Thursday, 10 April 2014

AtCor Medical

Since its invention in 1881, doctors, specialists, researchers, hospitals and pharmaceutical companies have been utilising the sphygmomanometer. Sph-what? Don't worry it's just the inflatable cuff that your doctor may have placed around your arm that is used to measure blood pressure. It's proven to be a very useful device for predicting and preventing cardiovascular disease, strokes, diabetes, kidney failure, eye disease etc. However, while it measures the blood pressure in your arm, known as brachial blood pressure in medical parlance, what we really want to know is the blood pressure around your heart, or your aortic central blood pressure. Until recently, the only way to find that out was to use an invasive catheter - basically a tube they stick into your body to reach the heart - and as such, this was typically done in a hospital. 

The SphygmoCor XCEL
However, in 1992, a company was co-founded by two clever guys and in 1994 they developed a device called SphygmoCor. It was able to take your brachial blood pressure (blood pressure in your arm) and mathematically derive your central blood pressure with a good degree of accuracy compared to the invasive catheter, in addition to a host of other useful measurements. The newest iteration of that technology called the SphygmoCor XCEL is in the cuff based form that GPs and patients are used to. The operator simply presses start, waits 60 seconds and all the data is fed to a computer.

As you might have guessed, I'm writing about all this because the device and its 8 patents are owned by AtCor Medical (ASX:ACG), which designs, manufactures and sells the SphygmoCor products all over the world with the help of distributors. Although I typically stay away from emerging biotech companies because they are often too speculative and too hard to understand, the risk/reward appeared compelling enough for me to buy 14,530 shares at $0.12 yesterday. I've actually been following this company since June or July last year, when shares traded at around $0.07 and I was very tempted to dip my toes in and buy some shares. My more intelligent friend purchased shares but regrettably I didn't, and I watched as the shares rocketed up to a high of $0.21 in October, before gradually dropping back to its current level. At a market capitalisation of $18.9 million, or $21.3 million assuming all options are exercised, I believe that this business could be significantly undervalued and will try to explain why. 

In the last decade, study after study has come out showing that central blood pressure provides more useful information than brachial blood pressure. Even though two people could have the same brachial blood pressure, their cardiovascular risk as measured by central blood pressure can differ significantly. Using central blood pressure helps doctors to diagnose people better, and a study has shown that it improves treatment too, since the better diagnosis allows them to prescribe fewer drugs to patients. In addition, pharmaceutical companies are able to develop more effective drugs with fewer side effects, cardiologists are able to better treat complex cases of hypertension (high blood pressure), renal physicians can improve treatment of kidney problems, and researchers are able to draw better conclusions in their studies. The list goes on. 

The body of evidence in support of using central blood pressure is growing every year, with over 100 new peer reviewed journals being published each year. At the forefront of this trend is ACG with its SphygmoCor technology, having been mentioned in over 700 per reviewed journals to date. As the first device to measure central blood pressure through a noninvasive method, it's been subject to a lot of scrutiny, and has held up quite well. So much so, that new devices are regularly compared to the SphygmoCor in academic papers to determine accuracy, and the management of Atcor labels its device the 'gold standard'. I am quite confident that this technology will eventually replace the old sphygmomanometers that only measure brachial blood pressure, but what I'm much less sure of is how long it will take. Some other important measures a SphygmoCor device can take include pulse wave velocity, heart rate variability and arterial stiffness, but I won't get into these (mainly because I don't understand myself)

Reflecting their usefulness, these machines do not come cheap, and although I am not sure about the latest figures, I believe they were being sold for $15,000 to $20,000 before. This is obviously why ACG has stunningly high gross margins of over 80%. Assuming they sell for $15,000, that means it only costs ACG $3000 to manufacture it. However, as a small company, administrative expenses, marketing and sales expenses, and research and development each away at a large portion of that gross profit. With a substantial amount of relatively fixed costs, ACG has a lot of operating leverage, which will supercharge profits when revenue increases, and vice versa. Only last year AtCor managed to report its first profit after many years of losses, and has had positive cash flow from operating activities for the last 6 quarters. Bear in mind however, that ACG has been receiving financial support from the government through grants and R&D tax concessions, and this will not continue indefinitely. Recent performance has meant the balance sheet is in much better shape than it has been in the past, with cash of $4.1 million and no debt. 

