It’s a testing time for investors, with so many hitherto great businesses on their knees, and others looking well over-priced. But it’s still possible to identify structural winners with a long growth runway at reasonable prices. I think one of these could be Sydney-based medical device innovator, Nanosonics (ASX:NAN).

Confronted with a highly uncertain global macro backdrop and a ‘lower for longer’ interest rate outlook, we have strategically positioned our portfolio towards the clear beneficiaries of positive structural trends which are accelerating in a COVID-19 impacted world, such as cloud, e-commerce, digital payments and medical technologies, and away from the most heavily disrupted sectors like old-world media, retail and REITS. In control of their own destiny, we expect these resilient and innovative structural winners to continue exploiting their competitive advantage, taking share from low-tech incumbents, and growing independently of the economic cycle.

Nanosonics – a structural winner

One company we have identified as a likely structural winner when looking beyond the next earnings print is Nanosonics, a global innovator in infection prevention within hospitals. The company’s cutting edge ‘Trophon’ technology is setting the standard of care in ultrasound probe disinfection practices, reducing cross contamination between patients and significantly improving hospital workflow efficiency. The fully automated smart device is displacing traditional cleaning systems which are increasingly falling behind the worldwide trend towards stricter infection prevention guidelines. Technology is providing the solution and adoption is expected to accelerate further as the pandemic escalates infection prevention as a major focus for hospitals.

Nanosonics was founded in 2001 and listed on the ASX in 2007. Headquartered in Sydney, the $1.9 billion market cap company also has offices spanning North America, the UK and Europe, and employs more than 200 people worldwide. Nanosonics is engaged in research, development and commercialisation of infection control and decontamination products and related technologies. The current product line, Trophon 2 EPR, decontaminates ultrasound probes using ‘NanoNebulant’ technology – very fine, nebulised droplets of concentrated hydrogen peroxide which kill microorganisms on surfaces. Nanosonics is forecast to generate FY20 revenue of $105 million (24 per cent growth) and $12.5 million NPAT (based on consensus estimates).

Quality and growth potential

Nanosonics screens very well for both quality and growth potential. We like the defensive business model which enjoys annuity revenue streams which grow in line with the installed base, and attractive unit economics. Barriers to entry in the heavily regulated health sector are high, while the company has established a strong and sustainable competitive advantage, underpinned by its technology platform designed to address a major unmet need within a large global market. Management are also highly regarded having executed the strategy very well to date; the CEO is ex-Cochlear (ASX:COH) and often talks about his ambition to steer the company along a similar success path.

Bulletproof annuity stream

The revenue model comprises both device sales (capital equipment) and consumables (cartridges of hydrogen peroxide and associated products used in each disinfection cycle). Trophon 2 devices sell for around A$10,000 and each installed device generates roughly A$3,000 in consumables sales per annum. Consumables accounted for 70 per cent of 1H20 sales revenue, providing high visibility on future cashflows. The model is also highly profitable with gross margins typically running at 60 per cent for devices and 85-90 per cent for consumables.

This annuity stream is bulletproof by design – consumable cartridges must be replaced each month to ensure a high level of disinfection is achieved. And in the not too distant future, replacements and upgrades will become additional sources of revenue with capital equipment traditionally lasting 5-7 years within hospitals.

The runway for growth

Importantly, there is still a long runway for growth. The total market for infection prevention is thought to be worth around US$76 billion and the company is targeting about 40 per cent of that, equating to a US$30 billion addressable market. The company’s core areas of interest for new product development within the infection prevention spectrum are instrument cleaning and disinfection, storage solutions, environmental decontamination and compliance and traceability. Rather than entering a crowded space and fighting it out for a 5 per cent prize, their preferred strategy is to identify a gap and capture the entire market opportunity.

The total addressable market for Trophon is conservatively estimated at 120,000 units, split evenly across the US, Europe & Middle East (EMEA) and Asia Pacific (40,000 units each). With an installed base of around 23,000 units worldwide, Nanosonics has achieved 20 per cent product penetration and has significant growth potential ahead. In 1H20, 90 per cent of it’s revenues were generated in the US where Trophon technology is considered the standard of care and strict mandates exist requiring high levels of disinfection driving strong adoption. In aggregate Nanosonics has sold around 20,000 units into more than 5,000 US hospitals and clinics, implying 50 per cent US penetration. Management are aiming for 70 per cent US penetration over the next three years, having initially gone wide and now going deeper into the hospital network.

International and new product expansion

Geographical expansion outside the US is a key component of the near-term growth strategy. Although the company has established a firm footprint across EMEA and Asia Pacific, Trophon penetration in these regions remains just 2 and 4 per cent, respectively. An increasing number of guidelines requiring high level disinfection and growing awareness supports a positive outlook for further international expansion. Nanosonics has recently built out sales infrastructure across key European markets ahead of a big strategic push while Japan and China have been singled out in the Asia Pacific as particularly promising markets (ANZ is well penetrated at more than 75 per cent).

New product development is the other important piece of the medium-term strategic growth plan. Nanosonics has strong internal research and development capabilities, spending around $15 million in R&D over FY20, and a deep new product pipeline. The second product is expected to be commercialised during FY21, subject to regulatory approval. Although details remain limited at this stage, it will reportedly involve a new novel technology addressing a major need and targeting a large market at least as big as the Trophon 2 opportunity. The client base will be the same hospitals using Trophon and the model will also comprise capital equipment coupled with recurring consumables sales. The smart money is betting on a novel technology platform to disinfect endoscopes….and we don’t expect the company to stop there.

Not COVID-19 immune, but ultimately a winner

The business is not immune to COVID-19 with near-term capital equipment sales expected to be impacted by difficulties in gaining physical access to hospitals busy dealing with the first wave of virus patients. There is also a risk that the new product pipeline is delayed while hospital budgets could come under pressure due to the disruptions associated with the pandemic. However, consumable sales should remain robust and the company has some levers to pull on costs. The balance sheet is in a very strong position with $82 million of net cash as at 31 December 2019.

Valuation

Valuing Nanosonics requires some vision since the company remains in an investment phase for geographic and product expansion. Assuming Trophon 2 eventually achieves 50-70 per cent global market penetration (vs 20 per cent now) doesn’t sound crazy considering where the US and ANZ are already at and the limited competitive landscape. This implied installed base of 60,000-84,000 units would generate $180-252 million in annual consumable sales, cutting through to $153-214 million gross profit (at 85 per cent margins).

Recurring cashflow streams like these are rivers of gold and attract very high multiples; applying 15x derives a $2.3-3.2 billion valuation for the consumables standalone business, before ascribing any value to the capital sales opportunity ahead which will also involve upgrade cycles, or the embedded optionality from the new product pipeline and the net cash balance sheet. So, it doesn’t seem too hard to picture what success could look like for Nanosonics or what the market would be willing to pay for it.