Covalon Technologies Ltd.

Price:                          C$2.99/share

Market Cap:              C$73.8 million

Enterprise Value:     C$64.4 million

Covalon is a medical technology company with currently three technology platforms and has been in a transformation process with many moving parts for some time. I believe that the company is now at a point where this transformation process is coming to an end and the company is in a position to reap the rewards from a much more focused strategy.

The company's three patented platforms consist of the “Collagen Matrix Platform”, the “Antimicrobial Silicone Adhesive Platform” and the “Medical Coating Platform”.

The Collagen Matrix Platform is used to manufacture a family of products under the brand name Colactive, which treats chronic and infected wounds, and the company works with a few wholesalers to supply the US healthcare system. This platform is not only responsible for the majority of sales but has also been the growth driver in recent quarters. While I believe we may see continued growth from this side of the business, in my base case I don't expect much further growth from this platform as Covalon already appears to have a significantly higher market share in a market that is growing in the mid-single digits.

The “Antimicrobial Silicone Adhesive Platform” is the part of the business where future growth is expected to come from, and these are the products that the company is emphasizing and where it sees its future. It is the foundation for a family of product solutions for pre- and post-operative procedures and vascular access that are designed to kill 99.99% or more of any bacteria or yeast that come into contact with the antimicrobial silicone. While the company does not detail the revenue split between the two platforms mentioned, I believe the company currently only derives between 20 and 30 percent of its revenue from this platform, with the remainder coming from the collagen platform.

This leaves no room for revenue participation from the “Medical Coating Platform,” and in fact, the company has not generated any meaningful revenue from this platform since the first quarter of 2024 (which ended in December, as the fiscal year of Covalon ends in September). Covalon's technology under this platform is based on a proprietary ‘grafting from’ process that uses photopolymerization to create active graft sites where new polymer chains are initiated and spread from the surface of an existing medical device. Covalon was very unhappy about several delays by a medical device company that had licensed its technology, resulting in losses for Covalon. Covalon tried to get meaningful price increases, but the medical device company instead decided not to pursue its coating projects.

Valuation

Covalon just reported two outstanding quarters compared to the company's historical performance in the quarters prior, and if that represents a new baseline for the company, I think the current valuation is way too low. But the market is still skeptical, and from the comments I've read, I think that's because many people think the business is very volatile due to historically volatile revenues. But how cheap is the valuation, assuming last quarter's figures are a new baseline for the company?

Let’s take a look at the P&L of the last quarter:

The first thing that is very noteworthy is certainly the large increase in revenue, and that almost all revenue comes from the product business, which is a result of the “wind-down” of the coating business that I mentioned earlier. But what is even more important is probably the overall result of C$ 1.7 million after an overall result of C$ -0.7 million in the same quarter last year. Of course, currency translation differences are not really a result of the company's actions and fluctuate in different directions, so we should definitely look at the net income of C$ 1,448 million. The company is unlikely to pay significant taxes for the foreseeable future as it has accumulated substantial net operating losses. If we base our valuation of the company on the assumption that this quarter represents a new baseline for the business and that we will see no growth or decline from here on out, we can simply multiply these earnings by four to annualize the earnings numbers. This would give us a run rate of C$ 5.8 million net profit. The company currently has a market capitalization of around C$ 73.8 million (ignoring 2,920,000 outstanding warrants and 1,382,500 options) and C$ 9.4 million in net cash at the end of the last quarter, giving it an enterprise value of C$ 64.4 million and therefore an EV/E ratio of 11.1. I would not consider this to be very expensive for this type of company.

However, we have not looked for any one-off headwinds or tailwinds during the quarter. A look at the inventory commentary shows an inventory reduction of C$ 0.425 million during the quarter. Based on management's comments this quarter and previous quarters, this is the result of past business decisions and will be phased out shortly. Therefore, I believe it is very reasonable to adjust the quarterly results accordingly. In addition, the company had a loss on the disposal of property, plant and equipment of C$ 0.085 million, which I believe is also not in the normal course of business. Without these two effects, Covalon would have generated a net profit of C$ 1.958 million. Multiplying this by four gives a net profit run rate of C$ 7.832 million and an EV/E ratio of 8.2, which is even less demanding and in my opinion makes for a really interesting investment case if you expect growth from here.

