Polynovo (ASX: PNV) earns most of its revenue from US sales of its NovoSorb Biodegradable Temporizing Matrix, or NovoSorb BTM. The product is a patented biodegradable synthetic scaffold to support the regeneration of skin when lost through surgery, trauma, burns, or other causes of tissue loss.

The shares are up more than 68% in the last year. They currently trade at a 167% premium to our fair value estimate of $1.

Polynovo is growing quickly. Fiscal 2024 sales rose 54% to $92 million, 2% ahead of our forecast, with 75% stemming from the main United States market. We raise our fair value estimate by 5% to $1.05 primarily due to the time value of money and slightly higher revenue forecasts. Our forecast five-year revenue compound annual growth rate increases to 26% from 25%. We expect the firm’s bolstered sales team to support market share gains.

Nonetheless, shares appear materially overvalued. We suspect the market is too optimistic about the speed and extent of Polynovo’s commercial rollout and the research and development spending required to stay competitive over the long term.

The burns market has many competing products and management highlights the importance of continuing to invest in R&D to future-proof the business. In addition, group profitability is likely to be diluted by lower-margin developing markets growing as a proportion of revenue. Full fiscal 2024 results and profitability will be disclosed on Aug. 23.

We think the market is also overly excited about potential new uses of Polynovo’s NovoSorb technology. While broader uses, including hernia repair and breast augmentation and reconstruction, are being considered and would greatly expand Polynovo’s addressable market, these are still very early in the development phase, with no firm timelines provided. We do not yet explicitly forecast new use cases in our base case particularly given the relatively low R&D spending directed toward these efforts to date.

Business strategy and outlook

Polynovo’s strategy revolves around expanding its geographical footprint to increase access to its products and open new hospital accounts. With its geographical reach the firm estimates its products are available to 800 million people as of fiscal 2023, but highlights the global market is underserved. The firm entered several new markets in fiscal 2023 including India, France, Spain, Canada, and Hong Kong, Polynovo intends to enter more geographies with new regulatory approvals, particularly with a focus on China and Japan through distribution partners. While the US market is key for Polynovo, representing roughly 80% of sales in fiscal 2023, new geographies would diversify the sales mix.

To support its organic top-line growth in existing and new markets, the firm invests heavily in expanding its sales staff as well as its in-house R&D. Product sales are largely through direct distribution, but Polynovo appointed distribution partners in select geographies including Germany, France, Spain, and Canada. Its R&D efforts center around exploring and receiving regulatory clearances for applications of NovoSorb products beyond the dermal substitute market.

Polynovo launched NovoSorb MTX in May 2023 to complement its main product NovoSorb BTM. NovoSorb MTX is like NovoSorb BTM but without the sealing membrane outer layer, and used in broader applications where it is not required. This is expected to drive sales with existing customers as sales staff can cross-sell products, with surgeons able to carry both products. Near-term, the firm is aiming to receive regulatory approval for full-thickness burns in the US and planning to complete recruitment of 120 patients for its associated US pivotal trial in fiscal 2024. The firm is also conducting clinical trials to receive reimbursement support for chronic diabetic foot ulcers and wounds. We think these efforts are likely to support growth.

We expect Polynovo’s NovoSorb products to pose a significant challenge to the traditional skin graft. We believe Polynovo will be successful based on the technology’s clinical performance and ease of use backed by a growing number of surgeon-led research and publications.

Fair value

Our fair value estimate for Polynovo is $1.05 per share and assumes the company is profitable from fiscal 2024 onward.

We forecast a five-year group revenue compounded annual growth rate ("CAGR") of 26% forward to fiscal 2028 versus a trailing two-year revenue CAGR of 50%. This is driven by Polynovo’s key US geography where we forecast a five-year revenue CAGR of 21% for the region.

