BFLY - Butterfly Network: Favoring Profits And A Possible Blueprint For AI Governance

2023-06-16 12:24:53 ET

Summary

• Butterfly Network is reinventing itself based on generative AI, which will help develop medical devices and deliver customer service, particularly in training medical professionals in imaging.
• The company aims to increase its software and subscription revenues, which will improve profitability, and leverage its cloud and AI capabilities for business operations.
• Butterfly Network could serve as a blueprint for regulated development in the AI field, as it operates under FDA scrutiny and prioritizes data privacy.

You may have come across ChatGPT, which allows the generation of reports on the fly through the use of generative AI. Mostly confined to technology companies till now, it is gaining wider adoption like with Butterfly Network ( BFLY ), a healthcare equipment play. This thesis aims to elaborate on the opportunities and what value it can bring to a stock that is way below its February 2021 high of $26.

For this purpose, I will mostly use details from the first quarter 2023 (Q1) earnings call transcript as well as draw insights from the business model, which is evolving from a handheld medical devices producer regulated by the FDA or Food and Drugs Administration to a technology-enabled software play. Going a step further, I show how for a field in need of regulation, Butterfly may be an example to follow in terms of AI governance.

I start with the short-term price action, highlighting to what extent this stock has become sensitive to AI-related news, also revealing volatility risks.

How AI can Stimulate Upsides and Volatility

Looking into the rear mirror, the Q1 earnings call was on May 11, and one month later, the stock has already appreciated by around 18% as shown in the chart below which, noteworthily, came in the aftermath of the CEO elaborating on Generative AI.

This performance cannot be explained by the financial results, as the company did beat EPS estimates but missed the top line. For confirmation purposes, one can observe the same scenario (or an earnings beat and a revenue miss) on February 28 for the fourth quarter of 2022 (Q4) financial results, but, with no upside. In sharp contrast, the April 4 announcement concerning the FDA approval of an AI-enabled lung device triggered nearly a 40% upside.

Therefore, this is primarily a news-driven stock, and, the absence of any can cause a downside at levels that can be too low for comfort such as at the end of February when it traded for around $1.6, or only 60 cents above one dollar. As such, this is a stock in danger of being delisted if its share price closes below $1 for 30 consecutive days.

Therefore, unless you are prepared to stomach volatility in the same way as Cathie Woods who owns the stock as part of her Ark Investment fund, this may not be for you. Still, for those who are prepared to take the risks, there is a higher likelihood of being rewarded thanks to the AI factor and the appointment of a new CFO too.

Reinvention Based on Generative AI

The strategy to reinvent itself is based on generative AI, and will eventually determine how medical devices are developed, and customer service is delivered. One of the areas to benefit the most is training medical professionals in imaging.

Detailing further, as the developer of the disruptive hand-held ultrasound by capitalizing on semiconductors, Butterfly is no stranger to innovation. Now, ultrasound is used to scan the body as part of medical diagnostics and the new portable version quickly gained traction, especially during Covid times when going to the hospital entailed higher infection risks. However, as shown by the quarterly progression in revenues in the table below, the company did manage to increase sales initially, but, the product failed to attain mass-consumption status by being present in every doctor’s pocket, in the same way as the stethoscope hanging around their neck.

Now, one of the difficulties in getting more adoption is healthcare practitioners' inability to interpret images of various features of organs, in order to distinguish a normal formation against a tumor, for example. This is because, in a hospital setup, it is a specialist doctor, normally a radiologist, who does the scans. This is where ChatGPT-style chatbots could help train more practitioners at point-of-cares to make sense of the images captured.

To obtain an idea of the sales prospects, roughly two-thirds of the world’s population may lack ultrasound and most practitioners cannot interpret the results of a scan, and AI-imparted training could remove a major barrier to wider adoption.

Now, in order for a ChatGPT-style training solution to be implemented in the first place, there is a need for data, a lot of them pertaining to ultrasound required for Generative AI algorithms' learning process. In this respect, one of Butterfly's advantages is it already operates in AI mode and delivers services through a cloud that is accessible by customers and branded as the “largest ultrasound image repository in the world” by its management as it contains data covering nearly 100K probes.

