Integra LifeSciences: Valuation Disconnect, Sell-Side Missing Impact Of Operating Efficiencies

Integra LifeSciences: Valuation Disconnect, Sell-Side Missing Impact Of Operating Efficiencies

Investment Thesis

Integra LifeSciences (IART) is in the late stages of a transition period, plagued by inconsistency and instability in the orthopaedics segment. Covid-19 has been a compounding factor to these challenges, largely due to the portfolio’s exposure to capital placements and hospital relationships. However, with the risk surrounding the recent Codman transaction now dampened, IART has meaningful growth drivers in place that balance the investment risk profile. We view a period of sequential growth activity for IART that is accompanied by a wider headcount in the salesforce, additional product offerings, a pipeline that is at capacity, and deeper channel penetration from reorganisation of the salesforce.

Figure 1. IART single-year performance

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Data Source: Author’s Bloomberg Terminal

The company is currently in a “show us” stage, and this is largely on the back of recent performance but is propped up by the points above in addition to recent divestitures in the orthopaedics segment. These moves will help simplify the operating model and help to drive sequential performance at the top. Therefore, considering the myriad of factors in the investment debate, we hold a bullish stance, with the scales tilted towards the upside from the weight in the bullish side of the case. Here, we cover all of the moving parts in the investment debate for investors’ own reasoning, and link Q3 performance, valuation and outlook to support our thesis.

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Data Source: Author

Meaningful Drivers – Orthopaedics Divestiture

We firmly believe the company has made the right move in the orthopaedics (“Ortho”) divestiture decision. Back in September, the company announced that it was selling the orthopaedics arm to Smith & Nephew (SNN) in an all-cash deal for $240 million (we’ve covered SNN previously detailing the same- link here). The offloading of this segment allows the company to prioritise capital allocation to higher margin segments exhibiting accelerated growth patterns, such as neurosurgery, advanced wound care, regenerative medicine and other tissue technologies. Management highlighted that the divestiture, on a pro-forma basis, would add ~50bps to cadence of organic growth in the core business, reduce the operating ratio by almost 200bps and increase EBITDA level margins by ~140bps, in line with long-term targets of 28-30%.

Additionally, the Ortho segment is capital intensive without the benefits of scalability. To illustrate, it generates ~6% of total sales, but comprised ~15% of net inventory valuation and almost 15% of stock keeping units, so one can clearly see the disconnect in capital requirements and contribution to organic growth here. Furthermore, the offloading of this segment will likely increase salesforce headcount to drive productivity, as the Ortho sales rep productivity outcomes were 3x behind the 2019 IART totals. We see the move as a positive step towards targeting margin growth and free cash conversion, by lowering capital requirements and placement expenses, whilst focusing attention to higher margin and higher growth segments, as mentioned. It would not be unreasonable to expect IART to target higher margin names or complementary products to the portfolio mix via acquisition activity either, putting the balance sheet and strong cash position to effective use over the coming periods. The other benefits will lie in operating efficiency, which has faced headwinds in the single-year period. To illustrate, days of sales outstanding have decreased YoY by 2 days to 66 days, whilst inventory turnover has fallen behind by ~11% to 1.71x YoY, meaning the days of inventory outstanding has blown out by 23 days to 213 days. The company has also increased accounts payable turnover to 7.3x in line with the number of days for accounts payable turnover to 55 days, which has directly impacted working capital management and the cash conversion cycle. As such, the cash conversion cycle has increased by 33 days to 229 days, resulting in a similar increase in the days of inventory to cash.

Figure 2. Cash conversion cycle variance YoY

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Data Source: Author

Therefore, the move is welcomed on the back of sequential operating performance, and we should see some reprieve to operating leverage as the time rolls on with the divestiture. Investors should pay close attention to these performance metrics, as we believe that The Street may be overlooking the importance of the divestiture to these indicators, posting a neutral/hold or sell mentality based on their analysis outcomes. We believe that the company will make a return to scalable growth over the coming periods, and if Q3 is anything to go by, then IART is already 1 step on the way to getting there, compounded by the formal reorganisation in the portfolio. Therefore, we see upside potential to shares based on the operating performance outcomes that will be reflected in these portfolio changes, and the market may be under-reflecting this potential in shares at this point in time.

