Description

Thesis

Covalon has good underlying medical device technology, but commercial success in the past five years has disappointed the market’s at-times elevated expectations. Headline results were messy since 2017 and conceal strong growth in Covalon’s core business in the US (revenue grew from $2 million in 2017 to almost $11 million in 2021). Underlying trends should become more apparent following the recent divestiture of AquaGuard and re-basing of the Middle East business. The 2020 appointment of Amir Boloor as Chairman (owns 3% of the company) brings the opportunity for a refreshed perspective on strategy and the cash from the AquaGuard sale (balance sheet is $25 million net cash vs. $58 million market cap) provides Covalon with the strength to invest in talent. Trading at less than 2x revenue, the stock is cheap relative to other growing medical device companies (for example, Sanara MedTech trades at 6x revenue).

Business Background

Covalon has three core businesses: collagen wound care, antimicrobial silicon, and device coating. The company divested its AquaGuard subsidiary in July 2021 for $38 million, transforming the balance sheet from $14 million of net debt to $25 million of net cash.

·         The collagen business treats difficult-to-heal wounds such as diabetic foot ulcers. This product is sold in the US and Middle East through distributors. There are many competitors in this business and the degree of differentiation is questionable, though Covalon has some studies showing superior wound healing with their product. Covalon’s product is made with fish collagen where peers use pig, explaining the success in the Middle East. Covalon claims their manufacturing process is differentiated and enables them to produce their product at a lower cost than peers. Most of the company’s $20-$25 million of revenue is from the collagen business and that business would be generating a few million of EBITDA standalone.

·         The antimicrobial silicon product is a higher-quality and more expensive alternative to acrylic tape for securing IV lines. Covalon’s product protects the patient against infection and is also gentler on the skin. 3M has something like 80% share in this market selling acrylic tape. Covalon’s patented design includes both silver and CHG antimicrobials on the tape – it is apparently difficult to manufacture a product with two antimicrobials. The company has initially targeted end markets with especially sensitive skin like pediatric and oncology.

Covalon had been attempting to cross-sell the antimicrobial product through the AquaGuard salesforce with limited success. Covalon retained the salesforce following the divestiture of AquaGuard and refocused exclusively on the antimicrobial product. In addition to the IV product, Covalon is placing a renewed focus on SurgiClear which disinfects incision sites prior to surgery. According to Covalon management, US hospitals are responsible for covering the cost of any hospital-acquired infections – insurance does not cover – giving the hospital a strong incentive to prevent infections.

·         In the device coating business, Covalon applies an antimicrobial coating to catheters to prevent infection. The coating essentially adds a feature to the device, facilitating upsell. For now, the business generates mostly consulting-type revenue from device manufacturers exploring the potential to integrate Covalon’s coating in their products. In 2018, Covalon announced a large agreement with a device manufacturer which, according to management, should be in production within the next two years. Covalon management says the agreement could generate $5-$10 million of annual revenue within the next five years. A chunk of the revenue from this agreement is royalty-type revenue and so should be very high margin. Regulatory approval for this agreement is still forthcoming and Covalon is uncertain to what degree the coated devices will replace the legacy uncoated devices in their partner’s sales.

On a headline basis, Covalon’s revenue track record is uninspiring, bouncing around the $25 - $35 million range over the past five years. But the consolidated figures conceal some important underlying trends.

By geography, a sharp decline in Middle Eastern revenue was offset by growth in the US. After significant success in 2017, Covalon discovered that their Middle East distributor was selling its own product in lieu of Covalon’s. Covalon cut ties with that distributor and is now rebuilding the business. Middle East revenue was up 90% in F’21 to $4.5 million. In the US, revenue was boosted by the acquisition of AquaGuard at the beginning of F’19 (added ~$13 million of revenue). This business was subsequently divested in F’21. F’18 US revenue also included about $5 million of one-time revenue related to the large device coating contract.  

If we look only at US revenue for the core collagen and antimicrobial businesses, the performance has been much stronger. Revenue grew from $2 million in 2017 to almost $11 million in 2021. Covid was a headwind because of reduced in-hospital procedures and diminished ability for the salesforce to make contact. Exiting covid, the collagen business is enjoying a tailwind from pent-up demand for wound treatment.

On an adjusted EBITDA basis, Covalon has been break-even plus or minus a couple million dollars over the past few years. Management expects the company to be essentially break-even in the near-term. The company is investing for growth and at maturity management says they should be above 20% EBITDA margins.

Covalon is a tightly-held company with the four largest shareholders controlling 54% of the stock. Long-time Directors Abe Schwartz and Martin Goldfarb own 31% and 16% of the company respectively. CEO Brian Pedlar and Chairman Amir Boloor each own a bit over 3%. Schwartz is a serial entrepreneur who had success as a public company CEO at Cedara Technologies in the early-2000s. Cedara was a software turnaround that roughly ten-bagged under Schwartz’s management. Schwartz and Goldfarb acquired most of their stock through 2013 warrant and convertible debenture financings. Schwartz had also minor participation in a 2017 financing while Goldfarb invested $2 million in 2019.

It doesn't sound like the company has any imminent plans to deploy the cash. The focus for the short-term is improving organic growth. Over-time, the company could look to use the cash for M&A or to fund operating losses to accelerate sales growth.

Valuation

At the current $2.25 share price, Covalon’s market cap is ~$58 million and the company has $25 million of cash. Excluding AquaGuard, Covalon generated just under $20 million of revenue in F’21 and appears set for continued growth in F’22 – the stock is trading for less than 2x revenue. The current revenue base includes only minor consulting sales from the device coating business and does not reflect the $5-$10 million of annual revenue that is possible from the large contract looking out a few years.

Peer Sanara MedTech sells collagen products and trades for 6x forward revenue. Sanara has a better execution track record and so deserves to trade at a premium to Covalon. At even 4x revenue, Covalon stock would double.

The company sold its AquaGuard business in mid-2021 for $38 million as part of a strategic review. Management says that the AquaGuard business carried limited IP and they believe that each of their other three core segments could be sold for more than $38 million. We must take this comment with some skepticism, but having just run a strategic process, the Board should have an idea of the potential sale value of their businesses. The stock is worth $5.50 (+130%) if each business were sold for $38 million.

The upside potential for Covalon is compelling. If management can deliver modest growth in the collagen business and get some sales traction with antimicrobial silicon now that the AquaGuard force is focused exclusively on that product, revenue growth could exceed 10-15% per year. In such a scenario, a re-rate from sub-2x revenue is likely. While uncertainty remains about the large device coating contract, additional confidence in the $5-$10 million of annual revenue could also drive meaningful upside for the stock. The downside is fairly well-protected through the $25 million cash balance (40% of the market cap) and strategic value of Covalon’s core businesses. Even at 1x revenue, there is only about 20% downside to the stock.

Catalyst

Good underlying organic growth trends become more apparent as the company starts to lap the AquaGuard divestiture.

Additional visibility and regulatory approval on the large device contract.

Hiring a new (and improved) CFO.