The next step is to assess how all this will be monetized.

A Technology-Enabled Software Company

For the newly-appointed CFO, the strategy is to take advantage of the customer base by selling them more software in addition to handheld devices (hardware). This is similar to server vendors bundling their product offerings with more software products, which normally means better gross profit margins. Well, this is precisely the aim here, with Butterfly now aiming to become a “technology-enabled software” company. Assessing the feasibility of this strategy, I plotted a chart of the year-on-year quarterly sales growth alongside the gross margins, as shown below.

The results show that despite growth slowing from 2021 levels (blue chart), gross margins have trended higher, as seen in orange. The reason for this is that in addition to raising the ASP or average selling price for its hardware, the company has been profiting from its higher installed base by harvesting more subscription revenues.

Thus, margins are not only determined by sales but also by a higher dose of software. Now, further ramping up this strategy, could lead to better gross profits trickling down the income statement to offset the higher operating costs, thereby ensuring that break even is achieved faster as per the chart below. It is to be noted that the company is loss-making, but these have been decreasing on a quarterly basis.

Therefore, by raising the value obtained per customer as well as putting in place the cost reduction measures, the operating margins can be improved further, and to this end, Butterfly may have an additional lever in the form of pricing. For this matter, in addition to competing with existing conventional ultrasound equipment which are becoming smaller thanks to technological evolution, there are also other handheld device suppliers to contend with. As per the management, Butterfly’s products are less expensive by about a third and thus, the ASP could be further increased. This, in turn, implies more revenues in FY-2023 than the $77.64 million estimated by analysts, or a 5.8% increase over last year's $73.4 million.

Deserves Better Value When Compared to Microsoft

To further support my optimism for a topline beat, the company is evaluating its go-to-market strategy, with an update to be provided during the second quarter's call. This strategy could also take the form of lower hardware prices to promote software sales.

Now, for valuation purposes, I consider that Butterfly is a technology-enabled software company, somewhat like Microsoft ( MSFT ) which sells gaming Xboxes as well as tablets . Looking at the Price-to-sales multiple, the stock's 6.16x is nearly half of the software giant's 12.12x as pictured below. Hence, assuming a P/S of 9x for the handheld device company translates to a target of roughly $3.5 ((2.35 x 9)/6.16 based on the current share price of $2.35.

To further justify my bullishness, there is the cash factor.

Here, while cash burned in operations has increased to $43.3 million in the latest quarter from $28.9 million at the end of last year, progress has still been made when excluding non-recurrent items like severance allowances and bonuses, or expenses associated with cost-cutting. Thus, cash usage has been reduced from $18 million monthly in Q4 compared to $11 million in Q1, which is significant and implies that the $198 million of liquidity available at the end of March can last longer, or 18 (198/11) months compared to only eleven before.

A Blueprint for Healthcare Equipment Plays and Big Tech Too

In conclusion, this thesis has shown that despite all the volatility, Butterfly possesses the ingredients necessary for driving growth. There is competition that may pressure pricing, but, promoting a higher proportion of software and subscription revenues in the product mix augurs well for profitability, and could trigger an earnings beat.

Furthermore, this is not a company that has made big announcements in the footsteps of Microsoft announcing its $10 billion investment in OpenAI at the beginning of this year. On the contrary, Butterfly prioritized cloud and AI long before the advent of ChatGPT.

Shifting to AI governance, in response to more calls to regulate generative AI, the company could be the very blueprint for regulated development in this field. In this regard, there is the element of data privacy, when dealing with information pertaining to the ultrasound images of various organs of the body, implying risks of disclosing the identities of patients and the disease they may be suffering from. However, to Butterfly's advantage, it is proceeding under the aegis of the FDA like for the approval of its AI-enabled lung tool, signifying that it is already subject to regulatory scrutiny, unlike big techs which regularly violate the privacy of their users and fined.

Consequently, this begs the question of whether Congress should not get inspiration from this healthcare play to put into place AI governance for big tech and others for a more harmonious evolution of this field.

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