We maintain our $4 fair value estimate and earnings estimates for narrow-moat Nanosonics (ASX: NAN). The shares trade at a 27% discount to our fair value estimate, as our view that recent earnings headwinds will be largely temporary differs from the market's view. Recent profitability has been negatively affected by hospital capital budget constraints, abnormally low ultrasound procedural volume, and Nanosonics investing in its next major product, Coris, ahead of its expected launch in fiscal 2025.

Coris aims to automate flexible endoscope cleaning. We assume first launches will be in Australia and Europe in fiscal 2025. Nanosonics remains on track after filing for regulatory approval in May. The firm also published positive results from a clinical study in June, demonstrating that Coris outperforms manual cleaning in biofilm removal in endoscopes. We expect the uptake of Coris to mirror Trophon and forecast annual sales to grow to $100 million by fiscal 2033; this is 24% of our fiscal 2033 group revenue forecast. Coris’ future earnings underpin about 18% of our fair value estimate.

Coris represents a significant opportunity to improve endoscope cleaning and help prevent endoscope-associated infections. Despite current manual cleaning efforts, flexible endoscopes can remain long-term reservoirs for infectious organisms and are linked to more patient infections than any other reusable medical device.

Our fiscal 2025 earnings before interest and taxes (“EBIT”) forecast of $30 million is unchanged and implies a strong recovery on our fiscal 2024 EBIT forecast of $4 million. First-half fiscal 2024 consumables revenue in the US was down 2% in constant currency. This was due to US ultrasound procedural volume for the period falling 4%, but volume growth rebounded strongly to roughly 10% across January and February.

Business strategy and outlook

Nanosonics’ Trophon solution for high-level disinfection of ultrasound probes has garnered substantial market share, evidenced by penetration of over 75% in Australia and New Zealand and 40% in North America.

We expect elevated growth over the next three years as Trophon continues to gain share in North America and launch in Japan, but high market penetration may be more challenging to achieve in developing economies, which may not be able to prioritize nuanced disinfection standards. Moreover, the device patent expires in 2025, leading to slower volume growth in the medium term.

Nonetheless, Nanosonics has a razor-and-blade business model and the installed Trophon base supports an ongoing revenue stream from high-margin consumables. In 2022 consumables contributed 58% of group revenue. We see the consumables revenue stream as more secure because it's protected from generic substitution until fiscal 2029, and we forecast these sales to climb to more than 70% of Trophon revenue over the next 10 years.

Nanosonics primarily distributes via GE Healthcare, its partner across multiple geographies. Recently, Nanosonics established a direct sales team in North America, adding to the operating cost base, however, we expect to see expanding gross margins from this and increasing revenue contribution from consumables. We estimate consumables to roughly earn a gross margin of 84% and devices 66% by fiscal 2027.

Outside Trophon, the company expects to launch a new product in flexible endoscope cleaning in 2023. Previously, management intimated the addressable market to be equivalent to Trophon and there is greater awareness of the infection issue this product addresses. We have made broad assumptions of a similar rollout pattern to Trophon from fiscal 2024 onward and equivalent margins. This supports our view that consolidated company EBITDA margins will climb to 35% by fiscal 2032 versus 6% in fiscal 2022. The pipeline product contributes roughly 17% of our fair value.

Moat rating

We award Nanosonics a narrow moat and think the combination of its patent intangible assets and switching costs will help deliver maintainable excess returns. The company earns an increasing proportion of its revenue from consumables used in the installed base of over 27,000 Trophon devices.

The consumables revenue stream is both higher-margin and makes up the majority of group revenue. Importantly, non-Nanosonics consumables are not compatible with the Trophon device as the patent protection of the consumables, which runs to 2029, includes the design of how the consumable bottle fits into the device. Thus, despite the device patent only extending to 2025, we see the installed base as supportive of the consumables revenue stream being largely unaffected in the next 10 years. We expect it will also take some time beyond the expiry date for competitors to gain regulatory approval and significant traction in sales.

In addition, the replacement cycle for the Trophon device is typically eight years, and due to a grown familiarity with a proven, efficient device, switching costs such as risk, inconvenience, time, and money are likely to reduce the number of hospitals switching to an alternative HLD device. Nanosonics’ Trophon is also compatible with over 1,000 different ultrasound probes, and an alternative HLD device or product like Cytocoat will need to prioritize this.

The risk of damage to far costlier ultrasound probes and cross-infection across patients will also likely trump switching to a potentially cheaper copycat Trophon device from 2025. A copycat competitor would also be challenged in designing its own original consumable that is compatible with the copycat device but does not infringe on Nanosonics’ consumables patent before 2029. This is also assuming a comparable quality product can be offered at a competitive price point with much less market share. As such, we do not expect significant disruption or market share to be ceded over the forecast period.

Due to the low invested capital and high gross margins earned in the Nanosonics business model, the company has posted an average annual return on invested capital, or ROIC, of 19% over the last five years. We anticipate the company’s ROIC to far exceed its 9% weighted cost of capital over our 10-year forecast period.

Infection prevention within hospitals is increasingly under the spotlight. We see ongoing clinical evidence to support more automated HLD, as well as hospital staff productivity and probe longevity improvements, as supporting ongoing adoption of Trophon. Trophon specifically targets HLD of ultrasound probes used in semi-critical procedures. Semi-critical procedures involve ultrasound contact with non-intact skin or mucous membranes and constitute an estimated 40% of all ultrasound procedures. These include injections where an ultrasound is used to guide the needle, gynaecological scans, biopsies, and scans across burned or wounded skin.

Traditionally HLD of probes is done by soaking the probe in chemicals (glutaraldehyde or ortho-phthalaldehyde) and this is still widely carried out. However, recent clinical studies have shown that these manual methods very regularly fall short of truly delivering the HLD of the probe, resulting in possible cross-infection of patients. Trophon automates and shortens the HLD process, provides better health outcomes, and records a digital audit trail of the probe used for each patient. This has allowed Trophon to experience ongoing market share gains and command leading positions of 40% in the U.S. and over 75% in Australia and New Zealand.

The global market for ultrasound equipment is growing in the mid-single digits with the potential for Trophon growth well ahead of that due to hospitals switching to automated HLD in less penetrated geographies such as Japan, South Korea, and Europe.
As ultrasound probes are sensitive to heat, Nanosonics’ Trophon works by using sound waves to create a chemical (hydrogen peroxide) mist within a closed environment. Nanosonics’ closest competitors are Germitec, which uses ultraviolet, or UV, light to HLD the probes, and Tristel, which uses a combination of wipes and semi-automated soaking in chemicals.

While Germitec’s product has the benefit of not using chemicals, UV light is reported to shorten the life span of the plastic elements of a probe. With the life span of a probe ranging between three and seven years, proper care is crucial when ultrasound probes can typically cost USD 30,000. In comparison, a Trophon unit is roughly USD 8,000, and when disinfecting multiple probes safely, can save hospitals money in the long term. Based on Nanosonics' current market share of 40% in the U.S. and being in over 5,000 U.S. hospitals, over 80%, it appears to be the preferred choice, with Germitec and Tristel having some success in Europe to date.

Being a single-product company, the primary ESG risk to Nanosonics’ moat is a product quality issue, such as failing to prevent cross-infection between patients, which would damage trust in its product worldwide. However, we view this as having a low likelihood given U.S. FDA clearance and a lack of noteworthy incidents since recording its first sales in 2009. While we view delays to its pipeline product as having a higher likelihood, we think materiality would not be as severe even in the case the product was completely scrapped.

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