Vericel Corporation (NASDAQ: VCEL)

Vericel is a leading producer of autologous cell therapies with two unique FDA-approved products: MACI for cartilage defects in the knee and Epicel for severe body burns. The company has also signed an exclusive license and supply agreement for NexoBrid, a registration-stage product for the debridement of severe burns with an expected commercial launch in early 2021.

Background: Aastrom Biosciences -> Vericel Corporation

Vericel began as Aastrom Biosciences (IPO 1996) with a focus on cell therapies produced from a patient’s bone marrow. The bottom fell out as the company did not get particularly compelling results. The FDA also gave hospitals a long list of rules and regulations to use bone marrow therapies. Hospitals ultimately ended up saying “no thanks” and stopped buying Aastrom’s marrow machines.

Aastrom pivoted toward cell therapeutics, focusing on ixmyelocel-T for the treatment of advanced heart failure due to dilated cardio myopathy. After doubling-down on small clinical trials, Aastrom found that this, too, was a tough model.

In early 2013, Aastrom effectively cleaned house and hired Nick Colangelo to be the new CEO.

In 2014, Aastrom acquired MACI, Epicel, and Carticel from Sanofi for $6.5mm as part of the legacy business leftover from their $20b acquisition of Genzyme. At the time, the business had declining revenues and negative gross margins. MACI was still in development stage, and Epicel wasn’t being invested in. Carticel was the main product, a first-generation, second-line autologous therapy for cartilage defects in the knee. Carticel was discontinued in 2017 following FDA approval and launch of MACI (December 2016 / January 2017).

Following the acquisition, Aastrom changed its name to Vericel Corporation and moved the headquarters to Cambridge, Massachusetts, initiating a transformation from a clinical-stage company to a commercial-stage biologics company.

Product Overview

MACI is a minimally invasive first-line implant for the treatment of cartilage defects in the knee. It is the only FDA-approved product (Dec 2016) that applies the process of tissue engineering to grow cells on scaffolds using healthy cartilage from a patient’s own knee.

The process begins with a tic-tac sized biopsy, which is sent to a lab for 4 weeks to grow and form more cartilage. If the patient elects to get surgery, the membrane with the new cartilage is then put back into the knee. Vericel earns revenue separately on biopsy kits and MACI implants.

Cartilage has limited intrinsic healing capabilities. An injured patient has three basic options for care:

1. Chondroplasty (palliative care) relives pain, but it does not address the underlying injury.

2. Microfracture (reparative care) is the most common procedure. The surgeon drills small holes into the bone, and bone marrow fills the defect. This ultimately produces fibrocartilage (“scar cartilage”) which lacks the durability of normal cartilage and has proven to be a relatively poor solution for medium to larger lesions.

Another reparative option is an osteochondral allograft (OCA), typically performed after a failed microfracture. This is cadaver-based, where the surgeon is mincing a corpse’s cartilage to plug a defect. With OCAs, the supply of grafts is often limited, and the procedure is highly invasive. Clinical trials have also not been run as tissue bank products are not well regulated.  

3. Autologous (restorative care) produces a more durable hyaline-like cartilage that is naturally present in the knee, leading to a more durable, longer-lasting treatment. The only current option in this space is ACI – Autologous Chondrocyte Implantation.

Data from the SUMMIT trial and follow up Extension study demonstrated statistically significant improvement from MACI over microfracture in terms of pain and function over 2 and 5-year periods. The Orthopedic Journal of Sports Medicine published another study in July demonstrating high levels of patient satisfaction and tissue durability beyond 10 years after an accelerated weight-bearing rehabilitation program. 

Patients are typically able to get back to full weight bearing in 6-8 weeks.

As a biologic, MACI has data exclusivity through 2028. There is no generic pathway to enter the market. A competitor must go through clinical trials.

MACI Competition

In the ACI space, MACI had a potential competitor in Histogenics’ NeoCart, but the therapy failed to meet its primary endpoint at the one-year mark in Phase III trials. Histogenics has since dissolved and sold NeoCart to Medavate.

