Summer Series: Avita Medical Ltd (ASX: AVH)

Bryce: [00:00:43] Welcome to another episode of Equity Mates, a podcast where we help you learn to invest in 45 minutes or less. We break down the world of investing from beginning to dividend so that you can hopefully make some returns. My name's Bryce and as always, I'm joined by my equity buddy Ren. How's it going, bro? [00:01:29][46.2]

Alec: [00:01:30] I'm very good. Bryce looking forward to another shallow dive into some interesting stock. [00:01:36][5.8]

Bryce: [00:01:36] The shallow dive continues. We've been suggested a number of stocks to look into over the summer period by our Equity Mates community. And we continue today with Avita Medical Ren we start moving into the micro-cap medical space, certainly not in my wheelhouse of competence when it comes to stocks like this. [00:01:58][21.5]

Alec: [00:01:58] I don't think it's a microcap. [00:01:59][0.6]

Bryce: [00:01:59] Yeah, it's one point two billion. So might as well start with that market cap, one point two billion added to the ASX 200 in November 19 off the back of some significant growth in their share price. Ren. Yes, and that's because [00:02:14][14.5]

Alec: [00:02:15] six hundred and fifty six percent in twenty nine is a huge [00:02:19][3.7]

Bryce: [00:02:19] growth. And we will discuss the reasons for that shortly. But, Avita, Medical, what is it? Well, obviously a listed company that dabbles in skin regeneration. Yes, well, I guess it does more than double it specialises in websites, is a novel approach to skin regeneration. Yeah, it is. And I guess it is a pretty interesting way they go about repairing skin. So, yeah. Anything to add for that Ren. [00:02:48][28.7]

Alec: [00:02:49] So they've got a technology that's essentially spray on skin. Yeah. And if we take a step back and we think about how skin grafts happen for burn victims and stuff, traditionally you take skin from another part of the body, extremely painful process. And then you apply it to like the burnt area in the in an effort to stimulate growth of new skin. Never had it done, but apparently extremely painful and apparently not that aesthetically pleasing. As a result, it is clear that there's been like a skin graft, essentially. Yeah, it's obvious. Yeah, yeah. [00:03:24][35.7]

Bryce: [00:03:25] Scars and all sorts of bits and pieces. [00:03:27][1.8]

Alec: [00:03:27] Yeah. And so what Aveda have done is developed a number of products that essentially make that process far less painful and far easier. They've got this spray on skin and then they've got this other product that is called a cell harvesting device. It's all in the effort of doing skin grafts with less pain and less skin required from other parts of the body. To give you an idea of how successful they have been in developing this technology, there was a couple of peer reviewed, a couple of journal articles, not sure if the journals were peer reviewed, but where they tested this technology and compared it to the traditional methods for second degree burns. It required ninety seven point five percent less skin required to do these skin grafts to third degree burns. It required thirty two percent less skin. So that's a great result. It's a good medical breakthrough. And, you know, there's a there's a lot of burn victims that will be thankful that this technology exists. [00:04:26][59.4]

Bryce: [00:04:27] Absolutely. [00:04:27][0.0]

Alec: [00:04:28] We're not here to do that, though. We're here to talk about it as an investment. So I guess it's great that they've developed this technology and this company has done that. But our question is more about at this point in time, is it something that we want to invest in? [00:04:41][12.7]

Bryce: [00:04:41] That sounds like you're setting up for a bit of a rant down the line. So Ren, it all started happening for Avita in twenty eighteen when they were granted. [00:04:51][9.8]

Alec: [00:04:52] That's just their latest technology, [00:04:52][0.8]

Bryce: [00:04:53] latest technology, which is, as you said, a spray on skin. And essentially they can create a suspension of skin to regenerate the outer layer and can be applied in as little as 30 minutes. So pretty revolutionary. And if you look at. So that was approved in September 2013. If you look at their revenues since then, you can see how much of an effect that is having on their balance sheet. So I guess we can use that as a Segway to move into financials. Ren market cap, one point two billion. It doesn't have a price to equity ratio, and that is because it's earnings per share is in the negative price to earnings. What did I say? [00:05:34][40.9]

