Description

Tactile Medical is a medical technology company focusing on treating underserved chronic conditions at the home.  The company has two main products 1) Flexitouch to treat lymphedema (chronic swelling in the arms, legs, and neck) and 2) Afflovest a vest for airway clearance for patients suffering from bronchiectasis and cystic fibrosis.  The Afflovest has a differentiated product and sales model from its competitors requiring much lower operating expenses than the traditional model with higher returns which is being overlooked by the investor community. 

Medical technology companies normally have a vertically integrated salesforce which sells to doctors, clinicians as well as staff to take care of customer returns, to properly train patients how to use the device and to make sure the patient has adequate reimbursement.  Tactile Medical has this infrastructure for its Flexitouch product to reach the vast patient population.  It is estimated that there are millions of people living with lymphedema in the US and ~1.4mm patients (according to TCMD) were diagnosed with lymphedema in 2020, up 10% from the prior year (TAM of $5 billion).  In order to reach this massive population, revenue growth must be supported by increasing numbers of sales people as well as reimbursement professionals.  In 2019, before covid hit, peak Tactile EBIT margins were 6.1% (EBITDA margins of 13%) for a product growing revenue 30%. 

Afflovest, which was acquired in September 2021, has a differentiated product (discussed later), but more importantly utilizes the 4,000-person salesforce of the durable medical equipment providers (DMEs) to sell its vest.  The DMEs are already reaching the bronchiectasis, COPD and cystic fibrosis population as these individuals are buying ventilators and oxygen tanks from them and are eligible for a vest.  The Afflovest sales team consists of 11 individuals selling into the DMEs and the DMEs then deal with reaching the patient, reimbursement, and training of the product.  The DMEs have an incentive to sell the vest because it is roughly a $10,000 product.  Due to the low operating expenses and high GMs (70% - 75%), Afflovest EBITDA margins are above 30% vs. 8% EBITDA margins for the only public competitor, Electromed. 

The model of selling through the DMEs is working

Since acquiring Afflovest in September 2021, the continued strategy of selling directly through the DMEs has worked very well.  The demand has been so great thus far in 2022, that the company not only increased revenue guidance for Afflovest from $20mm to $35 - $36mm, but they had to sign on a second source supplier (3Q:22) as they were unable to meet demand in the first half of the year due to having a sole supplier.  The quarterly revenues jumped from $7.3mm in 1Q:22 to $8mm in 2Q:22 to $11mm in 3Q:22 and are growing over 100% year/year assuming Tactile owned the business at the start of 2021.  Afflovest is expected to have their second source suppler fully ramped entering 2023. 

Differentiated product

The Afflovest is a battery-operated vest instead of one using pumps and hoses to expand and contract the vest, therefore the vest is lighter and can be easier to transport (the vest gets great reviews).  It also allows the patient to move around freely while using the vest vs. being plugged in and attached to a wall.

ROTC

Pre-covid, TCMD had ROTC (defined as NOPAT/(WC+PPE+Long-term Medicare AR) of high single-digits growing to high teens as they gained scale.  As Afflovest ramps, due to an 11-person salesforce, that in the short-term at least does not need to be expanded, and no reimbursement specialists (as the DMEs deal with this), ROTC should increase due to the high margins associated with Afflovest.  For reference, in 2019, sales and marketing and reimbursement, G&A accounted for 62.5% of sales for TCMD.   

Afflovest competitive landscape and market dynamics

The CEO of Tactile Medical, Dan Reuvers, knows the high-frequency chest wall oscillation (HFCWO) market (Afflovest) very well as he was President of the first vest company which was sold to Hillrom (the Monarch vest which is now the leader) and he was on the board of RespirTech, the number two player in the market, for ten years until being purchased by Philips.  Dan noticed the competitive advantage of not only having a more mobile, lighter vest using batteries, but that the product was sold through DMEs rather than having a salesforce.  At the Morgan Stanley conference in September 2022, Dan Reuvers states the following,

“And from the DME standpoint finally, with the placement of one of these vests at an average sell price retail.  And it’s a very regularly reimbursed kind of hit code at about $10,000 is equivalent to them having to set up more than 25 CPAP starts.  So the DME is interested in participating.  They just haven’t had a product to do it and we think that there’s a nice convergence of opportunity there.”

