GI Dynamics’ indigestion problems

The company, which sells intestinal liners, has lost nearly half of its market weight this year.

What’s eating GI Dynamics (GID)? The stock has lost nearly half its market value since the start of the calendar year and there seems to be little appetite from investors, despite its record low share price and huge earnings potential.

The $160 million market cap junior is trying to commercialise its intestinal liner to help fight obesity and diabetes – a global market that is measured not in the hundreds of millions but billions of dollars.

While the sharemarket may be in a low volatility environment, shareholders have been enduring a rollercoaster ride since I first wrote about the stock in July last year when it was trading at 60 cents.

The stock subsequently surged to a high of 95.5 cents in September before running out of puff and falling to a record low of 40 cents at the end of July. The depressed price isn’t drawing out the bargain hunters, with GI Dynamics currently trading a touch above that low despite the fact that it is worth $1.05 on my calculations.

It isn’t always easy to work out why a stock moves contrary to expectations, but the good news is that GI Dynamics isn’t being punished for all the “naughty” reasons. By that I mean the stock isn’t being sold off because of balance sheet concerns (it has around $70 million in cash and next to no debt), a loss of confidence in management or potential issues with its only product – called the EndoBarrier.

I can think of two possible reasons behind the sell-off. The first is investor fatigue as investors have become tired of waiting for the company to achieve certain milestones. Gaining approval to sell the product in Brazil is just one example.

Management told investors they expected to get the green light at the end of last year, but eight months into 2014 and there still isn’t any word on when the Latin American country will approve the use of the device.

Further, some investors might also have been put off by how long it takes for governments to put EndoBarrier on the list of reimbursable procedures. This is a big issue when it comes to driving market adoption in some countries, because their citizens expect medical procedures to be paid for by the government. There just isn’t a culture to pay out-of-pocket expenses for health services, regardless of how wealthy one is.

GI Dynamics is already selling the EndoBarrier in several European countries (including Germany and the Netherlands) but sales will likely stay modest until it qualifies for reimbursement. This possibly means sometime in 2016 for Germany and 2017 for France and the Netherlands.

In Australia, approval for Medicare reimbursement could come in 2015 and I am expecting a step change in sales growth from the September quarter of that year.

However, there are some markets that aren’t driven by government subsidies. Brazil, the Middle East and India are examples of jurisdictions where patients have a history of paying for medical procedures themselves.

The Middle East isn’t contributing much to revenue at the moment (the region only added $US20,000, or 2.4%, to total revenue in the June quarter) as it takes a bit of time to gain traction. As mentioned, the Brazilian authorities have not given their stamp of approval, and neither has India.

But when those approvals come, potentially in the next 12-months, GI Dynamics is likely to re-rate as those markets are huge. Around 5% of India’s 1.3 billion people are obese, and gaining just a slither of that market share will translate to hundreds of millions of dollars for GI Dynamics.

Brazil may have one-sixth the population as India but that market also holds great potential as Brazilians have an affinity for gastric bands, and the EndoBarrier is a direct substitute for gastric bands or gastric bypass surgery.

GI Dynamics claims there are between 60,000 to 90,000 gastric band procedures done in Brazil every year, compared with 10,000 for India.

You don’t need surgery with the EndoBarrier. The liner, which reduces the amount of food absorbed by the body, can be inserted through the mouth into a patient’s intestine. This means it can cost half to three quarters less to use an EndoBarrier compared with the other two existing procedures. The EndoBarrier costs patients $US8,000 to $US10,000.

The other issue that could be casting a shadow over the stock is a capital raising. Yes, another capital raising. Management just completed a $34 million private placement in May to help fund a pivotal clinical trial in the United States to secure approval for EndoBarrier in that market.

The company raised around $60 million less than a year before and, based on my estimates, could need a further $US10 million to $US15 million in 2015. I am assuming a slower rate of sales growth over the next few years due to the issues highlighted above. I am forecasting sales of $US8.2 million in 2015 (the company’s financial year ends in December), which is 45% under consensus forecast.

Having said that, GI Dynamics is planning to be dual listed in the US at the end of this year. Management has not released any details on this and the capital raised from a US float could more than offset any need for a capital injection here.

On the upside, GI Dynamics has a pretty impressive list of backers. Global fund managers like Capital Group and M&G Investment management are substantial holders, while Hunter Hall became a substantial shareholder in the company in June with a 5.4% stake and has continued to buy shares on market to take its total holdings to 6.4%.

Interestingly, health care giants Johnson & Johnson and Medtronic own around 6% to 8% each of GI Dynamics, which does raise the question about whether the company could become a takeover target at some point.

It is worth noting that Graham Bradley is on GI Dynamics’ board. Bradley is the chairman of ASX-listed property group Stockland Corporation and the former Business Council of Australia head.

GI Dynamics is a high-risk proposition that requires a lot of patience (no pun intended) given that a maiden profit isn’t expected until 2017. For this reason, I have a “speculative buy” recommendation on the stock with a price target of $1.05 a share.

To see GI Dynamics' Forecasts and Financial Summary, click here.