2023-09-01 17:38:51 ET
Summary
- Establishment Labs Holdings Inc. stock has been trading within a tight range for the past 2 years and recently reversed sharply to the downside.
- ESTA has several upcoming inflection points, including a launch into China and pushing its Mia segment in Europe.
- The economic realities do not support a buy rating for ESTA as the stock sells at exorbitant premiums to the sector without strong profitability.
- Net-net, reiterate hold.
Investment briefing
Establishment Labs Holdings Inc. ( ESTA ) continues to sell within a range that's held tight for the past 2-years. Following the firm's Q2 numbers, it reversed sharply to the downside, catching the bottom end of this range, as seen in Figure 1. Since the June publication , it has sold off around 8% lower as well.
There are several inflection points ESTA is set to deliver on in H2 FY'23, including a launch into China, and pushing its Mia segment in Europe after a summer approval there. A potential U.S. launch of its Motiva line could be on the way too.
Critically, the economic realities do not support a buy rating for ESTA right now in my view. Capital must be more valuable in a company's hands than our own, and that commands a strong clip in gross profit and pre-tax income on the capital provided by investors. As it stands, I'm not eyeing this kind of value in ESTA's stock right now. The stock sells at exorbitant premiums to the sector but this isn't squared off with the economics of the business. Net-net, I continue to rate ESTA a hold.
Figure 1.
Critical factors to reiterated hold thesis
1. Q2 FY'23 insights
Financial Performance
ESTA booked Q2 revenues of $48.6mm , up 18% YoY on a gross margin of 62.3%, producing gross profit of $30.3mm. For the YTD, the company has put up $95mm in sales from $79.6mm in H1 last year, and clipped a H1 FY'23 net loss of $28.6mm.
From a geographical perspective, ESTA's sales distribution was as follows:
- EMEA sales made up ~42% of global sales.
- APAC comprised 24% of total sales revenue.
- Latin America ("LatAm") accounted for the remaining 34%.
As a reminder, the company's flagship product is its Motiva line of breast implants. There are 3 products in the line, Ergonomix, Motiva Round, and the Anatomical TruFixation implant. Around 37% of Motiva's implant sales came from direct sales in Q2, while distributors managed the rest. Brazil-the company's biggest market-accounted for ~4% of Motiva's total sales for the quarter. Critically, Motiva has not obtained FDA approval at the time of this publication, but management confirmed it had received an investigational device exemption from the FDA on the earnings call. A U.S. launch may very well be on the way should this all go smoothly. This could be a tailwind if U.S. approval is achieved, but I'm not getting hopes up without the confirmation.
As a result of the H1 FY'23 momentum, management confirmed full-year revenue guidance of $200mm-$210mm. This calls for 29.8% growth at the top at the upper end of range. In my opinion, several factors are critical to it hitting these numbers by year-end:
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Motiva launch in China : ESTA is eyeing an approval and launch of Motiva in China during Q4 this year. No numbers about the potential launch curve have been provided just yet, but it would be worth paying close attention to this in the Q3 and Q4 earnings calls. Selling to China could potentially open up a substantial growth channel in my view.
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Mia launch in Europe : Its Mia product line has been launched in Europe. Note, this was done during the European summer, which is a seasonally slower period. The company anticipates an uptick in consultations during Q3, with procedural volumes are expected to ratchet up by Q4.
Cost considerations
Q2 saw ESTA encounter certain obstacles that proved to be meaningful headwinds to gross margin, specifically, business overhead and labor costs. In particular, it saw considerable FX headwind to its direct labor costs given the cross rate of the USD and the Costa Rican colon. At the time of writing, USD $1 = 539 colons. Whilst this shouldn't be a major headwind to its Costa Rican operations, it will prove to be a headwind when rotating the money back to USD. It has a number of FX hedges in place, which aren't discussed here, but I'd still be paying close attention to this point going forward. It also lost ~$4mm of leverage at the SG&A line over the last year.
I'd also note that ESTA sources the silicone for its Motiva implants from a single external source. This means it is susceptible to price risk for its raw materials, and this could impact margins and drive overhead higher. There are no global futures markets to hedge silicone price risk, but China did launch the first derivatives/futures contracts on silicone earlier this year on the Guangzhou futures exchange (being on just one exchange, contract liquidity could be an issue, therefore). Critically, China is set to reduce output, and this could see silicone prices respond accordingly.
Figure 2 outlines the global silicone price index priced in USD across major global markets. Prices are coming off a high point from 2021-'22, but are still relatively elevated compared to pre-pandemic range. This shouldn't be discounted as it may impact ESTA's propensity to get more inventories out the door.
Figure 2.
2. Capital allocation and profits on capital employed
Debt facility and access to capital
ESTA left the quarter with cash on hand of $90.2mm, up from $66.4mm reported at the end of FY'22. The increase in cash came from its share offering in April, where it issued 1.265mm shares. It has and will use the funds to finance its growth operations. Around $9mm was invested in CapEx towards its manufacturing facility (discussed below), whereas it continues to beef up inventory levels. It made these investments in preparation for a potential U.S. launch of Motiva, and for its launch in China
ESTA has a debt facility structure consisting of 2 tranches worth $50mm that are dependent on meeting specific sales and regulatory milestones. In addition to the cash of $90.2mm, the company therefore has access to ~$140mm in liquidity.
