2023-06-23 08:52:10 ET
Summary
- Pulmonx Corporation's entry into the Japan market and momentum in its Zephyr segment are potential catalysts to its market value.
- The company expects ~100,000 extra patient candidates from the move, adding a meaningful tailwind to long-term sales.
- My assumptions point to 20% growth per year into FY'25 to justify a valuation of $16 per share.
- Net-net, revise to buy.
Investment summary
Since my last rating on Pulmonx Corporation (LUNG) in February, the company has been valued 50% higher and has taken out my price objective of $12.90 per share.
Coupled with the firm's latest numbers, its entry into the Japan market, a major shift in sentiment, and the momentum it is building around its Zephyr segment, I am turning more constructive on LUNG and now believe it is worth a portion of capital from the risk budget.
Further, the market appears to agree as well. You can see the rally ensued since November last year, where the stock has run from $4 to $13 over the life of the move, 225% price return. Based on this, it stands to reason the market has revised its expectations on the company, and held these firm well into 2023. Net-net, I am revising my thesis on LUNG to a buy based on the findings presented in this report. I am looking to a price objective of ~$16 on this revision. Rate buy.
Figure 1. LUNG breakout from long-term downtrend
Critical facts to revised LUNG investment thesis
I've revised the thesis based on the culmination of fundamental and sentimental data that's emerged within the changing expectations. Chiefly, the firm's latest numbers are revealing of what to expect in FY'23. Further, investor sentiment has stretched much higher in recent months, as you'll see.
1. Overview of Zephyr valve therapy
The Zephyr valve therapy is a bronchoscopic procedure developed by LUNG for the treatment of severe emphysema/COPD. It is a minimally invasive intervention that aims to enhance lung function and overall quality of life for patients with severe emphysema.
The implantable device is designed to occlude airways in the affected lobe of a diseased lung that is affected by emphysema. By obstructing these airways, trapped air is released through the valve, resulting in a reduction in lobe volume, thereby aiding in respiration. Consequently, the remaining lobes of the lung can expand more fully, reducing pressure on the diaphragm and improving lung function.
The procedure, which typically lasts for 30 to 60 minutes, involves placing 3 to 5 Zephyr valves in situ to occlude the targeted lobe. The valves can be removed or replaced if necessary. Following the intervention, patients typically remain in the hospital for 3 nights, before being discharged home. Therefore, it is not a major surgery per se, but does involve reasonable costs.
2. LUNG building fundamental momentum
The firm is growing operations at a steady clip, pulling in Q1 sales of $14.5mm, 35% YoY increase. As you'll note below, both sales and gross profits are scaling higher, a reflection of the larger size of the business.
Figure 2.
Data: Author, LUNG SEC Filings
Further breakdown on the firm's latest numbers is as follows:
- Leading the charge, U.S. sales were up 55% YoY to $9.3mm, compared to international growth of 9%. Clearly, the U.S. numbers show an accelerated rate of adoption of the firm's Zephyr Valve therapy, but management also reports strong uptake throughout Europe.
- However, as mentioned in the last publication, one key factor underpinning a revised the Zephyr valve's regulatory approval in Japan. Critically, the firm estimates there to be ~100,000 candidates for treatment. This could be conservative. Estimates point to the fact there's ~20mm smokers in Japan, bringing the smoking "rate" to c.17%, with one of the world's largest tobacco markets. Hence, in my view, LUNG is poised to tap into a significant patient population that has seen emerging investment in recent years. Not only from Japanese firms themselves, but U.S. firms making entry in multiple markets such as dementia, dialysis, plastic and cosmetic surgery, and of course, emphysema and COPD, in LUNG's offering.
Moving down the P&L, LUNG pulled its sales growth down to gross of 73%, ~200bps down YoY. I'd expect to see some upside on this as asset utilization creeps up, and the company makes collections on its accounts receivable, thus reducing asset intensity and increasing cash flows to fund future inventories and so on.
