Perhaps this is a strange title to open with, paraphrasing one of Harold MacMillan’s more famous quotes. However, when considering the following investment opportunity, existing and prospective investors in Aortech (LON:AOR) should bear in mind that the true value of this company’s equity is not ‘outed’ in the traditional P/E ratio, or discounted cashflow model. Instead, it is the strategic IP (Intellectual Property) that the company possesses and which it has built up over many years that has the true value, as a number of sizeable US and European medical technology businesses will testify to.
I was very pleased to meet with Scotsman Bill Brown, recently appointed Non-Executive Director of AorTech International PLC, who, through Active Capital Trust PLC (Ticker: AIT), a listed investment trust managed by Bluehone Investors LLP, currently have an equity holding of approximately 18.45% of the business and who are one of the larger shareholders on the company register.
The Aortech business
Aortech develops and commercialises a range of specialised biostable polyurethanes coatings for medical implants which have strong patent protection and are branded as ‘Elast –Eon’ and its next generation Elast-Eon™ Carbonate Silicone (ECSil). The business model is based upon;
a) Attracting material supply agreements for the use of ‘Elast – Eon’ and next generation Elast-Eon™ Carbonate Silicone (ECSil) in third party medical device products;
b) Attracting higher margin component manufacturing contracts using the ‘Elast-
Eon’ material and next generation Elast-Eon™ Carbonate Silicone (ECSil);
c) Signing up-front license, milestone and royalty deals on AorTech ‘invented’ products, namely the revolutionary and patented polymer heart valve.
AorTech claim that ‘Elast-Eon’ and ‘ECSil’ have been designed to combine the biostability and flexibility of high-performance silicone rubber with the strength, tear resistance and abrasion resistance of polyurethane, to provide increased durability.
This leads to improved medical device performance in terms of reduction in costs and improved component performance.
AorTech expects to see the first human implantation of ECSil™ before the second half of 2012.
Three Reasons for share price appreciation
Interestingly, there has been quite a steep increase in the share price recently, something in the region of 50%. This has been linked to three recent developments:
Coming to America
The company has just completed a move of its manufacturing, research and development facilities from Melbourne, Australia to Rogers in the Minneapolis / St. Paul area of Minnesota.
Rogers is in the heart of what is colloquially known in the United States as ‘Central MedTech’ (or Medical Technology). There are a number of giant US based Medical Technology businesses based here – including Medtronic, 3M healthcare, EV3 Inc (now part of Covidien or Tyco Health in a previous existence), American Medical Systems and most importantly, St Jude Medical - as well as much of the ‘supply chain’ which supports these businesses.
Bill was quick to explain the move
“Prior to our move to Rogers in the United States, it was quite difficult for us to get the attention of new prospects, especially a number of the US ‘MedTech’ companies; we had a very long and strong relationship with St. Jude Medical and a number of European medical device manufacturers but it was not so easy for our prospective partners to visit our research and manufacturing premises in Australia. Now that we have moved, it would be fair to state that we have had a substantial increase in new US customer activity – it is now very easy for our prospective (and existing) clients to visit us and share with us some of their ideas and for us to show them what ‘Elast-Eon’ and ‘ECSil‘ can do for them.
“Our business has moved onto a completely new plain and we have exciting new relationships developing. I believe that we are now able to network freely with other ‘Medtech’ companies”.
Restructuring of Board
There has been a restructuring of the Aortech Board, whereby one current non-executive director – Eddie McDaid – has now moved into the executive finance director role and as previously mentioned, Bill Brown, representative of Active Capital / Bluehone investors (18.45% shareholder), was appointed in October of this year.
Eddie McDaid is also a 6.91% shareholder in AorTech and was previously one of the co-founders of the business in 1992.
The Scottish mafia has truly come to town and as my father used to say, wherever there is a Scotsman, there is the scent of money in the air!
Certainly, from an outsider’s perspective, it appears that shareholders and management interests are now very closely aligned.
