Outset Medical Is Trying to Upend Dialysis. What Should Investors Think of This IPO?

In this episode of Industry Focus: Wildcard, Dylan Lewis and Motley Fool contributor Brian Feroldi do a deep dive into Outset Medical (OM 4.67%), a dialysis system developer which recently came public. They discuss how Outset's system works, its advantages over traditional methods of dialysis, and why it could be a gamechanger in the space.

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This video was recorded on December 16, 2020.

Dylan Lewis: It's Wednesday, Dec. 16th, and we're talking about a company that's disrupting dialysis. I'm your host, Dylan Lewis, and I'm joined by Fool.com's new nurturer of knowing unique New York new-speak nonsense, Brian Feroldi. You know, [laughs] you did it, you mixed in the silent letters there, and you almost had me.

Brian Feroldi: I think my titles should just be "Sally sells seashells by the seashore" at this point, Dylan.

Lewis: [laughs] I'm reminded of all of the tongue twisters that Ron Burgundy did in Anchorman to warm up for his news broadcast. You know, it's a good exercise. [laughs]

Feroldi: I like that you get to do that while we're recording, so we could test if you could do it or not. Success again, Dylan. [laughs]

Lewis: The thing is, it's the triumph to start, but then I'm warmed up, I'm good to go. You've thrown whatever you can at me, Brian, and if I mess up during the show, it's really just on me at that point.

Feroldi: [laughs] That's right.

Lewis: [laughs] Brian, it is a Wildcard show. And for folks that have been missing out on some of our Healthcare Wednesday conversations, you are in luck -- we are talking about medical device companies today, specifically Outset Medical, a pretty interesting name in the dialysis space, and a relatively new company.

Feroldi: This company just came public in September of 2020. I mean, 2020, we've been spoiled with how many exciting newsworthy, show-worthy companies -- I found this from, one of my followers on Twitter sent me a message saying, have you ever heard of Outset Medical? As always, people send me ideas; I always check them out. And I dove deeper and deeper and deeper, and I was like, wow! There's a lot to like here.

Lewis: Yeah. And you know what, that's the beauty of what we do, Brian. We get to find our own ideas and, kind of, organically come across things in our searching and maybe some of the filters that we have set up for news curation. But because we spend so much time with people who are interested in companies, be it our fellow coworkers, be it listeners of the show who write in, and people who follow us on Twitter, we wind up with all these really great things coming our way, and it's really fun to sift through them and spend some time with them. That's exactly what we're going to do on today's episode.

Feroldi: To me, it's all about the power of community, Dylan. This is why you should never invest alone, you get more ideas, you get more filters, you get people to bounce ideas off of. That, to me, is my favorite thing about The Motley Fool.

Lewis: Yeah. And it's one of my favorite parts about doing this job. You know, we're going to be talking about a company and really a category that I admittedly am not super-familiar with. Brian, you have a background in healthcare devices, but I would put it out there, as we're having this conversation, we are not necessarily experts in the space, and if you work in this industry and you have some commentary, feel free to write in to the show, [email protected]. We love hearing from people who have a kind of boots-on-the-ground experience with anything that we're talking about.

Feroldi: Especially when we talk about medical companies. There's often some deep knowledge that you need to have in the industry before you could make an actual decision. So, if you have embedded knowledge about the dialysis space and we screw up something, please let us know.

Lewis: [laughs] So, Brian, having established that we are not experts in the space, let's spend half an hour talking about this company. [laughs]

Feroldi: Let's do it. [laughs]

Lewis: [laughs] Let's start with the classic -- who they are and what they do.

Feroldi: So, Outset Medical, the ticker here is OM. As I said, they came public in September of this year. This is a company with a market cap of about $2.2 billion. And they are in the process of commercializing a new type of system that is going to make dialysis far easier and cheaper for patients and providers to use.

Now, we should probably back up and say what dialysis is. For those that don't know, a dialysis is necessary when your kidneys no longer work. Kidneys are essential for filtering out the blood, removing toxins, regulating fluid levels. And if your kidneys fail, for whatever reason, dialysis is often your only option. Dialysis is essentially an external kidney. Blood flows out of your body into a dialysis machine, fluids and toxins are removed, then it is pumped back into you, and that blood is then filtered and cleaned. Unfortunately, there's no real cure for kidney disease. You have to be on dialysis, and it's a pretty regular thing if you are at end stage renal disease. You have to go three times a week for treatments, at least. Each treatment can last at least three hours; these are the minimums. Many people go more than that per week, and can be receiving dialysis for up to 24 hours.

