Wright Medical Group N.V. (WMGI) is a medical device company that focuses on products to treat damaged or diseased joints, tendons and bones. The products are marketed to orthopedic, trauma and podiatric surgeons. If you mess up any of your extremities (shoulder, elbow, wrist, hand, foot or ankle), Wright will be there to help make it right!
The company was formed by the merger of Wright Medical, a Tennessee based firm and Tornier, a Dutch firm, in 2015. Naturally, the combined company decided to domicile itself in Amsterdam and continue to be traded on the Nasdaq. However, it is hard to discern a corporate tax angle to this move as both firms were unprofitable, a legacy carried over to the succeeding entity. The company’s senior management continues to be located in Memphis, TN, with international headquarters in the U.K. 70-75% of its sales are from the U.S. International sales are not growing faster than overall revenue, indicating that the company is not driving into untapped markets.
The company has a sleepy shareholder base of large mutual funds, with Fidelity and T. Rowe Price being the two largest shareholders.
I will focus on the company’s financial performance and projections. Please refer to the company’s website for a list of products, etc. A representative sample of the company’s products includes bone putty, absorbable scaffolds, fusion plates, toe implants, compression screws, titanium anchors, shoulder prostheses, and high-strength sutures. The company’s CEO, Robert Palmisano, has been in the position since September 2011. For the curious, I have found no evidence that he is related to the former IBM (NYSE:IBM) CEO, Sam Palmisano.
In the most recent quarter, the company had revenue of $180 million, 5% higher than the year before. The company claimed that the growth rate was tempered by revenue dis-synergies that it had anticipated. Ignoring amortization of intangibles, the company had a slight operating loss. Interest expense on $830 million of debt amounted to $18 million. Thus the company is losing approximately $20 million a quarter. Free cash flow is a little better than this figure, but still negative.
The company has a market cap of $2.8 billion and $230 million of cash. Like most medical device companies, the firm is subject to litigation every now and then. Its balance sheet includes $150 million of additional cash held in escrow to fund a hip litigation settlement. Ignoring this, the company has an Enterprise Value of $3.4 billion. This represents 4.5x expected 2017 revenue and 40x expected 2017 non-GAAP adjusted EBITDA.
The company doesn’t seem to have any problem continuing with generating losses as it is focused on adjusted EBITDA (and even that is only marginally positive). On the flip side, the company’s end markets have secular growth due to an aging population, its revenue is higher YoY, and Amazon (NASDAQ:AMZN) has no plans to start making joint implants (as yet).
Valuation: Fair value of $20 for the stock
The company has guided for an acceleration in growth in the second half of this year, double that of the first half. There is certainly risk to this guidance. The company has set financial goals of mid-teens sales growth and non-GAAP adjusted EBITDA margins of 20% (double the current level). With most sales coming from a U.S. medical market that is growing nowhere near this figure, it is hard to see how the sales growth will increase sustainably to this level. There are no blockbuster products in the pipeline that will help.
At a 20% EBITDA margin and $800 million of sales, the company would have $105 million in operating income and $33 million in pre-tax income or $0.32 per share. This number could go higher if the company can re-finance its debt at a lower interest rate or if it can indeed accelerate its revenue growth. So I will be generous and double the figure, assuming it can go to $0.65 per share, which should also account for inflation from pro-forma exclusions. Analyst consensus calls for $0.08 in 2018 and $0.37 in 2019. Putting a 30x multiple on $0.65 per share, the stock is worth $20 at best. That is 23% downside from the current level above $26. I have chosen to use a pre-tax figure as the company has plenty of NOL carry-forwards and won’t pay meaningful taxes for many years. Please note that I do not generally use EBITDA multiples as I don’t find them helpful, but if you are interested, the fair value estimate amounts to 17x projected EBITDA.
In terms of comparables, Zimmer Biomet (ZBH) trades at 14x pro-forma EPS, although its quality of earnings is erratic, and the real multiple somewhat higher. Medtronic (MDT) trades at 17x EPS. Boston Scientific (BSX) is at 23x EPS after a good run, aided by excitement about new products.
Risks are manageable
The biggest risk to a short thesis is an acquisition of the company. At a sub $3 billion market cap, it is within the range of a possible acquisition by one of the larger medical device manufacturers, aided by investment bankers who can convince them that buying an unprofitable company can be justified by the synergies that can be found.
The short interest is moderately high (13% of float), so the chances of a short squeeze are not minimal. The company has convertible notes outstanding, so that could explain part of the short interest in the stock, as holders of such notes may short the stock to hedge their holdings.
Anything that is positive for the medical device industry e.g. repeal of Obamacare medical device taxes would be positive for the company.
Finally, there is a risk that the company succeeds in dramatically increasing its revenue, margins and earnings. I would view the chances of this happening to be slim.
Disclosure: I am/we are short WMGI.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.