This week we're diving into a medical technology company that may blast off, not like Dogecoin, but close, and whose rationality goes beyond "what will the next person pay" to actual measurable value. Don't hate me for saying that. Let's take a look at iRhythm Technologies Inc. (IRTC, Financial), which can also be known as iRocket!
Background
IRhythm Technologies is a San Francisco-based digital health care company that stemmed from Stanford University's Biodesign program. The company is "redefining" the way cardiac arrhythmias are clinically diagnosed by combining wearable biosensor devices worn for up to 14 days. The company uses cloud-based data analytics with powerful proprietary algorithms that distill data from millions of heartbeats into clinically actionable information. The company believes improvements in arrhythmia detection and characterization have the "potential to change clinical management of patients."
Here's the patch below - it looks like a large bandaid and can be worn while exercising, showering and other daily activities.
This is the standard model for using the patch as well as getting results or diagnosis.
Why it's sinking like the Titanic
Back on April 10, Novitas changed reimbursement rates for Current Procedural Terminology (CPT) codes 93243 and 93247 to $103 and $115. CPT codes are one of the common ways doctors bill insurance companies for services rendered. Novitas is a health care insurance program and serves as a Part A/B Medicare administrative contractor under multiple contracts for the Centers for Medicare and Medicaid Services. These new rates are retroactive to Jan. 1 and will replace the rates that were published in late January. According to iRhythm, although these new rates are higher than those published on Jan. 29, "these rates do not appropriately reflect the clinical and economic value that long-term continuous ECG monitoring offers patients, their care teams, or the Medicare system." Or in other words, the company doesn't like these new rates nor can it run the business with these prices.
We'll dig into these numbers later, but at these new rates, iRhythm will not be able to provide its Zio XT services at the Medicare fee for service section as the mere operating costs of the company are the same if not higher than the reimbursed rate. Due to these changes, the company may no longer provide Zio XT to this Medicare segment starting in the second or third quarter of this year.
As a result, iRhythm's stock has plummeted from its high of $286.19 to $70.35 (image below per Google Finance) in May.
Paths forward for iRhythm: Speculation
Before examining what options iRhythm may have, let's review some information.
This won't be exactly precise, but we can make a fair assumption that if Medicare is paying $311, the other insurance groups are also paying something close to $311 (some higher and some lower). However, Medicare is the one who sets the standard and other groups tend to follow.
Let's look at iRhythm's 10-K to calculate the numbers:
Looking at 2020 revenue, we can calculate the number of Zio patches used per year as 852,623 ($265,166,000 / $311 = 852,623 patches).
The cost of revenue per patch is $82.42 ($70,277,000 / 852,623 = $82.42).
Research and development expenses are$48.47 ($41,329,000 / 852,623 = $48.47).
Selling, general and administrative costs are $231.32 ($197,233,000 / 852,623 = $231.32).
The new 2021 reimbursement by Medicare is $103 to $115. Assuming that you get reimbursed $115 and we take the cost of revenue per patch of $82.42, this yields a gross profit of $32.58 ($115 - $82.42 = $32.58). At the rate of $115, iRhythm would have to figure out how to pay for its SG&A and R&D with the remaining $32.58. Given that R&D currently costs $48.47 and SG&A costs $231.32, a gross profit of $32.58 makes running the business very difficult. As Sweet Brown says, "ain't nobody got time for that."
We're going to make a lot of assumptions here, and again, this isn't exact, but let's see if we can come up with a bare minimum number for reimbursement. Given iRhythm's 10-K numbers, the scale of economies just doesn't seem to exist in their world, at least not yet. They'll have to continue to put money into R&D and they'll always need people to run the company and sell products. Again, hypothetically, let's say they need at least 50% of the R&D and SG&A, what number does this put them at?
$82.42 + ($48.47 / 2)+($231.32 / 2) = $222.32
This means that anything below $222.32 in reimbursement might as well be zero as the company won't be able to operate in its current form.
Now that we have back-of-the-napkin numbers, we can think through what the options are.
Business model changes - how does the company survive?
How does iRhythm survive and potentially become iRocket?
Medicare increases reimbursement to $222.32 or higher. (70%-plus this happens, in my opinion. My reasoning is this isn't iRhythm's first rodeo with a rate reduction. The same occurred in 2016 and Medicare retracted their reimbursement back to $300+).
a. Novitas is the MAC (one of 12 in the U.S.) that established pricing at $103 to $115. It is totally possible that a new MAC could establish favorable pricing and iRhythm could bill the MAC at this higher price. Alternatively, national Medicare steps in and establishes favorable pricing for everyone.
Business model shift (If option one falls through, there is an over 90% chance that one of these occurs).
a. Previous to iRhythm, what did competitors do?
b. Direct to consumer
c. Monetize the data (10+ years worth)
d. Something else. Verily-Google (Alphabet) to the rescue?