The only cure is to have a transplant done, so you get a brand-new kidney. But as we've talked about in the show before, there's a huge backlog for all kinds of organs, including kidneys.

Lewis: So, yeah, short of having a transplant, if you have any kidney disease, kidney issues, dialysis is just a reality of what you're living with.

Feroldi: That's exactly right. And because of that, there are currently, in the United States, about 810,000 patients that are receiving dialysis. And due to a number of long-term trends, such as diabetes, obesity, hypertension, and just general aging of the population, that number is expected to grow by about 30% between now and 2020. So, dialysis is here to stay, and there's likely to be increasing demand over the next decade.

Lewis: Yeah. And those numbers add up pretty quickly if you think about it. You know, hundreds of thousands of patients in the United States, this being something that needs to happen several times a week and needs to happen every single week, there are a lot of treatment sessions happening every single day.

Feroldi: Estimates are that 85 million dialysis treatment sessions occur annually in the United States. And this is hugely expensive. Outside estimates the cost is about $74 billion per year, with more than half of that burden being taken care of by Medicare alone. A statistic that kind of blew me away is, while only about 1% of Medicare recipients receive dialysis, dialysis accounts for about 7% of Medicare's entire operating budget. So, the numbers here are just massive.

Lewis: Yeah. And when numbers get big, obviously, there is money being put into solutions that can help lead to better patient outcomes and also grab a piece of that market. That's precisely what this company is trying to do. They're really trying to make it a little bit easier and, frankly, a lot cheaper for people to enjoy or experience dialysis treatment.

Feroldi: That's the real promise of what this company is trying to do. So, if you kind of break the dialysis market up, there's three primary places where patients receive dialysis care. The first is in the hospital. Typically, they've crashed, there is some kind of acute event, and they need dialysis while they're in the hospital. The second setting is in the outpatient clinic. This would be like a DaVita Dialysis, for example, if you've ever seen those shops set up, those are outpatient clinics that patients go to receive care. And the final place is in the home setting.

There are treatment options available today where you can get dialysis done at home. However as we'll get into, it is very underpenetrated. There are, typically, huge training burdens to having these machines in your house. There's a ton of cost that goes into it and a huge amount of complexity. For that reason, many patients choose to go to a facility to get their dialysis done as opposed to going home.

Now, depending on which setting you're in, there are different machines and different techniques that are used in each of those settings. What Outset has done is that it's made a device called Tablo, which not only simplifies basically everything about the dialysis process, but they're attempting to make it so that all three of those settings where you use dialysis, you can use this single machine.

Lewis: Yeah, and that's huge, because as I understand this space, it sounds like machines are fairly specialized and there's, frankly, a lot that goes into actually making them work, particularly with the water treatment that comes into play with these machines. And my understanding is that, basically, the existing, kind of, traditional dialysis machines require connection to water treatment rooms or very specialized water purification systems, which very much limits where you can actually access the machines.

Feroldi: And the keyword you said there, Dylan, which I think is correct, was "rooms." Treating the waste water from dialysis requires literally a specialized room to handle. One of the ways that Tablo, I think, is so disruptive is, their technology is like the size of, like -- geez! it's hard to come up with something that would be that big -- almost like a box that could be delivered by Amazon to your house, it's on wheels, it's a little pushcart. And they say that with this technology, you do not need a water treatment room. All that is handled by the machine itself.

In fact, they basically say, there's two parts to this system. There's the machine itself and then there's the replaceable cartridge that goes in; that's pretty much it. Then you just add water and electricity and it handles it from there. That is tremendously exciting. [laughs]

Lewis: It is. And I think, given just how much of a reality this type of treatment is for people that are dealing with kidney issues -- being able to do anything locally, you know, without having to go to a care facility, is a major swing. Because if you're talking about doing something several times a week every single week for, you know, basically the rest of your life, if you have this condition, that's a lot of time, and it's a lot of time to be sitting in a treatment facility.

Feroldi: Completely. This is hours upon hours of your life that you have to commit to being on dialysis. I can see it being much more convenient to be able to do this from the comfort of your home, but when you read through the materials that are presented, patients have to spend hours upon hours for themselves just setting up the machine. They have to memorize complex processes that have to go in the exact order to get it done. I can see that being hugely burdensome, not to mention the size of the current equipment that you have into your house. I could very much see patients saying, "Forget it, too complex, if I screw anything up my health is on the line, I am just going to go to a clinic." If Outset can dramatically simplify that process, which it seems like they've done, I could see that being huge for the homecare market.

