Sunshine Heart's Path Is Long, But The Rewards Could Be Enormous

http://seekingalpha.com/article/332...ath-is-long-but-the-rewards-could-be-enormous


Summary

• Sunshine has seen the FDA sign off on the resumption of its COUNTER HF study as well as an interim analysis that could accelerate approval by a year or more.
• Even with the launch of Novartis's new drug Entresto, there are likely to still be several hundreds of thousands of Class III/IV patients, supporting billions in revenue potential for Sunshine.
• The risks with Sunshine Heart are well above average, and it is still a long road to approval and commercialization, but the shares appear undervalued below $7.

In the multiple times I've written about Sunshine Heart (NASDAQ:SSH), I've tried to emphasize the point that this is a "consenting adults" type of stock - the commercial promise of an effective device therapy that can not only halt the progression of heart failure but hold the line (and maybe improve it) is tremendous, but this is an undercapitalized company that still has to establish that the device works and that they can commercialize it.
Looking at other cardiology device companies, I believe there is at least a credible chance that Sunshine can generate $300 million or more in revenue ten years from now, with a gross margin in the 70%s and an operating margin potentially in the 30%s. Discounted back and adjusted for further funding needs, I continue to believe that $7 to $9 per share is a reasonable valuation range for what could well be a high-risk/high-reward story.
Don't Worry About The Competition

A lot of Sunshine Heart investors seem to spend an inordinate amount of time worrying about this or that potential competitive threat. True, a stem cell-based therapy (or other pharmacological) that halts/reverses serious heart failure (Class III and/or IV) in a large majority of patients with few safety worries would be a blockbuster and a threat to the outlook for Sunshine. Only the most bullish of retail investors really believe that this is likely, though.
Novartis's (NYSE:NVS) new drug Entresto looks like the real deal in a market that has desperately wanted effective pharmacotherapies for years. Even here, though, there are going to be patients who cannot take/tolerate the drug for various reasons, as well as those who do not respond to the drug. Although the target markets for Entresto and Sunshine's C-Pulse System do not overlap exactly, even a bullish outlook for Entresto penetration (50% to 60%) would leave a lot of patients (hundreds of thousands) for Sunshine to target with the C-Pulse.
The device side is a somewhat, but not substantially, different story. There is a chance that Medtronic (NYSE:MDT), Boston Scientific (NYSE:BSX), and/or St. Jude (NYSE:STJ) will develop a more effective approach with cardiac resynchronization therapy, but I think it more likely that any improvements will be directed at the larger Class II and healthier Class III segments where CRT is currently used despite relatively unimpressive response rates and some evidence that, at least in some patients, CRT actually makes the problem worse over the long term. Given the problems with Thoratec's (NASDAQ:THOR) REVIVE-IT study and the inherent risks and engineering challenges of devices that interact with the bloodstream, I just don't see LVAD (or mini/micro-LVADs) therapy as a market-limiting threat for Sunshine right now.
But Do Worry About The Clinical And Commercial Progress

