 13.5% discount rate and 3.0% terminal growth. Based on these changes to our forecasts, we arrive at a target price of C$4.25, which represents an annualized return of 58.0% and continues to support our BUY recommendation.