Lewis: Yeah. And just to put some quick numbers to it, I think just about 90% of dialysis happens at clinics. Only about 10% to 12% is actually happening at home. So, this is kind of an underpenetrated element of this market and one that, I would think, would lead to probably better patient comfort, better patient outcomes as well.

Feroldi: That's the thing. And I can tell you from my time -- I worked in the diabetes market, we worked directly with patients. One of the biggest burdens with any medical device or any medical technology is training. Training is a huge component, because it takes such a long time to get up and running. And as I said, if you screw up anything, the patient's health is on the line. It really seems like there are so many steps that need to happen for dialysis to be done correctly, and what Tablo promises is to basically simplify that and reduce that training burden massively.

The numbers that they've done so far, and they do have some clinical data to back up, really prove that that's exactly what Tablo does.

Lewis: And when I hear you say, upfront training, complicated, and very large [laughs] pieces of machinery, what I hear is "expensive." That's really what I'm translating that to, both in terms of physically operating the machinery, but also all of the upfront investment that staff has to put into learning how it works and really just having people on hand to make sure that everything is going smoothly as treatment is being administered.

Feroldi: Yeah, remember that number from the top of the show: $74 billion spent on this. Yes, this is hugely expensive to do. And one thing that kind of blew me away is, if a patient requires dialysis while they are in the hospital, the hospital does actually not have a way to bill for that dialysis. It's just kind of bundled into the treatment option. As a result of that, about 60% of the time that hospitals use dialysis, they lose money on that patient. And this can be up to $10,000 and about one-third of cases; that's a huge financial burden for hospitals to try to take on. So, many of them outsource the dialysis portion in the hospital because it's a huge financial risk for them to do so.

Outset believes that because of the simplicity and the cost savings, that we'll get into, with Tablo, that they hope that many of those hospitals will actually take that back in-house and offer it to more patients.

Lewis: So, if we're going to, kind of, put a bow on the core value prop that Outset is offering here, it is a kind of cheaper and more flexible way for patients and care facilities to provide dialysis. Is that the simplest way to frame it, Brian?

Feroldi: Yes. They have a great slide in their presentation where they essentially take seven different processes and machines that are required for dialysis today, and they combine this all into one small package that is operated with a touchscreen and only has two parts. Again, there's the actual console itself, which is the size of like a small refrigerator on wheels, and then there's just a disposable part that is put into the machine in between usages that makes the dialysate and also filters the patient's blood as they go.

So, the innovation here really seems to be miniaturization and dramatic reduction in both cost and complexity, which leads to better patient outcomes.

Lewis: So, Brian, when we're talking about the healthcare space in general, you know, [laughs] one of the immediate places that my head goes is, you know, "Has it been approved? You know, where are we in the timeline here?" And what's really interesting about this business is, we're past the FDA approval already.

Feroldi: This has been significantly de-risked. And I'm glad that I've trained you to get your head to go there, Dylan. Because, yes, [laughs] it's not like tech, where it's like, "What do you mean, there's approval, what's this?"

So, the Tablo device received its first FDA approval in 2014, so that was over six years ago at this point, and that was for the acute care setting; so, like, in the hospital facility. More recently in March of this year -- I mean, think of what the world was like in March of this year, Dylan -- the FDA approved the home version of this product. And the timing there actually makes a whole lot of sense, because COVID and going in for dialysis treatments don't really mix. You can see the tremendous interest on the part of the FDA to offer dialysis, or try to get dialysis going, in patients' homes as opposed to having to bring them into the clinic.

Lewis: Yeah, if you could prevent someone from making a trip to the hospital or the clinic three times a week, that doesn't need to be there, you know, and free up space and appointments for people who need to be there for other reasons, and prevent them from having an exposure risk, that sounds like a win-win to me.

Feroldi: Not to mention that these people that are on dialysis have fragile healthcare needs as it is, so COVID for them could definitely be deadly, unfortunately. So, the timing there was fortuitous. But 2020 is going to be a big year for this company to make a push into going into patients' homes.

Lewis: Yeah. And so, that's a major switch for this business in both, kind of, how their product is being used, but also how they're positioning themselves in the market.

Feroldi: Exactly. And it's also a much bigger market opportunity for them. They do provide some Total Addressable Market [TAM] opportunity numbers for themselves. They believe that the acute care opportunity for them was about $2 billion-ish, but they think that the homecare opportunity for them is on the order of $9 billion; so, an order of magnitude bigger than their current opportunity.