Aesculap Biologics is currently performing a Phase III study for its product NOVOCART 3D in comparison to microfracture. Expected completion is May 2021.

Other competing products are cadaver-based. Zimmer Biomet markets a product DeNovo NT that does this with juvenile cartilage, but there is no clinical data yet to support the procedure.

As the only approved regenerative therapy for cartilage, MACI is alone in its class with a head start. Management sees no competition until “mid next decade”.

MACI Market Potential

Of the 750,000 cartilage procedures performed annually, Vericel narrowly defines an addressable market of 60,000 patients with large lesions who are likely to secure authorization for MACI. At ~$40,000 per surgery, 60,000 patients create an opportunity greater than $2 billion. More than 90% of covered lives in the US have access to MACI as all the top health plans have a policy.

After initially targeting 3,000 sports medicine surgeons, management has increased the target audience by 2,000 to include other orthopedic surgeons that do high volumes of cartilage repair. 1,300 surgeons have submitted biopsies in the last 12 months (+26%). This is a key leading indicator, and additional growth will come from increasing the number of biopsies per surgeon as well as improving the biopsy to implant conversion rate, which is how the sales force is incentivized.

Through the first half of 2019, Vericel had more implanting surgeons than it had in all of 2018.

Vericel’s sales force is the primary driver for MACI adoption and expansion. In the 3Q19 call, management announced the largest sales force expansion to date, highlighting the success thus far and opportunity ahead. The 48-person salesforce will grow to 76, and it will cover 9 regions versus an original 6. Reps are hired in 4Q, trained in 1Q, and enter the field in 2Q. Management expects productivity per rep to dip in 2020 before reaching new highs in 2021.

MACI sales are strongest in 4Q due to insurance timing and patient preference to rehab in the winter.

Epicel    

Epicel is a permanent skin replacement for burns covering more than 30% of one’s total body surface area (TBSA). It is the only FDA-approved permanent skin replacement for adult and pediatric patients with full-thickness burns. With Epicel, Vericel is able to take a post-stamp size biopsy of healthy skin and grow enough skin in two and a half weeks to cover a patient’s entire body. The manufacturing process is similar to MACI.

Autografts have traditionally been the go-to treatment for catastrophic burn patients, but for particularly large burns (> 60% TBSA), there is often not enough healthy skin to do repeat autographs. The skin required for an autograft is typically minimum ~75% the size of the burn.

A 25-year study published late 2018 in the Journal of Burn Care and Research demonstrated markedly increased survival rates for patients treated with Epicel at a mean 67.5% TBSA.

In February 2016, Vericel secured a pediatric label expansion for Epicel, expanding the market size and allowing the product to be sold for a profit.

Epicel Competition

In September 2018, the FDA approved Avita Medical’s RECELL to treat burns in patients 18 years and older. RECELL uses a small amount of a patient’s healthy skin to produce a spray-on-skin in as little as 30 minutes. One RECELL kit can treat a ~10% TBSA burn, and its relative cost is cheaper than Epicel at about $5-10k per unit. A credit card size skin sample can treat an entire back.

A key differentiator is that clinical data does not exist to support burns > 50% TBSA. 

RECELL launched in 1Q19 into what management initially views as a $200 million market opportunity in the US, with potential to expand to $2 billion. The product has quickly gained traction, as 56 of the 132 burn centers in the US placed orders in 2Q 2019. Avita stock (NASDAQ: RCEL) currently trades at a $900 million valuation, well above VCEL.

Epicel Market Potential

There are 40,000 hospitalized burn patients every year. About 1,500 fall within the Epicel label, but Vericel is typically treating burns > 40% TBSA, a category of about 600 patients annually. The average Epicel order is a couple hundred thousand dollars, so this equates to a $100mm opportunity.

Epicel remains underutilized to date due to lack of consistent promotional effort prior to Vericel’s acquisition of the product. Vericel has since grown the salesforce from 1 representative to 9.

Vericel is currently only treating about 100 patients per year with Epicel in ~40 of the 132 burn care centers in America. They’ve recently increased the Epicel salesforce (6 to 9) and hired clinical specialists to grow the customer base and develop deeper relationships at burn centers.