According to Electromed the current #3 player, the HFCWO market is very large and underpenetrated.  The current treated market is ~90,000 patients with 500,000 to 600,000 patients (~$5 billion market) diagnosed and 3.7 million patients undiagnosed.  The market is currently growing mid-single digits. 

It is estimated that Hillrom’s (Baxter) Monarch vests are ~$100mm of revenue, Philips’ RespirTech is ~$80mm in revenue and Electromed’s Smartvest has revenue of $41.7mm.  The Afflovest is currently run rating revenue at $44mm growing more quickly than its competitors, with a differentiated product and sales model.  Electromed, the only pure play public HFCWO company trades for 2x revenue and 9x EBITDA earning 4mm of free cash flow.  I would note that due to Baxter’s (bought Hillrom Dec. 2021) and Philip’s large size, a $100mm product is not something they would concentrate on.      

Valuation and why TCMD is mispriced

TCMD is a $230mm EV company with 26mm in net debt (less than 2x EBITDA), with ~$245mm in 2022E revenue and $16mm of 2022E EBITDA.  Afflovest should add $6 to $8mm of cash in 2023 and continue to grow double digits off 2022E revenue of $36mm due to the large market, four players of which two are not completely focused on their products, and the addition of the second source supplier.  The company’s free cash flow in 2022 is slightly negative, however, taking out the 3.5mm of cash used for litigation (non- recurring) and a $5mm payment to International Biophysics Corporation (milestone payment for Afflovest acquisition) in 2022, the company’s cash flow is expected to be ~$6mm.

However, the valuation on 2022E numbers does not seem that cheap.  So why is the company mispriced?

• TCMD has aggressively invested in their salesforce on the lymphedema side with lackluster sales growth due to covid variants delta and omicron.  As the salesforce ramps and becomes more productive and if covid continues to dissipate, sales should start to increase at a faster rate.  If they do not, I think the company will have to rethink how they allocate capital moving forward in terms of the salesforce expansion.  Overall, the company is underearning.
• Afflovest should drop down 50% - 60% of incremental revenue to the EBIT line which we have not seen yet as sales have just started to ramp.  In 2022, every incremental dollar created by Afflovest has been reinvested into the salesforce, both number of sales people and training to increase sales of Flexitouch.
• If we assume Afflovest sales of $70mm whether that is 2024 or 2025, which would assume sales almost double (currently growing over 100% yr/yr), you would have a business with ~$25mm of EBITDA (with little capex requirements) vs. the company’s current EV of $230mm.  You would be getting the $208mm of lymphedema sales for free in my opinion.  

Before the acquisition of Afflovest, TCMD traded at $40/share or an $800 million market cap with net cash of $49mm.  Today, TCMD trades for $10.30/share or $206mm market capitalization and $26mm of net debt (they most likely will owe International Biophysics Corporation $20mm in milestone payments, one in 4Q:22 of $5mm and $15mm in 2023.  The company stated that 4Q free cash flow will more than cover the $5mm payment).  The reason for the high valuation in 2021 was due to expectations of double-digit top-line growth for Flexitouch once covid dissipated.  As the new covid variants hit in the second half of 2021, investors lost confidence.  The stock cratered in November 2021 when Tactile lowered guidance in 3Q:21 as the Delta Covid surge really hurt them both from lower volume of patients in the clinics as well as salesforce churn due to required vaccinations as your selling into a population that is vulnerable to a more severe covid case.  Currently, the lymphedema salesforce is back up to 250 individuals and is gaining more experience each quarter.  It does take 6-12 months to get fully ramped, however, the 5% growth in lymphedema sales in 3Q:22 versus 1.1% in 2Q:22 and -5% in 1Q:22 was encouraging.  The company is in much better shape to grow the lymphedema business in 2023, although you are not paying for it at the current stock price.  On the 3Q:22 call, Dan Reuvers, the company’s CEO stated,

“I think first of all, on the lymphedema side, we have seen some recovery in the patient volume. So, we have talked a little bit about that. We are not at pre-COVID levels, but we are seeing some good improvement there. I think the opportunity for us to demonstrate improved productivity will be an important part of the ‘23 recipe. I think that probably the most foretelling piece is the fact that we were negative in growth in the first half. It’s been a tale of two cities. The second half, we just grew 5% in the third quarter, our guidance would imply something in the upper-single digits in the fourth quarter. And all I can say is we certainly think that that puts us in a much better on ramp to 2023. I think we are in a better position right now than we have been all year long as it relates to both sides of the business. But I think that the upper-single digit growth that we will be exiting in Q4 certainly is – it’s a good way for us to enter 2023.” 

