As Warren Buffett once said, "The three most important words in investing are margin of safety."
The margin of safety is a reminder that even the most profitable, fastest growing, or simply trendiest businesses can be overvalued. It's a painful lesson to learn, but the ongoing market correction is proving to be an excellent teacher.
Some growth stocks have done better than others at resisting precipitous drops in 2022. Shares of TransMedics (TMDX) have risen 192% year to date following successive quarters of raising revenue guidance. More impressive, they've reclaimed and surpassed the all-time high set in early 2021. Many growth stocks are years away from accomplishing that feat.
Despite the impressive leaps in revenue, the current market cap of $1.78 billion certainly places a steep premium on the company's growth. Does TransMedics offer an attractive margin of safety near current levels?
A Paradigm Shift in Organ Transplants
TransMedics developed the organ care system, or OCS, to help improve the success rates of organ transplants. A donor organ is typically prepared with special solutions and simply keeping it really cold before transplanting it into a recipient on a waiting list. That's not the best process for ensuring a successful transplant. Indeed, the status quo results in most organs available for transplantation going unused due to damage and the inability to keep them viable during transportation.
The OCS platform attempts to recreate the conditions of the human body with a mechanical device. Compared to cold storage and transport, the OCS platform significantly reduces damage, increases viability, and reduces post-procedure complications by over 50%.
TransMedics has earned FDA approvals and clearances for OCS systems designed for lung, heart, and liver transplants. The company has also wisely invested in commercial infrastructure to improve logistical challenges faced by transplant centers, including surgical retrieval and air transportation. The infrastructure, called the National OCS Program, was responsible for generating 90% of Q3 2022 revenue. The technical expertise, clinical development, and commercial investments are beginning to pay off for investors.
Impressive Growth vs. Margin of Safety
There's no denying the value of the OCS platform and the execution of the team.
- TransMedics reported revenue of $62.1 million in the first nine months of 2022, compared to only $20.6 million in the year-ago period.
- The company generated more revenue from each of its OCS Heart ($25.3 million) and OCS Liver ($30.0 million) systems in that span than it had in total revenue through the first nine months of 2021.
- The quick traction may have even taken management by surprise. TransMedics initially expected full-year 2022 revenue of $52 million at the midpoint, then $62 million, then $71 million, and now $82.5 million.
- The growth trajectory means TransMedics should easily eclipse $100 million in revenue in 2023, perhaps threatening the $150 million mark under the right circumstances
Here's the dilemma: A market cap of $1.78 billion represents a significant premium no matter how investors slice it. TransMedics is trading at 21 times full-year 2022 revenue (using the upper bound of guidance) and nearly 12 times full-year 2023 revenue (using the generous assumption of $150 million). Both are pretty pricey.
For reference, top-tier medical device companies typically max out near 10 times sales for the next 12-month period. Keep in mind that was the ballpark upper limit during the last decade or so, which was accompanied by near-zero interest rates for a historically unusual length of time.
Investors can always tilt their head and squint to justify the premium valuation.
- The OCS platform has the opportunity to become the standard of care in a market that has witnessed relatively little innovation in recent years.
- TransMedics could generate operating income in 2023 or 2024 while still delivering healthy revenue growth, which could be attractive during the upcoming recession.
- The business ended September 2022 with $204 million in cash, which provides a multi-year runway and allows for further investment in growth during the upcoming recession.
I'm not arguing TransMedics is a terrible business with limited opportunities – quite the opposite. But it's important to acknowledge the current valuation prices multiple years of revenue growth into shares. One reason to prioritize the margin of safety when scouring the markets for investment opportunities is that paying up for growth can backfire.
If the business misses Wall Street estimates for any reason during the next 36 months, then shares could get whacked overnight. That could unwind a significant chunk of gains in a single session. The current earnings season provides too many examples to count of reduced revenue guidance leading to precipitous share price declines – even for otherwise solid businesses.
Simply put, TransMedics offers a great example of the nuances encountered in investing. It boasts a solid business with tremendous growth and opportunity, but perhaps at a price that isn't so attractive at the moment.
