Nanosonics: Good results and goodbyes

When we recommended buying Nanosonics almost five years ago in Nanosonics builds a better mousetrap, it was the preserve of top US hospitals, but we thought other healthcare facilities would soon start buying the device due to increasingly stringent sterilisation guidelines. The company made $20m of revenue in 2013, and a net loss of $4m, but we expected sales to grow rapidly, delivering a profit within a few years.

It hasn't let us down. In the 12 months to December, Nanosonics earned $71m and made an operating profit of $8.2m. Revenue has more than doubled since our initial upgrade - and the share price has risen more than fivefold.

We think it's finally time to Sell.

It's always tough to say goodbye to such a strong performer and it wouldn't surprise us to see the share price keep rising. Certainly the company is performing well.

Nanosonics' revenue rose 36% to $41m in the six months to December, with the second generation of the company's sterilisation device - the trophon2 - being launched in North America, Europe and Australia. The installed base of trophon units worldwide is up 20% compared to last year at 19,310 units.

It's never fun leaving the party while everybody's dancing. But as value investors our main objective is to get home safely, not collect every last drop from the punchbowl.

Future value

Even though Nanosonics is now making profits, make no mistake that its valuation is entirely based on hopes about the future, not what it's earning today. The stock is now priced at 18 times revenue and has a triple-digit price-earnings ratio. Could Nanosonics meet the growth expectations embedded in those figures? Yes. It's possible. 

Management believes there's potential for a North American installed base of 40,000 units and room for 120,000 units worldwide. A trophon unit 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 $600m-$1bn a year in revenue. Cochlear, Australia's biggest medical device maker and one loaded with competitive advantages, earns a profit margin of 19%. Let's be generous and assume Nanosonics hits 20%. The company would then be earning around $120m-200m in net profit each year. 

That's an incredible sum given Nanosonics' current profitability. 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. That's not a lot of compensation given the risks. 

Obsolescence

Trophon 2 is arguably the best sterilisation device for ultrasound probes on the market, but that doesn't remove the risk of long-term obsolescence. And, to put it frankly, we're not convinced that research is the company's strong point.

New features of the second-generation trophon include a redesigned disinfection chamber to accommodate an expanded range of ultrasound probes, a quieter operation, a colour screen and a software upgrade. Those improvements required $45m in research spending and still took the better part of a decade to deliver after the first generation trophon was released. Unlike Cochlear, this isn't a company constantly churning out upgrades to keep customers on the hook, so we expect competitors to muscle-in pretty soon.  

Furthermore, Nanosonics overwhelmingly relies on one customer - GE Healthcare - which accounts for two-thirds of revenue. In February, Nanosonics expanded its relationship with GE, which now holds the distribution rights in Denmark, Finland, Spain and Portugal, as well as being trophon's distributor in the US. 

In July, GE will switch from being Nanosonics' distribution partner to a 'capital reseller'. Currently, GE makes the initial sale and takes care of all consumable sales and maintenance thereafter; however, the new contract only allows GE to make the initial trophon sale - Nanosonics gets to supply the consumable disinfectant cartridges directly. The upside is that Nanosonics will get a larger slice of those high-margin ongoing sales, so margins are likely to improve. The downside is that GE has a reduced incentive to make the initial sale if Nanosonics gets to keep the long-term earnings stream that follows it. 

It's too early to tell what effect that might have on trophon sales, but a slowdown is a real possibility. A lot of Nanosonics' success is due to GE's salesforce. GE is unlikely to end its contract with Nanosonics, but if it did a huge chunk of revenue would evaporate overnight and the stock would plummet. Nanosonics' relationship with GE is the risk we worry about most. 

In the 2019 financial year, at least, management expects growth in the installed base to be in line with 2018. Management also flagged strong growth in Europe, where new hospital guidelines are encouraging broader adoption of trophon.

Though Nanosonics may be worth significantly more than today's share price, it requires an increasingly large leap of faith to justify holding on. Given the increasing risks and sky-high valuation, we don't want to push our luck. SELL. 

Note: Our Model Growth Portfolio is selling its entire holding of 14,556 shares in Nanosonics at $4.28, giving a total proceeds of $62,300.