Nanosonics: Result 2016

From the moment the investor call started, you could hear Nanosonics' chief executive, Michael Kavanagh, smiling down the phone. And with good reason: the company posted record sales for the year, with revenue up 93% to $43m, and Nanosonics turned a profit for the first time.

The net profit of $3.4m in the second half of the financial year – and $122,000 for the full year – isn't anything to get excited about but the fact that the company is now self-sustaining, without need for constant capital injections, is.

Management attributed the strong sales result to favourable market conditions and increasing awareness of the company's disinfection device. New guidelines from the Scottish healthcare regulator were released and require higher disinfection standards for ultrasound exams. This helped boost sales in the region and new standards for England are expected to be released within the next few months. Nanosonics has one of the most thorough disinfection technologies around, so whenever requirements get stricter customer orders go up.

The company now has more than 10,000 trophon units installed worldwide and more than 8,700 in North America – an increase of 74% on 2015. Management boasted that the technology is now used in 48 of the top 50 hospitals in the US.

The installed base is the figure we watch most closely as it supports ongoing sales of high-margin disinfection cartridges.

Nanosonics' business model is similar to that of Gillette: the razor's base is sold relatively cheaply, but then the customer is locked into buying high-priced replaceable blades. With this in mind, as disinfection cartridges become a larger proportion of Nanosonics' sales, the company's margins increase – indeed, the gross margin rose from 69% to 75% over the year.

Nanosonics is working on future generations of trophon and increased research and development spending by almost 50% to $7.3m. Nanosonics has $49m of cash in the bank, which is more than enough to cover its expenditure needs as it grows, especially now that it's profitable.

Lock in profits

We laid out Nanosonics' big picture growth potential when we first upgraded the stock in Nanosonics builds a better mousetrap on 10 Mar 14 (Speculative Buy – $0.785). The stock has more than tripled since then.

Nanosonics' incredible success has left us conflicted when it comes to valuing the company and our official recommendation. On the one hand, the company currently has a market cap of around $800m – 19 times revenue. On the face of it, that looks like a ludicrous valuation for a young, risky, one-product company.

On the other hand, management believes there's room to have an installed base of 40,000 units in North America alone. A trophon unit costs around $10,000 and needs replacing every four to five years. On top of this, healthcare facilities need to spend around $3,000 a year on high-margin consumable items. If management gets anywhere near its goal, we would expect revenue of $200m or more, and a net profit of $30–40m doesn't seem far fetched given margins will almost certainly be higher than today. Suddenly, a market cap of $800m looks more reasonable.

We got into Nanosonics early, and we're reluctant to get out while the company has only reached a fraction of its potential. In these situations, we think it's better to focus on managing risks than trying to value the company with false precision. We're happy to hold Nanosonics for the long term but, given the share price rise, the stock may have become an dangerously large portion of your portfolio. If that's the case, we highly recommend that you lock in profits to maintain a maximum portfolio weighting of 2%.

Though this is arguably Nanosonics' best result yet, it's important to remember that this is still a one-product company in a highly competitive market, and that makes it risky. 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