Nanosonics (NAN) 1H17: Cash earnings beat grabs attention. Key points

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1 Date 21 February 2017 Theme Financial Results Company Nanosonics (NAN) 1H17: Cash earnings beat grabs attention We maintain our BUY rating with a revised price target of $3.72 per share. NAN shares have been volatile and experiencing some pressure below the $3-mark since reporting sustained growth over 1H, which prompted upgrades. With genuine earnings and growth having arrived, the valuation argument around the stock is getting more heated. Our sense is that the stock has corrected back towards trend but that it can push back up towards DCF over the next 6-12 months. For us the catalysts driving that will be: gross margin outlook, the exploration of new US business with ultrasound manufacturers other than GE, convincing the market that the change in UK business model will deliver faster NHS penetration and earnings, and finally the fruits of R&D investment being served up. Key points 1H17 result. Nanosonics executed a solid cash earnings beat with PBT +$3.6m ahead of our forecasts. Sales in the US business increased 144% to $34m. Outside the US, the business is doing better than the numbers suggest. The 1H sales growth of 30% to $2.2m does not reflect the consumables sales funnel being built in UK via managed equipment service (MES) contracts in NHS centres; which will also drive service revenue medium term. Opex looked very disciplined with SG&A controlled to ~36% of net sales. The EBITDA result of $10.5m was an impressive number (v $7.0m forecast) driving both cash profit and operating cash flow beats. There was a one-off tax benefit in the result leading Nanosonics to report $22m NPAT. Nanosonics still has $41m in accumulated losses to offset against medium-term tax exposure. The profit outlook is such that we expect Nanosonics to start paying cash taxes in 2HFY19 after exhausting jurisdictional losses. Non-cash tax impacts in P&L will be noisy between then and now we present normalised NPAT and EPS on a cash basis. Outlook. Management flagged possible softening of GE demand in 2H having re-built inventory. Notwithstanding that adjustment, we expect 63% sales growth as 2017 unfolds, supporting a $17.6m net profit (+27% upgrade). The European segment should start to see the benefit from some of the MES contract rollouts in the UK over 2H17 and beyond, particularly if favourable English high-level disinfection guidelines become available. For some time we have expected Nanosonics to announce moves into the Japanese market and still see a lot of value in making a start in that country, where the fundamentals for adoption are at a low base. We have also brought EU forecasts down in FY18-19 as we transition the UK part of our model across to MES contracting. Valuation and risks PT revised to $3.72/sh (DCF) BUY. As sales ramp through 2017 and the market becomes increasingly comfortable with the sales growth outlook of the combined Direct and GE/other OEM business, we believe Nano s valuation can develop back towards DCF. Important risks described p.5. Earnings forecasts Year-end June (AUD) FY15A FY16A FY17F FY18F FY19F NPAT rep ($m) NPAT norm ($m) Consensus NPAT ($m) EPS norm (cps) EPS growth (%) P/E norm (x) EV/EBITDA (x) FCF yield (%) DPS (cps) Dividend yield (%) Franking (%) Source: Company data, Wilsons estimates, S&P Capital IQ Recommendation BUY 12-mth target price (AUD) $3.72 Share 20-Feb-17 (AUD) $2.80 Forecast 12-mth capital return 32.8% Forecast 12-mth dividend yield 0.0% 12-mth total shareholder return 32.8% Market cap $834m Enterprise value $768m Shares on issue 298m Sold short 0.9% ASX 300 weight 0.0% Median turnover/day Shane Storey shane.storey@wilsonsadvisory.com.au Tel mth price performance ($) $2.0m 1.60 Feb-16 Jun-16 Oct-16 Feb-17 NAN XSI Rebased 1-mth 6-mth 12-mth Abs return (%) Rel return (%) Key changes 16-Jan After Var % NPAT: FY17F % norm FY18F % ($m) FY19F % EPS: FY17F % norm FY18F % (cps) FY19F % DPS: FY17F % (cps) FY18F % FY19F % Price target: % Rating: BUY BUY Issued by Wilsons Advisory and Stockbroking Limited ABN Australian Financial Services Licence No , a participant of ASX Group and should be read in conjunction with the disclosures and disclaimer in this report. Important disclosures regarding companies that are subject of this report and an explanation of recommendations can be found at the end of this document.