But as I wrote at the beginning of this section, a lot of people seem to be expecting lower numbers going forward due to the historical sluggishness of the business. Perhaps they have just had two excellent quarters and the business is a constant up and down. So before thinking about possible growth, it would probably be wise to address this perceived lumpiness.

Lumpiness of the business

Looking at the figures below, there is no doubt that the company's revenue has been very volatile indeed, with a revenue peak in FY 2019, a trough just one year later, LTM revenue still below FY 2019 levels, and essentially no growth in a period of almost six years. In addition, the company has made no profit, with the exception of a small profit in FY 2018 and a profit in FY 2021 in large part due to a one-off effect.

(source: tikr.com)

But does that necessarily mean that current business is also very lumpy? Of course not, and that's why you have to look behind the headlines and ask yourself how these figures were created. Something you should always do as a stock picker.

First of all, we have to recognize that Covalon doesn't just sell one product to one region, and so the first question is: has the composition of revenue changed, and if so, is the lumpiness of the past still a good indicator of the trend of the current business?

The first part of the question is answered very quickly. First, at the beginning of FY 2019, Covalon acquired a division of the medical device company Cenorin, LLC, called AquaGuard, which specialized in products for the important moisture protection of wounds as well as of surgical and vascular access. This business therefore contributed to the figures since the beginning of FY 2019, but the business was also already sold in FY 2021 and the figures in that year were classified as part of discontinued operations. The second major influence on the figures above, which is no longer a significant part of the business but still influences the LTM figures, is the business that revolves around the medical coating platform. The company had high hopes for this segment in the past, but recently the company has only had one customer in this segment.

Covalon generated income from license fees for its technology and, to a greater extent, from consulting fees due to support work for this customer's coating projects. Due to ongoing delays in the customer's projects, Covalon was unable to make money from this business. After attempting to achieve significant price increases, the medical device company decided to discontinue its coating projects. As a result, Covalon has more or less wound down this part of the business and the CEO said during the Q2 24 earnings call: “We've recently started a process to strategically review the medical coatings business and assess the best future actions here.” In the Q3 24 conference call, the CEO provided even more detailed insight during an answer to an analyst: “We've engaged of late with a strategic consulting firm to help assist us in trying to frame up the technology, our capabilities, the external landscape and so that work is ongoing. And I should have -- for next quarter, I should have a report out and a little bit more guidance. We'll make sure we include it as part of the presentation on what we're going to do with that business going forward.” In my opinion, this process will lead to a complete repositioning of the coating business or more likely a sale of the technology.

This leaves a business that develops exclusively from the sale of products from the collagen and antimicrobial platforms. The company has mentioned for several quarters that its focus is on US product sales. Therefore, I think the following chart is the most important one to assess the current trend of the business:

You can see here not only that the business area on which the company is strategically focused is not lumpy at all and is currently growing very fast, but also that US product sales now make up the vast majority of the overall business. In the most recent quarter Q3 2024, US product sales accounted for 87% of total sales, and this part of sales grew by almost 21% compared to the previous quarter.

Therefore, I have come to the conclusion that a strong cyclicality is not an obvious problem for the company in its current form. And it seems that the CEO is on the same page here, as he gave the following answer to a question about seasonality during the Q3 2024 earnings conference call: “We don't see a lot of seasonality in the business in the traditional sense. We do see some lumpiness coming out of more of our international business where tenders get announced, awarded and ultimately fulfilled and sometimes that schedule can advance or slip. And I'd say the second thing is in our collagen business where we have various partners, a small number of partners that, in turn, have large and small customers. So as things shift there, as they win books of business or turnover books of business, we can see some lumpiness there.” So while revenue can fluctuate from quarter to quarter, due to the timing of larger contracts, particularly in the international business, which is included in the chart above under “Other revenue”, the business itself is not very cyclical.

The growth trend and the future

So far this write-up has been about facts, but now we need to ask ourselves the really important question: How sustainable is the current growth trajectory? And of course, no one knows the future and so this part will involve feelings and probabilities and no certainty.

