Is Nanosonics a stock bubble?

Has Nanosonics' share price reached bubble territory or is this growth story just getting started?

Nanosonics (ASX:NAN)' stock has risen 1,033% over the past ten years. It's been an incredible success story, both for the company and our members. 

What troubles us is that for most of that time - or at least since our 2014 Buy recommendation - the stock has plodded along, with the share price moving upwards in lockstep with our estimate of its underlying value. But something changed over the past year - investors now can't get enough of Nanosonics. The share price has almost doubled since December, adding $700m to the company's market cap - more than double all the revenue Nanosonics has ever earned in the 19 years since it was founded.

Nanosonics made $71m in revenue for the 12 months to December 2018, compared to $61m in the 12 months to December 2017. Few companies can brag about a 16% increase in revenue - fewer still can say it led to a 65% rise in net profit due to the operating leverage associated with its 'printer and ink cartridge' business model. So that justifies at least some of the jump in share price.

Most of the jump, however, comes down to rising expectations for future growth. With unique technology and a recognisable brand - at least among hospital staff -  the company is expanding aggressively into the US and Europe. The installed base of 'trophon' units worldwide is up 20% compared to last year at 19,310 units.

Nanosonics is a well-managed company, has a well-liked product and we have every reason to believe the business will be bigger and stronger a few years from now. But, even with all it has going for it, is it really possible for Nanosonics to be worth 21 times revenue and 150 times net profit? Colour us sceptical.

Share prices are set based on perceived future growth rates, and the simple fact is that investors today are paying for an extremely rosy outlook. We need look no further than Nanosonics' own history to see what happens when optimism fades.

Right, but wrong

Between June and September 2016, the stock shot up 64% to $3.51 when new guidelines from European healthcare regulators were released that required higher disinfection standards for ultrasound exams. Investors thought tightening standards would be a tailwind for the company and help to boost sales in the region. 

Over the next couple of years to December 2018, the stock lost 25% of its value.

But here's the punchline - in those two years, Nanosonics' revenue increased 42% and operating earnings even more so. Those jolly investors of September 2016 had been absolutely correct in their forecast for growth. They just overstretched when paying for it.

Management believes there's potential for a North American installed base of 40,000 trophon units and room for 120,000 units worldwide. A trophon device costs around $10,000 and lasts around five years. It also generates roughly $3,000 a year from consumable disinfectant cartridges. 

If management reaches its goal, Nanosonics could someday be earning revenue of $600m-$1bn a year. Cochlear (ASX: COH), Australia's biggest medical device maker and one loaded with competitive advantages, has a profit margin of 19%. Let's be generous and assume Nanosonics hits 20%, up from 14% today. The company would then be earning around $120m-200m in net profit each year. 

That's an incredible sum given Nanosonics' current net profit of around $10m. But how long would it take to get there? If the installed base keeps growing at 20%, it could be the better part of a decade. If we assume Nanosonics trades on a price-earnings ratio of 20 in 2029 - which would be reasonable for a mature, growing healthcare stock - then today's investors might expect an annual return in the high single digits if profitability is at the upper end of our range. If profits arrive at the low end, investor returns would be less than 5% a year. 

That's not a lot of compensation given the risks of owning a one-product company - especially one where a single customer, GE Healthcare, accounts for two-thirds of revenue. 

Nanosonics has had a tremendous year, both operationally and in terms of its share price. But, as you have probably read ad nauseam by now, past performance doesn't guarantee future results.

Is Nanosonics' share price a bubble ready to pop or an accurate estimate of its future success? As investors, the question that really matters is whether there's room for error. And when it comes to Nanosonics, you can bet your ink cartridge there isn't.

Disclaimer
Intelligent Investor provides general financial advice as an authorised representative under the AFSL held by InvestSMART Publishing Pty Limited (Licensee). InvestSMART Funds Management Limited (RE) is the responsible entity of various managed investment schemes and funds and is a related party of the Licensee. The RE may own, buy or sell the shares suggested in this article simultaneous with, or following the release of this article. Any such transaction could affect the price of the share.

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