Q3 Walkthrough Illustrates The Wider Picture

Q3 performance came in above consensus, with total sales of ~$370 million, which was driven by above-expected performance in both arms of the business. Codman came in well ahead of expectations by ~$11 million and this was backed by Orthopaedics and Tissue (“OTT”) beating the Street by $18 million. Margin pressures were lifted this quarter also, as gross margins saw a ~190bps tailwind from sales, whilst R&D expenditure was down by ~60bps, plus the company also gained some leverage on the SG&A line of ~350bps. Organic growth in the core business was estimated to be flat by management, although we would point out that major Covid-related headwinds may have disproportionately impacted organic performance via the pandemic’s effect on hospital capital spend. Overall, it was a solid sequential improvement for the company, and US sales came in strong with ~170bps upside from the previous quarter, however, the international segment saw headwinds of ~9% that offset strengths domestically. Again, Covid-related headwinds were the culprit internationally, evidenced by European sales which declined in the high single-digits, as recovery is slow there and Covid-19 cases are again on the rise in the back end of the quarter coming into winter. Management also indicated that capital equipment sales saw a ~50% sequential growth pattern, however, anticipate a sharp decline for FY2020 relative to FY2019.

Segmentally, neurosurgery saw headwinds of ~340bps, despite strengths in cerebrospinal fluid management sales, whilst precision instruments led the growth in the portfolio with ~6.7% expansion organically. This was underlined by the fact this segment is tightly linked to hospital budgeting. Wound reconstruction also saw ~20bps headwind quarter/quarter but recovered well on the back of a more favourable environment for inpatients and outpatients. There was also strength in the skin, PriMatrix, nerve and amniotic tissue segments which all saw growth into the mid single-digits, whilst extremities was an out-performer exhibiting 5.3% sales growth, driven by pent up demand and a rebound in surgery deferrals. The private label segment also saw ~17% upside on the back of end-market recovery, which was also underscored by pent up demand and deferrals in spinal and dental procedures.

Free cash conversion was strong this quarter, and regained traction from Q1 beating Q3 2019 conversion by ~3 percentage points at ~$63 million, with a conversion rate of ~17%. Gross margins came in at ~69%, following the tailwinds from revenue volumes and a slower than expected increase in COGS. Although management pointed to the improvement in capital equipment volumes, the major headwinds on the near-term horizon are centred around Covid-19 case numbers, especially in relation to surgery patient volumes and bed accessibility. To illustrate, surgical turnover is contingent on ICU bed availability, which is heavily utilised by Covid-19 patients at this time, notwithstanding the distancing policies that are currently in situ throughout all hospital ICUs. So much is true in the US and abroad, especially in regions like Europe, where the pandemic has regained speed and is beginning to impact surgery deferrals once more.

Q4 Guidance Contingent on Covid-19 Outcomes

As such, guidance for Q4 is now more conservative than previous. Management see uncertainty across the 4th quarter and believe a flat sequential pattern to the low single-digits is reasonable, based on a wide set of scenarios that are correctly in place, based on the current environment. If the current trajectory is held, management believe that sales will be flat YoY, whilst tissue growth will converge to the upside in sales growth. Offsetting this view, however, is the volatility in medical and surgical markets in many geographical zones (particularly Europe), which may impact overall sales volume across markets, leading to a flat YoY and quarter/quarter growth pattern.

Hospitals certainly are better prepared for any up-spike in cases, based on our ongoing conversations with hospital executives. However, most are remaining cautiously optimistic about the resurgence in cases in both the US and Europe. To illustrate, ~20% of ICU beds are being held for Covid-19 patients in Europe and other pandemic-infused zones, and any increase on this figure will likely lead to deferral situations and halt recovery in surgical volumes. Holding tight at 20% bed utilisation or below will not have this impact, however. Therefore, IART is well positioned to capitalise on the situation, particularly given the portfolios exposure to capital equipment placements, as total sales are exposed to ~7% of total sales from this segment. We are confident that the company can build on its Q3 capital equipment cadence and continue to converge to the upside there. Balancing the view of the point that this segment is certainly not immune to the potential Covid-related headwinds that remain in the scope of the wider scenario analysis.

Should trends begin to normalise over the coming periods, then management see YoY margin expansion at the gross and EBITDA levels. This should be compounded by the recent divestiture, although management are remaining conservative on the same. Margin guidance has come in at ~28%-30% at the EBITDA level, which is in line with the long-term targets outlined earlier in the year. We have updated modelling to reflect a YoY decline of ~9.5% in 2020E, with the road to recovery clearly defined following this period. We view growth at the top at CAGR of ~6% into 2025, which we feel will carry through the income statement, to gross margin and EBITDA margin expansion of ~220bps and ~620bps, respectively. We believe that free cash conversion will remain strong, holding at the 10% level in 2020 and regaining traction up towards 18% FCF conversion by 2025. We also see FCF expansion of ~17% by this period also, driven by revenue volumes and operating efficiencies with the Ortho divestiture.