I believe there will be plenty of patients for Sunshine to serve when it reaches the market, so I consider the issues of clinical development and commercialization to be far more relevant to the stock's future.
On the clinical side, the news has been mostly good of late. The FDA recently approved the restart of the COUNTER HF study after some minor protocol changes. The four patient deaths that prompted the halt were not deemed to be device-related and excluding patients with severe renal disease seems like common sense, but I believe the changes will still necessitate new IRB approvals. Given that the company was apparently on a trajectory to enroll 20 or more patients per quarter before the halt, I think the disruption will be modest. What's more, the establishment of an enrollment committee should improve the screening/enrollment process and perhaps relieve some of the disappointment that has come with the slow pace of trial enrollments.
It's also worth noting that the FDA earlier this year signed off on the company's request for an interim efficacy analysis. Sunshine can enroll half the intended patients (194) and analyze the results after one year of therapy - if the results are good enough to lead to an early halt of the study, approval in 2018 is a possibility. The requisite number should be enrolled by the end of 2016, but one thing to remember with the data analysis in 2017 is that there will be a higher bar of efficacy.
Now, on the less positive side, the company did see its SVP of Clinical Affairs Kimberly Oleson leave the company in mid-June. As the hiring of a former Medtronic executive was lauded at the time, I don't think her departure can be dismissed as inconsequential. I believe that Sunshine has the requisite clinical infrastructure in place to continue on without major disruption, but it is worth wondering why she would leave a company with so much potential upside.
It will be another two and a half years (at least) before there is a definitive "works/doesn't work" verdict on the C-Pulse. The feasibility study has been encouraging, but I would remind readers that there is a reason that the FDA requires companies to conduct larger pivotal studies. Even if the clinical data are good, there will still be significant obstacles to surmount with respect to marketing, reimbursement, and the blocking-and-tackling of commercialization. No therapy, no matter how bad the disease or how desperate patients are for a treatment option, sells itself and many promising technologies in cardiology have seen slower-than-expected revenue ramps with higher-than-expected marketing spending - so much so that in my sell-side analyst days I used to joke that investors needed to take the estimates of emerging med-tech companies and adjust the revenue by 0.66 and the expenses by 2.0.
Estimating The Value

Prior to the halt, Sunshine had more than half of its COUNTER HF sites activated and more than 10% of its target patient count enrolled. At a clip of 25/quarter (assuming that the second quarter is a wash), the company will be on track for completing the required number for the interim study by the end of 2016. I would expect the enrollment rate to continue increasing (if not, that's a bad sign), allowing the company to complete enrollment by the end of 2017.
Along the way, management is going to have some decisions to make regarding the conservation and use of resources. Applying the basic C-Pulse approach to the pulmonary artery as a treatment for pulmonary hypertension is worth exploring, but the company doesn't exactly have an abundance of riches or personnel to pursue full-scale development. Likewise, I believe management's progress with a fully implantable version of the C-Pulse (which would eliminate the risk of infection at the exit site) is encouraging, but is likely to proceed slowly from a clinical standpoint.
As I have said before, Sunshine needs only single-digit market share of the 1.5 million U.S. residents with Class III heart failure to achieve multiple billions of dollars in revenue, let alone considering ambulatory Class IV patients and patients in the EU. I am modeling what I believe to be a very conservative up-take of the device, given what I believe will be limited commercialization resources. If the clinical data are good enough to support an early halt after the interim analysis, I believe the commercialization potential would improve meaningfully and the company should be able to leverage the public markets for funds to accelerate the launch.
My base case remains "doesn't halt early," though, and I'm looking for over $100 million in revenue in 2021, almost $300 million in 2024, and close to $800 million in 2029. Given that the C-Pulse is less complex than the LVADs manufactured by Thoratec and Heartware (NASDAQ:HTWR), I'm modeling gross margins of more than 70%. I think I'm being relatively conservative with my marketing and R&D assumptions, with SG&A at 30% of sales in 2024 and R&D of 11% of sales; R&D could be higher if the company is more aggressive in pursuing the PAH and fully implantable opportunities.
I do expect Sunshine to consume a lot of cash over the next five years, and my model does factor in additional funding events. I expect this to be a case of "it takes money to make money," and I believe Sunshine could generate FCF margins above 20% on a steady-state basis. Discounted back at an elevated rate to reflect the above-average risk, I believe $7 is a fair DCF-based value today. I arrive at a higher $9 target on the basis of applying a growth med-tech multiple of EV/rev 7x to 2024 revenue and then discounting back to today.
The Bottom Line

Sunshine is one of the very rare device companies with multibillion-dollar revenue potential, but the company has to overcome the loss of momentum in its clinical enrollment and re-convince the Street that the slow pace of enrollment seen thus far is a reflection of its limitations as an underfunded med-tech and not a reflection of a lack of enthusiasm for the therapy. As high-risk, biotech-like device stories go, though, I do like Sunshine after this nearly 40% decline from my last piece and I think this is an interesting name to check out for investors who can take the elevated risk.
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