While Covalon doesn't give a sales breakdown between the collagen and antimicrobial products, they clearly say that both product categories are growing very strongly: “I think at a high level, we did see growth -- strong growth on both the collagen side as well as products -- our focused products in the U.S. hospital space such as VALGuard and our IV Clear. But just the level of detail there is a little bit below where we tend to publicly comment.” (CEO on the Q3 2024 earnings)

The collagen business is much larger than the antimicrobial business and I estimate that 70-80% of the revenue comes from the collagen products. Unlike the antimicrobial products, the collagen products are sold through distributors and not through a direct sales channel. The distributors are not disclosed (with the exception of the Hartmann Group), but from my research, simply looking up the relevant products in the product catalogs of the major distributors, I believe they at least include McKesson, Medline, Henry Schein, Health Products for You, and the Hartmann Group.

I also suspect that Covalon is the supplier of the McKesson brand collagen product as the ingredients, form factor and product characteristics are identical. However, this is pure speculation on my part as there is no official information on this.

If this is the case, it could be significant in conjunction with another development, namely the spin-off of 3M's health division. 3M Health is now Solventum Corporation, and in their most recent half-year report, the numbers and commentary for the segment that includes advanced wound dressings weren't really great. Not only is Solventum reporting sales declines for advanced wound dressings in a market that is growing in the mid-single digits, but this is even happening after they’ve increased prices. The price increases were explained with higher input costs and it is also mentioned that the new stand-alone structure has led to higher costs, which will not be beneficial to their competitiveness either.

(source: H1 2024 report Solventum Corporation)

Solventum is already offering a very expensive product, and as a customer you are now faced with even higher prices. I think it is likely that many customers will opt for other products. I assume that many customers will naturally look to their largest supplier for an alternative, which in many cases will be McKesson. If Covalon does indeed produce the McKesson branded product, we could see even more growth in the collagen space.

The following quote from the Q4 2023 MD&A should also be highly relevant in explaining the growth on the collagen side of the business:  “The increase in customer demand is a result of being designated as a primary vendor by one of our key Distributor, as well as increases in the number of customers through Covalon’s distribution channels.”

It appears that Covalon has become the main supplier to one of its distributors, which should naturally lead to more sales to this unknown distributor and should have been very beneficial to collagen dressing sales.

In addition, during the Q2 2024 earnings release, the CFO said the following, suggesting that Covalon's production costs have decreased or may be decreasing even further, while its main competitor just reported the opposite:  “Within the operating expenses, we have had better cost absorption due to higher manufacturing activity levels as we continue to grow and improve our manufacturing process.” This could put Covalon in a position to win even more business in this area against a seemingly somewhat struggling market leader.

However, this is only the collagen business, which is currently the largest part of Covalons' business, and things seem to be going well, but it is also a business that operates in a relatively small market, which limits further growth, and the company is dependent on distributors for this part of the business. So what about the antimicrobial side of the business?

The CEO said the following during the Q3 2024 results conference call: “And here, we've been able to add over 60 new customers into the Covalon family within the past 9 months. These new customers have already accounted for over 15% of our year-to-date revenue growth in the U.S. hospital market. So again, not a super complicated commercial growth strategy, but it's the right one for us at the present day and one that we are driving effectively to achieve encouraging results. Add these 3 growth levers up and our U.S. hospital business is up 60% year-to-date. It's a really significant growth driver for our company.”

So things are looking very good on that side of the business as well, and that's not really surprising since infections in US hospitals not only pose a serious health risk, but also expose the hospital to serious liability.

It is also not a very small issue: “In 2014, the CDC published a multistate point prevalence survey of healthcare-associated infections involving 11,282 patients from 183 US hospitals. According to this report, about 4% of hospitalized patients suffered from at least one of the HAI. In absolute numbers, in 2011, an estimated 648,000 hospitalized patients suffered from 721,800 infections. The dominant infections (in descending order) include Pneumonia (21.8%), surgical site infections (21.8%), gastrointestinal infections (17.1%), urinary tract infections or UTIs (12.9%), and primary bloodstream infection (9.9%, and include Catheter-associated bloodstream infections).” (Hospital-Acquired Infections, by Alberto F. Monegro; Vijayadershan Muppidi; Hariharan Regunath)

Covalon has products that at least can help to prevent some of the surgical site infections and catheter-associated bloodstream infections. The flagship product in this segment is VALGuard. “VALGuard® is the only vascular access line guard with a quick-release strip for immediate and easy access to the catheter hub.”

