EP52: Hearts Afire
EP52: Hearts Afire
Stock Ideas From Investment Professionals
Welcome, subscribers! Today, we share pitches for two SMid caps, one in medicine and one in technology—plus four ideas from two of the most famed investors of all time.
Read on to learn more. 📕👇
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Headwaters Capital Management provided detailed theses for two new positions in their latest investment letter. TransMedics (TMDX) is the leader in a new technology used to preserve organs in the organ transplant process. Insight Enterprises (NSIT) is an IT services integrator that should benefit from increasing IT complexity/intensity. We include an extended excerpt of both theses below but encourage you to click through to read their entire letter.
TransMedics: “Heart in a Box” Technology Revolutionizing the Organ Transplant Industry
Summary Thesis
1) Organ Care System drives market share gains through displacement of existing cold storage standard of care; market share gains supplemented by overall market growth as technology enables increased utilization of existing donor pool combined with expansion of donor pool.
2) National OCS Program removes barriers to adoption and drives transplant center efficiency, serving as the catalyst for transplant center acceptance.
3) Recent manufacturing capacity expansions combined with upcoming investments in a dedicated logistics network represent an inflection point for adoption.
4) Broad support from all stakeholders as OCS technology improves patient outcomes, lowers cost of care for hospitals/insurers and drives increased volumes at transplant centers.
Company Overview
TransMedics (“TMDX”), headquartered in Andover, MA, is a leader in normothermic machine perfusion technology utilized for organ preservation during the organ transplant process. TransMedics’ Organ Care System (“OCS”) is an FDA approved portable organ perfusion system that is designed to replicate near-physiologic conditions for donor organs outside of the human body. The OCS pumps (perfuses) warm (normothermic), oxygenated blood through organs attached to the system, which enables extended organ retrieval distances along with assessment and optimization of donor organs during transport. By replicating the physiologic conditions of the body, the OCS systems improves post-transplant outcomes and facilitates increased utilization of donor organs. The OCS device is approved for use with lungs, hearts and livers and is the only FDA approved device for multiple organs.
To support broader adoption of the OCS technology, TMDX has designed a National OCS Program (“NOP”), which consists of on-staff surgeons and perfusionists located in 16 cities across the country who can procure and deliver donor organs to recipient hospitals. The NOP effectively serves as an outsourced procurement and logistics network for transplant hospitals, which increases surgeon capacity. In addition to the efficiency gains, the NOP network also lowers barriers to adoption of the OCS technology as hospitals are no longer required to purchase the machine nor train staff to use the console.
Organ Care System: Improving Organ Donor Utilization
Due to limitations on geographic transplant distance and reluctance to use extended criteria organs, organ donor utilization rates have remained stubbornly low. This has led to poor outcomes for patients on transplant waitlists and excessive costs for the healthcare system while patients remain on the waitlist. Prior to FDA approval of the TMDX OCS console, static cold storage was the industry standard for donor organ transportation. After donor organs were procured by the recipient transplant center, they were placed on ice in an Igloo cooler for transport back to the recipient hospital. This static cold storage approach deprived the organs of oxygenated blood and subjected the organ to ischemia, or time-dependent injury due to a lack of oxygenated blood. Ischemia risk from cold storage limited the time a donor organ could be maintained outside the body to 4-6 hours, thus restricting the geographic distance between donors and recipients. Additionally, diagnostic tests and therapeutic treatments could not be performed on the organ since the organ was not metabolically active during cold storage. As a result of these limitations, marginal organs were unutilized because transplant centers could not ensure optimal posttransplant outcomes. The cold storage standard of care has been a key factor that has resulted in surprisingly low organ donor utilization rates: 18% for lungs, 27% for hearts, 62% for livers.
TDMX’s OCS system eliminates many of the variables that cause low utilization of donor organs. The perfusion of warm, oxygenated blood minimizes the ischemia risk and extends the amount of time an organ can be held outside of the body prior to transplant. This enables broader geographic matching of donors, a significant limitation for organ utilization prior to the OCS technology. Additionally, by placing the donated organ on the OCS system, transplant centers can assess the viability of the organ through diagnostic tests and can even perform therapeutic work to improve post-transplant outcomes. This has served to increase the use of marginal organs, or extended criteria organs, which has improved overall donor utilization rates. Data from TMDX’s clinical trials exhibits how the OCS technology significantly increased donor organ utilization.
