Distributor set for a healthy future
LAST year saw Montgomery Funds participate in several floats. Keep in mind that a new float isn’t always new business.
LAST year saw the Montgomery Funds participate in and support several floats. At first blush you might wonder how such activity fits with our preference for businesses with “demonstrated track records”. Just keep in mind that a new float isn’t always a new business.
Perhaps the least covered float, and one we supported, was that of medical device distributor LifeHealthcare.
LifeHealthcare is no speculative biotech dreamer, nor is it a business replete with patented intellectual property. Unlike a Cochlear or ResMed, it does not research, design or build hi-tech devices. It mostly distributes them for others.
LifeHealthcare raised $76.6 million through an IPO and listed in December. With so many other notable listings, it was easy to overlook. Its shares initially fell below the $2 issue price, thanks to what we believe to be its small size and the quick trigger fingers of institutions that were looking for a quick flip. The shares are now at $2.16.
LifeHealthcare’s biggest selling points are leverage to the defensive healthcare sector, rising demand for medical devices, and a strong industry position and record. Its position as a large, independent distributor of medical devices is deceptively complex. Its advantage is, I believe, built on three sources. The most important is the 62 highly trained sales representatives, often with medical backgrounds, who form relationships with surgeons, specialists and hospitals. The depth of this team — and its relationships — are valuable assets.
The second plank of its competitive advantage is customer relationships. Surgeons are the key customers for LifeHealthcare’s devices. In FY13, LifeHealthcare provided implantable devices to 300 surgeons in Australia and New Zealand who were responsible for 91 per cent of revenue from its large implantable device division. A key metric is the number of “active surgeons”, which LifeHealthcare defines as those generating more than $50,000 in annual revenue. The company’s first-half FY14 earnings presentation showed 91 active surgeons and it is on track to meet the FY14 forecast of 97.
The third plank of competitive advantage — supplier relationships — is just as vital. This is a fiercely competitive and lucrative market. LifeHealthcare has to continue sourcing the latest products from the best suppliers to satisfy customers. As it adds more “active surgeons”, suppliers are attracted to LifeHealthcare’s leadership in its key markets. Suppliers know that if they want to get their products into the hands of key surgeons, they need distributors that have the relationships. LifeHealthcare has deepened the supplier relationship through a range of services. For example, it works with suppliers in areas such as regulatory affairs and clinical education.
Taken together, these competitive advantages provide the seeds of a powerful network effect. Having the best people with the best relationships selling your products becomes a formidable barrier to entry for new players.
The best measure of competitive advantage is returns on equity over long periods. As shareholder equity builds, and the return on that equity rises, the company’s intrinsic value increases. LifeHealthcare’s ROE has risen from 20.3 per cent in FY10 to a whopping 41 per cent in FY13. Net debt of $23.3m in first-half FY14 implies a net debt/equity ratio of 56.5 per cent. The debt should fall over time given its surplus cashflow and ability to fund growth internally. The business has clear growth opportunities. The implantable devices market enjoyed compound annual growth of 7.7 per cent in Australia and 12 per cent in New Zealand over the five years to 2013. That will surely rise as the population ages.
There is a lot to like about LifeHealthcare. But the market is well aware of its strengths — at least for now — judging by recent price gains. We estimate LifeHealthcare’s intrinsic value to be $1.97 a share, rising to $2.03 in two years. At $2.16, LifeHealthcare is fair value, but not a bargain.
Roger Montgomery is the founder of Montgomery Investment Management.