ACG's head office is based in Sydney, but it is in their American office that the CEO Duncan Ross resides. Why? Because for many years ACG has been focusing on driving penetration in the US market. Rich, developed nations that seek out the best technology are the perfect target for ACG, and America falls into that category. In addition, the majority of big pharmaceutical companies are based in America, and around 60-70% of ACG's sales come from selling devices to these companies for their trials. Astonishingly, as of late 2012, SphygmoCor had a 95% share of the market in this pharmaceutical trials sector and speaking with management on the phone, it seems Atcor's position may have even turned into true monopoly. Aside from providing higher quality data, one of the reasons for this is because ACG adds further value by offering data management services to pharmaceutical companies, which can be quite a hassle for these companies if they are running big trials. AtCor's exceptional service has led to a 100% retention rate in this market. Apparently one pharmaceutical company tried a competing product, in the end coming to ACG and saying that they regretted it. Management reckons that the market for selling these devices to pharmaceutical companies is US$110 million annually. With only single digit penetration so far, ACG would be hugely successful if it could continue to maintain that monopoly whilst take up within the industry heads higher, given its total sales were just $9.1 million last year. 

Unfortunately, the pharmaceutical trials market is quite lumpy, and delays in contracts has led to ACG's sales dropping 51% in their most recent half (56% on a constant currency basis), knocking the share price down a fair bit. Nevertheless, I believe that this is only a temporary hiccup that the market is too impatient to look past. Encouragingly, sales to US clinicians grew 77% in spite of uncertain market conditions. One major short term risk is that in FY13, $5.3 million out of AtCor's $9.1 million in sales were from just two customers (which I presume are pharmaceutical customers). This helps to illustrate how ACG's revenue could easily fall dramatically, as it did in the first half of FY14. Fortunately, results are expected to improve in the second half, and the pipeline of potential new pharmaceutical business is quite strong at more than US$16 million. 

The other three markets that ACG is targeting are the clinical specialists (such as cardiologists, nephrologists and endocrinologists), researchers (universities and affiliated hospitals), and the clinical - primary care market (GPs, internists, executive health, wellness centres). The research market has the smallest potential at US$22 million annually, followed by clinical specialists at US$100 million, pharmaceutical trials at US$110 million, and finally the clinical - primary care market at US$268 million. In total, the global market potential is around US$500 million annually. Penetration in the research market is 11%, while the other three categories are in the low single digits. As you can imagine, with its current margins, even if ACG manages to capture even 10% of that $500 million total, shareholders at the current price will do very well. Driving adoption in the specialists is particularly important, because general practitioners want to see that the specialists are using a procedure before they adopt it themselves. 

For years ACG has been trying to get the CPT code I, which means that Medicare in the US will reimburse clinicians every time they take someone's central blood pressure. Private payers, such as insurance companies, generally follow Medicare's lead on what they will reimburse for and how much. While AtCor managed to obtain a CPT code III for their technology a couple of years ago, this is a temporary code reserved for emerging technology/processes and is generally not reimbursed. I was told that the reimbursement rate for ECG, which is around $50 per test, would be quite a reasonable amount in the event that ACG gets the CPT I code (keep in mind there are variations based on geographical regions). At this level, the payback for doctors would be around 6-9 months, while the device can be expected to last around 4-5 years. I agree with management that these are very compelling economics, and one could expect sales to increase quite rapidly if this does eventuate. Although I am no expert on the approval criteria, it seems to me that success is more likely than not as almost all of the boxes have been ticked, and for what it's worth, management has a 'good degree of confidence'. ACG is expecting to file for a CPT I code later this calendar year with the backing of the Renal Physicians Association (who also played the same role for the CPT III) but even if it is approved, the earliest it could come into effect is 1 January 2016, so patience is required on this front. The existing CPT III code and the CPT I code will only apply to FDA approved products, of which there are only four, and only products that utilise the central waveform. Most competing devices that spit out numbers don't actually use the central waveform and therefore won't be covered by the CPT code. 

