Healthcare: 3 Little-Known Medical Device Makers

Most investors never come in contact with the products made by medical device companies. That can make it hard for them to research these types of businesses. However, when a medical device company creates a game-changing product, it can often go on to create huge shareholder value. On this week's episode of Industry Focus: Healthcare, host Shannon Jones sits down with Fool.com's Brian Feroldi to talk about three hidden medical device makers that could be on the verge of generating meaningful returns for their investors: ViewRay (VRAY), Nevro (NVRO 1.59%), and LeMaitre Vascular (LMAT 1.45%).

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This video was recorded on June 19, 2019.

Shannon Jones: Hello and welcome to Motley Fool Industry Focus, the show that dives into a different sector of the stock market every single day. Today is Wednesday, June the 19th, and we're talking Healthcare. I'm your host, Shannon Jones, and I am joined by medical device medtech specialist Brian Feroldi. Brian, how are you?

Brian Feroldi: Hey, Shannon! I'm doing great! My kids just had their last week of school last week so we are on the verge of taking a family trip to California next week. I'm doing great! How are you?

Jones: I am doing well! Looks like you're tearing up the road. You were recently here for Fool Fest, a big annual meeting of Fools from literally across the world. I must say, Brian, at Fool Fest, I think we had almost a thousand attendees, great to sit and talk with a lot of the fans of the show. Many of them brought you up, particularly the older lady demographic, Brian, which I thought was really interesting. You've got some fans out there. But, as always, thrilled to have you on the show!

Feroldi: As long as I do really well in the older lady investor population, that's exactly what I'm going for. Wonderful! Yes, I had a blast at Fool Fest. Always awesome to see so many listeners and fellow Fools in person. So much fun!

Jones: I definitely think it's that stock picking prowess that you have. About today's show, Brian, you, of course, always digging into the medical device med tech space, looking for those under-followed hidden gems. Today's show is all about that. You've got three stocks right now on your radar that you think should be on the radar, if not in portfolios, for many of our investors. We'll dig into those three. And I'll get a chance to pick your brain about which is your top pick.

Let's dive right in with the first company. It's a company that is really making technology and going after a market that we talk about a lot on the Industry Focus: Healthcare show. And that is a company called ViewRay, VRAY. Brian, what is it about this company and their tech specifically that really attracted you to this and really stands out for you?

Feroldi: ViewRay is a sub $1 billion medical device company that is focused on the radiation therapy market. I think most investors know, when it comes to cancer treatment, there's three primary forms. There's surgery, there's chemotherapy, and then there is radiation therapy. Radiation therapy has actually been used for over 100 years to treat cancer. ViewRay, a few years ago, won FDA approval for their device, which is called the MRIdian Linac system, which is the world's first combination radiation therapy/ MRI machine. This is a new tool that healthcare [professionals] can use to really use targeted radiation therapy to treat a number of cancers. Historically, one of the problems with radiation therapy is that it basically kills cells indiscriminately. Whatever the physician targets with that radiation therapy, it just destroys. That includes both cancerous cells as well as healthy ones. So, the goal in the radiation therapy market has been to develop products and tools that make it so that it only destroys cancerous cells while leaving healthy ones intact. With the MRIdian Linac system, because it combines both MRI and radiation therapy in one system, it allows physicians to see in real time what cells are being destroyed in the body. They can view and make subtle changes to the beam to focus it to make sure that they're destroying cancerous cells while leaving healthy ones intact.

Jones: Brian, I think this is a company that really underscores a lot of the major themes driving not just oncology cancer care, but really trying to drive down the cost associated with treatments. They've got a technology that is really about precision therapy. Recently had a chance to visit Georgetown University Hospital with Motley Fool co-founder and CEO Tom Gardner. We were really able to pick the brains of many of the top doctors there. Huge shout out to the team there that hosted us. But really one of the big themes is about this precision therapy. It's about lowering the toxicity when treating diseases like prostate cancer, breast cancer, lung cancer, etc., and really about fewer treatment sessions because you can be more precise with treatment. Overall, what this means is just better economics for the hospital and ultimately for the patient. A company like ViewRay is very much in line with where we're seeing the healthcare landscape focus and change over time.

Let's talk, though, about what this means in terms of financials. What are we seeing in terms of just overall growth for a company like ViewRay?

Feroldi: ViewRay has been in hyper revenue growth for a few years now, ever since they won approval for this next generation system of theirs. So revenue has just taken off since then. To give investors some context, for 2019, they're guiding for about $118 million in total revenue for the year. That represents about 45% growth year over year. These are big machines. They require a lot of work to be physically moved and installed and verified. So it is quite a lengthy process, when a customer goes from a purchase order to actually using the device. Because of that, ViewRay is building up a backlog of business that they report to investors. As of the most recent quarter, that backlog was about $238 million. At their current installation rate, that represents about two years' worth of sales that are basically already booked. That does give investors a lot of visibility into the near-term revenue growth of this company.

