In conversation with Charles Haff

By Len Zehr

As a senior research analyst at Craig-Hallum Capital Group, Charles Haff covers medical devices and ancillary healthcare services. Previously, he covered medical devices at Dougherty & Company and was a buy side healthcare analyst for 12 years at Thrivent Asset Management, a Minneapolis insurance company, Security Global Investors and JPMorgan Asset Management, where he covered all sectors within health care. Mr. Haff tends not to think about his coverage universe in a vacuum but by tapping his broad background, he understands how companies fit into the healthcare ecosystem and researches those companies. Mr. Haff earned his B.S. from the University of Nevada, Las Vegas and his M.B.A. from Xavier University. In this interview with, he discusses industry trends in the healthcare sector and a couple of his favorite investment ideas.

How does Craig-Hallum differ from other banks?

We’ve been around for about 15 years and our primary focus is to make money for our clients. How we’re different is number one, we’re focused on micro-and small-cap investments for institutional clients only. We do not have retail clients. Other investment banks, as they get larger, tend to move up-cap to keep growing but we’ve been able to find a model where we stick to our knitting in micro-and small-cap and it works for us. Number two, is that we are a research driven organization. While other investment banks lead with investment banking and tuck research under that, we lead with research. We believe this approach leads to higher investment returns for our clients.

What trends are you seeing in health care and specifically medical devices?

The sector is going through consolidation, culminating with the acquisition by Medtronic (NYSE:MDT) of Covidien (NYSE:COV) in a cash and stock transaction valued at about $50-billion. As the U.S. healthcare system tries to eke out more value from the system, it’s causing medical device companies to merge and consolidate. The low interest rate environment is also added to consolidation of the industry and companies making acquisitions can show accretive financials by using low interest rates on debt.

The other trend we’re seeing is adoption of a value-based health care model under the Affordable Care Act and we’re moving away from a fee-for-service model. Take, for example, a patient that receives a medical device implant. If that patient develops pneumonia while in the hospital, the hospital now has to take care of that patient or face financial penalties. In the past, a hospital would receive revenue for treating that pneumonia. Now, hospitals are on the hook for readmissions and adverse outcomes. So, we’re seeing growth in the antibiotic market, more prudent use of antibiotics, more treatments for hospital-acquired infections and improving health care practices to avoid adverse events.

What’s the state of the medical device industry’s relationship with the FDA?

The regulatory burden is increasing. Five years ago, the FDA began moving away from 510(k) applications, where a company only had to show its device was substantially equivalent to a previously cleared device. Now, the FDA is emphasizing de novo 510(k) applications, where some clinical testing is required. The FDA also is requiring more premarket approvals (PMA), where clinical trials are required to show a device is safe and effective.

Any other issues impacting the medical device sector?

For the past two years, some innovation in the industry has been curtailed because of the 2.3% excise tax that medical devices companies paid on their sales in the U.S. That burden was lifted, effective Jan. 1, 2016, with President Obama signing into law a two-year suspension of the medical devices tax. Hopefully, the suspension will become permanent.

How do you see the election impacting the healthcare sector?

I’d expect all of the candidates to push themes such as increasing value for the health care system, with value measured either by reducing costs or more effective therapies. In the U.S., we spend more on health care patients than any other country in the world but studies have shown, that outcomes here are not the best in the world. So, we are not getting the most value for our dollar spent on health care. I think the candidates will push that theme.

What stocks do you like in the sector?

The first one I would mention is Novadaq Technologies (NASDAQ:NVDQ; TSX:NDQ). Novadaq designs, manufactures and markets point-of-care imaging systems, which allow surgeons to visualize blood flow and tissue perfusion in real time. Novadaq fits into the value-model proposition that I’ve mentioned already in that using the SPY technology improves clinical outcomes. The company has shown clinical value in the past and it has more studies coming out that should validate SPY’s clinical value.

We’re excited about the progress Novadaq has made over the past year bringing its SPY ELITE business into its own direct sales force after the company ended a marketing and distribution deal with LifeCell.

We also like the deal Novadaq has made with LifeNet Health to be the exclusive worldwide distributor of its DermACELL tissue products for wound and breast reconstruction surgery. We believe DermACELL has best-in-class tissue products. DermACELL revenues this year could be at least three times what they were in 2015. And longer term, we believe DermACELL is a $100-million annual revenue opportunity for Novadaq.

The final thing I’d like to mention is Novadaq’s specialized sales force to sell its LUNA product directly to wound care centers. Recently, Novadaq separated its sales force into surgical and wound segments and as a result, we expect LUNA sales to gain traction in the marketplace. Novadaq has about five direct LUNA reps now and we expect the company will add 15 more reps in 2016, which should drive higher sales in 2016 and beyond.

Any other healthcare companies you’d like to mention?

Nobilis Health (NYSE MKT:HLTH; TSX:NHC) also fits into our model of companies that can add value to the U.S. healthcare sector. Nobilis is capitalizing on the improved safety of certain minimally invasive surgical procedures, which no longer have to be performed at in-patient hospitals but can be done in low-cost, out-patient and ambulatory surgical centers.

The second investment theme for Nobilis is that the company is able to secure patient referrals to their ambulatory centers without going through the traditional referral system, where the general practitioner refers a patient to a specialist, who performs the surgery. Physician referrals often add cost to the system. Under Nobilis’ business model, the company is able to find patients that, for example, have already undergone a MRI test for back pain or are absent from work because of back pain and bring them into their centers for those necessary surgical procedures.

Additionally, we expect Nobilis to continue to acquire underperforming facilities in the very fragmented U.S. ambulatory surgery center industry. Industry studies have shown that 74% of ASCs in the U.S. are individually owned. We believe that with Nobilis’ unique growth model, there are many accretive opportunities there.

We also believe that Nobilis has fixed its recent operational challenges, which are not uncommon for small-cap companies following a major merger or acquisition. For example, the company recently hired Crowe Horwath, the eighth largest accounting firm in the country, which will go a long way to tightening financial controls. Audited third quarter 2015 results and a 10-Q have been filed with the SEC and Nobilis management has reiterated 2016 guidance, which implies 55%-plus growth in EBITDA. Lastly, we also like the fact that management and board members have made open market purchases in recent weeks.