Lewis: Yeah. Do you think that that at all has a reason or is, kind of, an explanation for why they're choosing to go public now or why they chose to go public earlier this year?

Feroldi: I think they just are looking at valuations. They are like, hey, if we're going to raise money, now is a darn good time.

Lewis: Yeah. Well, they're not wrong, [laughs] you know. We've seen a lot of companies absolutely explode so far in 2020. And what I hear here with the value prop is really strong. I think, in general, a lot of people would look at the healthcare space and say there are a lot of ways to improve patient outcomes, to reduce costs, and to make care more personal and way more comfortable for the people receiving it. This company checks a lot of those boxes.

I guess we talked a little bit about the appearance of the device, and it looks almost like a dorm minifridge, basically, with a little iPad on top. Is there anything else that you think would be helpful for people to, kind of, wrap their head around what this thing is and what it does?

Feroldi: Yeah, the iPad on top, I think, is a key component. It does have two-way connectivity that is really important from a documentation standpoint. You can imagine, not only do patients have to kind of manage these dialysis systems at their home, they also have to document it and communicate it back to the doctor's office. One of the nice things about Tablo is it has two-way communications built into it, so if there's, say, something wrong with the machine or something is not operating correctly, Outset gets, kind of, that notification immediately, and they can help to service that machine right over the phone.

More importantly, the doctors can actually see the machine running and get two-way communication with it. So, they can know that the patient is using it properly, getting their appropriate level of dosage and treatment times, and they can see all that even if they're getting it done in their home. That is a major advantage that I can see a whole lot of providers liking.

Lewis: Yeah. And I mean, it seems to just be generally where the industry is going, you know. If you're doing anything in the healthcare space and you're talking about machinery or really anything that involves treatment, it seems like it needs to be connected at this point; you know, if you're going to be heavily investing in the development of a system?

Feroldi: Yes. I mean, why not? Nowadays that kind of stuff is so -- it's almost expected that there would be a cloud component to any new product that comes out. [laughs]

Lewis: Yeah. And from a business perspective, it's a huge selling point, because there are operational efficiencies that come with that for care providers, and you're also making the documentation, the recordkeeping, all of those things far easier for care providers and for patients.

Feroldi: Uh-huh. And we can't do justice by saying what this is over a podcast. So, if you're interested in this company, go check out their website. Again, it's OutsetMedical.com. They have all kinds of pictures up there. You can look at training videos for how to get these things done. They have great graphics that show kind of the difference between the size and scale of what currently exists and what they have today.

And what's equally exciting to me, Dylan, beyond the ease of use and the training, is that there is opportunity for substantial cost savings. They actually did a study at Cleveland Clinic, one of the premier healthcare names in, really, the world, where they did an analysis of pre-using Tablo and post-using Tablo. And their analysis showed that Cleveland Clinic could save about 55% over the course of a year in its annual dialysis cost. 55% by switching to Tablo! If that's even remotely accurate, that is a huge reason to switch.

Lewis: Yeah. I mean, you take that number and then you tie it back to about 60% of dialysis treatments being money-losers for care facilities, that becomes a pretty compelling pitch pretty quickly.

Feroldi: It really does. So, if it's good for the patient, if it's easy [...] and it saves money, that's a very compelling proposition.

Lewis: Okay. So, let's talk about how this all comes together as a business, because we've been really product-focused and patient-focused, which I think is important, but obviously, bills got to get paid, you know, and we have to have a viable business here. So, how are they making money and what exactly does it look like?

Feroldi: So, the exciting thing here is that they are following a business model that is tried and true. And if you are a fan of Intuitive Surgical, like I am, it's a very similar model there. So, they not only sell the Tablo system, which is a capital sale -- I didn't see an exact price, but I'm sure it's not cheap. So, that is one way that they make money off the sale of the system itself. But more importantly, there's also a recurring revenue component here from the treatment. Every time there's a treatment done, there is a consumable part of the device, and in addition to that, there's also an annual service contract for each of the machines. So, they make money off of the capital sale, they make money per treatment, and they make money from a service contract. Those latter two are the more exciting ones for investors, because they are recurring revenue. And if they're anything like Intuitive Surgical, in time they will be very high margin.

Lewis: Yeah. No, I mean, that's really the way to do it, if you can, is to create something that allows for you to make money as people use the service, it generally bodes well, both for the business and it proves out that the thing is in fact useful and not a waste of upfront purchase for whoever ends up buying it.

