Nanosonics: Interim result 2018

There was good in bad in Nanosonics' latest interim result. The bad was reflected in headline falls of 17% in revenue and 64% in pre-tax profit compared to the prior corresponding period.

At least that's what the headlines should have been. Management, which has a knack for marketing, likes to flip-flop between referencing the 'prior corresponding period' and the less conventional 'prior half' depending on which is more favourable. So it's a little disappointing, though not particularly surprising, to see them lead with comparisons against the final half of the 2017 year, against which sales fell only 4% and pre-tax profit rose 3%.

This was the first time the unconventional measure was used exclusively in a results announcement since 2015, so we were disappointed to see a return to the old tomfoolery. It isn't dishonest, but it isn't the straight-shooting we like to see. For more of these reporting tricks, see How to spot fake news this reporting season.

On the bright side, the 64% decline in profits was mainly due to an increase in administration and staff expenses in anticipation of future growth. Research and development (R&D) expenses also rose 7% as the company explores new uses for its infection control and decontamination technology.

The drop in revenue was attributed to a reduction in sales of consumable products and accessories to GE Healthcare – the company's biggest customer, accounting for half of revenue – due to GE reducing its inventory.

Sales volumes continued to grow, with the installed base of the company's flagship Trophon sterilisation device increasing 14% to 14,100 units in North America.

The installed base is arguably the most important measure of how Nanosonics is doing as it locks customers into years of follow-up purchases, supporting sales of high-margin disinfection cartridges. Management said there is ‘ongoing opportunity for further Trophon adoption in North America where the market opportunity is estimated to be approximately 40,000 units'. Management thinks there's room for 120,000 units worldwide.

New sales models

UK sales nearly doubled after new guidelines from the British Medical Ultrasound Society and the European Society of Radiology recommended stricter requirements for the disinfection of ultrasound probes.

However, the UK operates under a different sales model to other regions, called a managed equipment service (MES) contract. Under an MES, Nanosonics doesn't sell the Trophon device to the healthcare facility, but rather continues to own it after installation. The hospital then pays an all-inclusive price for the disinfection cartridges and maintenance over a set timeframe. Around 90% of UK sales are under this model.

Speaking of the different distribution models that Nanosonics employs – equipment sales, rentals, MES etc – management commented: ‘all are attractive, profitable models in the long term with annuity revenue growing as the installed base grows'.

Management has said previously that MES is the preferred method as sales are less capital intensive for the customer, making the sale easier, and the customer can pay up to twice the normal price of consumables, for a gross margin above 90%. The downside is that low capital intensity for the customer – a Trophon machine would normally cost $10,000 upfront – makes Nanonsonics itself a more capital-intensive business as it must build the machines and only earn a return on them over time. Revenue is essentially pushed back to later years. Thankfully, with consumables usually costing $3,000–5,000 a year, the ‘free' unit pays for itself quickly, with years of high-margin sales made thereafter.

Taking profits

Nanosonics has $67m of cash in the bank, an increase of $3.5m since June 2017, which is plenty to cover the company's expenditure needs as it grows.

The company continues to expand and has changing healthcare regulations as a tailwind. However, this result is a reminder that Nanosonics is still a small, speculative company subject to large changes in revenue and profitability due to its reliance on a few major customers and a single product.

Even after Friday's 11% fall, the share price has more than tripled since we originally upgraded the stock in 2014 in Nanosonics builds a better mousetrap. We highly recommend gradually taking profits to ensure a maximum portfolio weighting of 2%. HOLD.

Note: The Intelligent Investor Growth Portfolio owns shares in Nanosonics. You can find out about investing directly in Intelligent Investor and InvestSMART portfolios by clicking here.

Disclosure: The author owns shares in Nanosonics.