I've never been so happy to see one of my largest holdings drop 20%.

To be clear, there's nothing wrong with AVITA Medical or its first-quarter 2023 performance. It was simply a little overvalued relative to expected performance this calendar year.

Solt DB Invest anointed AVITA Medical as a Dicerna Level conviction on December 7, 2022. The stock was as much as 144% away from our modeled fair valuation and led our Margin of Safety Dashboard for 51 days between July 6, 2022, and January 16, 2023. But our model also signaled that the valuation became a little stretched in recent months. Overshooting our modeled midpoint by 30% isn't a reason to panic or sell, but rather suggests there are better opportunities elsewhere.

The stock's roughly 20% plunge on Friday, May 12, 2023, is simply nudging the business closer to its fair valuation based on expected performance this calendar year.

By The Numbers

AVITA Medical turned in a solid performance in the first three months of the year. Total revenue grew 40% in the year-over-year period while gross margin remained strong. The company expanded its field sales team from 30 reps to 69 reps – one shy of its target for the end of June.

What the market might be misinterpreting is the revenue growth rate. The business has guided for full-year 2023 revenue to grow 47% from last year. Growing at "only" 40% in the first quarter might be interpreted as being behind that trajectory. Of course, the growth rate in the second half of 2023 will be significantly higher once the ReCell System launches in soft tissue repair. The business is on track to meet or exceed its guidance.

If investors want to nitpick, then perhaps U.S. revenue was a little lighter than hoped for. But higher-than-expected Japan revenue made up the difference.

Data Source: SEC filings.

As always, there's additional context and nuance behind the data.

Gross margin improved significantly in the year-over-year comparison. However, the first quarter of 2022 was the only period of the last two years with gross margin of less than 80%. The most recent period's gross margin is in line with expectations and the recent trend. It doesn't represent a sudden leap higher.

AVITA Medical has also started breaking down revenue by country.

• The United States generated $9.4 million in commercial revenue during the first three months of the year, representing growth of almost 29% from the $7.3 million generated in the year-ago period. That's meaningful, but Solt DB Invest had modeled over $10 million.
• Japan generated just over $1.0 million in revenue during the first quarter, compared to nothing last year. Solt DB Invest had modeled only $0.65 million for the full year, so the differences between U.S. and Japan essentially cancel out.
• AVITA Medical has international approvals in other countries, but doesn't prioritize sales outside the U.S. or Japan. It generated $0.104 million in revenue from Australia and the United Kingdom in the first quarter of this year. Solt DB Invest was previously unaware of revenue in the U.K.

We F*nched Up Our Japan Model

Before we share our updated modeling of revenue and expenses for 2023 and 2024, let's walk through the errors in our modeling for Japan.

AVITA Medical has a revenue sharing agreement with COSMOTEC in Japan through which it receives 40% of total sales in the country. The ReCell System is only approved for burns in Japan, although an additional approval in soft tissue repair will follow in 2024. Meanwhile, the vitiligo indication could launch in Japan (2024) sooner than in the United States (2025)

Solt DB Invest estimated Japan would deliver full-year 2023 revenue of $0.65 million for the business based on our model for inpatient burns.

• The serviceable addressable market (SAM) is approximately 1,400 patients per year.
• Each patient receives an average of 1.67 procedures, which is dictated by the severity of the burn and the total body surface area (TBSA) affected. This determines how many ReCell kits are needed to treat a patient.
• COSMOTEC has earned reimbursement coverage of 970,000 Yen, or roughly $7,200 per kit.
• At 40% revenue share and a blended market penetration of 10% throughout 2023, AVITA Medical would realize roughly $654,000 in annual revenue.

However, AVITA Medical reported first-quarter 2023 revenue of $1.0 million. This would suggest the company has a 60% market share after only seven months on the market, which is nonsensical. COSMOTEC could be stocking inventory for the rest of the year, but when combined with inventory purchases at the end of 2022 this would suggest a market penetration rate of nearly 30%. That doesn't make sense either.

Our model is flawed because we only included the 1,400 individuals for inpatient procedures. The approval and reimbursement coverage in Japan actually includes roughly 6,000 individuals per year who are treated in both inpatient and outpatient procedures – the burn injury only needs to require grafting. This patient population has burns with lower average TBSA and requires 1.16 procedures per treatment, but at the same price point per kit. Using this model instead, first-quarter 2023 revenue of $1.0 million would represent just under 20% market penetration across 2023, which makes more sense.

That said, our 2023 model for U.S. burn revenue is now lower, so the differences in our Japan model simply get canceled out.

AVITA Medical said it will soon rework its agreement with COSMOTEC which, among other things, will allow the business to provide revenue guidance for Japan by making it more predictable.