Feroldi: Exactly. And the good news is, we do have some numbers. I mean, they are still pretty early on with the commercialization here, but we do have some numbers that show that this isn't just all talk, that there is clear product market fit being demonstrated. And Dylan, we should back up and say, when we go through presentations like this, we are, you know, amateurs when it comes to dialysis, and we're kind of learning as we go. I take the mindset of, I believe you, management, I believe all the things that you're saying, just prove it to me by producing huge revenue growth, right? I buy your thesis, but you have to prove it to me by showing explosive revenue growth. That's how I really buy into the concept.

And what we're seeing in 2020, and again, very early on in the commercialization, but the first nine months of 2020 this company more than tripled its top line. It reported 309% revenue growth to $33 million. And of that, the system sales are the primary driver so far, because that is a huge upfront fee that they get, but service revenue, so the consumables as well as the annual service contracts, that's also growing extremely quickly.

Gross margin, because we're still so early on here, Dylan, is negative, it's -36%. That's fairly typical when you're just launching a product, but that did show enormous year-over-year improvement. And management thinks that they have a very viable path forward to get that number positive and growing very quickly. Given that the gross margin is negative, you can imagine what the bottom line looks like. So, last quarter they lost $29 million. After the IPO, it looks like they have about $377 million on hand. They shouldn't need to do a capital raise for a long time, but make no mistake -- they have been de-risked and revenue is growing, but there's still a whole lot of work to do before they become profitable.

Lewis: Yeah, Brian, I think, kind of, going back to what you're saying about, you know, show me that the thesis is playing out. I think if you have FDA approval [laughs] that that eases a lot of concerns for me, right, just as someone who's kind of an outsider in this space. I'm sure there are, though, some people hearing that revenue number and kind of doing the math quickly and saying, okay, it's a $2.2 billion company, we're looking at about $39 million in trailing 12-month sales, so a pretty high price-to-sales multiple. They've had FDA approval on the acute side for about six years now. And should we be seeing more revenue given how long that's been available? Is that something that you've thought about at all, kind of, looking at their numbers?

Feroldi: Yeah, it's a completely fair question. And what they reported was just when they got FDA approval. Getting FDA approval and actually commercializing aren't the same thing. Sometimes you're just not ready when you have FDA approval to actually start making the device, getting it through, and getting it through reimbursement. That's another big barrier there when it comes to scaling up a medical device. Just because you have FDA approval doesn't mean people are going to actually pay for it. So, there are numerous barriers to knock down.

Once you start to see tremendous top line growth, and I would definitely count 300% as tremendous, that is a clear sign that payers are onboard, patients are onboard, healthcare providers are onboard, and the government is onboard.

Lewis: So, that timeline is really helpful, because if we're looking at them in the acute market and seeing this lag -- you know, we are talking about how they're looking to get into patient homes and how that is kind of the much larger market for them. Even though they got approval earlier this year, there's probably going to be a lag on that as well, right?

Feroldi: Definitely. I mean, it takes time to go in and educate doctors on how this works, to let alone to try and convince patients to use this in their house. And again, reimbursement has to get set up. Meanwhile, they're doing this during the year of COVID. Can you imagine how hard it is to try and do all this kind of stuff over Zoom? It's just tremendously challenging even if you can be there in person. So, I am very impressed by the numbers we see thus far.

Lewis: So, we talked about some of the opportunities in front of this company. Obviously there are a lot of industry incumbents that are currently capturing most of that spend. How do you look at them when it comes to competitive risks and their ability to kind of establish a moat and stick out in a space where there's a lot of money being spent, but there's a lot of powers that are probably pretty happy to collect that money?

Feroldi: Yeah, there are $74 billions going to other companies that definitely want to maintain the status quo. So, this company building itself a moat is going to be incredibly important. For now, typically, right after launch, the only moat that you really see is patents and know-how. I think that they have a lead, at least a multiyear lead, with this type of technology over other people, over the existing incumbents, but that is something that we're just going to have to see.

Longer-term, as their commercial footprint gets built out, I do think switching costs will become an advantage for this company. Once you get up and trained and switched over to this system and it's integrated with your EMR, I could see doctors being very reluctant to switch away from it. But that reluctance is what's working against this company right now as they try to penetrate and get the market out there. So, a very, very weak moat right now, but over time I could see it getting wider.