The most profound impact of OCS technology on extended criteria organs has been through the expansion of the donor market through utilization of donation after circulatory death (“DCD”) organs. Prior to the availability of OCS technology, donor hearts were only available from donation after brain death (“DBD”) donors given that hearts that stopped beating (DCD) were considered too risky for use in transplantation. With the approval of the OCS technology, DCD hearts can effectively be brought back to life with the TMDX system. Use of DCD hearts has expanded the pool of available donor organs and has contributed to the growth in total heart transplants.
NOP Supporting OCS Adoption, Surgeon Capacity Expansion
The OCS technology is clearly an improvement upon the cold storage standard of care for organ preservation, however adoption of the technology was slow prior to TMDX’s launch of the National OCS Program. Hospitals were hesitant to spend CAPEX on the OCS system given high costs and uncertain utilization of the machine. Additionally, usage of the console required training of staff, which further increased the cost of ownership and negatively impacted transplant center efficiency. By introducing the NOP, TMDX removed these barriers to adoption: hospitals avoid the CAPEX required to purchase the console and training of staff is no longer necessary. Removing barriers to adoption was important, but the efficiencies gained by transplant programs through utilization of the NOP have served to further increase market acceptance of the OCS technology. Transplant centers that utilize the NOP no longer dispatch transplant teams to procure organs, which effectively doubles the capacity of their transplant teams. Importantly, all NOP costs are reimbursable, which means that the profitability of the transplant center is not impacted by utilization of this service. Utilization of the NOP has increased from 47% of all TMDX transplants in Q4 2021 to 89% of all cases in Q1 of 2023. Going forward, the NOP will likely account for the majority of TMDX’s volume.
The significant growth of the NOP in 2022 has led to logistics constraints for the company. Currently, TMDX utilizes private jet brokers to arrange planes for organ recovery and delivery, which adds significant costs to the process. More importantly, TMDX has outgrown this brokerage network as the capacity of available jets is running low. Given projected growth of OCS adoption over the next few years, TMDX believes demand will exceed brokered jet capacity and has made the decision to build its own air transportation fleet. Through the issuance of convertible notes in May 2023, TMDX raised $400mm which will be utilized to either buy or lease a dedicated fleet of private jets. Control of the logistics network will not only enable more efficient transport of organs, it will also lower the logistics costs for transplant centers as brokerage fees and rental fees to plane owners will be eliminated. The efficiencies and cost savings that the NOP will enable for transplant programs should drive even faster adoption of OCS technology. While the OCS is the core technology improving transplant outcomes, the NOP will enable adoption of the technology and serve as a barrier to entry for future competitors. The cost to build a competing network combined with uncertain utilization is likely to deter competitors from replicating the TMDX NOP, which is poised to have a significant first mover advantage compared to peers.
Competition
The competitive environment for TMDX is fragmented and consists of both direct competition from companies with NMP devices as well as indirect competition from other technologies. TMDX is the only company with FDA approval for a NMP device for multiple organs and is the only company with a complete procurement and logistics network (following acquisition/lease of jets). As such, TMDX is the clear industry leader and I believe the combination of superior technology with a robust service component will enable the company to maintain its lead over potential competitors. A summary of the competitive landscape is outlined below.
1) XVIVO: FDA approved NMP device for the lungs and recently received FDA approval for a clinical trial in hearts that will utilize hypothermic machine perfusion. Similar to TMDX, XVIVO has a competing organ recovery service, Star Teams, that they acquired in 2021. STAR has 8 thoracic surgeons on staff and only offers lung and heart retrieval. During Q1 ’23, XVIVO retrieved 146 organs, or 1/3 the volume that TMDX’s NOP platform procured during the same time period. STAR’s reception in the market demonstrates viability of the outsourced organ retrieval business model. Interestingly, XVIVO announced a private jet partnership in early July 2023 (5 planes), also noting that logistics capacity would be critical to future growth. XVIVO currently has $18mm of cash on hand and likely needs to raise significant capital in order to compete with TMDX. The commercial viability in 3 organs along with a scaled service offering provides TMDX a significant first mover advantage relative to XVIVO.
2) OrganOX: FDA approved NMP device for livers. Limited funding prevents commercial viability today.
3) Hypothermic machine perfusion (“HMP”): Paragonix has an FDA approved HMP device for hearts and there are multiple companies with clinical trials in the organs that TMDX targets. HMP technology supplies oxygen to the transplant organs, which can extend ischemic times. From a commercialization perspective, the key question is whether the organ performs better post-transplant when preserved at lower temperatures than experienced in the body. Current research suggests that normothermic conditions are better for extended criteria organs, at a minimum. Per Paragonix’ website, their HMP device is only approved for 4 hours, which is the same time allowed for transplant using existing static cold storage, which does not solve the geographic limitation on donor/patient matching.
