Baillieu Holst Reaserch

Nanosonics (NAN) – Cleaning up
BUY. Target price $1.15
 COMPANY DESCRIPTION. Nanosonics’ lead product, called trophon EPR (yes, lower
case ‘t’ in trophon, to make the brand more distinctive), disinfects ultrasound probes at low
temperatures using ‘nanonebulant’ technology. Nanosonics gained FDA approval for
trophon EPR in February 2011 and in May 2011 the company named GE as its exclusive
North American distributor. Nanosonics’ FY13 revenue, driven by GE sales of trophon EPR,
was $14.9m. We see considerable upside for trophon EPR given the lack of adequate
disinfection alternatives for hospitals and the high cost of treating hospital-acquired
infections.
 The Nanosonics product is ground-breaking. trophon EPR disinfects ultrasound probes
by generating a hydrogen peroxide nanoparticle mist. It works quickly (ie. in just seven
minutes), does not damage the probes, is able to achieve high-level disinfection (ie. high
levels of microbes killed) and avoids potential exposure to hazardous chemicals on the part
of hospital workers. Comparisons with conventional disinfection systems are compelling.
One Nanosonics-supported study, for example, found 79.5% of ultrasound probe handles
manually disinfected with glutaraldehyde were still contaminated (see Nanosonics market
release,10/10/2013). trophon EPR’s advantages have provided Nanosonics and its
commercial partners with a ground breaking new product that has attracted a lot of attention
in hospital administrator circles. Consider, for example, the March 2013 endorsement by
America’s Scripps Health network, which has described trophon EPR as ‘ground breaking’.
 Nanosonics helps to cut the cost of hospital acquired infections. Hospital acquired
infections (HAIs) are a serious issue globally. In the US it is estimated that there are around
2 million HAIs p.a., contributing to 100,000 deaths. Each HAI probably costs US$5,000 on
average to manage. With inadequate disinfection tools a key contributor to the rise of HAIs
it’s reasonable that a product as advanced as trophon EPR will gain a sizeable following on
the economic benefits alone. There has already been favourable data generated in the cost
effectiveness of its product (See J Ultrasound Med. 2013 Oct;32(10):1799-804).
 trophon EPR is on its way to becoming the ultrasound industry standard for probe
decontamination with an increasing number of probe manufacturers now assessed by
Nanosonics and certified for use with the trophon EPR technology. We expect that as
governments look at managing their healthcare systems more efficiently, tools such as
trophon EPR will become mandated as a preferred disinfection system. We look for such
regulatory change in places that have serious issues with HAIs such as the UK.
 The GE relationship bodes well for Nanosonics. As at January 2014, 38 of the Top 50
hospitals in America have used trophon EPR, showing GE’s market reach. In August 2013
GE announced that it would set up a dedicated trophon EPR sales organisation rather than
just sell the product through its existing ultrasound sales team. We are particularly
impressed by GE’s commitment to trophon EPR. In addition to marketing the product, GE
has also invested in the growth of Nanosonics as a company. GE’s Healthymagination
Fund, which invests in highly promising healthcare technology ventures, took a A$7.5m four
year 6% convertible note investment in June 2012. These notes convert at A$0.75.
 Toshiba is also a trophon EPR proponent. In April 2013 Nanosonics secured Toshiba as
a non-exclusive distributor for trophon EPR in the UK. We see this development as highly
positive given Toshiba’s established presence in the market for ultrasound machines and
the potential for Toshiba to take on other markets later on.
 Nanosonics continues to innovate, with the company developing two significant new
trophon EPR products in FY13 – a ‘traceability package’ that can record each disinfection
cycle, and an ‘in-field validation kit’ that allows independent inspectors to certify that a
trophon EPR system is working properly on a customer’s premises.
 Nanosonics has a solid balance sheet. As at March 2014 the company had $23.8m in
cash reserves and no debt, having raised $15.5m in a May 2012 placement at 53 cents per
share.
 Stock remains undervalued. We value Nanosonics on a DCF basis at base case $1.20 /
optimistic case $1.77. Our target price of $1.15 sits at around the low point of our valuation
range. We see Nanosonics being rerated to our target price as further commercial partners
sign up and as GE’s push for trophon EPR in the US gains traction.
Most top hospitals in
America now use
trophon EPR
BAILLIEU HOLST RESEARCH
13 June 2014
Baillieu Holst Ltd ABN 74 006 519 393 www.baillieuholst.com.au Please read the disclaimer at the end of this report. Page 25
 VALUATION METHODOLOGY. Our DCF of Nanosonics21 was built as follows:
- Our WACC was 12% (Medium risk, to reflect the fact that trophon EPR now has a
commercial following);
- We modelled a declining growth rate for trophon EPR sales after our FY14-16 forecast
window, from 30-35% in FY17 down to 4-10% in FY23;
- We assumed COGS as a percentage of revenue stay the same (base case) or decline
about 600 bp, from 33% to 27% (optimistic case);
- We assume that growth in other operating costs gradually converges on the sales
growth rate by 2023;
- We use a 3% FY24 terminal growth assumption for a base case and 4% for an
optimistic case, with EBITDA margins falling back to 35% for the terminal measure;
- We assume no further equity capital needs to be raised.
 MAJOR SHAREHOLDERS. Maurice Stang (10.8%), Allan Gray Australia (10.8%), Bernard
Stang (10.5%), Steve Kritzler (5.2%).
 KEY RISKS. 1) GE’s commitment to trophon EPR; 2) Cost saving efforts in hospitals; 3)
Funding risk.