Sector Rerating Has Cast A Shadow Over Penumbra Stock (NYSE:PEN)

Brain stroke

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One of the more time-tested pieces of investment advice is “don’t fight the tape”; I can (and have) complain all I want about how sector-wide valuations can be elevated (or too low), even unreasonably so, but it can take a long time for that process to correct. In the meantime, investors have the not-so-fun choice of either sticking to their well-established valuation principles (and seeing opportunities go by) or trying to pick and choose when to bend those rules.

I believe this is relevant Penumbra (NYSE:PEN) today. Down about 25% since my last update, the company has not underperformed to any meaningful extent. Instead, valuation multiples have come down for many high-growth med-tech names, with stocks like DexCom (DXCM), Inari (NARI), Intuitive Surgical (ISRG), and SI-BONE (SIBN) down around 15% to 20% as well, largely on market rerating.

None of this automatically makes Penumbra conventionally cheap – the shares do still trade at over 6x FY’23 revenue and the company will need to generate considerable revenue and cash flow growth over the next decade (and beyond) to drive attractive appreciation. I believe they can and will, though, and I think this may be a reasonable time to consider these shares again.

Double-Digit Growth, Even With Market Challenges

Between a stagnant U.S. stroke market and a vascular procedure market that has seen challenges from supply shortages (including contrast) and staffing challenges, Penumbra nevertheless delivered another quarter of double-digit growth in the second quarter, as well as better-than-expected gross margins.

Revenue rose 15%, just beating expectations. Neuro revenue rose more than 4% in constant currency, as the company managed to generate double-digit growth in the sluggish U.S. stroke market (suggesting share gains). The vascular business saw better than 24% growth, with Penumbra’s thrombectomy business growing more than 30% (compared to over 50% growth from Inari and 11% growth from AngioDynamics’ (ANGO) thrombectomy business).

Gross margin was down just 10bp from the year-ago period and up 180bp sequentially (to over 64%), as the company continues to do a good job of navigating pandemic-related disruptions, a new facility, and input cost inflation. Gross margin beat expectations by over a point, and operating income returned to a modest positive (a 0.8% operating margin).

Management’s guidance for the full year was on the low end of the prior range, mostly due to the impact of foreign exchange, and management did back a $1B-plus target for FY’23 (I was previously at $1.05B). Management also projected that gross margins could return to the high-60%’s and expand into the low 70%’s relatively soon as the company laps pandemic disruptions, works through supply chain challenges, and generates better operating leverage.

Refocusing REAL VR

As part of management’s discussion of financial guidance, they indicated that they intend to trim $10M from opex tied to the REAL VR business over the next 12 months. While management hasn’t given much detail on the spending to build this opportunity, they have said in the recent past that the company would be “meaningfully profitable” without the efforts to build this business.

To drive that opex reduction, Penumbra will be refocusing around the most immediate opportunities for the technology, including stroke rehab. This is a logical decision, and I think it is a good compromise between going full steam ahead on an unproven immersive health technology (unproven at least in terms of customer adoption and addressable revenue) and cutting off a potentially significant long-term revenue stream just to save on opex in the short term.

As a reminder, REAL VR is an immersive healthcare technology approach aimed at labor-intensive tasks like neuro rehab (stroke and neuromuscular disease), mental health (CBT, pain, exposure therapy), and motor/cognitive improvement. These are resource-intensive tasks for healthcare professions and between staffing shortages and budgetary concerns, many patients do not get the rehab they need. REAL VR can fill that gap, and while I think it will be years before this makes a positive contribution to Penumbra’s financials, I think it’s very worthwhile.

Looking For New Products To Revitalize The Growth Story

Penumbra has multiple irons in the fire that should maintain, if not accelerate, revenue growth and the company’s return to more substantial profitability.

In the international business, the company has launched Lightning 12 and 7 in Europe, as well as the Indigo in China. In the Vascular business, the company will have data on the first 60 patients in its STRIKE PE trial (using the Indigo to treat pulmonary embolisms) in October (at the PERT Symposium), and the STRIDE trial (using the Indigo for acute ischemia in lower extremities) should finish enrollment by year-end. The company is also working on launching vascular thrombectomy products for Japan – a potentially underappreciated opportunity given the demographics.

Penumbra is also getting underway with its THUNDER trial for the Thunderbolt. The main appeal of Thunderbolt is an ability to detect engagement with the clot and modulate the suction (12 times per second, I believe); this approach should reduce the frequency of clots clogging the aspiration catheter and allow for complete clot clearance in a single pass (and in a market where “time is brain”, speed matters). If the trial is successful, the device could get FDA approval in the second half of 2023 and give Penumbra a valuable tool for share gains in the stroke market.

The Outlook

I’ve done a little fine-tuning to my modeling assumptions for FY’22 and FY’23, but nothing that’s particularly material – my revenue estimates are now about 1% smaller than before and my operating margin assumptions are a little lower, but the changes aren’t too large. I’m still looking for long-term revenue growth in the low-to-mid-teens range, with FCF margins eventually approaching 20% (and above) as the business scales up.

Within these assumptions, REAL VR is still a huge unknown; this could become a highly profitable business for Penumbra in five-plus years’ time, or it could flame out. So too with coronary applications of the company’s technology; the CHEETAH study was quite encouraging, but the coronary market can be tough to crack. Last and not least, while some investors may be concerned by increasing competition in vascular markets, I’d note that the market itself is growing as more clinicians opt for mechanical (instead of medical) solutions.

I think it’s also worth discussing valuation in the context of the company’s outlook. Even though the market has historically paid around 5x to 8x for med-tech companies capable of growing consistently at a mid-teens to mid-20%’s rate (and sometimes upward of 10x for particularly attractive growth stories), multiples for many growth med-techs stretched out to the mid-to-high teens (12x to 20x) for similar growth between 2019 and 2021. Penumbra was one of those companies to enjoy an exceptional expansion in multiples and the rerating process over the past year or so has been painful.

The Bottom Line

By discounted cash flow, I believe Penumbra is priced for a high single-digit long-term annualized return – good, but not great. Using a growth-driven multiples-based approach (EV/revenue, as discussed above), I get a fair value of around $185 based on how the market has behaved over the last five years; a return to the expanded multiples of 2019-2021 would drive that target well past $250, while a return to the “old ways” would give me a fair value around $155.

There’s no science or exactitude when it comes to valuing stocks, let alone growth stocks, so there’s no set-in-stone answer as to what Penumbra is worth. That said, I think the rerating and share price decline has created an attractive opportunity and I think these shares are worth a closer look.

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