4) Normothermic regional perfusion (“NRP”): A process that involves restarting the heart inside the body to naturally perfuse organs. This technique bears watching as a potential competitive threat to TMDX. However, there are ethical questions surrounding this process and NRP does not solve the geographic limitations that TMDX’s OCS system solves.
Insight Enterprises: Architect and General Contractor Enabling Digital Transformation
Summary Thesis
1) Ongoing IT innovation and increasing IT complexity serve as secular tailwinds for NSIT’s solutions integrator business model.
2) Market share gains driven by scale of product distribution, breadth of vendor relationships and depth of IT expertise.
3) Margin and ROIC improvement from portfolio mix shift to a greater proportion of software and services revenue, augmented by specific margin improvement efforts in each product line.
4) Multiple expansion potential as revenue contribution from higher margin and less cyclical software and services revenue grows.
Company Overview
Insight Enterprises (“NSIT”) is a technology solutions integrator serving Fortune 500 companies globally. NSIT defines solutions integrator as a partner that can leverage technical expertise to deliver products, software and services that solve a client’s needs. I think it is easier to think of the company as an end-to-end enabler of digital transformation for large corporations. NSIT’s team of 4,500 IT experts can provide upfront consulting services to design a project roadmap to solve a client’s IT needs. NSIT then leverages the company’s roots as an IT reseller, where it’s relationships with over 6,000 OEMs and expertise with supply chain procurement and customization is a key differentiator versus traditional consulting firms. NSIT’s IT experts can then implement the project for the client and provide ongoing maintenance services following completion. This full life cycle management differs from pure IT resellers who don’t have the technical expertise for complex projects and from pure consulting firms who don’t have the supply chain procurement expertise. Specific digital transformation focus areas for NSIT include cloud migrations, infrastructure modernization, cybersecurity, modern apps and data/AI.
A representative project helps to provide a more concrete overview of the business. NSIT has used the example of a global airline that is introducing in-flight payments for food and beverage (slightly dated example, but helpful in understanding the business). While this seems like a simple project, it is far more complex than it appears on the surface. NSIT might be engaged upfront through a consulting project where the company’s IT experts can provide advice on appropriate hardware and software for the project. NSIT would then be hired to procure the hardware and customize the devices with credit card readers and customized corporate packaging. Devices must also be configured with software that ties into existing corporate systems as well as cybersecurity protection. Given the volume of devices for a project of this size, customization is performed at one of NSIT’s integration centers. Once the devices have been configured, NSIT handles the distribution of these devices globally. Finally, NSIT can manage the maintenance and replacement of these devices once they have been distributed. In this example, global scale, product breadth and supply chain management are critical to this complex IT solution.
Like the example above, NSIT’s business has historically revolved around procurement, customization, and management of client devices (laptops, desktops, etc). However, through a series of acquisitions and internal human capital development, NSIT has built a team of IT experts focused on consulting and implementation for data centers and cloud migration. Cloud migrations, specifically, are complex projects that require upfront consulting engagements and the procurement of multiple hardware, software and infrastructure products. Following implementation, these IT projects carry more back-end maintenance and service revenue for NSIT. As discussed in detail below, this shift to more software and services will benefit margins and ROIC going forward and is a critical piece of the NSIT investment opportunity.
IT Distribution Industry & Competitive Positioning
The solutions integrator business model is a bit of a gray area in the IT distribution and services landscape. NSIT has overlap with customers/competitors in the IT reseller space, IT distribution, business process outsourcing and IT consulting. NSIT’s differentiation lies in its IT reseller background combined with a deep pool of IT experts. Converge Technology provides a good overview of the competitive landscape and where each company fits in the value chain.
NSIT’s role in the IT value chain is important to both vendors and customers. NSIT serves as an outsourced sales and implementation provider for OEMs, who can’t profitably operate a competitively scaled sales and service infrastructure (especially smaller OEMs). From a client perspective, NSIT offers a similar outsourced service in that they provide objective consulting, procurement and implementation expertise to customers across an extensive range of products (6,000 OEM relationships). As the IT landscape becomes more dynamic and complicated, the broad expertise of NSIT’s IT specialists only grows in importance. NSIT noted that an average project has ten different partners, which highlights the value that NSIT can provide to both OEMs and customers via coordinating these complex digital transformation projects. Hence the construction analogy: NSIT serves as the architect on the project upfront and then acts as the general contractor, overseeing the implementation of the roadmap through to completion.
