Tuesday, May 23, 2006

Aspect Medical Systems Reprise

Way back when Value Discipline started, in November of 2005, I had expressed some concern about the valuation of Aspect Medical Systems (ASPM.)

Link- Aspect Medical Systems (ASPM)

Following the approval of a brain monitoring system by Japanese health regulators, a number of brokers were recommending the stock. I had commented on its generous valuation and in particular on the language used in one of the "research" reports:

"We believe traditional metrics do not reflect the market upside potential for Aspect Medical."

On the close of the day of that post, the stock went out at $37.91. Today, the stock was hit fairly hard and went out at $20.95 down 6.9% for the day and about 45% since we last posted.

Aspect Medical is a leading manufacturer of brain monitoring solutions for surgeries using general anesthesia in the operating room and patients under sedation in the ICU. The Company has 3 additional potential applications for the Depression, Alzheimer's and Sedation markets.

Other than the obvious dramatic fall in market capitalization, the business itself is doing well. The company is developing a razor/ razor blade model of selling high margin sensors and lower margin monitors. Although combined revenue from monitors and modules increased only 11% in 1Q06, unit sales were up more than 38%. This sort of discounting is very unusual for a company that tends to portray itself as having leading edge technology. But not to over-react, gross margins on a TTM basis are still very healthy at 78.3%. Return on invested capital is 13.8% over the TTM and the company is generating a tiny amount of free cash flow.

I am pleased to see costs come under better control with SG&A growing only about 6.6% YOY relative to the fast pace of revenues of almost 30% on a YTD versus last year's YTD.

Enterprise value is now only about $445.6 million versus last November's $786 million. But back to those metrics...EV/EBITDA is now 52 times, well down from last November's 122 times but still nosebleed territory for a value guy. Similarly, EV/ EBIT is now 63.5 times.

A little more on recent clinical news. Psychiatrists have been concerned about the effectiveness of SSRI ( Selective Serotonin Reuptake Inhibitors) in children and adolescents. Such antidepressant drugs include Prozac, Zoloft, and Paxil. Findings from two
studies presented yesterday at the annual meeting of the American
Psychiatric Association document the capability of Aspect Medical
System's EEG-based research technology to predict an individual's
likelihood of responding to treatment of depression with an SSRI at
one week after initiating medication. Generally, it takes several
to determine if a patient has responded to this regimen. ASPM's technology predicted the 8 week clinical response with 73% accuracy after only one week of treatment. Expansion of the trial into nine centers provides some encouragement about this technology. An accuracy rate of 73% seems low, but clearly is an improvement over today's hit or miss approach. Major depressive disease afflicts some 15 million Americans annually and the unpredictable response of patients to expensive therapeutics is currently based on trial and error.

The potential remains significant for this company and at least the price has come down to somewhat more understandable levels. Wall Street remains infatuated with this company and its prospects with a consensus earnings growth rate of about 44%.

Though the science is very interesting, the risks remain high with this cheery consensus.

Disclaimer: Neither I, my family, nor my clients have a current position in this stock.


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