2 Price target DCF methodology Valuation WACC (%) 10.0 Terminal growth assumption (%) 3.5 PV of forecast FCFs ($m) 118 PV of terminal value ($m) 871 Enterprise value ($m) 989 Net debt / (cash) ($m) -65 Equity value ($m) 1,055 Price target Key assumptions Revenue growth (%) EBIT growth (%) , NPAT growth (%) , EPS growth (%) , EBIT/sales (%) Tax rate (%) ROA (%) ROE (%) DCF valuation ($/sh) 3.72 Price target ($/sh) 3.72 Interims ($m) Half-year (AUD) Dec 15 Jun 16 Dec 16 Jun 17 1HA 2HA 1HE 2HE Sales revenue EBITDA EBIT Net profit Norm EPS EBIT/sales (%) Dividend (c) Franking (%) Financial stability Year-end June (AUD) FY16A FY17F FY18F Net debt Net debt/equity (%) <0 <0 <0 Net debt/ev (%) <0 <0 <0 Current ratio (x) Interest cover (x) 0.7 <0 <0 Adj cash int cover (x) <0 <0 <0 Debt/cash flow (x) Net debt (cash)/share ($) <0 <0 <0 NTA/share ($) Book value/share ($) Payout ratio (%) Adj payout ratio (%) EPS reconciliation ($m) FY16A FY17F Rep Norm Rep Norm Sales revenue EBIT Net profit Notional earn Pref/conv div Profit for EPS Diluted shrs (m) Diluted EPS (c) Returns FY16A FY17F FY18F FY19F ROE (%) ROIC (%) Incremental ROE Incremental ROIC Profit and loss ($m) Sales revenue EBITDA Depn & amort EBIT Net interest expense Tax Minorities/pref divs Equity accounted NPAT Net profit (pre-sig items) Abns/exts/signif Reported net profit Cash flow ($m) EBITDA Interest & tax Working cap/other Operating cash flow Maintenance capex Free cash flow Dividends paid Growth capex Invest/disposals Other inv flows Cash flow pre-financing Funded by equity Funded by debt Funded by cash Balance sheet summary ($m) Cash Current receivables Current inventories Net PPE Investments Intangibles/capitalised Other Total assets Current payables Total debt Other liabilities Total liabilities Minorities/convertibles Shareholder equity Total funds employed Page 2

3 Nanosonics 1H17 results Results analysis Table 1: Nanosonics 1H17 results vs pcp and Wilsons estimates ($ in mn) 1H16a 1H17a %chg Forecast %chg Var (abs$) %var Segments USA % % 1.4 4% EMEA % % (0.3) -30% APAC % % (1.0) -43% Group revenue % % 0.0 0% COGS % % 0.8 9% Gross profit % % (0.8) -3% SG&A (16.4) (13.0) -21% (16.7) 2% % R&D (3.3) (4.3) 30% (4.2) 28% (0.1) 2% Other income % Operating result (3.5) % % % D&A % % (0.2) -25% EBITDA (2.8) % % % Net Interest, other % % (0.0) -10% Pre-tax profit (3.2) % % % Tax expense (benefit) - (11.7) - (11.7) NPAT (3.2) % % % Normalised NPAT (4.0) % % % NDiluted EPS (cps) (1.2) % % % Operating cash flow (3.9) % % % % of net revenue 1H16a 1H17a 1H17a Gross profit 81.1% 72.8% 75.0% SG&A 105.2% 35.9% 46.2% R&D 21.0% 11.8% 11.6% Group EBITDA -18.1% 29.1% 19.4% Normalised NPAT -25.8% 28.4% 18.6% FY17 Guidance nil Source: Nanosonics, Wilsons estimates INCOME STATEMENT 1H revenue increased 132% to $36.1m as per the company s previous quarterly updates. Gross margin was off our forecast by ~22bpps but operating expense control provided a significant beat on cash earnings. Strong EBITDA number of $10.5m with all the ~$3.5m beat driving the cash interim profit. Underlying $10.3m PBT probably the best indicator of the result versus pcp. One-off tax benefit of $11.7m inflated the reported interim profit to $22m. Americas. Sales increased 144% to $34m. Management flagged that GE had built an inventory position over the 1H and that 2H sales would be more representative of clinic/hospital level demand. We have adjusted our 2H forecast lower to account. ROW. Both non-us jurisdictions continued to undershoot our expectations. CASH FLOW AND BALANCE SHEET Operating cash flow increased 223% to $8.8m and was $1.6m higher than our forecast. Nanosonics reported cash of $57m. Fully funded to bring new products to market over the medium term. Page 3

