An enduring principle in value investing is to buy at the point of maximum fear. When a company becomes embroiled in complicated and uncertain legal troubles, it becomes shunned by Wall Street, and its stock can often be bought at unbelievable bargains. Such stocks often rapidly regain their true value as soon as the legal troubles are cleared up. A discerning investor who is able to correctly analyze all the legal issues involved and predict a probable outcome may be able net a spectacular return in a relatively short time. Cardiac Science (CSCX) is a company in such a situation.
Cardiac Science is a company that primarily makes automatic external defibrillators (AEDs). AEDs are required to treat people suffering from sudden cardiac arrest (SCA), which is a sudden electrical malfunction of the heart that causes cardiac arrest. A cardiac arrest is different from a heart attack, where blood flow to the heart is impaired. A cardiac arrest may be caused by a heart attack, or a heart may simply spontaneously develop an abnormal electrical rhythm and stop beating normally. If heart contraction does not resume within 4 minutes of arrest, the patient suffers irreversible brain damage, and death occurs rapidly thereafter. Due to the extremely short window during which medical treatment must be administered, the mortality rate for SCA is 95% for an out-of-hospital attack, whereas immediate treatment with an AED brings mortality rate down to 50%. An AED is able to automatically detect whether abnormal heart rhythm is present, and will give an escalating series of shocks to restart the heart, and will not shock the heart if abnormal rhythm is not present. Modern AEDs are safe enough to be used by even untrained personnel, and AED use is covered by Good Samaritan laws, which prevent liability for AED users if the device is used by volunteers in good faith. All emergency response personnel are equipped with AEDs, and laws mandate that AEDs be available at schools, cruise ships, airports and bus terminals.
CSCX sells the well-regarded PowerHeart AEDs, and holds a wide range of patents relating to AED technology, including patents on software that allows AEDs to self-test frequently, and patents on AED mounts that sound an alarm and automatically alert emergency services when opened. CSCX was experiencing rapid growth in sales as a result of laws mandating AEDs in various buildings. However, in 2009, it was revealed of its entire installed base of 300,000 AEDs manufactured before August 2009, approximately 1 in 75,000 contained 2 components that could fail, and this has resulted in a failure to deliver therapy in 2 cases over the past 6 years. The company suspended production for 5 weeks as it sourced alternative components, and resumed production in September 2009. Still, there remains the important problem of 300,000 potentially faulty AEDs in the field.
Under advice from outside experts and lawyers, the company decided that it was irresponsible to recall all 300,000 AEDs when it did not have the inventory to replace the AEDs, and given the low frequency of the failure, it was safer to leave the AEDs in the field than to recall the AED and have the AED unavailable for weeks. A main reason that the faulty components took so long to come to light was that the self-test software had been unable to detect the failure, and the company decided to work on a software update that would detect the failed components, and then specifically replace those AEDs. The software update was completed ahead of schedule in February 2010, just in time for CSCX to be hit with an FDA warning letter, which stated that FDA views the software update to be an unsatisfactory response to the problem, as it only detects the problem and does not fix it, and that leaving faulty AEDs in the field constitutes disregard of public safety on the part of CSCX. The letter threatens possible fines, seizures and injunction for CSCX if the matter is not resolved promptly. The gradually recovering stock promptly took another swoon.
Before the disclosure of the faulty AEDs, CSCX had free cash flow of approximately $12 million in 2008, up from $7 million in 2007. In 2009, CSCX set aside $18 million as liability for the recall, and posted an earnings loss. The company has $30 million in cash, $60 million in book value, and no debt. Currently, CSCX has a market capitalization of almost $50 million. A number of future scenarios are possible
Worst case scenario: FDA gets a court injunction forcing the company into an immediate recall of all 300,000 AEDs, and the company is barred from selling AEDs until the recall is complete. This leads to the collapse of the company, as the company is unable to replace all AEDs, and all $30 million of cash is expended in recalling whatever AEDs it can, leaving no value for shareholders. This scenario is unlikely to happen, as FDA will realize that it essentially means the death penalty for a company with a relatively minor infraction, and is an anti-consumer move since it leaves a huge installed base of AEDs without future service and support.
Medium case scenario: FDA fines the company $10 million for the delay in recall. The company spends $50 per AED to roll out its software update and replaces faulty AEDs, at a total cost of $20 million. This consumes all of its cash. Reputational damage results in severe decrease in sales, resulting in a 60% drop of free cash flow to $5 million annually. Applying a PE of 10 to that cash flow brings us to the current $50 million market capitalization.
Best case scenario: The company rolls out its software update to all AEDs, and expends $20 million in so doing. All faulty AEDs are replaced. The FDA is satisfied that this is a reasonable and responsible course of action, and fines the company a relatively modest $5 million. Reputational damage is minor, leading to a free cash flow of $10 million. Applying a PE of 10 to that cash flow brings us to $100 million market capitalization, a double from current levels.
Given that there has been multiple recalls of other brands of AEDs recently, and that Cardiac Science has a longstanding reputation as a purveyor of quality products, I believe that CSCX will survive this crisis in good shape.
Risks : CSCX is at risk of monetary fines and injunctions from the FDA.
Disclosure : I have a long position in CSCX.
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Great blog! Just found it today.
I had a look at the FY Results for CSCX which became public a few days ago. I removed Corrective Action costs and reduced the General and administrative Operating expenses by an estimated 4M covering the legal issues they are in. Even then they made an operating loss of about 11M , and had a negative free cashflow (almost regardless of how it is calculated I think (not sure how you calculate it)).
So that’s a bit worrisome – might still be a good investment though. Guess the legal issues have affected the sales as well, hard to know how much of the sales decrease is due to the recession vs company specific problems.