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Morningstar | LivaNova's 4Q Disappoints, but We Think Underlying Drivers Will Remain Intact Over the Long Run

LivaNova reported a disappointing end to 2018. Delays in the product pipeline, a sizable litigation reserve, and a softer-than-expected 2019 outlook combined to drive shares down by a mid-single-digit percentage Feb. 27. While investors are likely frustrated with unexpected hiccups following otherwise solid results to date, we think the underlying growth drivers for this narrow-moat business remain intact. Specifically, the cardiopulmonary and neuromodulation segments continued to put up solid performance growing 6.8% and 14.5%, respectively, in constant currency during the quarter. As we roll our model and take recent performance into account, we'll likely only make modest changes to our $92 per share fair value estimate, if any.

While suspension of the firm's INTERLUDE trial is likely the focus for investors given the long-term growth opportunity apparent in the transcatheter mitral valve market, we hadn't explicitly included financial contribution from this product within our forecast. That said, we view clinical progress for the product as a key catalyst for the stock over the coming years and the delay likely pushes out its potential timeline to market by at least a year, at best. Additionally, with the trial stoppage driven by two patient deaths, we'd suggest investors ratchet down their long-run expectations for the product. The company isolated the point of failure to the valve's anchoring mechanism, not the valve itself, and expects to complete redesign and restart trial enrollment in early 2020.

Additionally, management's outlook for operating margin and earnings in 2019 fell below our expectations, as incremental investment spending behind clinical trial enrollment elsewhere in the portfolio and a planned business line exit are set to leave EPS roughly flat year over year. However, we think there remains long-term opportunity for the firm to expand its profitability, illustrated by better-than-expected gross margin improvement during 2018.

The firm's 2019 revenue growth outlook of 5%-7% in constant currency, while appearing weak on the surface, actually compares reasonably well to our current forecast nearer 8%-9%. The planned OEM distribution exit accounts for roughly 300 basis-points of lower year-over-year revenue growth, and management anticipates currency will account for an additional 100-basis-point headwind assuming current exchange rates. Multiple moving parts in 2019 mask underlying performance out of the firm's moatworthy assets, in our view, and we expect both the neuromodulation and cardiopulmonary segments to be supportive of high-single-digit top-line growth over the next several years.

Separately, management booked a $294 million litigation reserve covering costs associated with its legacy heater-cooler liability stemming from concerns around the potential for patient infection, which surfaced in 2015. This number is before any potential insurance recoveries, and management believes it is sufficient to resolve outstanding claims. We'll be watching progress on this front closely as product liability in healthcare frequently ends up more costly than originally anticipated.

Finally, the company intends to seek an extension for filing its 10-k, due to weakness in financial controls uncovered during the carve-out of its CRM business and expansion of its enterprise SAP platform. Management indicated that no material misstatements have been identified in the financials, but this is an additional risk for investors to keep in mind as we await the filing.