At the moment, there is very little competition in the US for ACG as most of its competitors are based in Europe and focus on selling their products into European countries, potentially allowing ACG to build up a decent first mover advantage in the US. This is partly due to the regulatory environment in Europe, which has a simpler regulatory regime than the US and therefore has lower barriers to entry. However, the European market for these devices is more reliant on the government than private payers, and as we all know, the government budgets for European countries are generally not too great at the moment. In addition, most of the European sales are made to researchers, which is the smallest market for central blood pressure devices. These factors help explain why AtCor hasn't been very profitable in Europe. Asia doesn't yet have a culture of funding healthcare and new technology, although this is gradually changing as the middle class grows. Recent regulatory approvals in China, Canada, Mexico and Korea should help boost sales, although are unlikely to be very significant in the short term. Excluding pharmaceutical sales (which are grouped in the Americas segment even though they are increasingly globalised), sales between Americas, Europe and Asia Pacific are fairly even, with America a little bigger than the other two. Over time, I believe governments will recognise that it is in their economic and social interests to adopt this technology. As Benjamin Franklin said, 'An ounce of prevention is worth a pound of cure', and this is very true of central blood pressure measuring devices. It is cheaper for governments and insurance companies to prevent people from developing serious complications by funding these devices than to spend years trying to treat people.

My main concern with ACG is its competition - if AtCor is unable to differentiate its product, it is quite likely that its gross margins will get crunched, or sales will simply stall. Regardless of competition, management expects gross margins to contract as clinical sales become more important as clinicians don't require all the extra features that researchers and pharmaceutical companies purchase. The bigger problem is that even though ACG markets itself as the gold standard, and has had its technology validated through many studies, the competition is catching up and may even be better than the SphygmoCor technology. Indeed, another listed competitor, Uscom (ASX:UCM) has recently started calling its central blood pressure measuring device the gold standard. This was in response to a study that rated UCM's Cardioscope II product as having more 'clinical applicability' than SphygmoCor. Bearing in mind that this study was only conducted by one researcher, who acknowledged the ratings were entirely subjective, and who did not refer to the product comparison at all in the rest of the paper, I was quite sceptical as to how much reliance should be put on this piece of information. Nevertheless, I quizzed management about it, who aside from pointing out the above, said that the main reason why the Cardioscope II and the Centron cBP301 were rated higher was because unlike the SphygmoCor they do not require a computer for data to be fed into. The requirement for a PC enables clinicians to keep a patient history and connect to AtCor's proprietary data management system, which is why AtCor believes it is actually an advantage rather than a disadvantage. 

Although that study may not be the best source of information to draw conclusions about the relative merits of each product, after reading dozens of other academic comparisons, I get the impression that while AtCor still provides more metrics than its competitors and has the overall technological edge, the accuracy of the data that its competitors do measure is quite close to the SphygmoCor. Another issue is the expiry of patents, some of which AtCor has had for a long time (patents generally last to a maximum of 20 years). Encouragingly, even though an important patent - the generalised transfer function (the mathematical model used to derive central blood pressure) - had expired three years ago, management says that the competition has so far been unable to fully replicate it. They also interestingly mentioned that one patent that ACG holds is unlawfully being used by a Japanese competitor called Omron Corporation, but since Omron is quite large, ACG has decided not to pursue a costly legal battle with them at the moment. Fortunately, most of AtCor's competitors are very small and are in a weak financial state (take a look at Uscom, which had sales of only $387,119 in their most recent half and will be out of cash in the next 6 months if they continue their performance). I was told by management that 'AtCor is well and truly the largest player', which is a little surprising given ACG is still a very small company itself. 

As you would expect, ACG isn't resting on its laurels and is developing new versions of its SphygmoCor technology that is tailored to each market (eg. one for researchers, another for clinicians etc). In addition, it has formed alliances with three other companies to either develop new products (one of which is due to be launched in July this year) or to help market the SphygmoCor XCEL to new segments such as urologists. AtCor is investigating complementary technologies, such as optimising pacemakers using central blood pressure and are also working on applications in cerebral vascular and intensive care medicine. I view all of these additional opportunities as an extra bonus if they do turn out to be successful, but in the short to medium term, all eyes will be on how well SphygmoCor goes. 