To that point, management maintains its projected gross margin range of 73%-74% in FY'23. It also has $110mm in cash, more than sufficient runway for the coming 2-years. Further, scaling gross profits against asset growth, the firm has increased gross capital productivity by 2.25x from 2020 on a rolling TTM basis, from $0.08 on the dollar to $0.18. Should these trends continue --and I estimate they will-- it sets up a tremendous springboard for coming periods.
Figure 3.
Data: Author, LUNG SEC Filings
3. Sentiment shifting higher
There are 3 common factors to consider when analysing sentiment that conforms to a good set of mental models. These include the movement in analyst ratings, options positioning and price momentum. Looking at each factor for LUNG, there are positives indicating an uptick in sentiment. Why?
One, there have been 5 upward revisions to LUNG's earnings in the last 3 months, coupled with 3 to revenues. This is critical to the reformed investment view on my end. Whilst I in no way rely on sell-side targets in my own modelling, the progression of targets (higher, lower, etc.) is tremendously valuable in gauging the market's sentiment on the company's outlook. The point is, that many do actually follow the ratings, plus, they are representative of the sell-sides view (taking consensus, that is). You've got an entire substrata of the market's viewpoint in that regard, and it is turning bullish on LUNG.
Two, investors are positioning heavily for a turn to $15 as indicated by the open interest in contracts of this strike price (August expiry). O ptions-generated data is perhaps the most valuable sentiment indicator as it shows directly the positioning of investors (both the institutional crowd and the public) who have actual money at risk- not just commentators. There's a big difference, especially with all of the behavioural economics at place. This shows investors are bullish on speculation for LUNG and are looking to $15 by August, ~13% upside by then.
Figure 4. LLUNG options chain, August expiry
Three, the stock is trading above all moving averages ("MAs") as well, further indication of the bullish sentiment. Notably, the MAs are important levels here as they show the "average" price level on different frames, and that LUNG is trading "above average". Good news happens in uptrends, get used to it. Further, the company's stock price is a reflection of the market's consensus of expectations on its prospects for the future. It, therefore, stands to reason that investors believe LUNG will produce "above average" results pushing forward as well, with the price action.
4. Valuation factors for consideration
Much like other unprofitable med-tech names obtaining a multiples-based valuation is difficult. The stock does trade at 8x forward sales, a clear indication of the market's expectations going into FY'23 and beyond. Critically, the market has valued the company at 3.5x its book value, indicating LUNG's capital investments have created an additional $3.50 in market valuation- tremendous economics in my view. It suggests the market is placing a high value on the company's capital/assets.
It's important to note that management projects $65mm in turnover this year, and I am content with this figure as it implies another 21% growth in sales. It could do $50mm gross on this which is an attractive figure if you ask me. The question is if paying 8x sales is worth it at this stage or not. As a decision rule, you need another variable --growth-- to distinguish the value. Using my growth assumptions, you're paying 8x forward for 20% growth per year into FY'25, a cumulative rate of 72.8%.
I believe there is scope for these numbers to rate higher as the firm ratchets up its operations further as well. Hence, I am happy to pay 8x forward for estimated 73% sales growth in the next 3 years. Moreover, the market is paying this with relative ease too- no objection to the stock trading above all moving averages, as mentioned. At 8x my FY'24 sales estimates, this gets me to $16.31 per share in equity value (8x77.3/37.75 = $16.31). These facts support a buy rating.
Table 1. LUNG forward estimates
Data: Author estimates
In short
Aggregating the factors discussed here it would appear there are building tailwinds for LUNG. By all means, these are expected to continue going forward in my investment lens. The company's entry into Japan is a meaningful catalyst for sales growth as is the uptake of its Zephyr valve therapy in the U.S.. The data is telling here, indicating favourable reception. Looking forward, my numbers have the company to grow revenues at 20% per year into FY'25, justifying today's multiples. In that vein, the factors discussed here are enough to revise my investment thesis from a hold to a buy.
For further details see:
Pulmonx: Entry To Japan Market Bullish For Zephyr Volumes (Rating Upgrade)