Figure 3. Key Actuals and Forecasts (Annual, 2020E-2025E, base case)

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Data Source: IART SEC Filings; Author’s Calculations

Valuation

Shares are trading at ~31x FCF on a FCF yield of 3.97%. The company has $4.70 in cash per share and ~$62 in EV per share, indicating the potential in value disconnect to shares and overall company value. Shares are trading at a decent discount to peers, averaging ~43% discount across all multiples examined. Trading at ~20x P/E and ~16x Q3 EBITDA highlights the discount, and trading at 3.5x book value signifies excellent value creation for shareholders albeit at a very reasonable valuation. Therefore, the valuation is attractive for immediate entry on a multiples basis.

Figure 4. Trading at ~43% discount to the peer group

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Data Source: Author’s Calculations

Based on our 20.2x P/E and assigning this to our 2021 EPS estimate of $2.91, then we see a price target of ~$59, roughly in line with today’s trading (subject to change with publication times). Blending the current P/E figures with forward P/E estimates on our end using a 50% weighting schedule, then we see a blended forward P/E of 32.6x, and applying the same to our 2021 EPS estimates see a price target of $91. Taking the arithmetic mean of the 2 bounds in the data set for our multiples valuation, we see an overall price target of $74, ~28% upside potential on today’s trading. We believe that IART shares have the potential to converge to the upside based on the current discount to peers, steady ROIC scores holding the line at ~2.2% (not fantastic, but stable) and the divestiture away from Ortho, which will help drive operating leverage in the times to come. We, therefore, believe that the sell side may be missing these points, and the wider market may be under-reflecting this in IART shares at this point in time. Therefore, we feel this is a relevant factor to the bull case in the investment debate.

Further Considerations

On the charts, shares have held their sideways trend since the consolidation of the March selloff. Recently, in October, in timing with Q3 financials, we’ve seen a large uptick in pricing distribution that has driven shares upwards towards the longer-term resistance level. Shares have already broken the previous high in June, and the mouth of the ascending triangle formed by the upper trend line of the longer-term resistance level is narrowing, indicating the potential for further upside based on pricing trajectory. We are confident that the fundamental momentum gained by the company this quarter will continue to manifest on the charts over the coming periods and, therefore, would encourage investors to pay close attention to the pricing level relative to the ceiling of the longer-term resistance level, indicated by the white line on the chart below.

Figure 5. Pricing distribution activity YTD

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Data Source: Author’s Bloomberg Terminal

Based on this pricing activity since October, we feel that the current investor sentiment is bullish, and this adds to our thesis also. Adding in the facts of the valuation disconnect and potential for above-peer performance on the operating level in the coming periods, then we feel investors should pay close attention to IART’s shares’ next movements, in order to gauge entry and exit decisions on the same. Should shares continue at the current trajectory, we feel that the sum of the forces will continue to drive shares northwards.

In Short

IART is in the end stages of a transition period that will be rounded out by the recent divestiture of the Ortho segment to SNN earlier this year. We feel this move is welcomed by investors, as the company can maintain focus on higher margin and higher growth segments of the business, and remove the scale challenges that the Ortho segment presents, being so capital intensive. Additionally, the company has had a period of sequential growth, which we feel has the legs to continue, should international Covid-19 case numbers begin to diminish, especially in key zones such as Europe and the US. The company left the quarter with almost $400 million in cash and has strength on the balance sheet. Therefore, we would not be surprised to see IART begin to target higher margin names or complementary products the portfolio mix now that there is free space via the Ortho offloading.

Additionally, shares are trading at a discount to peers on a multiples basis, which we feel may contribute to shares convergence to the upside over the coming periods. We believe that the market and the sell side are under-reflecting the recent changes in operational structure for IART, and feel that operating efficiencies will be realised in the coming quarters on the back of the formal portfolio reorganisation. We would encourage investors to pay close attention to the cash conversion cycle, inventory to cash days and FCF margin over the coming periods, to gauge the true performance of the company, aside from revenues alone. If the company makes solid improvements on the numbers from this quarter, then we feel this adds weight to our thesis in the investment debate. As such, shares have seen a recent uptick in prices to the upside, and we feel the current setup on the charts supports the view of a further walk northwards in pricing distribution for IART shares. We look forward to providing additional coverage.

Disclosure: I am/we are long IART. 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.

Credit: SeekingAlpha

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