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Morningstar | LivaNova's 1Q Pressured by New Drug Competition; Lowering FVE

Narrow-moat LivaNova reported first-quarter results that were consistent with revenue figures released in early April. We initially lowered our fair value for the firm slightly to incorporate weakness in the firm's U.S. neuromodulation segment. However, we'll likely revise our $90 fair value estimate lower by another mid-single-digit percentage now that we have a better understanding of the underlying competitive dynamics, an estimate of how long it might take for the business to get back on track, and a sense for how profitability will be affected.

In April, we hypothesized LivaNova was seeing stiffer competition from Medtronic's implantable device that received its epilepsy indication last year. While this is likely partly to blame, the bigger culprit ended up being competition from GW Pharma's Epidiolex that was approved by the Food and Drug Administration in January with an indication for resistant epilepsy. We're surprised by the sizable slowdown in new patient implant rates simply as a consequence of a new drug hitting the market, but the novelty of a new active pharmaceutical agent in cannabidiol likely has something to do with it. We're more concerned with management's suggestion that a few high producing sales reps left to join the ranks of GW, as we don't typically see reps move between devices and pharma all that frequently. Management expects the trialing and evaluation period for the new compound to last roughly six to nine months, meaning we won't begin to see improvement in at LivaNova until the end of the year at best.

While disappointing, we don't think these developments erode the firm's economic moat. The firm's VNS device remains one of the few options for patients that don't respond to traditional drug therapy and is supported by decades of efficacy data. We think this product will continue to fill an important niche, and expect LivaNova to earn high returns on capital in 2019 despite this year's temporary growth slowdown.

Notably, management indicated they saw strong patient lead generation, with a gap between patient identification and subsequent implant rates. This supports management's Epidiolex theory, and suggests minimal change to the overall market opportunity, leaving us optimistic around the firm's longer-term trajectory.

With sales growth set to fall near zero for the full year as a result of this channel disruption, operating deleverage is expected to weigh on earnings more dramatically than we initially thought. The firm's step-up in research and development to support its product pipeline and investments in its commercial strategy limit the company's flexibility in managing near-term operating expense. Our initial EPS reduction in April got us approximately halfway to management's updated guidance range of $3.00 to $3.10 for the year, largely attributable to higher expenses.