Lewis: Yeah, that's the tricky thing about switching costs, right, [laughs] is they generally work against you before they work for you. [laughs]

Feroldi: That's right. Which is why, again, I always look for revenue growth -- it's proved to me that everything that you say, and you can overcome the switching cost from the incumbents to actually prove that you have product-market fit. When you see very high revenue growth in an industry, especially the medical device industry, that is always super impressive to me.

Lewis: Yeah. And I think when you look at things that can overcome those switching costs and the friction of having existing systems that work, cost savings is probably one of the most compelling ones. And so, I do think that that is a strength that they're able to offer as they're having these conversations, and possibly something that they can help overcome some of those switching costs they can run into.

Feroldi: Exactly. But when it comes to healthcare, there are so many stakeholders that you have to keep in mind. You have to keep in mind hospital administrators, you have to keep in mind doctors, you have to keep in mind patients, you have to keep in mind payers. If you can get all four of them onboard, [laughs] and that is very challenging to do, that's when you really start to see hypergrowth.

Lewis: So, hypergrowth is what we've seen so far, at least as a percentage basis, Brian, because we're working on some kind of small numbers here. But there is pretty big potential when we look at what this company has in terms of TAM, really big numbers. We touched on them briefly before; I just want to reemphasize them here. $11 billion TAM in the U.S., and that's broken out with that $2.2 billion for hospital care, $9 billion for home-based care, which is kind of the market that could evolve for them, but it hasn't quite yet materialized.

I don't know much about this space, Brian. Are there other people that are working in this? Like, it doesn't feel like the homecare side, in particular, is a very penetrated market.

Feroldi: There have been other companies. One former Fool rec was called NxStage Medical -- they were acquired, I believe, by the biggest company in the space, which is Fresenius. They are kind of the top dog in the industry. But again, those products that were designed for the home have failed. They're just still underpenetrated for all the reasons we discussed before -- mostly training and complexity. Patients just abandoned home therapy and ended up going back to the clinic. Can Outset break through and into that market? If so, that is a lot of blue ocean for them to capture.

Lewis: So, regular listeners know that there is a kind of classic checklist that we like to run through as we're looking at companies, particularly S-1s. And we've kind of vaguely hit on them, we've kind of gone through them normally as we would just kind of have the conversation about the company. But I do want to revisit some of those as we hit the back half of the show, Brian.

And one of the first things that you generally like to look at is the customer base for a business, and how the money comes in, is it recurring, all of that. What do you see when you're looking at that element of this business?

Feroldi: Yeah, in general, if there's no recurring revenue, I'm not interested. I mean, it's just a broad rule. There are so many companies out there that do have recurring revenue -- why bother with those that don't? So, because Outset has chosen to follow in the footsteps of Intuitive Surgical, this company will definitely have a tremendous amount of recurring revenue later on in its growth phase. For the first couple of years, the primary method that they're going to be growing their top line is through the capital equipment sales. That's the exact same thing that we saw Intuitive Surgical go through. Over time, I would expect that its consumables and its annual service contract become a larger and larger portion of the total top line.

So, for right now, is there a recurring revenue? Yes, but it's a smaller part of the revenue base. Over time, I want to see it become larger.

Lewis: And to tie that back to the financials discussion we're having, that's why you're willing to accept the negative gross margins right now, right, is because that's kind of, in some ways, the cost of doing business and building up all of this equipment business, so that you can then enjoy the recurring revenue later.

Feroldi: It's a very common thing we see with all of the companies that are in the very early innings of their growth cycle. Going from no revenue to some often requires having an extremely negative gross margin in the beginning, [laughs] and you just have to hope that the company can get that into the positive territory as soon as possible.

Lewis: [laughs] I'm waiting for the day that I see in a prospectus, "We're going from no revenue to some." [laughs] I think that that would be a great quote for a management team to work in there at some point.

Speaking of, you know, I know you like to look at management as well, Brian. What do you see when you look at the folks at the helm for this business?

Feroldi: I was very impressed with what I've seen so far. So, the CEO here is named Leslie Trigg. She seems to have numerous companies behind her that have been successful, none of them that are well-known in the space. But if you look at the rest of the management team, there are some names here that you will recognize. I see Illumina, I see BD, [Becton, Dickinson], I see CareFusion, I see DaVita Dialysis, I see Bard, [CR Bard], I see Hologic. So, the management team here appears to have plenty of industry experience, especially in dialysis. That's important.

