This is a deep dive from Activist Strategy dated Feb. 1, 2016. HeartWare, targeted by Engaged Capital, got a buyout offer at a near 100% premium today. Here’s a case study of sorts on why we were long.

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I. Introduction

We have a new TV show set to hit the screen in March – it’s on NBC and called Heartbeat. It’s kind of like a Grey’s Anatomy but focused on a female heart surgeon. There are only a handful of female transplant surgeons in the world. And what does the main character like to do in her spare time? “I like long walks on the beach, hot bubble baths, and the sound of cracking a patient’s chest open like a lobster.”

The beauty of heart surgery and heart transplants is that it’s a very big deal in the real world. One company that deals solely with the heart is Heartware (NASDAQ: HTWR) – the maker of heart pumps.

II. The Business

Heartware is a medical device company. It develops and manufactures miniaturized implantable heart pumps or ventricular assist devices for patients suffering from advanced heart failure. The HeartWare Ventricular Assist System (HVAD System), which includes a ventricular assist device (VAD) or blood pump, patient accessories and surgical tools, provides circulatory support for patients in the advanced stage of heart failure. The core of the HVAD System is a continuous flow blood pump, the HVAD pump. The HVAD System is designed to be implanted adjacent to the heart, avoiding abdominal surgery, directly adjacent to the heart. It has a hybrid system used for suspending the impeller. The impeller is suspended within the pump housing by the opposing forces of passive magnets and hydrodynamic thrust generated by the pump impeller, which circulates a cushion of blood.

III. Activist Involvement Overview

This is another “special case” where the key activist owns just 1.3% of the company. However, there is Hudson Executive Capital, which owns 5%. This is Hudson’s first activist campaign. Yet, Engaged is a seasoned pro here. Glenn Welling runs Engaged and before founding Engaged worked at Ralph Whitworth at Relational Investors.

Engaged has been around for years, taking on small- and mid-cap stocks. It’s returns on official campaigns is pretty impressive.

Broad overview of Engaged and the Heartware target:

IV. Thesis: Why Does The Opportunity Exist?

Heartware got hit hard as manufacturing issues plagued its new pump, and then its clinical trials were suspended. Its MVAD mini-heart pump, which is about half the size of its current HVAD pump, is the product in question.

Heartware is now trying to figure out a fix to the issue leading to adverse events in the MVAD product. In one of the worst case scenarios, this could involve a product redesign.

So the big overhang is the MVAD delays. The trails that were stopped in September hasn’t been addressed and there’s little clarity over the exact issues with its MVAD pumps. The issues appeared to be minor problems, but the company announced in January that the pumps would need to altered, sending shares in freefall. The worst case is that a full redesign means a 12-18 month delay before it comes to market.

We don’t have any insight into the September events that caused uncertainty around the MVAD approval timing. The company has been somewhat mum with this. Now, the company is in a position to restart the clinical trials sooner than the 12-18 months if it decides to move forward without pulsatility for the MVAD – something I feel the market is overlooking. A change in the suction alarm could help Heartware avoid suction and an effective algorithm change can fix the major issues. If a change in pump geometry is necessary, we’ll likely have a delay in the restart of trials by 12-18 months. Of note, Heartware is already working on a new MVAD design as a hedge, in case the current MVAD modifications are not successful.

MVAD has big potential as a staple in heart transplants. Right now, it does have the HVAD pumps, but they are only used as a bridge to a heart transplant and don’t act as a heart replacement.

As well, Heartware was trying to buy Valtech Cardio. However, Valtech didn’t appear to have any high-growth products, making the acquisition a bit nonsensical. Nonetheless, Engaged Capital pushed back against the deal and Heartware dropped its plan to buy Valtech last week.

V. Catalysts: Closing The Valuation Gap

  • With the MVAD issue, Heartware had a similar issue with its currently approved HVAD pump. It had to stop a study for this device, but eventually resumed trials after putting in place a screening process to weed out pumps that were outliers in terms of variability.
  • The Valtech buyout has been called off. This comes as Heartware has had its own internal issues. The move will allow the company to focus on getting back on track, eventually, attracting a buyer of its own. The stock is trading at $40 a share, which is less than half where it traded before the Valtech deal was announced — around $85 a share. This will allow Heartware to focus on the VAD (MVAD/HVAD) market and avoid the high risk of the Valtech pipeline products. Engaged has noted that bankers and senior executives at other medical device companies, including companies that are the likely acquirers of Heartware, have confirmed the view of the long-term attractiveness of the VAD market.
  • Engaged will also jointly select, with Heartware, an independent board member for the company’s board.
  • One key catalyst could be a buyout of Heartware. This would likely come after the MVAD situation is sorted, but could include the likes of Abbott, Edwards Lifesciences and Boston Scientific. Part of that is getting its HVAD device in place as a “destination therapy.”
  • It still has its HVAD products, for which, it plans to seek approval to use them in destination therapy, as opposed to being just a bridge to a transplant. It’ll push for approval in mid-2016, versus the previously expected timeline for the second half of 2017.

Right now, shares are trading as if the company will have to do a full-blown MVAD redesign, which is unlikely. For the VAD pump franchise, Heartware expects revenues of $525 million by 2020 and continues to grow at an 18% growth rate from there. In that case, you’re looking at a company that could be worth upwards of $140 a share by 2020.

On the other hand, even if the VAD franchise only hits $450 million in revenues by 2020 and then grows at a 10% growth rate, fair value is still over $90 a share. Looking at it another way, Heartware could be an acquisition target. Using the St. Jude buyout of Thorate as a benchmark, Heartware could be worth $180 by 2020.

The best way to think about the valuation is, that shares still have little downside if there is a complete redesign of the MVAD (i.e. no approval of tweaks), while there is meaningful upside if the MVAD is approved. This comes as its HVAD product can take share relatively quickly once it gets approval for destination therapy.

VI. Conclusion

Again – a slight deviation here from our normal programming, as Engaged Capital owns 1.3% of the company. However, there’s also another activist involved – Hudson Executive Capital, which is ran by former JPMorgan CFO Doug Braunstein, owns 5%. Their key thesis was to block the Valtech acquisition. Hudson went activist in January and is invested at a price of around $40 a share. They have successfully blocked the Valtech acquisition.

The beauty of Heartware is that it’s one of only two companies in the heart device industry – an industry with high barriers to entry. So the key is that Heartware still has viable products. Its business is still intact, with the MVAD overhang being an interim issue. With the Valtech acquisition no longer an overhang, it’s much more likely that bigger companies could make a run at Heartware. The upside is between $90 and $180 over the next 24-48 months.

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