St Jude Medical link and a $1.65bn Credit Suisse upgrade
St Jude Medical (http://www.sjm.com/) - an important Aortech customer and a $12.3 billion market cap business - has been recently upgraded by Credit Suisse due to its successful use of a coating, marketed as ‘Optim’, which acts as the insulation for all of its pacing products. The IP to this ‘coating’ is owned by Aortech and is known as ‘Elast-Eon’.
The upgrade to St Jude Medical potentially adds around $1.65bn to the market cap of this ‘MedTech’ goliath (equivalent to $5 a share).
Aortech, on the other hand, has a value 1/100th of the upgrade in value of St Jude Medical.
Aortech had been working with St Jude Medical for many years prior to the announcement that they made on the 20 March 2006
This is the first official notified agreement between both companies for an initial upfront payment of $2m for the exclusive licence and supply of ‘Elast-Eon’ otherwise known as ‘Optim’. Further maintenance payments were paid over the coming two years.
This was followed some years later by a further extension of the agreement by St Jude Medical on the 29 January 2009.
As more and more success was had with the ‘Optim’ coating, it was becoming clear that St Jude Medical was widening its scope for the usage of ‘Optim’ into a number of other products, as stated in my next section.
Most interesting, the following Aortech RNS directly quoted a Wall Street Journal article which highlighted the success that ‘Optim’ was having.
“That the company [St Jude Medical] told doctors that newer leads with a type of insulation…Optim – sold with Riata ST Optim and Durata leads – have demonstrated a better than 80% reduction in abrasion-related observations after 44 months compared with silicone leads.
St Jude Medical stated that it had converted 97% of its production to ‘Optim’.
St Jude Medical Product Portfolio employing ‘Optim’ technology
There are quite a number of existing St Jude products that have adopted the ‘Optim’ / ‘Elast-Eon’ product. It is anticipated that there will a great deal more prospective products currently in development between St Jude and Aortech which have yet to be announced to the market.
The following products currently employ ‘Optim’ / ‘Elast-Eon’:
- Riata® ST Optim® Defibrillation Lead
- Tendril® ST Optim® Pacing Lead
- Durata® True Bipolar, Active-Fixation Defibrillation Leads
- Durata® Integrated Bipolar, Active-Fixation Defibrillation Leads
- Durata® True Bipolar, Passive-Fixation Defibrillation Leads
- IsoFlex® Optim® Passive-Fixation Leads
St Jude Medical very recently launched and had approved its Unify Quadra(R) cardiac resynchronization therapy defibrillator (CRT-D) and Quartet(R) Left Ventricular Quadripolar Pacing Lead ‘The Quartet pacing lead’, which is built on the proven QuickFlex(R) u lead platform, featuring Optim(R) insulation.
A substantial amount of St Jude's revenues are generated within the Cardiac Rhythm Management (CRM) arena, which equate to over $3bn per year. Total group revenue is estimated to be $5.56bn for the year ended 31 December 2011. So, the CRM space is worth just under 54% of total group revenues.
As already stated, prior to employing Aortech’s ‘Optim’ / ‘Elast-Eon’, St Jude Medical had a large failure rate in their ‘Riata leads’ when using a more traditional silicon insulation coating.
It is possible that if St Jude Medical were no longer able to use the ‘Optim’ sealant in their CRM leads, their sales could be adversely affected.
Other Customer Contracts
It would be wrong for the prospective investor to assume that AorTech is a ‘one trick customer pony’ in terms of having only one ‘key’ customer. There has been a stream of new contract wins over the past two years with a number of unnamed customers, many of whom are almost certainly likely to be large global ‘Medtech’ businesses headquartered in the US.
The ‘Elast-Eon’ polymer is used in a US based customer who provides Urology Products (May 2010), a multi-billion dollar NYSE listed business providing a Neurostimulation implant /pain management device (December 2010), a non-exclusive licensing agreement has been signed with a leading multi-national orthopaedic firm for the first use of its Elast-Eon™ polymers in a next generation orthopaedic implant (January 2011) and a recently announced new contract with an unnamed “ large multi-national device / drug partner” for the use of company’s ECSil™ polymers in the field of medical sensors as well as new licences in Blood Glucose monitoring.
