AirSeal Concerns Have Let Too Much Air Out Of Conmed’s Valuation (NYSE:CNMD)

bfk92/E+ via Getty Images Writing about CONMED Corporation (NYSE:CNMD) (“Conmed”) back in the fall of 2023, I mentioned some concerns about being bullish on this smaller med-tech company in the face of a weak environment for med-tech stocks and worries that Conmed could see significant competition from a competitor’s insufflator being integrated into the newest Intuitive Surgical, Inc. (ISRG) platform. Med-tech stocks have since recovered nicely, but Conmed shares have been hit hard by the news that the new Intuitive daVinci 5 platform does indeed include an integrated insufflator from Novanta Inc. (NOVT). Conmed’s shares are now down about 30% since that last article. Competition with an integrated insufflator will almost certainly have some negative impact on Conmed’s growth and profitability, but I believe this selloff is excessive. Even incorporating fairly pessimistic numbers for the impact of the AirSeal competition, I believe Conmed can generate revenue growth and margins sufficient to support a price closer to $95, though I realize the Street will likely need some reassurance before rerating the shares higher. AirSeal’s Contributions Will Be A Little Deflated The launch of Intuitive’s new daVinci 5 surgical robot earlier this year confirmed one of the bearish theses on Conmed – the new system does indeed include an integrated insufflator (developed by/with Novanta) that will compete with Conmed’s AirSeal. As AirSeal has been a very successful product for Conmed (fast-growing and high-margin), this is certainly a threat to the business, even if I believe the reaction has been a little extreme. Insufflators are must-have tools for laparoscopic surgical procedures, and surgeons use them to fill the surgical area with air to improve visualization and access for the procedure. AirSeal generates around $175 per procedure from disposables (in addition to a $30,000 system), and AirSeal has long been priced as a premium product compared to regular insufflators (which cost about $80 per procedure, with a $15K-$20K capex component), with that premium justified by features like lower inflation pressures, a valve-less design (which makes the procedure simpler), and proven reductions in surgical times, post-op surgical stay, and post-op pain. While surgeons can still use AirSeal with the new daVinci system, they don’t have to – there is an onboard insufflator that they can use instead. I have no doubt that there will be surgeons who consider that onboard option good enough for their procedures, and new surgeons may likewise conclude that they don’t need to bother with the learning curve for AirSeal. I would also imagine that at least some hospital administrators will argue the “good enough” line, and try to improve per-procedure profitability by turning away from AirSeal. Time will tell just how big of an impact this integrated offering has on AirSeal usage. I’m sure it is indeed good enough for many regular procedures, but I’d note that it does not appear that the integrated insufflator can match the AirSeal on low-pressure functions, meaning AirSeal could still have an advantage in thoracic procedures where pressures are more important. There are also ease-of-use advantages with AirSeal, like the ability to recirculate warm humidified air that won’t fog up the camera, and AirSeal is still the only insufflator with clinically validated better outcomes. Last and certainly not least, surgeons are creatures of habit and can be very reluctant to switch from routines that have worked for them for many years. Conmed management has elected to guide for 2024 with a worst-case scenario in mind that includes a 50% decline in conversion rates with the new robot. I’ve seen updated estimates that AirSeal might have contributed around 20% of 2023 revenue (I don’t believe management has ever confirmed the exact amount), and I believe the business has been growing around 20%. With around 60% of AirSeal revenue coming from robotic procedures, that suggests a roughly 1% impact on 2024 revenue and a roughly 110bp impact on the revenue growth rate – not trivial, but not catastrophic either. Looking at how the Street has traditionally valued med-tech growth, that corresponds to a roughly 0.25x smaller multiple on revenue, or a $16.50/share impact versus the $45/share year-to-date decline. Even granting that AirSeal had above-average margins (management has said it has a low-70%’s gross margin versus the company average of 55%+), a $0.08/share – $0.16/share or so annual impact, making various assumptions about the operating margin, seems pretty digestible. There Are Still Multiple Growth Drivers Even with the headwinds for AirSeal, I still think the Street is losing sight of the overall growth potential at Conmed. Per management’s commentary at sell-side conferences, about 40% of the company’s product families are growing at a double-digit rate and almost 50% are growing at a single-digit rate (with the remainder declining) and the business can grow at a low double-digit rate “when everything is working right” against underlying market growth of 5% to 7%. Not only is AirSeal still a profitable growth product (again, management’s guide for a 50% decline in robotic conversions is what they believe to be a worst-case scenario), but so too is Buffalo Filter, a smoke evacuation system leveraged to increased use driven by state-level mandates. Given that there are around 25M to 30M U.S. surgical procedures a year that generate smoke, at a $20 ASP the potential addressable market scales rapidly even at far less than 100% penetration. While I’m sure companies like Novanta and Stryker Corporation (SYK) will seek to exploit this opportunity too, Conmed enjoys a strong share today and once again I think surgeons will generally opt to stick with tools they’re familiar with unless/until there’s a clear reason to switch. Beyond these products are growth opportunities like in2Bones, an extremities implant business (where integration has admittedly been a little problematic), and BioBrace, a bio-inductive implant for soft tissue repair procedures (like torn rotator cuffs or ACLs) that increases the thickness of the tendon/ligament and addresses a potential $2B+ market opportunity (around 800K to 950K eligible procedures at a $2,500 ASP). The Outlook I’m now at the low end of management’s revenue guidance for FY’24 and I’ve made other reductions to revenue that drive a roughly 10% reduction in my long-term revenue estimates (my 2032 revenue estimate is now 11% lower). I’m doing this out of an abundance of caution that AirSeal growth is significantly impacted, as well as some conservatism on the near-term benefits from the in2Bones deal given some integration challenges. My long-term revenue growth rate (like for like) moves down from 9.2% previously to 7.7%, or a little more than 6% with the new 2023 starting point. I’m modeling a roughly one-point margin impact from weaker AirSeal and some other mix challenges, but I’m still expecting the EBITDA margin to improve by almost two points in FY’24 (to over 20.5%), another two points in FY’25, and another point in FY’26, with operating margin improving from 14% in FY’23 to 18% in FY’25 and continuing to improve thereafter. That should help lift free cash flow margins into the low double-digits and then the mid-teens over time, with mid-teens annualized free cash flow growth. Discounted cash flow, growth-driven multiples, and margin-driven multiples argue for a fair value above today’s price. Even if I cut my forward revenue multiple by 0.75x, which is excessive relative to the impact on the company’s revenue growth and margins, I get a fair value close to $98 on 3x forward revenue. The Bottom Line I think it will take a little time for the Street to get comfortable with the new reality for AirSeal and it’s well worth noting that there is still plenty of uncertainty as to what the real impact will be on Conmed’s business. It may be the case that management’s guidance proves too conservative and most surgeons continue to use AirSeal, or it could be the case that management isn’t conservative enough and AirSeal usage falls off even more in robotic cases. I think the Street is already pricing in a much weaker outlook (revenue declines in the AirSeal robotic business), and I think these shares have appeal for contrarian investors willing to invest in an “it’s not actually that bad” thesis, to say nothing of the other diversified growth opportunities that Conmed offers.

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