Valguard is a very cheap product with no real competition (as far as I am aware) that can help reduce catheter-associated bloodstream infections. The product was only launched in late 2022 and comments from CEO Brent Ashton, who has only been on board since January this year, suggest that the product was not really marketed well by the internal sales team prior to his arrival. Despite slimming down the sales team, the company seems to have found a new approach to targeting the market effectively and has managed to win over 60 new customers for its antimicrobial segment since the start of the year, and with a smaller sales force than before. Now the CEO wants to build on this success and increase the sales team again, which I think is a good idea considering the current sales trend.

Valguard has the potential, and we are probably already seeing this, to be a door opener for many new customers, and Covalon has great cross-selling potential that they can realize after they have won the customer. Other antimicrobial products include: CovaClear® IV, IV Clear® and SurgiClear®. Unlike its competitors, Covalon uses two antimicrobials (chlorhexidine and silver) for its products, allowing the use of a lower concentration of chlorhexidine, which is known to irritate the skin. The company's entire product portfolio and product descriptions can be found here.

The new CEO and conclusion

I didn't mention until the end of my write-up that the company has a new CEO since the beginning of the calendar year. This wasn't because I think Brent Ashton is a bad manager, but because I don't think he's had a significant impact on most of the recent growth we've seen so far, as most of the potential reasons for the increase in collagen revenue couldn't have been influenced by him. Nonetheless, his actions are obviously becoming more important to the story, and I think he's saying the right things.

And he really should know what he's talking about, since he was at 3M for 15 years and ended up running the very part of the business that is now part of Solventum, competes with Covalon, and is the market leader and Covalon's main competitor. It can't be that bad to know your main competitor from the inside and he probably also has a very good network in the industry. To speculate a little: He probably also knows some very good sales people who might be interested in joining a very high growth company with good products that could make it a little easier to earn good bonuses and commissions.

I want to reiterate that we can’t judge Brent Ashton by his actions so far and we don’t know if he is a great CEO yet. But from the look of it and based on his resume, I don't think someone could be a better fit for Covalon than Brent Ashton. Some may even question his decision to go to a very small company like Covalon after managing a multi-billion dollar P&L at 3M, but fortunately he already gave us the answer to that himself during the Q3 2024 earnings call:  “The reality is our current revenue base is quite small in relation to the opportunities that are ahead. So while I've been pleased with the growth since I took over, what really attracted me to Covalon was the potential to significantly grow our revenues so over multiyear time frame. We're obviously still in the early stages of our journey. And while there may be some variability quarter-to-quarter, the long-term outlook from my standpoint, from the team standpoint is very promising.”

Primary vendor status with a distributor in the fourth quarter of 2023, internalization of production and optimizations earlier this year probably combined with the ability to offer better value for money, as well as a struggling main competitor. Additional you have somewhat unique products in the portfolio that are growing very quickly, albeit from a low base.

There are strong signs of sustained, strong growth in the antimicrobial segment, and I think even if you assume that the collagen business will not continue to grow from here, you could see low double-digit growth rates for the overall business going forward. At a EV/E ratio of around 8.2, this is reason enough for me to be excited about the future of this company and it would be even more exciting if we are going to see further growth in the collagen business.

However, I am also aware that nobody can really judge from the outside what the real reason for the rising collagen revenues is, and that there is a risk that things can change quickly, as the company is very dependent on few very large distributors as customers in this area. Ultimately, investing is always about probabilities and I have decided for myself that I see a very good risk/reward ratio here.

Please be aware that what I have written here about is only a fraction of the information I looked at before deciding to invest in the company and I also do not know if I will follow up with further posts about the company.

Disclaimer: The sole purpose of this report is to explain the rational behind the investment I made on my own behalf. This report reflects an opinion and is for informational and entertainment purposes only. It is not intended as investment advice. It may contain errors, and I may change my opinion expressed in this report at any time. You should always do your own due diligence and never blindly follow anyone in an investment. I as well as the company I control and members of my family hold this stock in personal accounts.

Unfortunately, due to the limited investing universe at wikifolio, it is not part of the portfolio of the wikifolio FinancialSkeptic Value, which I manage and which is mirrored by an investable (probably only for Germans, Austrians and Swiss) certificate. You can find more information about my Wikifolio with this link (German).