Unusually, AorTech did recently announce the name of a new client by signing a co-development and manufacturing agreement with Establishment Labs (www.establishmentlabs.com), a breast aesthetic (breast implants) speciality company based in Costa Rica. Establishment Labs will employ Aortech’s patented second generation ECSil™ polymer.
It is very likely that more contract announcements will be announced in the coming months based off the back of Aortech’s successful move to Minnesota.
New Projects announced to the market
The interim results announced on 14 December 2011 were also quite revealing in that they, for the first time, shed light on new projects that Aortech is involved in. This included long term indwelling catheters, coronary artery grafts, AV fistula (Arteriovenous fistula - an abnormal connection or passageway between an artery and a vein) and pacemaker headers.
The company also announced two new areas which hold promise for the expansion of applications for the ‘Elast-Eon’and ‘ECSil’ polymers in the area of devices requiring specific gas and water vapour transmission rates as well as a drug elution programme requiring the formulation of a proprietary polymer capable of eluting a combination of a licensee's drugs at a specific rate.
Assistance moving to America
Interestingly, within AorTech’s final results which were announced in early August that the
“…total cost of this strategically important move [to Rogers, Minnesota] is expected to be $1.8 million, which will be fully funded from payments that the Company will receive following the restructuring of certain customer licences (amounting to $4.2 million)”.
Aortech has never formally announced which customer(s) “restructured…their licence” but without this customer’s assistance, it is likely that the move to the US would not have been possible perhaps without further funds required from shareholders.
In addition, the company has also sublet their new research and manufacturing facilities in Rogers, Minnesota, from St Jude Medical.
This was highlighted in a recent planning application to the local authorities in Rogers.
Polymer heart valve – Termination of $32m Co-development agreement
In July 2007, Aortech announced a licensing and supply agreement for the evaluation of ‘Elast-Eon’ by a global device company, rumoured to be one of the large US ’MedTech’ businesses. This agreement
“allowed the licensee to acquire certain AorTech intellectual property rights and encompassed potential milestone payments of up to $32 million”.
The Agreement between AorTech and the licensee has recently been terminated by mutual consent with AorTech. Aortech will re-acquire all of its Patents, supporting data and its IP at the end of this notice period, stated as 1 March 2012.
It is believed that there is substantial value in this IP above the $32m stated by AorTech and that it is “a key driver(s) to creating shareholder value” in the long-term.
AorTech have indicated that in order to develop this valuable IP it may follow a number of possible routes which could include
“licensing, forming a joint venture development company or raising capital through a special purpose vehicle set up for the project. The US market has provided capital to a number of early stage heart valve companies”.
Possible AorTech Strategic Review
When asked what the “strategic path of the company“ might be in the medium term, Bill was quite guarded but he was happy to state that the Board were certainly looking at a number of options moving forward which could include possibly involve selling the business or parts of the business, to a third party(ies) or simply carrying on developing the business by leveraging off the great success that has been generated since moving to Rogers.
There can be no doubt that Aortech possesses extremely attractive and important IP which is embedded / developed in a large number of medical applications. It is very likely that there will be interest in the company should there be a decision to look to ‘sell on’ the business from any number of ‘MedTech’ businesses, not just in the United States but also in Europe.
The company makes reference in its recently announced interim results that
“The Board recognises that the Group's intellectual property portfolio and its applications will be of increasing interest to a number of other medical companies”.
However, it is possible that there is also the strong option of continuing to build on the long standing relationships which AorTech has developed with its client base, including St Jude Medical et al by developing more prospective business with new US based ‘MedTech’ companies in the St Paul / Minneapolis conurbation. Clearly, the company is developing a much higher profile and has an enormous array of options available to it.
Active Capital Trust – 18.45% strategic shareholder
Active Capital Trust has stated that “The Company aims to realise value from the Company’s portfolio of investments and progressively return cash to Ordinary Shareholders.
There will be a continuing evaluation of the portfolio in order to assess the most appropriate realisation strategy to be pursued in relation to each investment”.