We expect the firm increasing its sales staff to support market share gains. In addition, we expect the recent product launch of NovoSorb MTX to increase penetration within existing hospital accounts given its broader applications. Our forecast five-year revenue CAGR for geographies outside the US is 40%. This is driven by recent entries in India, France, Spain, Canada, and Hong Kong, as well as planned entries into China and Japan. As such, we forecast revenue contribution from the US to drop to 65% of group sales in fiscal 2028 from 79% in fiscal 2023.

On the profitability front, we expect group midcycle operating margins to settle at around 35% by fiscal 2033. We forecast Polynovo’s maiden profit in fiscal 2024 and margin expansion from operating leverage. Our estimates deliver EPS growth of 18% at midcycle. We forecast average annual capital expenditures of roughly AUD 6 million over the next 10 years, or 3% of group sales. We also factor $25 million in capital expenditure over fiscal 2025 and fiscal 2026 to fund a new manufacturing facility which has capacity to service an additional AUD 500 million in annual sales.

Risk and uncertainty

Our Morningstar Uncertainty Rating for Polynovo is Very High. There is risk surrounding the pace and success of Polynovo’s global sales rollout, timing, and cost needed to get potential further indications approved, and the cost base required to support the firm’s revenue ambitions. With the company still in the early stages of its commercial rollout, there is elevated uncertainty. However, the company raised capital in fiscal 2023 which we expect to tide it over until it becomes cash flow positive in fiscal 2027.

The key unknowns are regarding potential new indications and new geographies. Polynovo is targeting China and Japan as new geographies to enter but this is dependent on finding suitable distribution partners, receiving regulatory clearances, and completing registration processes. Management have also suggested potentially lowering pricing in emerging markets to increase access for patients. The firm is also exploring design options to utilize NovoSorb technology for much broader indications including hernia repair and breast augmentation and reconstruction. If successful, this would materially contribute to growing Polynovo’s addressable market.

The primary environmental, social, and governance risk to Polynovo is related to product governance, where a significant failure in quality or safety leads to a product recall or redesign. A serious failure may also expose Polynovo to patient liability claims and severe reputational damage. However, we view this as having a low likelihood given US Food and Drug Administration clearance in 2015 and a lack of noteworthy incidents given NovoSorb’s robustness in the presence of post-surgical infection. Failure to recruit or retain adequate sales talent may also contribute to declining sales growth. However, we do not think Polynovo will be challenged in managing human capital, with the company offering competitive compensation and accelerating the number of employees added over the last five years.

Terms used in this article

Star Rating: Our one- to five-star ratings are guideposts to a broad audience and individuals must consider their own specific investment goals, risk tolerance, and several other factors. A five-star rating means our analysts think the current market price likely represents an excessively pessimistic outlook and that beyond fair risk-adjusted returns are likely over a long timeframe. A one-star rating means our analysts think the market is pricing in an excessively optimistic outlook, limiting upside potential and leaving the investor exposed to capital loss.

Fair Value: Morningstar’s Fair Value estimate results from a detailed projection of a company's future cash flows, resulting from our analysts' independent primary research. Price To Fair Value measures the current market price against estimated Fair Value. If a company’s stock trades at $100 and our analysts believe it is worth $200, the price to fair value ratio would be 0.5. A Price to Fair Value over 1 suggests the share is overvalued.

Moat Rating: An economic moat is a structural feature that allows a firm to sustain excess profits over a long period. Companies with a narrow moat are those we believe are more likely than not to sustain excess returns for at least a decade. For wide-moat companies, we have high confidence that excess returns will persist for 10 years and are likely to persist at least 20 years. To learn about finding different sources of moat, read this article by Mark LaMonica.

Uncertainty Rating: Morningstar’s Uncertainty Rating is designed to capture the range of potential outcomes for a company. An investor can think of this as the underlying risk of the business. For higher risk businesses with wider ranges of potential outcomes an investor should consider a larger margin of safety or difference between the estimate of what a share is worth and how much an investor pays. This rating is used to assign the margin of safety required before investing, which in turn explicitly drives our stock star rating system. The Uncertainty Rating is aimed at identifying the confidence we should have in assigning a fair value estimate for a stock. Read more about business risk and margin of safety here.

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