Here at HBI, we're constantly on the hunt for selective, underexploited opportunities within the healthcare biosphere. Within this circle, there's multiple names that pique our interest, ranging all along the market capitalization spectrum. One name our indicators are now pointing to is the small cap offering Electromed, Inc ( NYSE:ELMD ) a company with expertise in pulmonary rehabilitation. As a reminder, ELMD develops and manufactures therapeutic products for airway clearance. It's been around since 1992 - and been on our radar for quite some time - however, it's the most recent developments that's gotten us most constructive on the company.

Specifically, the FDA granted ELMD 510-K clearance for ELMD's SmartVest Clearway Airway Clearance System ("SCACS") on November 30, and in our opinion, herein lies the alpha opportunity looking ahead.

SCACS utilizes high-frequency chest wall oscillation ("HFCWO") therapy, a non-pharmacological intervention indicated in the removal of airway secretions usually seen in complex pulmonary and cardiopulmonary disorders. We will discuss these in detail here today, along with their epidemiology and classification, demonstrating how SCACS is able to help these patient populations. Net-net we rate ELMD a buy and are seeking price target objectives of $11 and then $22.50 based on fundamental and market data.

As mentioned, ELMD received 510-K clearance for its SCACS unit as we rolled into December. We'd note the market's reaction was quite mute, however, at the same time, this is an under-covered name that we believe will take time to reach pricing equilibrium/efficiency. Hence, we are looking to now as an exciting time for entry.

Put simply, SCACS uses HFCWO therapy to remove the excess mucosal secretions associated with complex respiratory disorders. It involves the use of a mobile phone app, Bluetooth and AI to collect data and provide a bespoke treatment to patients.

Let's take a step back here and analyse what's in front of us, as there's actually quite a bit to unpack there to understand our investment thesis.

HFCWO has been around for some time, and has its roots in Physiotherapy, via the pulmonary rehabilitation arm. We regularly speak to pulmonologists, physiotherapists and other respiratory specialists in the field on the current state of the treatment market, so we understand the mechanism of action here. To give some context, Physiotherapists will perform a treatment on patients with excess mucous secretions, using a method called 'percussions and vibrations' [Percs' and vibes' for shorthand]. This is often combined with positive expiratory pressure ("PEP") treatment for maximum benefit. Data shows good efficacy at a rate of 2-4Hz, otherwise 2-4 percussions each second.

Basically, the repeated impact and 'vibrations' is thought to dislodge thick, stubborn mucous from the bronchi, that otherwise remains 'stuck' within the airways. This therapy forms the bedrock of what is HFCWO, and is well accepted within the nomenclature as an effective line of treatment in complex respiratory conditions. As such, the SmartVest performs these percussions, albeit in the absence of a therapist, and controlled by the patient wearing a vest.

Predominantly, ELMD is focusing on the bronchiectasis and chronic obstructive pulmonary disease ("COPD") corners of this market. However, there are multiple added benefits to the cystic fibrosis ("CF") population, along with pulmonary oedema ("PO"), type 2 heart failure ("T2HF") and the likes. Although, bronchiectasis looks to be the main avenue of differentiation for ELMD's device from our analysis.

For those unfamiliar, bronchiectasis results from chronic inflammation and/or build up of scar tissue in the airways and lungs. This removes the elastic recoil of the lunch tissue, leading to a state of constant-widening. This causes difficulties in respiration [inhalation, exhalation] and therefore physical activity, whereas patients are susceptible to forming chronic respiratory infection, including chronic pneumonia. It is irreversible, and hardly ever caused by smoking. More so, chronic infections, genetics, allergies and co-morbidities are risk factors. Uncontrolled coughing and shortness of breath are the major symptoms of bronchiectasis and leads to a lower quality of life. Epidemiological studies put the number of US patients at 350-500,000, however as high as 4 million considering it often gets undiagnosed. It's more common in those aged over 60+.

Exhibit 1. Pathological, physiological presentation of bronchiectasis: classical dilation of airway present with excess mucous secretions

Source: National Heart Lung and Blood Institute

Source: National Heart Lung and Blood Institute

COPD on the other hand is a chronic inflammatory condition of the airways that results in airway obstruction, shortness of breath and loss of physical condition. The major cause of COPD is thought to be smoking in >95% of cases, although there is a 5% genetic incidence.

It is one of the main respiratory causes of hospitalization amongst adults. Patients are often hospitalized with an exacerbation of the condition, especially in flu season. The CDC lists ~16mm Americans to have the disease, worldwide, approximately 392mm people. Alas, it is a condition in need of a remedial breakthrough.