Alec: [00:05:34] Plus, the equity [00:05:35][0.4]

Bryce: [00:05:36] price to earnings. It's hot in the studio now. [00:05:40][4.3]

Alec: [00:05:41] You're a hundred percent. Right, but to your point, around the pickup in revenue. So two years ago in F seventeen, it made a scratch under a million bucks revenue. Nine hundred K. Yeah. The year after one point two million. Yeah. And then in the year, the financial year that's just gone, that jumped up to seven point seventy one million. So a massive increase. And you'd be so you'd be very happy to say that topline number jump up what you wouldn't be too happy about as an investor is that. The profit line, the earnings line didn't have a commensurate increase. In fact, it's gone backwards. So the last three years in terms of the losses that it's made, eleven point five million and then sixteen point five million, and then that's ballooned out to thirty five million in the year that that's just gone. And obviously, they've got a new product. They need to commercialise a manufacturer or get a sales team out there to sell it. There's costs that are associated with that. So it's not the end of the world, but it is something to keep in mind that their revenue jumped up about six and a half million dollars, but their profitability dropped about 17 million dollars. [00:06:57][76.7]

Bryce: [00:06:59] If you look at the cost increase in their sales and marketing department Ren since 2008, it's pretty much in line with what you expect. They've gone hard on trying to go out there and sell this product. So whilst revenues are increasing, as you said, their cost of, I guess, cost of sales and cost of doing business is also significantly increased as they're trying to get this product out there. And to your point, Ren, when I think about these companies as well. One thing to consider is the cost that goes into research and development. And we know that they pour money into this, hoping to get products new to the market and then and capture the market, I guess, be first to market. They, interestingly, have done a capital raise of one hundred million quite recently at a share price of 59 cents. So just below what it's currently trading at. But the reason for doing that capital raise is for product development and research purposes. So, yeah, looks like they need some more cash. [00:07:53][54.3]

Alec: [00:07:54] So to your point around its research and development costs, it's that's definitely been a big cost line over the last three years. In the year when it made nine hundred K in revenue, it spent about 11 million dollars in R&D in the year after when it made one point three million in revenue, it spent about twelve and a half million in R&D. And then last year it spent about 14 million in R&D. And that's not to be unexpected for a medical company. R&D is extremely expensive and essentially the business model for medical device companies and for pharmaceutical companies is raise money through the R&D patent, the technology or the drug that comes out of it, and then exploit that patent to patent to pay back the R&D and to fund the next round of product development. So all to be expected. The question is just what's the opportunity like to exploit this technology and is it a good investment, which I guess brings us to valuation unless you want to speak about the company. [00:08:53][59.5]

Bryce: [00:08:54] No, no, let's do it. [00:08:55][0.8]

Alec: [00:08:58] But they might. So the share price is currently 60 cents. It becomes tough to value because it's got losses and its losses are expanding. So to your point around no price to earnings ratio, we can't really compare it to its industry peers. What we can do is look at something like price to sales and compare that to its industry peers, because then we're talking about revenue and the company does have revenue. If you look at it on a per share basis, its revenue is about one cent per share and it's trading at about 60 cents a share. So it's price to sales ratio is 60. So comparing it to a bunch of its industry peers, the price to sales of 60 is definitely on the high side. There's a few that are higher, but most are lower. So if you want to look at it from a relative basis, then you can you can consider it that way. So then if we move to some of the other metrics or the other valuation methods that we're talking about during this series, a lot of them become difficult to do because the company is making a loss in. Those losses are expanding. So if you think about something like a discount cash flow when it's starting with negative earnings and those negative earnings are expanding to estimate what the future cash flows will be and then to discount them back becomes difficult. We would have to make some pretty big assumptions around how successful their push to sales is to sell. This technology is going to be what the market size is going to be and then how are they going to deliver around cost cutting and stuff like that? I don't think we're in a position to do that. So I don't think really the DCF is relevant here. No, not much you can do. And similarly, because the company's return on equity is currently negative, because the losses are expanding, we can't use the Roger Montgomery style of valuation either. Do you have anything from Morningstar? [00:11:01][123.0]

