Polynovo (ASX: PNV)

We initiate coverage on medical device provider Polynovo with a fair value estimate of $1.00. Shares are currently overvalued, trading at a 34% premium. Morningstar equity analyst Shane Ponraj suspects the market is likely too optimistic on the speed and extent of Polynovo’s commercial rollout and is underestimating competitive pressures.

Ponraj thinks the market is also overly excited about potential new indications of Polynovo’s NovoSorb technology. While broader indications including hernia repair and breast augmentation and reconstruction are being considered and would expand Polynovo’s addressable market, these are still very early in the development phase. Our Uncertainty Rating for Polynovo is Very High, and we assign a Standard Capital Allocation rating.

Polynovo’s main product, NovoSorb BTM, is a patented biodegradable synthetic scaffold to support the regeneration of the dermis when lost through surgery, trauma, burns, or other causes of tissue loss. Polynovo’s current strategy revolves around increasing its sales staff, expanding its geographical footprint, and exploring new uses for its NovoSorb technology beyond the dermal substitute market. With its geographical reach, the firm estimates its products are available to 800 million people as of fiscal 2023, but highlights that the global market is underserved.

Ponraj does not award Polynovo an economic moat given low switching costs for clinicians to adopt competing products and concerns over the durability of intangibles related to NovoSorb. He thinks Polynovo will have little to defend its position when faced with stronger competition in the coming decade, particularly when its key patents expire in fiscal 2028.

Financial success in medical devices is also dependent on distribution networks, hospital relationships, brands, and marketing expertise that larger competitors may already have and can utilize more effectively.

Light & Wonder (ASX: LNW)

We initiate on electronic gaming machine provider Light & Wonder with a $135 per share fair value estimate which is ~18% below the current share price of $110.77. Morningstar equity analyst Angus Hewitt assigns Light & Wonder a Morningstar Uncertainty Rating of High, and a Capital Allocation Rating of Standard. He does not think Light & Wonder benefits from an economic moat.

While stringent regulatory licensing requirements in major markets create barriers to entry for new players, the market is already highly competitive, and Hewitt does not believe Light & Wonder has garnered the appropriate intellectual property or brand assets to enjoy excess economic returns. Hewitt’s valuation implies a fiscal 2023 price/earnings ratio of 36 and an enterprise value/EBITDA of 11. Our discounted cash flow model uses a 7.8% weighted average cost of capital.

Hewitt expects it will prove difficult for Light & Wonder to capture material and maintainable share in the electronic gaming machine market. However, he does not expect the firm to cede share to smaller players either, as its research and development spending is multiples of most of its smaller competitors.

Light & Wonder significantly simplified its business by divesting noncore lottery and sportsbetting assets. Light & Wonder is now a more focused entity, cut in much the same image as dominant competitor Aristocrat, with operations across social casino, iGaming, and EGMs. Research & development (“R&D”) investment can be leveraged to drive game performance across all remaining business units.

R&D is the lifeblood of any electronic gaming manufacturer, especially given a trend to more rapidly changing technology. Although insufficient to warrant an economic moat, continuous product development allows Light & Wonder to maintain game quality and differentiate products from lower-end competitors.

Link Administration (ASX: LNK)

We initiate coverage on Link Administration with a fair value estimate of $1.50 per share and assign the group narrow moat, High Uncertainty, and Standard Capital Allocation Ratings. The shares are currently trading at a level we consider fairly valued.

Link derives its revenue mainly from delivering administration services to corporations and/or financial services companies in Australia and the United Kingdom. The firm is the largest provider of superannuation administration services and the second-largest provider of share registry services in Australia.

Morningstar equity analyst Shaun Ler expects Link to refocus on its higher-returning core businesses. Link’s diverse product range and long-term contractual agreements create switching costs for its clients, while business volume growth and its scalable client platform give rise to durable cost advantages.

Ler expects revenue growth from foreign markets, expansion in superannuation members, cross-selling, and higher interest income on client cash balances. However, future margin expansion may be limited by falling customer fees, investment in platform development overseas, and rising competition from local players in foreign markets. Still, Link's low capital intensity, high proportion of recurring revenue, and ongoing improvements in operational efficiency should ensure a robust balance sheet and steady dividends. As long as

Link maintains its current considerable scale over peers, it can keep pricing its services competitively, driving customer retention and new business wins.

A main investor concern is the potential for further contract losses following Hesta Super's recent termination. This is Link’s first material contract loss in the last five years. However, Ler sees this as an isolated customer loss. In general, Link has a sticky clientele and continues to win new client contracts, most recently ANZ Staff Super, Ampol, and First Sentier in fiscal 2023.