Interesting article by Graham Witcomb from Intelligent Investor.
The article is primarily about Avita (AVH) but makes mention of Aroa.
Interesting read.
Avita is in the 'regenerative medicine' business. Founded in 1992, the company spent its first decade in obscurity. But in 2002 its unique 'spray-on skin' gained attention after it was used to treat victims of the Bali Bombings.Burns are usually treated with grafts - taking skin from one part of the body and moving it to another - but this comes with several drawbacks, including severe scarring, extra pain, and difficulty treating full-body burns, where a patient may have very little skin left.
Avita's technology, called Recell, solves many of those issues. Surgeons require only a small piece of a patient's skin, and then use the Recell device to break it down into individual cells and strip away unwanted parts, like hair follicles. What remains is then suspended in a proprietary solution and sprayed onto the patient's wounds, which aids the healing process by allowing the wound to heal from the inside out, not only at the edges.
Key Points
·US market is huge and Avita could become dominant player
·Patent and competition risk is significant
·Share price and red flags demand caution
The main advantage of Recell is that scarring is significantly reduced, and the technology is useful for the treatment of large burns because a small patch of healthy skin can treat an area 80 times its size.
Not only does it meet an important medical need, but a valuable one at that: the immediately addressable market - burn victims requiring a hospital stay - is worth around US$200m a year in the US, where Recell was approved by regulators in September 2018. Avita is seeking additional approvals for outpatient burn victims and pediatric scalding, which could eventually expand the market to around US$900m.
Management believes Avita will serve around three-quarters of the inpatient burns market by 2025. On that basis, the company could be generating $150m of revenue a year, and if its clinical trials successfully expand the market to other areas, sales could double again by 2030.
The company only earned US$14m in 2020, so there's potential for a 10- or 20-fold increase in sales over the next decade. And gross margins could be as high as 90%.
While sales and marketing expenses will be high in the medium term, profitability could sky-rocket a few years from now because those expenses should grow at a slower pace than sales once surgeons become more comfortable with the technology. Salivating yet?
Patent impending
Avita's ability to commercialise its technology hinges on its intellectual property which, to be frank, is a snake-infested minefield.
We aren't surgeons and don't claim to have a bulletproof understanding of the company's technology - nor the patents protecting it from competition, which is partly why we're forgoing a formal recommendation.
What we can say is that Avita has patents in its major markets covering the Recell device, methods employed, and unique composition of the final cellular suspension used in treatment. Basically, anything that's new and contains an inventive element has been patented.
The catch: new technologies usually only have patent protection for 10-20 years in most parts of the world. You have two decades to milk your invention for all it's worth because, after that, copycats can start building and selling it at a lower price, which inevitably erodes your profits.
Unfortunately, there's an even bigger catch: those patent expiry dates are based on when the application was lodged, not when the technology was approved for sale by the US Food & Drug Administration (FDA). In Recell's case, the patent clock started ticking when the technology was developed in the 2000s, yet the FDA only granted approval in 2018. It has been locked out of the most valuable market for most of its life.
We can debate why it took so long for approval to be granted, but that would miss the point: Avita's patents only extend to 2034, and some key protections will be axed as soon as 2022. Large market share gains are possible in the near term but, over the coming decade, we expect competitors to slowly sweep in and copy Recell's success. Indeed, they're already here.
Competitors multiply
US-based RenovaCare is similar to Avita in almost every way - they overlap in target market, scale, and technology. The main difference is that RenovaCare's spray-on-skin isn't yet approved by the FDA, but it has some other triumphs up its sleeve: namely, winning a 2017 patent infringement case brought by Avita. There's no guarantee RenovaCare's product will get FDA approval, but it's clear Avita sees it as a threat and it could be a major competitor if or when its device gains approval.
Another competitor is closer to home: New Zealand-based Aroa Biosurgery, which is around half Avita's size and focuses on healing complex wounds and deep burns. The company's main product, known as Endoform, provides a collagen scaffold that new skin cells can rapidly adhere to, supporting tissue growth and reducing healing
Aroa isn't a direct competitor, but its product has a similar function to spray-on-skin and can be used as a substitute in some cases. Aroa has regulatory clearance to sell Endoform in 38 countries, including the US and most of Europe.
So far as we can tell, Recell appears to be a superior treatment, at least within its target market of major burns, but Endoform is a lot cheaper - it costs around 50 US cents per square centimeter of treatment area compared to over US$3.00 for Recell.
What's more, last month Aroa received US approval for a new skin substitute called Symphony, a treatment for various ulcers and trauma wounds. That shouldn't affect the burns market, but it does start to crowd the US$550m trauma market that Avita hopes to expand into.
Paying for growth
Avita's share price has more than halved since February after several COVID-19 related setbacks. The company has had to reduce its onsite hospital sales team due to new COVID-19 protocols, and the cancellation of major professional conferences has made it difficult to access new surgeons and teach them about Recell. Management says this will slow growth.
Sales could still grow materially over the next few years and Avita has a clean balance sheet with net cash of US$71m - but something about Avita just doesn't sit right with us.
The technology has been approved in Europe and Australia since 2005, yet annual sales never topped $4m in these markets. Investors have stomached losses for 20 consecutive years.
The company is still bleeding cash as it invests in sales, marketing and new clinical trials to hopefully expand its market (see Chart). Management doesn't expect Avita to break even for another few years, which is hard to reconcile with the company's ambitious claims around market size and penetration over that time. Either the opportunity is smaller than suggested or expenses are going to explode.
There are other red flags, too: the company's clean balance sheet was achieved with a $120m capital raising last year, but it was only open to institutional investors - retail shareholders were heavily diluted, so the company doesn't pass our 'shareholder-friendly' test.
Then there's chief executive Michael Perry's 2020 pay cheque of US$17m in cash and stock grants, with a further US$8m going to five senior personnel. When management takes home more than their company earns in revenue, our eyebrows are firmly raised.
With a market capitalisation some 41 times revenue, significant growth expectations are already built into the share price. While we hope Avita's technology does prove to be a commercial success, we aren't willing to bear the risks.
Come on finish 1.60 plus, page-101
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