Manufacturing capacity expansion
ESTA is executing its growth strategy by increasing its manufacturing and warehouse space by an additional 35,000 sq. feet, which will effectively double its current manufacturing capacity to over 1.5mm units annually. Management said this would meet ~50% of its current global demand. It also has the ability to add a further 45,000 sq. feet of manufacturing space in the future if its product demand permits.
The new facilities are set to include a number of R&D labs, a global learning center, and an on-site surgical theatre + procedure rooms. Curiously, it is aiming to be a beacon of sorts by providing medical education and training, scalable to meet the needs of its global business operations. Per the CEO on the call:
Our goal was to build a centre for creation and innovation, where our employees, healthcare professionals and partners from all over the world can usher new standards for the future of plastic surgery. And with the opening of the Sulayom, we are certain we have succeeded. We are better positioned than we have ever been to create and expand new markets and to make a meaningful change in the lives of women around the world. - Juan José Chacón-Quirós - Establishment Labs CEO
Question is, what return on investment will this bring for the company and, more importantly, for shareholders going forward?
Growth investment in economic terms
As it would stand, the company is diverting plenty of resources into growth investments for the future.
Figure 3 depicts the degree of growth investment ESTA has deployed on a rolling TTM basis. Growth investment is considered to be all CapEx (including that into intangibles) over the maintenance capital charge. The maintenance capital charge is considered to be roughly in line with sequential depreciation and amortization. No inventories are included.
What this shows is that, of the CapEx made each period, the majority has been growth investment since Q1 FY'22. In the 12 months to Q2 2023, it allocated $28mm, of which $23mm was attributable to growth.
A more thoughtful analysis is required on what these investments are producing for shareholders. The new assets aren't as valuable if profits aren't recognized on them.
Figure 4 shows the gross capital productivity from all assets employed into the business. It is calculated as the rolling TTM gross profit as a function of total assets each period. All core and non-core assets are included.
ESTA rotated back $0.40 in trailing gross for every $1 in assets employed last period, down from $0.48 last year. A figure above $0.3 is considered to be high. It also put another $76mm on the balance sheet and has $285mm in gross asset value at the time of writing, but it remains to be seen what profitability effect this will have going forward. It would need to do ~$150-$155mm in TTM gross in order to bring gross productivity back to FY'21-FY'22 levels. But it expects ~100bps YoY gross margin contraction this year, calling for ~65% on $210mm in sales, otherwise $136.5mm.
A more granular representation of the company's profitability is shown in Figure 5. It illustrates the operating income/losses produced on the capital provided (debt, equity) to the ESTA since 2020. Capital provided is considered capital employed into the business.
Critically, $237mm in capital produces an ongoing set of losses, hitting negative 8% ROI in the TTM to Q2. This isn't out of historical range, and investors have had to endure ongoing losses on investment across the testing period.
This is important to know, because a firm creates value for its shareholders when the earnings it produces on capital tied up in the business outpace market rates of return (over the long term). You can consider this hurdle rate around 10-12%, based on long-term market averages.
Hence, it's difficult to prescribe a buy rating on ESTA when it is diverting large sums of capital to new facilities and so forth without the economic returns or economic leverage to show for these investments (just yet, anyway). This may be one reason why the stock has sold within a range these past 2 years.
Valuation and conclusion
The stock sells at 7.8x forward sales and more than 27x book value, meaning the market has valued its net assets at $27 for every $1 in NAV. Critically, the latter multiple is >1,170% higher than the sector. Are ESTA's net assets worth more than 1,170% compared to its peers?
Based on points raised earlier, my best estimation is no, they aren't. Why?
One, the company is cycling back reasonable amounts of gross profit on all assets employed. But the economics of the business mean these don't fall further down the P&L-where it matters for equity holders.
Two, said another way, you're looking at paying $27 for every $1 in net asset value to buy ESTA today and buying the company at $1.5Bn. At this market value, the company values the capital employed by ESTA at a 6.3x multiple, far less than the 27x listed earlier.
But I just can't get there without the economic characteristics to back this up. Our portfolios demand a 12% return on capital at the minimum, to outpace long-term market returns on capital. We look to buying productive assets and avoiding non-productive ones, and finance the purchase of securities through the buying and selling of such assets. This is in contrast to looking at multiples derived from 'value' alone. Hence, I reiterate ESTA as a hold for the time being, and this view is shared by the quant rating system as seen below. These are objective findings derived from a composite of inputs, and thus take a lot of the "guesswork" out of it.
Figure 6.
In short, ESTA is making strides in growing its business and core operations. It has a number of inflection points in store for the remainder of 2023, including product launches in China (and potentially, the U.S.), and also, potential adoption of its Mia product line in Europe, after successfully launching it there already.
However, the economic realities are too impactful to ignore. The pre-tax income that is produced off capital employed in the business suggests these investments aren't pulling their economic weight. Further CapEx into beefing up capacity is indeed noted, but I'd need this to fall toward the bottom line (in net operating profit after tax and free cash flow) to see ESTA creating value. Net-net, reiterate hold.
For further details see:
Establishment Labs: Inflection Points, Valuations, Don't Match Business Economics