The IT solutions market is highly fragmented, with the top 4 players representing only 10% of the market.
NSIT has a significant scale advantage relative to the fragmented set of smaller competitors, which is even more important for large corporate customers. Smaller competitors do not possess the geographic footprint required to serve these global customers. Additionally, few companies have the breadth and depth of NSIT’s vendor relationships, again positioning NSIT well when serving the diverse needs of large corporations.
CDW is the closest competitor to NSIT, but primarily competes in the SMB space and doesn’t have significant overlap with NSIT in the large corporate market. CDW’s focus on SMB enables higher margins and lower working capital requirements as payment terms are shorter for SMB customers versus large enterprises. Smaller publicly traded peers and a fragmented landscape of private competitors that typically have a specific vendor or customer relationship present limited competition for NSIT in the large enterprise space.
Given the fragmented competitive landscape combined with the sheer size of the market, the industry has historically seen steady consolidation. Acquisitions are strategically attractive as smaller companies often fill product and/or geographic gaps, thus increasing the scale advantage of larger players. Additionally, M&A is financially accretive as there are often significant expense synergies realized through consolidation. IT Industry Growth Through a cycle, IT industry growth generally outpaces GDP by 200-300bps. Although backward looking, CDW provides good data on historical IT spend that has averaged ~6%. Given a growing focus on broad digital transformation combined with growing complexity in the IT landscape, I would expect this to be a floor growth rate for the industry going forward.
Valuation
As this portfolio transition materializes, I expect investors will reward the company with a higher multiple. NSIT has historically traded in a range of 8-10x EBITDA compared to CDW, which has traded in a range of 13x-18x. CDW has a structural advantage over NSIT by serving the SMB segment, which allows for better pricing, higher margins and more favorable payment terms. As such, I don’t expect the valuation gap to CDW to close entirely. However, I do believe that NSIT could easily trade in a 10x-12x EBITDA range over the next few years as the quality of the portfolio improves and returns on capital grow. Assuming a 10X EBITDA multiple on 2027 EBITDA $783mm (6.5% margin), yields a price target of $260, or a +16% annualized return from today’s price. A 12x multiple on 2027 EBITDA yields a price target of $322, or a +20% annualized return. EV/EBITDA is the appropriate valuation metric given that NSIT’s balance sheet is under-levered compared to peer CDW, which operates with leverage between 2- 3x, thus boosting EPS. Optimization of NSIT’s capital structure through a combination of M&A/share repurchases provides an opportunity for further EPS growth.
Summary Thesis
NSIT is effectively a tax on the secular growth of IT spend combined with increased complexity of IT deployments. The advent of cloud delivery, specifically, has increased IT complexity as this drives a need for decisions around onpremises v. off-premises (or hybrid) and coordination among multiple hardware and software vendors. NSIT’s role as a solutions integrator becomes more important in this dynamic technology landscape as clients increasingly rely on outside IT experts for advice and management of a complex network of vendors. While the secular growth drivers are attractive, the opportunity for NSIT’s stock lies in an improved financial profile as growth from higher margin software and services revenue outpaces hardware revenue growth, leading to structurally higher profit margins and higher returns on capital. Over time, I expect the improved financial profile of NSIT to materialize into a higher multiple for the business.
Greenlight Capital added to two small positions in the quarter, NET Power (NPWR) and Onex Corporation (ONEX-CA). NET Power is a clean energy company focused on carbon capture technology. Onex is a private equity/credit fund manager. They briefly detailed both theses in their latest letter.
We added to one small long position and initiated another small long position during the quarter.
NET Power (NPWR) is a clean energy company with carbon capture technology that captures about 97% of the CO2 emissions in natural gas plants. It became public this quarter through a SPAC. What could be less popular than that these days? We think that just might be part of the opportunity. We believe that carbon capture will be a large market and NPWR has strong backing. The CEO is Daniel Rice, and he and his family have been extremely successful in the natural gas industry. The company has partnered with Occidental Petroleum, Constellation Energy and Baker Hughes. NPWR is in the early stages of its commercial deployment and if it doesn’t work out, the downside is more than we would usually stomach. However, the upside also appears to potentially be a multi-bagger and we have managed our risk by sizing the position appropriately. We established our position earlier in the year around the public offering for an average price of $10.10 per share. NPWR ended the quarter at $13.00 per share.