There is another write-up on VIC back in 2017 that lays out a short thesis on TCMD at $20/share (Flexitouch revenues at he time were $109mm).  The thesis is around the Flexitouch product being a commoditized product, pushback from insurance companies to cover the Flexitouch, and the company’s stated TAM of $5 billion is way too high.  Again, the Afflovest product is the main reason for my bullish thesis for TCMD, however, I do not believe that Flexitouch is a commoditized product.  I am not completely sure of the TAM being $5 billion dollars the company claims and I do think insurance companies continue to push back and require certain stipulations before covering a $5,000 product (this has not changed over the past 5 years).  However, up until covid, the company grew top-line 30% per year.  I would suggest to anyone interested in Tactile to go to inspire.com and look at the comments from the National Lymphedema Network around the Flexitouch.  They are incredibly positive and show that people who use this device love it and how it has helped the quality of their life.  Again, I am not saying that the Flexitouch is a double-digit grower and there is always a possibility that the product declines in the future due to insurance pushback or a new device or treatment therapy, however, the Flexitouch is a good product and reading many reviews, seems to be better than the competition.  Overall, I do not think the lymphedema revenue segment for Tactile goes back to 30% growth, but from what I have read, I do think it is a growing product line into the future.  However, growth needs a certain amount of operating expenses such as reimbursement and sales individuals to support it unlike the company’s Afflovest product making the Afflovest a higher ROTC and overall better business.    

In conclusion, you are paying $230mm for a company that should earn $20-$30mm plus of free cash flow over the next two years, fully pay off the $15mm owed for the Afflovest acquisition, while continuing to reduce debt which is already sub 2x EBITDA.  You have a $36mm product growing double-digits with low to mid 70% GMs and fixed operating costs and a lymphedema product that was growing 30% a year, ran into problems around covid, and is now potentially accelerating to high single-digit growth in 2023. 

If I think about TCMD over the course of two years, assuming the lymphedema business can grow 5% per year and Afflovest is a $70mm revenue company in 2024, then gross profit will improve by $41mm.  The only real variable cost is commission to the salesforce for selling more product, but let us assume they increase R&D $2mm over that time frame (6.75mm in 2022E) and Reimbursement and G&A grows $12mm over those two years, with sales and marketing growing $5mm over those two years.  Then $22mm will drop down to the EBIT line and $16mm to cash flow.  You will have a company in 2024, with revenue of $299mm, EBITDA of $38mm, and free cash flow of $22mm.  Assuming Tactile can earn $10mm of free cash flow in 2023 and completely pays off the remaining $15mm of milestone payments for the Afflovest acquisition, you would have cash increase by $17mm or $40mm of cash with total debt of $50mm.  I think this would be a $350mm company or $340mm EV with 20mm shares or a $17 stock price vs. the current $10.30 stock price. 

Risks:

• Lymphedema is truly a declining asset as some of the pushback seen over the past few quarters from Medicare Advantage plans continues.  However, Medicare Advantage plans are ~20% of private pay in the lymphedema segment or $30mm of total revenues. 
• Afflovest does not continue its growth due to lack of execution
• The company’s costs grow more than expected mainly due to hiring more sales reps for the lymphedema segment, which would therefore tell me that the reps they have hired are not as productive as they should be or the product has lost some appeal to competing treatments.
• Remains free cash flow neutral or negative due to increased costs.

Catalyst

• Lymphedema revenue expands to high-single, double-digit growth as covid eases and the salesforce ramps
• Afflovest continues to increase revenues higher than expectations and adds meaningfully to cash flow over the next few years.
• Reduction of debt
• Acquired by a larger company that has overlapping costs or more capital to reach an underserved population allowing for increased top-line growth and a more profitable company