With that in mind, this company is still not big enough to produce profits. Their cash burn for 2019 is estimated to be about $70 million. They do have $146 million in the bank. That represents about two years' worth of burn at current spending rates.

Jones: Brian, pretty respectable top line growth. You mentioned about 45% there. But I look at a company like this and I do get a bit worried when I see a cash burn at this particular rate, especially given that they've got $146 million in cash. And then, as you mentioned, not profitable. I also worry about 2019 revenues not being nearly enough to offset losses. What's the way forward for them in terms of just overall market opportunity over the long term? And what does that look like in terms of their current market cap as well?

Feroldi: Sure. The company's current market cap is about $850 million. It's also important to keep the overall size of the global radiation market in perspective. Total worldwide global radiation market spending in 2015 was about $4.6 billion. That number is projected to grow to more than $6 billion by 2020. That's a very big number when compared to ViewRay's current estimated revenue of this year of about $120 million. If their tech can withstand the competition, if more hospitals do become interested, given the advantages we highlighted before, it's a very clear growth story for this company to double their top line multiple times. If they can do that and become profitable, then today's market cap of sub $1 billion could look very small in a couple of years.

Jones: Huge growth runway if it indeed plays out the way that the market opportunity looks right now. Brian, for you, what do you think are the most important things an investor should take into account when it comes to ViewRay? And what do you think is maybe the most misunderstood aspect of their business right now?

Feroldi: Sure. This is definitely an exciting growth story, but it's also very high risk, and there are a couple of negatives for investors to keep in mind. To me, first and foremost, this is a very expensive piece of medical equipment that takes a long time to go from even purchase order to installation and the booking of revenue and the receiving of cash. The company says that, from the time that it receives a purchase order from a hospital to the time that it's actually installed and being used is between four and six quarters. So you're talking about a year or more before the company can actually book revenue. This is a multi-million-dollar purchase. Not only do they have to convince the hospital that it's worth it, but they also have to get it through the hospital budgeting cycle. That can be a very arduous process. Finally, since they are losing money, the market here is actually quite competitive. They're competing with Varian Medical Systems and Accuray, which are two bigger and more established companies with longer track records. This company is in a market share stealing mode as opposed to creating a new market. There are a substantial amount of risks here for investors.

Jones: So, a lot of risk, but this could be one of those very high risk, high reward opportunities for those who can stomach some of the volatility that I'm sure will be there, especially considering the lumpiness and that long sales cycle that they have.

Brian, let's turn our attention to the second stock on your radar. The next company is, probably the best way to say this is, probably this is one not for the faint of heart. This is a company in the midst of a turnaround replete with activist investors, pretty thorough overhaul of management. That company is Nevro, NVRO. The stock was down about 43% in 2018. Year to date, the stock is up about 61% vs. about 15% for the S&P. Brian, before we get into all the turnaround dynamics going on with this company, what exactly does this company do? What is it about their tech that's intriguing?

Feroldi: This company is a medical device maker that is focused on the chronic pain market. They compete in a market called neuromodulation, which is the use of electrical or pharmaceutical agents that act directly on nerves. They compete in a market called a spinal cord simulation. They developed a product which is called HF10 therapy. It's a pager-sized device that is actually implanted into the body. It hooks up with the spinal cord to help people that are dealing with chronic pain. The story here is basically that they have developed a better mousetrap than anything that has existed before. This is a market that has existed for a couple of decades now. Physicians have been using spinal cord simulation and neuromodulation to treat pain for a long time. But their device is smaller. They have the data to show that it's more than twice as successful at treating back pain and leg pain than traditional therapies. Their device is also shown to have lower complication rates and less than half the explant rate, which is a terrible problem, which is when a device needs to be removed because it's not working properly, so they have to go in and surgically remove the device. Their rate of explant is less than half of the competition. Their most recent device launched a couple of years ago and they have grown very quickly over the years as they've steadily taken market share.

Jones: Let's talk about what that growth has translated to in terms of financials. Overall, when I look at their revenue growth, it's pretty much an up and to the right story for them in terms of top line revenue. But the stock did take a pretty hard hit in 2018 after growth seemed to stagnate somewhat. When you look under the hood, Brian, what do you see in terms of financials right now?

Feroldi: Yeah. To exactly your point, the top line growth here has looked very fantastic for a long time. This company's revenue in 2014 was $33 million. Their estimate for 2019 is $387 million. You're talking about 12X top line growth in about a half a decade. That's very fast. They've seen pretty consistent growth, too, over the last couple of years. They're also split nicely between both the U.S. and the international markets. Another nice thing for investors here is, the margins here are quite good. 70% top line growth. The business itself is on pretty good footing from a top line and margin perspective.