Onex Corporation (Canada: ONEX) is an alternative asset manager focused on private equity and credit. We acquired our current stake at an average price of C$70.96 per share. In addition to managing third-party capital, ONEX makes substantial investments in its own deals. At the end of the first quarter, its direct investment portfolio was worth C$130.25 per share, without ascribing any value to its nearly $35 billion of third-party fee-generating assets in the asset management business. The market has been disappointed with (1) the challenges in raising new capital for the company’s next flagship private equity fund, and (2) modest third-party asset management segment losses before carried interest. However, ONEX’s long-term track record is attractive and the asset management business is likely to generate future profits on third-party capital, inclusive of carried interest. Management appears to be attuned to the discount in the stock price and has begun aggressively repurchasing shares. ONEX ended the quarter at C$73.17 per share.
Third Point provided an update on two of the fund’s biggest holdings, Danaher (DHR) and Shell Plc (SHEL). Both mega-caps have underperformed the market so far this year, but Dan Loeb and his team still believe they represent compelling opportunities.
Equity Position Update: Danaher (DHR)
Danaher is our longest held investment and remains a top five position. Danaher has underperformed the S&P 500 this year due to a slowdown in the bioprocessing industry and more cautious spending by biopharma customers. Bioprocessing is a key end-market that drives more than a quarter of Danaher’s profits. Bioprocessing products are the main inputs that biopharma companies use to manufacture biologic drugs, which are the fastest growing category of drugs, growing low-to-mid-teens and representing a sizeable portion of the clinical pipeline.
The bioprocessing industry experienced significant growth in 2021 and 2022, driven by Covid vaccines and a strong biotech funding environment. Several participants, including Danaher, lowered their 2023 growth outlook in large part due to customer inventory destocking and biotech funding weakness. We anticipate that this slowdown is temporary, and the bioprocessing industry will return to normalized growth of high-single digit to mid-teens in 2024 and beyond.
Danaher has created significant value over decades through its unique operating system and superior M&A, and its low leverage balance sheet should allow it to take advantage of depressed valuations in the life science tools sector to continue to add to its portfolio. More importantly, Danaher stands to benefit from the surge in new projects and drug discovery spending occurring in the post-Covid world. Danaher’s Biotechnology and Life Sciences segments are poised to accelerate from data analytics and computational biology, which will grow meaningfully as AI and eventually quantum computing technology advance. We would not be surprised to see Danaher’s growth rate move from high single digits to the low teens over time, implying a long runway for Danaher’s business and stock price to increase sustainably while they enable the discovery and manufacturing of key life-saving drugs.
Danaher is on track to spin-off its Environmental & Applied Solutions division in Q4 of this year, which marks the last step in the company’s transformation into a pure-play life sciences tools and diagnostics company. The spin-off, to be named Veralto, has a strong ESG profile with well positioned assets in the high growth areas of water quality and product identification end markets. As a stand-alone public company, Veralto will benefit from tailored capital allocation and meaningful inorganic investments.
Equity Position Update: Shell Plc
We initiated a position in Shell in the summer of 2021 and highlighted the company’s significant discount to intrinsic value as well as to US-listed peers after decades of poor performance. While shares have performed well since we initiated the investment, the company still trades at staggering discount to intrinsic value and represents a compelling investment at current levels. We initially argued (and still believe) that the fastest path to improved performance and better valuation would be a separation of Shell’s business units to better attract shareholders and improve accountability, the latter of which was essential when the company was in the hands of executives who had demonstrated virtually no focus on shareholder value creation.
The most important change at Shell over the past two years has been the upgrade in the management team, with the appointments of Wael Sawan as CEO and Sinead Gorman as CFO. They have demonstrated an unwavering commitment to shareholder value, capital discipline, and improved returns. At their recent analyst day, Mr. Sawan stated “underpinning all that we do will be a ruthless focus on performance, discipline, and simplification.” It was the third time they used the term “ruthless” in their presentation, sending a strong message to shareholders.
Mr. Sawan and Ms. Gorman are backing up their words with actions. In their brief tenure, they have already cancelled several projects with poor return profiles, eliminated meaningless targets that in many cases were divorced from economic value creation, and made it abundantly clear that Shell’s highest priority is generating a return for its investors by increasing shareholder distributions and paring back capital spending.
At just 7x consensus earnings, we see significant further upside in the stock. Enhanced focus and discipline will allow Shell to generate mid-teens shareholder returns via cash flow per share growth and dividends through the end of the decade, with additional upside from potential portfolio actions. While Shell has so far insisted on maintaining its conglomerate structure, we see positive signs that it has arrived at a coherent and compelling strategy for value creation and believe the company is in the right hands to materially improve its standing relative to peers.
Until next time! - EP