The thing that kind of blew me away, and I really said "Wow!" out loud when I looked it up, Dylan, was the Glassdoor reviews. The CEO here, Leslie Trigg, gets a 99% CEO approval rating. And this company gets 4.6 stars out of 5 on Glassdoor. There's only 77 reviews, so we're not talking about hundreds, but that's still enough to make me go, wow!

Lewis: Yeah, those are impressive stats. [laughs] I mean, it doesn't really get much better than that.

Feroldi: It really doesn't. And I am particularly impressed by that, given that this is a medical device company. I worked for a medical device company. I can tell you they are tough, tough environments to work in. When I see these kinds of numbers, I am incredibly impressed. And it's also worth pointing out that this company is based in San Jose, I believe, which is in the heart of Silicon Valley. So, there is a war for talent in that area, so they really have to have a top-notch culture in order to attract the best and the brightest.

Lewis: Yeah, to your point, Brian, you're talking about technology in a way that is very Silicon Valley with this world, right -- where it's very innovation-heavy, it's very futuristic. But you also, as a management team, need to navigate all these legacy systems and [laughs] just the infrastructure of healthcare, which is so different. And I think that requires such a unique skillset. So, having people that are bought-in and really believe in the management team is definitely a big part and a great sign of approval for what they're doing, and what folks in the industry seem to think of the folks at the helm here.

Feroldi: Totally, totally. Now, I did look at inside ownership, and that is not nearly as impressive. CEO Leslie Trigg only owns about 2% of the business, and executives, as a group, own about 3%. That's not entirely surprising, because taking a medical device company from nothing to FDA approval often requires a tremendous amount of capital and multiple capital raises over time. That tends to mean that insiders at medical device companies own far less than you would see at, say, a SaaS business or something like that. So, I'm not, like, thoroughly impressed, but I'm not that disappointed.

But overall, the CEO here has 2% of the business, you know. At current prices that's $40 million. That's some incentive to see it go higher.

Lewis: Yeah. And a $2 billion business, really, the management team is going to have a lot of sway, power, and influence over what happens with that company. You know, we talk about it all the time, Brian, but if you're a sub-$10 billion -- really, sub-$5 billion -- business, the management team matters a lot.

Feroldi: Yes, I think that that's -- especially at this stage of the game. And I would even say, it's not so much about the market cap of the business, as it's more of the stage of the business. They're going from "This doesn't exist" to "We are trying to take market share away from incumbents." Boy! Is that tricky to do. So, yes, the management team here will have an outsized role in this company's success.

Lewis: Yeah. And there are going to be some uphill battles for this company to fight, the current infrastructure probably being one of them; we've talked about that a good amount. But I don't think that's the only risk here with this company. Even just kind of looking quickly at the back of the envelope on the valuation, Brian. You know, a $2.2 billion company, just about $40 million in trailing sales, we're looking at 55 times trailing sales, just for valuation. So, this is obviously a business where growth is a huge part of the story, and living up to that growth is basically going to determine whether or not this investment works out.

Feroldi: And that 55 times sales. I mean, that's a high number in any circumstance, but you've got to remember, with medical device companies, it's exceptionally hard for them to post the kind of growth that, say, a software company can produce, because they have to go out, they have to train, they have to physically ship. There are many more barriers in place to ramping up the commercialization than it is for, again, software, which can be infinitely duplicated and delivered over the cloud. So, this is a company that I would expect, if it can grow its top line at a 50% rate for the next couple of years, that would be a very good number. So, that price-to-sales multiple is not going to decline as fast as it is for, say, a company like Snowflake.

Lewis: Yeah. And something that investors will kind of have to wait and see a little bit on is what winds up happening with gross margins when they've hit scale, if they reach scale, because [laughs] you know, we'll accept negative gross margins for a certain amount of time, Brian, but you really want to see a margin profile come out that makes sense and kind of ultimately factor that into what you're willing to accept from a valuation standpoint as well.

Feroldi: Yes. Because the risk there is that it costs them more money and it takes them longer to scale than necessary, and at some point down the road they have to dilute shareholders again with yet another capital raise. So, that is something to look out for. I think they have a couple of years of runway for now, but yeah, the next couple of years are going to be critical.

Lewis: Any other major risks that you noticed looking through the S-1?

Feroldi: Yeah. Again, this is a $74 billion industry that has been extremely resistant to disruption. They have a huge challenge ahead of them, to say nothing about the competitors that want to keep it that way. Another risk here is, given that it's so early in the game here, customer concentration is a big, big risk at this point. So, their top three customers accounted for 23%, 17%, and 16% of revenue. That is over 50% of their revenue coming from just three customers at this point. That is a problem that should hopefully take care of itself in time as it grows, but for right now, if they lost any of them, for whatever reason, look out below.