Forecast & Modeling Insights

(New 2024 model.)

We shared highlighted metrics from our 2023 and 2024 models in February 2023. Highlighted metrics from our updated models are provided below.

• Full-year 2023 revenue of approximately $51.68 million, gross margin of 84.0%, operating expenses of $85.9 million, and an operating loss of $42.5 million. Revenue includes:
• $48.28 million in commercial ReCell revenue in the United States (down from $51.08 million previously)
• $3.4 million in revenue sharing from COSMOTEC in Japan (up from $0.65 million previously)
• $0 in BARDA revenue
• Our 2023 model doesn't include the potential to sign a new procurement contract with BARDA. We expect an increased probability of such a scenario before the end of 2023, potentially adding $7.5 million to $15 million in revenue by the end of 2024.
• Full-year 2024 revenue of approximately $82.81 million (vs. $77.59 million previously), gross margin of 85.5%, operating expenses of $89.3 million, and an operating loss of $18.5 million.
• Revenue and gross margin are significantly higher than our previous model due to increased visibility into the impact from ReCell Go (detailed below).
• Our 2024 model doesn't include the impact of expanded international distribution deals. We expect AVITA Medical to provide an update on at least its international strategy on the third-quarter 2023 earnings call in November 2023.
• Our 2024 model doesn't include the potential to sign a new procurement contract with BARDA. We expect an increased probability of such a scenario before the end of 2023, potentially adding $7.5 million to $15 million in revenue by the end of 2024.

AVITA Medical provided new details on the third-generation, fully-automated device ReCell Go. A premarket approval (PMA) supplement for the device is expected to be submitted to the U.S. Food and Drug Administration (FDA) by the end of June 2023. The product candidate has Breakthrough Device designation, which means it could earn regulatory approval by the end of 2023 or early 2024. Approval is not guaranteed and might require an additional clinical trial (or more real-world data), which would negatively impact our 2024 model.

Nonetheless, the device is crucial for accelerating the growth trajectory.

• ReCell Go will be a small benchtop system that automates sample preparation. A skin sample will be placed onto the deck, which the device will then automatically disaggregate in an enzyme solution.
• A ReCell Go device will cost roughly $3,500 to manufacture. AVITA Medical expects each device can be used approximately 300 times before it needs to be replaced. That works out to roughly $15 per use, which would significantly lower the company's cost of goods sold and improve its overall unit economics. This could increase gross margin to the high 80%s or low 90%s over time.
• Each use of ReCell Go will require a cartridge, which will replace the kits used today. These cartridges will have the same average selling price (ASP) as today's kits, or roughly $6,500 apiece. Reimbursement codes will be the same, too.
• If each ReCell Go device can be used approximately 300 times and each use generates roughly $6,500 in revenue, then each device will have a lifetime value of $1.95 million on a revenue basis. AVITA Medical has over 125 accounts at burn centers across the United States and sees procedural volumes of roughly 900 per quarter. These numbers will increase to include trauma centers when ReCell launches in soft tissue repair in July 2023.
• Importantly, the convenience and lower training burden of ReCell Go is expected to significantly increase uptake and procedural volumes across all indications. If the device earns approval and launches on schedule, then AVITA Medical should easily surpass $100 million in annual revenue in 2025 without stable vitiligo.

Margin of Safety & Allocation

(No change.)

AVITA Medical is considered a Growth (Quality) position. The current Margin of Safety range for the company based on our 2023 model is below:

• Current Price (market close May 11): $15.72 per share
• Likely Undervalued:         <$8.77 per share
• Midpoint:                           $11.40 per share
• Likely Overvalued:            >$14.03 per share
• Allocation Range:             Up to 15%

We will likely switch to our 2024 model by August 2023. The Margin of Safety range based on this model is below:

• Current Price (market close May 11): $15.72 per share
• Likely Undervalued:         <$14.03 per share
• Midpoint:                            $18.24 per share
• Likely Overvalued:            >$22.45 per share
• Allocation Range:              Up to 15%

AVITA Medical reported 25.328 million shares outstanding as of May 2, 2023. The Margin of Safety range above assumes 29.127 million shares outstanding, which prices in 15% dilution. We expect a public offering of common stock of $30 million to $50 million (gross) immediately following FDA approval of the ReCell System in soft tissue repair and stable vitiligo in June 2023.

Further Reading

• May 2023 press release announcing first-quarter 2023 operating results
• May 2023 regulatory filing (10-Q) detailing first-quarter 2023 operating results
• February 2023 research note reviewing first-quarter 2023 operating results and full-year 2023 revenue guidance