Finally, CF is the third major patient group that is set to benefit from the therapy. Unlike the other two, CF is a genetic condition that impacts the mobilisation of sodium and water across the cell membrane. It mostly impacts children to middle-aged adults, as the worldwide life expectancy is around 44 years old for those with the condition. It results in a thick build up of purulent mucous in and around the bodies tissues, especially the lungs and digestive tract. The Cysitc Fibrosis Foundation estimates there are 40,000 children in the US with CF, with around 1,000 new cases diagnosed each year.

With the understanding of each condition, we feel it's now important to discuss just how impactful the therapy is deemed to be. Suppositions from Nicolini and colleagues established a causal relationship in the benefit of HFCWO therapy and bronchiectasis as far back as 2013. The author's study identified the "HFCWO technique provides an improvement both in pulmonary function and quality of life related parameters in patients with chronic hypersecretive disease...[s]ince those patients need daily airway clearance...".

Exhibit 2. Traditional 'chest physio' involving manual percussions on patient's chest wall

Exhibit 2a. Example of HFCWO device in situ [this is not the ELMD's unit, simply a demonstration of the setup].

Data: Darbee & Kanga (2006): Physiologic Evidence for High-Frequency Chest Wall Oscillation and Positive Expiratory Pressure Breathing in Hospitalized Subjects With Cystic Fibrosis, Researchgate

Data: Darbee & Kanga (2006): Physiologic Evidence for High-Frequency Chest Wall Oscillation and Positive Expiratory Pressure Breathing in Hospitalized Subjects With Cystic Fibrosis, Researchgate

Exhibit 3. ELMD's SmartVest airway clearance system in situ.

Note: This is NOT an advertisement or solicitation to purchase the ELMD SmartVest unit. We have no affiliation, despite owning the stock. (Data: Electromed Website)

Note: This is NOT an advertisement or solicitation to purchase the ELMD SmartVest unit. We have no affiliation, despite owning the stock. (Data: Electromed Website)

Meanwhile, Barto et al. (2020) submit that HFCWO effectively reduces the incidence of hospitalizations in non-CF bronchiectasis from 49% to 24% in the study cohort. Patients showed "improved self-reported outcomes associated with the initiation of HFCWO therapy as measured by number of hospitalizations, antibiotic use, and the subjective experience of airway clearance". Similar evidence is corroborated by Sievert and co-authors (2016) and Henkle and colleagues (2018) in treating patients with bronchiectasis HFCWO.

But what about the cost-benefit, especially for commercial payers? Thankfully, Ansaripour et al. (2022) describe a hypothetical model demonstrating the benefits of HFCWO versus chest-wall physiotherapy, from a US-commercial payer's perspective. Noteworthy, the research covered complex neuromuscular disorders, those which result in respiratory muscle weakness [and lack of airway clearance].

The model, built on 1mm members, identified 2099 patients eligible to receive the therapy, over 5 years. Data illustrated an estimated saving of $1.594mm in 1 year and $9.591mm over 5 years using HFCWO vs. traditional chest physio for commercial payers. This translated to a saving of $9.46 per-member-per-year.

Hence, there's a multitude of benefits apparent for both the commercial and patient side in utilizing HFCWO systems. Following the 510-K clearance, we should note that the limited market release of ELMD's SCACS will roll out within the month. We'd encourage investors to stay on top of this one.

Switching to the numbers briefly, we were pleased to see upsides from the company from the top to bottom line. Note, it was the Q1 of ELMD's FY23, so we will be talking in terms of this from here.

In particular, we saw that Q1 revenue increased 700bps YoY to $10.7mm, on core EBITDA of $200,000, down from $700,000 a year ago. Management note that it was able to fulfil 97% of its shipped orders which we note is a strength in the current state of supply chains. Segmentally, the revenue split was 89.7% or $9.6mm to home care, with $554,000 from home care distributor sales.

It brought this down to a gross profit margin of 78%, a decompression of ~100bps YoY, and quarterly operating income of $44,000, down 91% YoY. We should note, however, that management also increased its rep headcount to 44 by Q3, resulting in $218,118 of revenue per rep in the home care division [$890,000 annualized]. It hopes to end the next quarter with 48 reps, targeting an annualized $850,000-900,000 in home care revenue per rep for the full-year.

You can see a wider spectrum of ELMD's operating performance in Exhibit 4, with corresponding revenue upticks along the way.

Exhibit 4. ELMD quarterly revenue, core EBITDA, TTM FCF yield clip, FY16-date.