3. Buy out.
4. Doesn't necessarily survive --- liquidation (less than 1% as iRhythm appears to have superior technology).
5. Sell overseas and negotiate with governments on more favorable terms (this is already happening in the U.K.).
Going into more detail on a couple of these:
Option 2A: Previous to iRhythm, what did competitors do?
Let's take a closer look at BioTelemetry Inc. (BEAT).
Biotel's Investor Presentation - August 2020
Based on these projections, we can figure out the potential revenue of holters, event recorders and MCTs for the entire North American Market. For those with a keen eye, Biotelemetry's presentation decided to "forget" the number of patients per year of the Extended Holter Monitor market, which is also known as Zios. But don't worry, we know it's close to 1 million. All Biotel had to do was read iRhythm's 10-K!
*Holters: $50 x 2.5 million units = $125,000,000
*Events: $200 x 1.5 million units = $300,000,000
*MCT: $800 x 0.5 million units = $400,000,000
Given the data above, we know two things from the $435.4 million trailing 12-month revenue: 85%, or $370 million, came from cardiac monitoring and Biotelemetry treated around 1 million patients. This means Biotelemetry is primarily making money from its mobile cardiac telemetry product. How do we know this? Using quick, back-of-the-napkin math, again, say Biotel has 50% of the MCT market and 50% of the Event market.
If we look at the Event Recorder market, we can estimate that Biotel is selling 750,000 million units (1.5 million patients/year x 50% of the market) at $200 each. This would equal $150 million ($200 x 0.750 million units = $150 million).
If we look at the MCT market, we can estimate that Biotel is selling 250,000 million units (500 million patients/year x 50% of the market) at $800 each. This would equal $200 million ($800 x 0.250 million units = $200 million).
This would add up to total revenue of $350 million.
*Total units = 1 million (from Biotel's investor presentation)
*Pretty darn close to $370 million.
What are the Analysts Missing?
Business Model Shift
IRhythm has a not-so-secret Trojan horse that Wall Street analysts haven't taken into account in their reports. Not sure why? Are we missing something or are they?
Introducing Zio AT
Zio AT looks and functions similarly to Zio XT, however, it's a MCT product! The clinical data indicates that the Zio AT solution is able to detect critical arrhythmias up to five days sooner than the leading competitor (hmm, wonder who that is?). Further analysis indicates that Zio AT achieves a higher diagnostic yield in half the time of leading competitive MCT services (83% diagnostic yield in just 14 days versus 61% of a competitive service over a 30-day prescription period).
Zio AT functions just like the Zio XT service, which monitors continuously for up to 14 days, delivering a comprehensive report after return and analysis. IRhythm delivers the same comprehensive final report, but also provides physicians with actionable notifications during the wear period. These timely alerts are provided via a Bluetooth capability in the Zio AT monitor that sends data to a wireless gateway. The wireless gateway, slightly larger than a smartphone, is provided to the patient at the time of monitor application and will collect and transmit data from the monitor to the cloud via an LTE protocol. The current Zio AT market is roughly 10% as reported by the company's CEO.
Originally, Zio XT was positioned as the workhorse service while Zio AT was appropriate for the smaller percentage of the population that required timely notification. Yeah, not anymore. This Trojan horse is about to become the money maker. (Side note: We realized Medicare has a lot going on, but do they not see that they're about to cut off their nose to spite their face? Makes you wonder, or maybe not, why health care costs are such a big part of gross domestic product.)
Ok, remember these Zio XT numbers from before?
2020 revenue of $265,166,000 / $311 = 852,623 Zio patches
As we see above, the reimbursement for MCT is a nice healthy $800, not $115. Zio AT could realistically replace Zio XT for treating the Medicare population should iRhythm be forced to pivot and survive. Now let's say iRhythm actually pivoted from Zio XT to AT, what would the hypothetical revenue look like? We'll assume Zio AT replaces 25% to 30% of Zio XT.
25% of the market:
*$800 x 852,623 x 0.25 = $170,524,600
+ Zio XT revenue
*311 x 852,623 x 0.75 = $198,874,315
= $369 million
30% of the market:
*$800 x 852,623 x 0.30 = $204,629,520
+ Zio XT revenue
*311 x 852,623 x 0.70 = $185,616,027
= $390 million
Total iRhythm revenue would land somewhere between $369 million and $390 million. (Side note: As a shareholder, why isn't iRhythm doing this already? As a tax-paying citizen, is Medicare crazy? What sort of strategy is picking up pennies in front of a bulldozer?)
This looks a lot better than the reimbursement at $115, and they can survive on this. If you can't survive on this when the competitors have, there's obviously a problem.
Assuming iRhythm makes this pivot, which is not much of a stretch considering this is what its competitors presently do, let's take a look at possible stock price targets. I say targets instead of valuation because iRhythm is presently marching to the beat of the price drum at not necessarily discounted future cash flows.