Lewis: Yeah. No, [laughs] that can become a problem very quickly. And you know, you hope with something like this, because of all the things that it offers and because the switching costs that we highlighted before, you know, customers aren't customers for a year, they are customers for years or decades. And you're able to really become installed there.

What isn't clear to me, having looked through the S-1 probably a little bit less than you have, Brian, is whether customers are exploring them as an option but also maintaining the legacy systems, or whether they've fully switched over. If they've fully switched over, those customers are probably going to be there for a while. If they're exploring both options, you know there is the risk that those customers can disappear.

Feroldi: And the management team did call out that they believe that they have growth potential, not only from capturing new customers, but they said that they see a lot of room to grow within their existing customer base. So, I think with this kind of technology, it would be common for those on the bleeding edge to give this technology a try, but not use it on all of their patients or in all of their clinics. It takes time to transition their entire clinic. So, I could see this being in the testing phase for now. And if it goes well, they could scale up in time.

So, again, I expect these numbers to fall over time, but for right now, there's a whole lot of risk.

Lewis: All right. We've talked about the good, we've talked about the bad. Brian, where does this one sit for you?

Feroldi: I'm very excited about this company, and I could easily see myself becoming a shareholder here. I think that they have the technology, the leadership, and the market opportunity to become a multi-bagger, even from today's $2 billion valuation. However, I break up my portfolio into three broad categories. There's kind of, like, high-risk growth, low-risk growth, and then 10 times speculation. This is definitely in the 10 times speculation part.

So, if I buy, it would be as part of a basket approach to, kind of, taking very small positions in a lot of companies that have tremendous potential. But what I want to know [is]: Is it on Dylan Lewis's radar?

Lewis: [laughs] You know, it is. And there's going to be an Industry Focus episode coming out the holiday week where we kind of roundtable and we talk a little bit about financial resolutions. And I've been sitting on the sidelines with a ton of cash this year, because we had some home renovation projects that seem[ed] like they were going to happen, and as it turns out, they're not going to happen. And so, [laughs] I have a lot of cash for 2021 to deploy. And I am very excited, because having done so many shows with you in 2020, Brian, and listening to all of the content on Motley Fool Live and our podcast, I have a lot of investment ideas that I'm pretty excited about at this point. [laughs]

Feroldi: Yeah, that is the exciting thing. Again, 2020, God! how many shows have we done on so many exciting companies. Again, it's like you have more ideas and more potential ideas [laughs] than you do capital, so narrowing them down is always a challenge. But again, I am a fan of finding great companies that you think can grow, taking small positions in each, and then buying more of the ones that execute.

Lewis: Yeah, I think this is, if it is something that you're interested in, if you're putting it on your watchlist, if you're considering it for your portfolio, allocate accordingly. I think that's kind of the big one here. I think you put it very well, Brian, with the idea that, you know, that small basket where you're spreading your bets and expecting -- you know, if you're putting them in that 10 times basket, you know that there's only going to be so many of them that really wind up working out. That just kind of comes with the territory of investing with that style.

Feroldi: But you just need one or two of them to work out for the entire process to be worth it.

Lewis: Yup. And it's fun, you know, as an investor, you kind of get to adopt a little bit of a venture capitalist approach to things.

Feroldi: That's right.

Lewis: [laughs] We get to be our own sharks, Brian. [laughs]

Feroldi: [laughs] I never thought about it like that, Dylan, but from now on, I'm going to be thinking about it like that.

Lewis: Yeah, you can just talk to the S-1 and be like, all right, make your case? [laughs] State your case to me.

Feroldi: [laughs] Not impressive, I want a royalty.

Lewis: [laughs] All right, O'Leary. Brian, thank you so much for hopping on today's show.

Feroldi: Thank you, Dylan.

Lewis: Listeners, that is going to do it for this episode of Industry Focus. If you have any questions or you want to reach out and say, "Hey!" shoot us an email at [email protected], or you can tweet us @MFIndustryFocus. If you're looking for more of our stuff, subscribe on iTunes or wherever you get your podcasts.

As always, people on the program may own companies discussed on the show, and The Motley Fool may have formal recommendations for or against stocks mentioned, so don't buy or sell anything based solely on what you hear.

Thanks to Tim Sparks for all his work behind the glass today, and thank you for listening. Until next time, Fool on!