Note: Dates are shown in calendar years, so Q3 FY22 corresponds with the 3 months ending September 30, 2022. This contrasts to ELMD's reporting period, which is June 30-June 30. This should be noted by investors. It still shows the accurate quarterly walk through nonetheless. Second, given the free cash outflows since Q2 FY22, we've decided not to show the negative FCF yield on the chart. TTM FCF yield is calculated as [FCF TTM / rolling enterprise value]. (Data: HBI, Refinitiv Eikon, Koyfin)

Note: Dates are shown in calendar years, so Q3 FY22 corresponds with the 3 months ending September 30, 2022. This contrasts to ELMD's reporting period, which is June 30-June 30. This should be noted by investors. It still shows the accurate quarterly walk through nonetheless. Second, given the free cash outflows since Q2 FY22, we've decided not to show the negative FCF yield on the chart. TTM FCF yield is calculated as [FCF TTM / rolling enterprise value]. (Data: HBI, Refinitiv Eikon, Koyfin)

We believe that with the launch of the SmartVest, this has meaningful potential to see these numbers drift even higher, and pulling to the bottom line in doing so. In fact, we see tremendous EPS upside each quarter into the coming 2-year period.

Our growth assumptions forecast 287% YoY EPS growth to $0.15 in ELMD's Q2 FY23, stretching up to a 500% YoY growth by the following quarter. It's not unreasonable to expect ELMD's bottom line to grow at triple digits per quarter on average over the next 6-8 periods in our estimation. A breakdown of our EPS growth assumptions is observed in Exhibit 5.

Exhibit 5. ELMD's FY23-25E' EPS growth assumptions [quarterly, annual; internal estimates].

Note: Unlike in Exhibit 4, these dates are presented in ELMD's reporting period. So Q2 FY23 is equal to the 3 months ending December 31 2022. (Data: HBI Estimates)

Note: Unlike in Exhibit 4, these dates are presented in ELMD's reporting period. So Q2 FY23 is equal to the 3 months ending December 31 2022. (Data: HBI Estimates)

We'd note that consensus has the stock valued at 37.7x forward P/E, well ahead of the S&P 500's forward P/E estimate of 18.18x. Therefore, like us, investors expect ELMD to outperform the benchmark by >2 turns this coming year.

We do believe, however, that consensus is undervaluing the growth potential of ELMD downstream. Especially given our EPS growth assumptions listed above.

Our calculations would value the stock fairly at 42.4x forward earnings. We are therefore ahead of consensus in our position, thereby adding to the alpha opportunity. Rolling our ELMD FY23 EPS estimates of $0.26 forward and applying this multiple derives a price target of $11.02, our first price objective in this name [Exhibit 6]. Further evidence of this target is seen in Exhibit 8.

Exhibit 6. Fair forward P/E of 42.4x EPS Est. = $11.02.

Note: Fair forward price-earnings multiple calculated as 1/fair cost of equity. This is known as the 'steady state' P/E. For more and literature see: [M. Mauboussin, D. Callahan, (2014): What Does a Price-Earnings Multiple Mean?; An Analytical Bridge between P/Es and Solid Economics, Credit Suisse Global Financial Strategies, January 29 2014] (Data: HBI Estimates)

Note: Fair forward price-earnings multiple calculated as 1/fair cost of equity. This is known as the 'steady state' P/E. For more and literature see: [M. Mauboussin, D. Callahan, (2014): What Does a Price-Earnings Multiple Mean?; An Analytical Bridge between P/Es and Solid Economics, Credit Suisse Global Financial Strategies, January 29 2014] (Data: HBI Estimates)

Adding further weight to our upside thesis, we see that February 23' calls in the ELMD option chain extends from a range of $10-$22.50, thereby indicating investors bullishness up to that price and beyond. We'd note the chain is stacked with calls but there's only 1 put contract with an OI of 20 at $10. This adds to our bullish thesis, as mentioned. We are therefore seeking price objectives of $11 then $22.50 in this name.

Exhibit 7. ELMD Feb 23' option chain [calls' volume and OI only]

Data: Seeking Alpha, ELMD: "options"

Data: Seeking Alpha, ELMD: "options"

Net-net we rate ELMD a buy and believe there's an alpha opportunity ahead of us in the next 3-6 months with the movements in its SmartVest device. We are seeking objectives of $11 and then $22.50 based on fundamental and market data. Key risks to the investment thesis are located in the "investment summary" section at the start of this report.

Exhibit 8. ELMD fibonacci retracement from previous May 22' high lends price range of $10-$12, with $11 at the 78% mark. Note, 161.8% of the move is at c.$17.

This article was written by

Disclosure: I/we have a beneficial long position in the shares of ELMD either through stock ownership, options, or other derivatives. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.