In terms of the people running the business, I don't have strong views one way or another. Duncan Ross has been CEO since 2006, when he replaced co-founder Ross Harricks, while the other co-founder, Dr Michael O'Rourke remains as a non executive director. Directors and executives hold a modest number of shares, and their compensation seems sensible to me. While progress since the IPO in 2005 has been slow, I think management have largely done as good a job as they could have, and am comfortable with them continuing to manage the business. Peter Manley, the CFO, was very generous with his time in answering the numerous questions I had by phone and email, so one might infer that the company's attitude towards shareholders is quite positive. Either that, or they've got too much time on their hands. 

To summarise this post before it drags on any longer, although there are most certainly substantial risks to investing in ACG, and it is definitely not a stock for everyone, I believe that the potential upside more than compensates for the risk. I won't present any singular valuation because the probabilities of various scenarios are too difficult to estimate with any reasonable degree of accuracy, but I'm confident that with even modest success in growing sales, AtCor will be rewarding shareholders quite handsomely. 


  1. This is an excellent piece of research, and I have no hesitance in saying that you just provided some really useful high quality content. However, I will add a couple of tidbits that I have that you don't/

    First, for GPs, blood pressure measurements are considered generally to be a blunt diagnostic monitoring tool, so for many aortic blood pressure is actually more precise than required. I do not dispute the increasing evidence that aortic blood pressure measurements can improve patient outcomes - I'm merely concerned that GPs are a long way from recognising.

    You have hit the nail on the head with your examination of the "payback period" required for aortic blood pressure, but I'm not sure what assumptions you're using in terms of how often the GP would choose to take that measure instead of merely checking with the old machine. At present, I'm skeptical about how quickly GPs will take up the new machine, although your argument that specialists might lead the way is a novel idea to me (and perhaps will turn out to be accurate).

    The other point I'd make is that I think the margins received from clinical trials are likely to be higher, in the long run, than margins possible for actual clinicians. That's because clinical trials and research probably requires more accuracy than most clinicians feel is necessary. After all, the accuracy of results in those setting is extremely important, but clinicians are using blood pressure measurements mostly as a monitoring tool - ultimately monitoring and diagnosis is just one part of clinicians' responsibility. Time pressed as they are, I can imagine many prioritising speed and convenience over accuracy, though it would appear that is sub-optimal for patients.

    Just some thoughts. I hope you don't mind if I link to this post on my website. I think the research is great! Just for the record I bought shares in Atcor last year at just under 10c and sold at 13.5c - giving you a rough idea of where I valued it last year.


    1. Hi Claude, thanks for your feedback! I'm not sure about the argument that aortic blood pressure it too precise - if SphygmoCor has been proven to significantly improve diagnosis of patients, and as long as the system and its data are simple enough for GPs to interpret, I can't see why they wouldn't prefer the device over traditional sphygmomanometers. In many areas where reimbursement for the device is nonexistent, GPs (albeit a small number of them) are purchasing SphygmoCor because they truly believe it's in their patients' best interests. However, I do share your concern that awareness of the technology is low amongst GPs, and Atcor may be forced to significantly ramp up its marketing spend in order to drive sales.

      In terms of the payback period of 6-9 months and the economic lifetime of 4-5 years, I'm simply quoting what management disclosed to me. Taking into account the cost of the device, the level of reimbursement and the payback period, you could work backwards and come up with a range of how frequently management expects GPs to use their device. And once again, the notion of specialists leading the way isn't my novel idea, this is the strategy that Atcor is taking with the explicit goal of eventually turning their full attention to GPs.

      Agreed on the declining margins. As I briefly mentioned in the post and as you say, the pharmaceutical companies and researchers generally purchase Atcor's more expensive models because they require more in depth data than clinicians. With increasing sales to GPs in the future, the product mix will change, margins will decline somewhat, but the impact on net profit would be more than offset by increased revenues. As long as decreasing margins aren't caused by the competition, investors should view the decline as perfectly acceptable. Of course, determining the impact of the competition will be very difficult unless you have management that is very honest about any contraction in gross margins.

      Glad to hear you did well out of ACG and I certainly wouldn't mind if you linked my thoughts. I didn't want to inundate readers with every little detail, but if you'd like more, just message me and I can forward the email response I got from Peter Manley.

      P.S Saw your interview on ACN today, very interesting!