However, as you alluded to, sales growth has recently stalled. That growth attracted some activist investors, who took a position in the company. It appears that a lot of those problems are homegrown. The company basically grew too fast to retain salespeople, and it just had turnover. The former CEO was booted out. There were changes to the board. A lot of that was caused by activist investors. The new CEO has only been on the job for about six or seven weeks. He has basically told investors to expect 2019 to be a transition year of sorts.

Jones: It's an interesting choice for this new CEO who took the helm here a few months ago. I know it's still very early in their turnaround story, but the new CEO, D Keith Grossman, he actually came from Thoratec Corporation and Conceptus, both of which were ultimately acquired. Would not be surprised if this company was a takeover target for a lot of those reasons. I must say, listening to their recent conference call, just in terms of a strategic focus, I don't think there have been many CEOs who have been at the helm for as short amount of time that really seem to just be as focused and as strategic as he is already, and really good at articulating their next growth opportunities, too.

Feroldi: Yeah. I mean, this guy was hand chosen by activist investors. He really does appear to have a good track record of taking medical device companies and getting them sold. That is certainly a reason for some recent optimism in the stock.

The long-term potential of this business could still be there. Their device is currently used to treat just back pain and leg pain. But down the road, they do have a pretty substantial R&D pipeline where they hope to expand into neck pain, diabetic neuropathy pain, refractory back pain, abdominal pain, and more. Another potential positive for this business is that they are an alternative to the use of opioids. There's a lot of attention, rightfully so, about the big problem in this country about excess use of opioids. This is a medical device solution to people that have chronic pain issues. That could also be another tailwind for them.

The market as they see it today is $2.25 billion in potential. Through those R&D efforts and pipeline that I just explained, they hope to grow this number to about a $40 billion opportunity by 2020. Again, for perspective, they expect about $387 million in revenue this year. Even today, despite their success, there is a substantial amount of growth potential embedded in this business if management can turn the ship around.

Jones: Yeah, if they can turn the ship around. I'll tell you what, Brian, one indication that really stands out to me, and you mentioned it, is this painful diabetic neuropathy indication. Basically, it's nerve damage caused by diabetes, where ultimately, the high blood sugar damages nerves, especially in the legs and feet. 30-40% of patients with diabetes have symptoms suggesting some sort of diabetic neuropathy. As we've talked a lot on the show, I know you and I have talked about it, Todd and I have talked about it, it's just the huge diabetes space and how it continues to be a growing epidemic, especially here in the U.S. Matter of fact, according to the CDC, over the last 20 years, the number of adults diagnosed with diabetes has more than tripled. I see that being a huge opportunity for them. It looks like they're looking at a 2020 launch of HF10 in this particular indication. A lot to like about this company. I do think the question does come down to, can management execute? We'll have to keep our listeners up to date on all the latest there.

All right, Brian. Next up, we've got a medical device company which, unlike the other stocks that we've talked about today, really is pretty impressive in terms of cornering very niche markets. This is a company that's been around since the early 80s. I believe 1983 was when this company was founded. A bit more mature than some of the others we've talked about. It actually pays a dividend. I'm talking about none other than LeMaitre Vascular, LMAT. Brian, you actually had a chance to visit this company, talk with their CEO. Before we dive into some of your key takeaways from that, can you just give our listeners a brief overview of what they do and what they're best known for?

Feroldi: Sure. The company LeMaitre Vascular, they buy or build medical products that are used in niche vascular diseases by vascular surgeons. Peripheral vascular disease is a blood circulation disorder that affects about 200 million people around the world. Basically, this is when there's build ups of fatty deposits inside blood vessels that can restrict blood flow and cause a wide range of problems down the road. LeMaitre was actually founded by a vascular surgeon named George LeMaitre who was frustrated with the products that were available to him in the early 1980s. So he hired an engineer to build him his own custom products. They developed a company around that. The company was very successful over time. And now, the founder's son, who was also named George LeMaitre, is actually the CEO and running the show. He's been doing so successfully for many years.

What attracted me to this company was that they focus on very niche products, as you alluded to before. They sell 15 different products, things like shunts, grafts, patches, catheters. 97% of their sales come from market segments that rack up less than $125 million in total annual sales. The reason that I like that is because those markets are way too small to really attract the attention of competition. That allows them to really dominate these small markets, capture market share, and eventually raise prices over time. Sometimes it can really pay off to focus on small markets just because the competition there is so low.

Jones: This is a company that's not a one trick pony. I like to see a company with multiple product lines. You mentioned 15. But they also have a pretty impressive global reach. They sell directly to hospitals in 21 countries and through distributors in more than 60 countries. LeMaitre is going after these markets, less than $125 million in total annual sales, as you mentioned. But this is where they can dominate, often getting No. 1, No. 2, just in terms of market share with their products. But what does that translate to, Brian, in terms of financial performance and sale?