Epicel sales are volatile and difficult to predict, but demand is typically strongest in 4Q and 1Q when the weather is cold and people are building fires, using heaters, etc.

NexoBrid

In May 2019, Vericel entered into an exclusive license and supply agreement with MediWound to commercialize NexoBrid in North America. NexoBrid is a topical product that enzymatically removes dead tissue (eschar) in burn patients without damaging healthy tissue. This initial step applies to almost all 40,000 hospitalized burn patients whose current standard of care is a surgical procedure that leads to healthy tissue loss and blood loss, but the product focuses on the other end of the spectrum for Vericel – patients with burns less than 30% of TBSA.

Vericel is targeting a BLA submission in 2Q20, and pending approval, launch in the first half of 2021. In the meantime, the companies have announced an expanded access treatment protocol (NEXT) to allow for continued use of NexoBrid to treat patients and further familiarize physicians and burn centers.

Vericel will pay MediWound $7.5 million upon approval and up to $125 million if certain sales milestones are met. The first milestone payment of $7.5 million will come when NexoBrid sales surpass $75 million. Vericel will also pay MediWound HSD/LDD percentage royalties.

MediWound is obligated to supply NexoBrid to Vericel on an exclusive basis for five years.

The addition of NexoBrid has potential to more than triple the size of the burn franchise’s addressable market to over $300 million.

NexoBrid Competition

Smith & Nephew market Santyl, the only currently approved enzymatic debriding product. While Santyl can be used for partial thickness burns, it focuses more on ulcers and wounds. Clinical data does not exist for the application of Santyl on burns.   

Investment Thesis

Almost 3 years into the MACI story, Vericel appears to be hitting its stride as the management team just announced the largest sales force expansion to date. Vericel has a virtual monopoly in an underpenetrated articular cartilage market, and I expect compounding benefits as MACI adoption and awareness grows.

Current studies focus on new therapy X vs microfracture. Absent of head-to-head data against MACI, many surgeons will be hesitant to switch, and the multi-year commercial head start for MACI offers a significant barrier to competitor adoption.

While Epicel is not a home run product and does face competition, it does well in a niche segment and is a revenue source that is not economically sensitive. NexoBrid increases Vericel’s addressable market in burn care and should lead to deeper relationships in the space.

There is a clear runway for growth with an operating model characterized by high incremental margins (80% GM, 50% EBITDA) and limited capital investment needs. They’re at an inflection point of profitability and consistent cash generation, and I believe the 3Q19 surprise in operating cash flow was a sign of things to come.

The combination of difficult-to-predict sales and usually conservative guidance has led to consensus estimates that appear beatable. Operating leverage may continue to surprise going forward.

Catalysts

4Q19 – 28 new MACI reps are hired and begin training

2Q20 – New MACI reps enter the field

2Q20 – BLA submission for NexoBrid

1H21 – Potential commercial launch of NexoBrid

Commentary

“Since acquiring this business five years ago we’ve more than doubled the volume of MACI and Epicel without any material increase in fixed costs. As a result, we consistently increased gross margins, a trend we expect to continue given that we can meet forecasted demand for several years without significant capital investment . The increase in gross profit combined with the operating margin leverage resulting from our high sales force productivity gives us confidence that we’re well positioned to generate strong profit and cash flow growth in the years ahead” CEO Nick Colangelo, 3Q19 call.

“We expect to maintain strong double-digit revenue growth in the years ahead, and based on the operating leverage of our business to generate gross margins in the mid 70% range and operating income 20%-plus range in the next few years” CEO Nick Colangelo, 3Q19 call.

Beatable 4Q19 (Report late Feb / early March 2020)

Guidance provided in the 3Q19 call was for full-year net revenues of $116 – $118 million. MACI revenue growth of 35-36%, implying 33-36% in 4Q. Epicel growth of 10-15% for the full year. 4Q gross margin in the mid-70s, bringing the full year gross margin to approximately 68%. Full year operating expenses including the $17.5mm NexoBrid payment (2Q19 R&D) will be approximately $92 million.