4 Earnings outlook Table 2: Revised forecast detail FY16-22e ($ in mn) 1H16 2H16 FY16 1H17 2H17 FY17 FY18 FY19 FY20 FY21 FY22 USA APAC EMEA Medical device revenue pcp device growth 132% 23% 63% 17% 33% 31% 26% 18% COGS Gross profit SG&A R&D Other (1.2) (0.6) (1.8) (1.6) (0.7) (2.3) (1.4) (1.4) (1.5) (1.6) (1.8) EBITDA (2.8) D&A EBIT (3.5) 3.1 (0.4) Net interest Pre-tax profit (3.2) 3.2 (0.1) Tax Normalised NPAT (3.2) 3.1 (0.1) Normalised EPS (1.2) 1.2 (0.0) Operating cash flow (3.9) Gross margin 81% 71% 75% 73% 73% 73% 73% 73% 72% 72% 72% SG&A 84% 45% 59% 35% 39% 37% 36% 30% 25% 22% 20% R&D 23% 14% 17% 13% 13% 13% 11% 9% 7% 6% 6% Source: Wilsons estimates Table 3: Changes to forecasts Earnings revisions FY17e FY18 FY19 FY20 Sales revenue - Before $m Sales revenue - After $m Change % -5.9% -8.6% -8.2% -5.2% EBITDA - Before $m EBITDA - After $m Change % 23.7% -5.6% -12.3% -8.9% NPAT (normalised) - Before $m NPAT (normalised) - After $m Change % 27.8% -3.1% -18.2% -8.0% EPS (normalised) - Before cps EPS (normalised) - After cps Change % 26.1% -4.4% -19.0% -9.0% Source: Wilsons estimates Page 4

5 Nanosonics (NAN) Business description (NAN) develops, manufactures and markets equipment for the high level disinfection of ultrasound probes and other pieces of medical device hardware. Its products are underpinned by a NanoNebulant technology very fine, nebulised droplets of concentrated hydrogen peroxide which kill microorganisms on surfaces. Its lead product, the Trophon EPR, is now available in most major markets for disinfecting obstetrics/gynaecologic probes. Investment thesis Our thesis on Nanosonics is that in time regulatory pressure will build within the healthcare industry to provide greater safety and traceability for high level disinfection of medical devices. This should entail a shift away from the use of toxic, bulk liquid disinfection practices. Revenue drivers Has a non-exclusive distribution arrangement with GEHC for the US and Canadian markets Network of third-party device distributors in Europe Revenue a function of both device sales (capital equipment) and consumables (cartridges of hydrogen peroxide and other products used with every disinfection cycle) Margin drivers Gross margins: devices (c.60-75%); consumables (c.80-90%) Contract pricing may be variable Business development expenses expected in both Europe and US business building channels, increasing awareness, providing additional customer support Key issues/catalysts Upside risks: Faster-than-expected sales traction in the US by GEHC and Nanosonics sales forces Decision to scale-up manufacturing a leading indicator of demand Partnering transactions on other projects disinfection units for transesophageal transducers, other applications Risk to view Downside risks: Disappointment on quarterly sales development Regulatory and/or clinical practice changes take a long time to change All device manufacturers face scale-up, quality control risks Adverse pricing outcomes New technology competition Balance sheet Nanosonics had c.$57m cash as at end-1hfy17 Board Mr Maurie Stang (Non-Exec. Chairman) Mr Michael Kavanagh (Managing Director) Ms Marie McDonald (Non-Executive Director) Mr Richard England (Non-Exec. Director) Dr David Fisher (Non-Exec. Director) Mr Steven Sargent (Non-Exec. Director) Management Mr Michael Kavanagh (CEO, Executive Director) Mr McGregor Grant (CFO) Dr Ron Weinberger (President Technology Development) Dr Steven Farrugia (Senior VP Design & Development) Contact details Address: 14 Mars Rd, Lane Cove, NSW 2066 Australia Phone: Website: Page 5

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