Feroldi: When you cobble all of their products together, their sales are just over $100 million. We're not talking about a huge number. Compared to the other two companies that we talked about, their top line growth rate is far more modest. They expect to grow about 8% in 2019.

But what I like about this story is that the business is very stable because they're focused on markets that are really very niche. They've been able to generate fantastic returns for their long-term shareholders just because of the nature of their business. They do modest top line growth, but through margin enhancements, cost initiatives, as well as stock buybacks, they've been actually able to grow their bottom line number at a far faster rate than their top line number.

They also are a very conservative company financially. They have about $48 million in cash, zero debt. A big part of their growth story is buying other very small vascular products that operate in their niche markets, but only after they've been de-risked and actually have sales. They can take these products, they pay a very low multiple of sales on the private market, and then they use their substantial salesforce, over 100 reps worldwide, to roll out these products around the globe to their network of vascular surgeons. Because of their hyper focus on the vascular surgery market, that's relatively easy for them to do.

I asked management, "Tell me, how big is this? How big is the potential market here?" They believe that niche vascular products has a current TAM of about $1 billion. Compare that to their $100 million, and it's pretty clear to me that this is a company that should be able to just grow its top and bottom lines very consistently for a long period of time.

Jones: Yeah, and they've got some pretty impressive international growth opportunities. I had a chance to look over their quarterly earnings. Europe and Asia grew 14% and 52% respectively, which accounted for about 42% of Q1 sales. So, a huge opportunity there with that TAM, especially in relation to the market cap. Makes this a really attractive company. I also like this founder-led aspect. We did an internal study here at The Fool maybe a couple of years ago that was really looking at founder-led companies. And what we found is that founder-led companies across The Motley Fool universe of stock recommendations returned about 195% compared with 95% for non-founder-led picks, and 61% is for overall S&P picks. So, when you look at the founder-led aspect, this is a steady-eddy business; granted, it's not a high flyer in terms of growth, but you're getting very consistent opportunities. 8% is certainly not something to necessarily cheer about, but for a steady-eddy business, we'll take it.

Brian, one of the more interesting things to me is that they pay a dividend, yielding about 1.3%. For a company like this, that still does have massive opportunities to grow, massive opportunities to reinvest some capital into the business, what are your thoughts about them being a dividend player right now?

Feroldi: Yeah, that was one of the questions that I asked to management. I said, "Why bother paying a dividend when you can just (unclear 25:07) that cash internally and use it to fund either stock buybacks or pursue your acquisition strategy. And what they basically said was, this is a family run business, the CEO does own about 16% of the stock, and they just wanted to realize a cash on cash return of their investments. So they were the ones that pushed for a dividend. It is a very modest dividend in the grand scheme of things. They can still fund their acquisition and R&D efforts while paying out this modest dividends. Because of the nature of their business, that they do have such substantial insight ownership, that's the reason for it. But I agree, it did puzzle me, as to why a small company with a relatively decent growth trajectory would bother paying a dividend. But when I learned that, it did make sense.

Jones: Yeah, makes sense in that context. A lot to like about this company. Brian, of the three companies we talked about today, which one would you say would be your top pick for investors?

Feroldi: I think there's reason to put all these stocks on an investor's radar. But if I had to choose my favorite, I would definitely say LeMaitre. The company is profitable, it's cash flow positive, it's run by a founder who definitely cares much more about the long-term viability of this business than to be there for just collecting a paycheck. It also trades at a modest multiple of both earnings and cash flow. Since it has a sizable growth trajectory, it's definitely my favorite of the three. How about you?

Jones: Yeah, I'll have to agree with you there. As I love high growth, high risk opportunities, I do love the fact that this is a company that's been around, it has that founder/ family led element to it, and ultimately, it's solving needs across multiple indications. Again, not a one trick pony. I don't like companies that only have either one drug or one technology. They have many. There's so much to like about this company.

Brian, how about we bring you back on this show? Apparently your fans want more of these picks. How about we do this again really, really soon?

Feroldi: Got to give the fans what they want, of course!

Jones: Especially the older lady fan base that tends to follow you around.

Feroldi: That is my core! [laughs]

Jones: [laughs] Sounds like a plan! That'll do it for this week's Industry Focus: Healthcare show! Thank you so much for tuning in! As always, people on the program may have interest in the stocks they talk about, and The Motley Fool may have formal recommendations for or against, so don't buy or sell stocks based solely on what you hear. This show is being mixed by Austin Morgan. For Brian Feroldi, I'm Shannon Jones. Thanks for listening and Fool on!