Per StockNews, you can see a meta of various price targets. Before the Medicare announcement, iRhythm's price target range was $220 to $280, 3 to 4 times from today's prices and Zio usage (unit volume) is still growing at 31% year over year and firing on all cylinders, per iRhythm CEO Mike Coyle on the first-quarter earnings call.
At the potential revenue range of $369 to $390, iRhythm is way ahead of its end-of-year 2020 numbers. This is assuming zero growth in the market. Imagine if the 10-K reported Zio AT with 25% or 30% market share. The price would blow way past the high set in January of $286.19. Talk about a nice 3 to 4 times from today's price in the $70s.
Option 2B: Business model shift to direct-to-consumer
IRhythm takes its technology directly to consumer.s I'll go into more detail later about its collaboration with Verily.
It also has a subscription model similar to OneMedical. Think of this as wearing the device like the Oura Ring or WHOOP, but having someone on the other side who will review the ECG charts if you're having a cardiac event. OneMedical charges about $200 per year for its concierge medicine service.
Option 2C: Business model shift to monetizing the data
IRhythm has more than 10 years' worth of data that it has been collecting, but has yet to monetize. According to the 10-K, since receiving clearance from the Food and Drug Administration in 2009, "We have provided the Zio service to over 3 million patients and have collected over 750 million hours of curated heartbeat data, creating what we believe to be the world's largest repository of ambulatory ECG patient data. This data provides us with a competitive advantage by informing our proprietary deep-learned algorithms, which may enable operating efficiencies, gross margin improvement and business scalability."
The company's moat is its data, and it is sitting on a boatload of it. So what will the company do with all this great information about arrhythmias that's sitting in the cloud?
Maybe a company like Snowflake (SNOW) could be the catalyst that allows iRhythm to sell its data.
Option 2D: Verily to the rescue?
Verily recently received an FDA 510(k) clearance for its Study Watch, which is a watch with "sensor-based device for non-invasive, continuous monitoring." On Jan. 23, 2020, it announced an additional 510(k) clearance for an irregular pulse monitor it collaborated on with iRhythm. In Verily's press release, they state that "iRhythm's own research estimates that 10 million Americans are at high risk for atrial fibrillation (AFib) -- the most prevalent irregular heartbeat that can lead to blood clots and stroke. Our objective is clear: work together to develop best-in-class solutions for improved screening, diagnosis and management of patients with AFib."
New 510(K) boosts iRhythm, Verily efforts for AFib screening.
IRhythm closed on a $115 million stock offering in September 2019 to support this partnership with Verily. Together, they will develop artificial intelligence-based screening, diagnosis and management technology. Who knows what lies ahead in this collaboration, but I could see more deals ahead or some merger and acquisition action.
What can go wrong? What's the downside?
Without a doubt, there are several risks:
The company is stubborn and fails to adapt a new business model -- medium risk: In this case, the management team and board of directors believe the company will survive regardless of the current landscape, and the company goes bankrupt. It's absolutely possible that the company is too narrow-minded, believing its technology success will save them. It does have the best product in the space and the company has collected an unbelievable amount of data which it still hasn't monetized. Maybe the company is drinking the Kool-Aid and underestimating the potential downside. It's an absolute possibility that would crush the company.
There is an opportunity for mergers and acquisitions, but the other company wants to wait it out until iRhythm is low on cash -- low risk: The management team and board of directors most likely will not sell the company as a fire sale. Their technology is arguably still the best product out there.
IRhythm needs to raise capital and can't get a good deal -- low risk: This would happen in about one and a half to two years as its runway is good through then. If the company is failing, a shelf offering would send the stock spiraling downward even further and the current shareholders would be diluted. Fortunately, debt is currently cheap, so they could take that option.
Competitors release a product that's equally as good, if not better -- medium/lowrisk: I see this as a medium risk for a large tech company such as Google/Verily, Apple (AAPL) or Amazon (AMZN). I see this as a low risk for a smaller startup as 1) they are years behind on capturing data, 2) the market penetration would take years to take away from iRhythm and holter monitors and 3) the companies that shown me their pitch decks are literally just trying to copy the company and their products aren't better. However, the larger tech companies do build almost everything in stealth mode, so it is possible that the new Apple watch has improved to catch more than 12 arrhythmias (although their wrist capture isn't nearly as accurate and currently can't catch enough). Overall, iRhythm is still a prescription product and needs to go through a doctor, and a tech company would not go through this route.
What's the recommendation?
With every company there's always risk. Could the company go down from here? Yes. This would be caused by a management team that decides to go down with the Titanic rather than take advantage of the opportunity they have right here. I'd say this would be an amateur mistake and highly unlikely given the credentials of their new CEO. However, I view this as a company that has taken an absolute beating by Wall Street and I doubt that the price will go down much more.
I like the opportunity here and see it as a potential three to four-bagger, getting back to the $250s just by switching the model to Zio AT. If the company announces this, the stock will jump right back up to where it was in the good old days.
As always, would love to hear your thoughts on iRhythm and if you hear of any other companies/ideas that are up and coming that you want me to cover.
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