Consensus estimates call for 4Q revenue of $39.15 million, a gross margin of 73.3%, and net income of $8.777 million. I think each of these is beatable.

Management has been conservative in its guidance, consistently increasing revenue as the quarters pass. Quarterly estimates have proven low, which is why I project a modest beat in my 4Q19E numbers.

I back into 4Q MACI revenue using the high end of management’s guidance for 35-36% full year. In 2Q they guided for 37-38% of the year’s revenue coming in 4Q. 35.8% growth in 4Q implies 37%.

Projecting Epicel is difficult, but the sell-side expects a drop y/y. I’m seeing estimates for $5.8mm, -6.8% for the quarter, which would hit the midpoint of guidance for full year +10-15%. 3Q was exceptionally strong, but those sales have no effect on 4Q demand. The Epicel sales force is now double the size that it was when 4Q sales were last below $6mm (4Q16). I think guidance may be conservative yet again.

On to 4Q gross margins, management set expectations for 4Q in the mid-70s and full year gross margin of approximately 68%. Management regularly touts their incremental margin profile – 80% gross margin, 50% adjusted EBITDA (aggressively defined). In the past, they’ve talked about 15-20% marginal cost of goods. It’s been showing in the numbers, and 3Q was a surprise to analysts. Again, a likely conservative guide:

The sell-side estimate is below guidance:

I believe 68.5% gross margin can be expected for FY 2018, as that would imply 74.2% in 4Q and an incremental GM of 80.2%, which has proven possible. This would lead to a full year incremental GM of 81.3%, below 86.3% over the last twelve months.

Finally, 4Q net income is projected to be $8.777 million (range $8.2mm – $9.58mm). I think this is a fair number but certainly beatable if revenue and/or margins surprise.

Beatable Longer-Term

If an ~80% incremental gross margin proves sustainable, these estimates will have to move closer to the margin profile that Nick talked about in the 3Q call (highlighted above under “Commentary”).

Risks

• Vericel is protected by limited IP. Epicel is not patent protected, and only portions of the MACI process are still patented. While trade secrets, the long trial process, and commercialization are barriers to entry, companies with know-how in cellular regeneration could produce a competing product.
• Heavy competition is on the way. Aesculap’s NOVOCART 3D is due to complete phase III trials in May 2021. It is unknown how long the product could take to reach the market if approved. Other different but one-step (vs MACI two-step) therapies will continue to receive significant investment and research.
• Breakdown in expected operating leverage. Vericel hasn’t shown enough to prove the operating leverage in the model over four quarters, which is part of why shares trade at a discount to more profitable peers. Without operating leverage, revenue growth and incremental gross margins will not be enough for investors.    

Valuation

VCEL shares trade at 4.9x EV/Sales on a blended forward basis, below an average ~5.2x EV/Sales since a blowout 4Q17 report in March 2018.

Since March 2018, VCEL has:

1. More than quadrupled its addressable market for MACI from 11,000 patients to 60,000 patients, representing an increase of over $1.5 billion in market opportunity (Aug 2019)
2. Tripled its addressable market for the burn care franchise with NexoBrid (May / Aug 2019)
3. Primary competitor NeoCart failed its phase III trial, delaying commercialization of competition (Sept 2018)
4. Raised $74.8 million in equity (May / June 2018) 🚩
5. Began generating cash flow and has paid off all debt

Increased estimates + equity dilution have justified a flat multiple over the near-term, but Vericel’s medium and long-term prospects have improved.

At 4.9x EV/Sales, VCEL trades at a discount to other high-growth MedTech peers (7.7x). Removing the larger more profitable companies (ISRG, EW, ALGN) leads to a more homogeneous group trading at 6.7x. This implies a valuation range of $20-23 for VCEL.

I expect shares to outperform over the next few years through better-than-expected results and a multiple re-rating, leading to a price target of $22. Analysts should be able to value the company on more of a profitability and cash flow basis come 2020/2021.