JadeThaiCatwalk/iStock via Getty Images

JadeThaiCatwalk/iStock via Getty Images

I was concerned about Inogen's (NASDAQ:INGN ) supply chain risk back in August of 2021, but that situation went from bad to worse since, culminating in a roughly one-month suspension of manufacturing. While there have been encouraging developments (including growth in the rental business), supply chain and margin challenges are likely to loom over the company and the stock for the remainder of 2022.

These shares have fallen another 45% since my last update, and they look pretty washed out at this point, with little sell-side support and a pretty undemanding valuation. With ongoing growth opportunities in the rental and international channels, I think this is a name that could come back to life when the supply situation improves (likely 2023), allowing for revenue reacceleration and margin leverage.

I don't think quarterly results are the best reflection of the health of the company right now, as supply constraints have significantly impacted the company's ability to meet demand and have led to the company reprioritizing and reallocating capacity across its business lines.

To that end, the fourth quarter saw a nearly 20% sequential decline in revenue and the first quarter isn't likely to be much better (flattish sequential performance). Within those numbers, though, the U.S. direct-to-consumer business declined less than 10% qoq in the fourth quarter and the rental business grew close to 10%, with a 6% qoq increase in patients on rental service. Overseas demand has remained relatively healthy, and the company's business-to-business operations have taken the brunt of the supply-driven capacity limitations, with revenue down more than 50% qoq in the fourth quarter.

Underlying demand, though, continues to look strong. Nothing in the commentary from ResMed (RMD) or Philips (PHG) suggests underlying erosion in demand, and Inogen's direct-to-consumer business was only down about 4% on a two-year (pre-COVID19) annualized stack, and that's with the company's shift toward growing the rental business and weaker consumer demand on lockdown restrictions. Likewise, underlying prescriptions for oxygen therapy do not appear to have meaningfully changed.

I also believe the current environment could be supportive of even more growth in the rental channel and, once supply challenges are resolved, more sales to home medical equipment companies. Given that the traditional tank-based business requires drivers, and those are in shorter supply, and improving reimbursement (not to mention patient satisfaction), more respiratory care companies may find that this is a good time to accelerate the switch from portable oxygen tanks to portable oxygen concentrators.

Inogen's semiconductor supply situation worsened to a point where the company actually paused manufacturing across its company-owned and third-party facilities for about a month starting in early January. That pause allowed the company to accumulate chip inventory and also make further progress in redesigning motherboards to make use of the chips that the company can get on the market.

While the company hasn't gone into more detail (and I wouldn't expect them to), I wonder if the company has swapped out MCUs for FPGAs, as the former are booked out months ahead, while there are still FPGAs available. By and large, FPGAs are a more expensive option than a purpose-designed MCU, but they can fulfil the same functions.

In any case, I do expect that Inogen will have to pay more for chips through the end of the year, and nothing from the guidance I'm hearing from chip companies suggests a meaningful improvement in availability before late in 2022. Chip companies are adding more capacity, but they're also seeing customers step up and offer premiums for assured supply, so it's not as though there is much "slack" on the way in the supply chain even with the capacity additions.

Looking out to 2023, I expect component availability to improve meaningfully. It may be optimistic to say that the supply situation will be back to normal, but it will be better, and I don't think it will be the limiting factor on revenue.

On top of the supply-related challenges, Inogen is facing some regulatory challenges in Europe. Due to a new regulatory process in Europe (Medical Device Regulation replacing Medical Device Directive), Inogen's prior Medical Device Directive certificates will expire on May 18, and with them, the right for the company to market its products in Europe. The company is already underway with the regulatory filings for the new process, and has also applied for specific country exemptions, and management expects a surge in orders ahead of the certificate expirations.

The long and short of it is that the European operations could see some disruption with big orders in front of the expiration and the gap between the expiration and the new regulatory approvals (likely late in Q2, or early in Q3). While this has been a known issue for a few quarters, it does arguably limit near-term upside from that market (a high-teens percentage of sales in 2021).

One question I have, and I haven't found an answer in management's presentations, commentary, or filings, nor in sell-side reports, is how this situation came about in the first place. The company knew the regulatory change was coming (it was disclosed in the 10-K for 2020, for instance), but yet there will be this gap. My assumption, and I want to emphasize that is just an assumption on my part, is that there were backlogs with the regulatory counterparties in Europe due to the pandemic and Inogen has simply had to wait its turn.

I do think that Inogen has seen some share loss in the short term from these supply challenges, but management has prioritized its direct business (direct to consumer sales and rentals), and I think that's the right call. As the supply situation improves through 2022 and into 2023, I expect the company to regain share, as I continue to expect portable oxygen concentrators to take share of the oxygen therapy market and for Inogen to retain product feature/performance leadership.

I'm looking for around 3% to 4% revenue growth in FY'21, followed by multiple years of high single-digit to low double-digit growth as the company not only benefits from its growing direct rental business, but also ongoing growth in direct sales and sales to home medical equipment companies. Long term, relative to pre-pandemic levels, I expect annualized revenue growth of around 6% to 7%.

While the underlying oxygen therapy market is likely to only grow at a low single-digit rate, I see more growth for Inogen as more patients realize the benefits of portable concentrators, including patients in adjacent markets like bronchiectasis and heart failure that haven't traditionally been core target markets.

With the revenue reacceleration, I also expect margin leverage, with EBITDA margins improving from the low single digits toward the high single digits in 2024 and double digits in 2026. While I still believe high-teens FCF margins are possible, I don't see that until past 2030, though improvement toward the mid-teens can still drive double-digit FCF growth relative to pre-pandemic levels.

Weak near-term margins and revenue growth prospects argue for a lower forward revenue multiple (around 2.25x), but that still supports a fair value in the mid-to-high $40s, and that multiple should expand as revenue growth and margins come back. Moreover, the shares look undervalued on the basis of discounted cash flow.

There was already uncertainty about whether Inogen could continue to generate attractive growth with a new business model that reprioritized rentals, and then the supply chain issues hit. At this point, there's really not much benefit of the doubt in the valuation, and I believe these shares could outperform in 2023 if management can show ongoing progress in direct sales channels and resolve its supply chain issues. This remains a risky story where management execution is critical, I can see a path to a higher share price later this year and into 2023 as the business recovers and rebuilds momentum.

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