Bill was quite candid and in his Scottish burr confirmed:
“Yes, the investment trust is looking to wind up and pay funds back to its shareholders by August 2013. What I must stress to existing and prospective shareholders in Aortech is that we (Active Capital Trust / Bluehone) will be extremely focused on AorTech’s shareholder interests over the short / medium term. We wish to be seen as a ‘guardian’ for all shareholder interests and that nothing will be done without strong consideration to all shareholders interests”.
The company has recently announced solid interim results for the half year ending 30 September 2011 highlighting a maiden pre-tax profit of $626k (loss of $1.619k, 2010) before exceptional items of $464k which relate directly to the move from Australia to the US. Finance income of $122k was also received leading to an operating profit of $284k after exceptional items.
Group revenues were $2.64m ($1.03m, 2010) and group cash is showing a healthy balance of $2.258m at the half way stage.
Bill made further comment
“There are our first results denominated in US$; as you would expect, almost all our revenues are generated in dollars now and all our expenses (in terms of manufacturing and research) are also denominated in the same currency. So, it made perfect sense to re-denominate our reporting currency from sterling to the US dollar”.
“We also expect to boost our cash balance yet further with an additional $2m for previously announced re-structured licences which should be received before the year-end (31 March 2012)”.
As you would expect of a “high-tech” business, there is no debt in the company.
Unfortunately, there is no recent broker forecasts in the market at the time of writing (Aortech’s broker and NOMAD is Evolution), although I am reliably informed that a new note is due out soon. As such, there are no up to date financial forecasts available in the market for 2012 and 2013.
It’s not all rosy in the garden…..
Despite the great deal of positives surrounding the Aortech story, prospective and existing investors should be mindful that there are still risks associated with this investment; the shares are highly illiquid, with a large dealing spread and the company also has a record of perpetual operating losses until the recently announced interim results.
Interestingly, the company has a history of failing to meet market expectations in the past, having being described as “one of Scotland’s great technology white hopes” a decade ago (the company originally developed and manufactured ‘Elast-Eon’ in Scotland until 2004 when the operation was closed down and moved to Australia) with a history of over-estimating early potential revenues. Most importantly, there has been a much slower than anticipated take-up of ‘Elast-Eon’ by US ‘MedTech’ businesses who had a preference for ‘local’ US suppliers as opposed to suppliers who were more inconveniently located geographically.
Finally, the Executive management team have had a patchy record in terms of formulating good commercial deals, although this is beginning to unwind now with the restructuring of previously agreed licenses in favour of the company – an additional $4m will have been received during this current financial year from re-structured license agreements.
So, clearly, this is not a stock for ‘widows and orphans’ as risks still exist. DYOR.
Aortech International PLC appears to be at a real watershed moment in its development; the recent move to the US is an extremely sensible and strategically correct decision for the company to make.
There have been other positive actions by management – notably by Frank Maguire (Chief Executive Officer) who very recently (August 2011) purchased 25,000 shares in Aortech at £1.92 equating to a total personal cost of £48,000. This clearly shows considerable confidence in the company’s future success.
It is also important to state that the two board changes in August and October 2011 represent shareholder interests of approximately 25.36% of AorTech’s shareholder base. This is also key to what may occur in the coming months / year ahead; shareholders have certainly been taken on quite a roller coaster ride over the preceding fifteen years or so but it is now clear that AorTech has extremely valuable IP to a number of large ‘MedTech’ businesses. It is possible that this value may be ‘outed’ very soon.
Aortech is a compelling investment opportunity supplying cutting edge medical materials, protected by strong patents supplying blue chip clients in proven medical devices already generating sizeable revenues for end customers. Should the company ever ‘come into play’, there could be interest from a number of parties for a whole host of strategic reasons.
This is an interesting story which has yet to unfold. The company is still greatly misunderstood and unappreciated by the market. Perhaps Aortech’s time in the limelight will soon come.
Disclosure of interest: The author, Simon Murphy has a direct investment in Aortech International PLC.