Bryce: [00:11:02] I do have something from Morningstar. And you would be surprised Ren, that for the first time in these episodes, in order of how we have recorded them anyway, Morningstar has come in with a fair value of zero point five three, so fifty three cents trading below what it currently is at the moment. [00:11:20][18.5]

Alec: [00:11:21] There you go. So that's broadly in line with where I was going to go in terms of the last way that I would think to value the company in. One of its producers have said that the market opportunity is worth two billion dollars a year in terms of pure skin graft, in terms of skin grafts, but in all of its various iterations. So if you were to say you could go top down, if you were trying to value it, you could say the market opportunity is worth two billion, that let's say they capture X percent of the market. I mean, look, if the technology is that much better, for argument's sake, let's say they capture all two billion dollars worth of the industry and let's say that revenue becomes two billion dollars a year, then you can work it down. All right. What's there? There currently the margin is negative because they're making a loss. But you could say, what's that gross margin? And then you could make some assumptions and then divide that per share. Its current market cap is one point one, two billion. I think a lot of that upside is captured if the total market opportunity in the US is two billion. But, yeah, you could go down that way. Tough. [00:12:23][62.5]

Bryce: [00:12:24] Tough to do. Yes. When a company is losing money, it is. [00:12:29][4.6]

Alec: [00:12:29] It is. I mean, I think with a lot of these biotech companies and stuff like that, you're really making a zero or one bet. You're either saying it's going to kill it and probably get acquired by, you know, the big players in the pharmaceutical space, like you could say, you know, Johnson and Johnson doing taking this technology and doing sprout brown skinned investors in that case are going to do very well for themselves or the technology doesn't work, doesn't pan out. And then it's sort of it's a zero. Yeah, I think this technology is well, it's it's been proven. It's FDA approved. It's in, I think, 50 percent of burn clinics in the US at the moment. It's well on its way to success, but it rose six hundred and fifty percent this year. Like investors, the market is very aware of this stock. [00:13:18][49.0]

Bryce: [00:13:18] Yeah, yeah, yeah. It's been priced in and they're obviously on the move to look for something new or continue with research and development into other products, because I guess there's these sorts of things have a Atayal. You know, they're not going to continue growing at that at that rate forever. And they're probably going have to continue spending money on sales teams and whatnot to continue to sell this resell product into, I guess, the industry. So interesting company, Ren, but one that certainly doesn't fall within my circle of competence. I would say it's relatively low, don't really know a whole lot about the skin graft business and also aware of the pitfalls that can come with with investing in Covid. Is that spend so much on research and development and are reliant on, I guess, as you said, zero one hit or miss. Yeah. What's your thoughts on competency yourself? Look, it's [00:14:05][47.1]

Alec: [00:14:06] probably outside of it, but once again, I would be very interested in this stock. If they commercialise, they start making profits from it. And then like the applications of it, a very broad you could say. I mean, you know, the bushfires are happening at the moment. You could say it's sort of being a military application as well. Like if it becomes easy to do skin grafts and it becomes cheap and I could be big right away. You go product, but you're [00:14:36][30.1]

Bryce: [00:14:36] buying skin grafts off the supermarket shelf before [00:14:37][1.7]

Alec: [00:14:38] we know it. But yeah, I think at this point it's outside my circle of competence. Yeah, I think it's really cool. [00:14:44][6.4]

Bryce: [00:14:45] Yeah, nice. Would you have anything to add or would leave it there. [00:14:47][2.4]

Alec: [00:14:47] No, that's that's about it. [00:14:48][1.0]

Bryce: [00:14:49] Nice. All right. Well we'll continue on with our Christmas Shallow Dives next episode. [00:14:53][4.5]

Alec: [00:14:54] Sounds good. [00:14:54][0.0]