Description

Thesis:

The equity of Integra Life Sciences (“Integra”, “IART” or the “Company”) is worth as little as $6/sh based on 2013E projected EBITDA of $80 MM and the industry average EBITDA multiple of 8x, representing downside of 80%+ from the current share price of $35/sh.  Even if the Company achieves peak sales of almost $860 MM and returns to 2012 margins from before its recent product recall, the stock would be worth $14/sh, downside of 60%. 

Integra has long distorted its true earnings power by backing out a series of “nonrecurring” expense adjustments ($44 MM, $26 MM, $24 MM, $52 MM and $45 MM in 2008, 2009, 2010, 2011, and 2012, respectively) while also masking the organic growth of its underlying businesses via repeated acquisitions.  There are now three catalysts which should help fair value to be realized: 1) the recent recall of its largest and most profitable product, DuraGen, which is likely to cause market share loss, 2) IART’s inability to make additional acquisitions to mask organic growth due to existing leverage combined with what will be deteriorating earnings and cash flow in 2013 from the DuraGen recall, and 3) IART trips its credit covenants.

Background:

Integra produces medical implants and other devices used in orthopedic, neurological and spine procedures.  We discovered Integra as part of the competitive analysis for another investment where our field calls consistently painted a picture of Integra as a poorly run company that paid and treated its employees poorly with an increasingly less visible industry presence.  From there we found additional red flags including three separate FDA warning letters sent to Integra along with a history of excluding large “non-recurring” expenses from its adjusted earnings calculations that produces “adjusted” 2013E EPS of $2.50 versus real economic EPS of $1.00.  The Company is also the byproduct of a multi-year acquisition roll-up financed with significant amounts of debt, currently 3x “adjusted” net leverage but 5.5x true economic net leverage, in an industry that generally eschews debt.

In December 2011, the long-time CEO resigned with no good reason provided by the Company, another red flag.  the company touted the new CEO upon his appointment for his experience running a large division of a leading global medical devices company, but we discovered he was let go by his former employer in October 2010 after his division faced a national recall of a mass-market medication resulting from deliberate product tampering.  Integra never mentioned this, while the sell side has never made note of it either. 

Our analysis also indicated management was providing fairly aggressive revenue guidance while acquisitions masked the real organic growth rates of two key divisions, Extremities and Spine.  YTD through Q312, Extremities was growing by ~30%, but acquisitions comprised ~25% of that growth, implying organic growth in the MSD range.  The true growth rate was again overstated in Q113 at 18% as IART experienced unusually weak Q112 sales of $27 MM vs. $32 to $33 MM per quarter for the remainder of the year due to overhauling the acquired Ascension sales force in the first quarter.  Management never broke out the details and guided to indefinite mid-teens growth while industry competitors are growing in the 8% to 12% range while our field research indicated Integra’s product portfolio was relatively commoditized and meaningfully weaker than its peers’.  We expect future organic growth of 10%.  Similarly for Spine, acquisitions provided growth YTD through Q312 in the ~20%+ range while organically we backed into a business in mid-single-digit decline, which matched the organic growth rates for the industry.  However, Integra guided to an indefinitely flat business. 

In the first quarter of 2013, Integra announced a product recall for its largest and most profitable product, DuraGen.  The Company had received three warning letters from the FDA for separate production facility violations over the prior year and a half leading up to December 2012, at which time Integra claimed these letters were customary with full remediation efforts in place and no expected business interruptions.  IART then preannounced first quarter results with “adjusted” EPS of $0.35 versus prior guidance of $0.82, with the stock subsequently trading down 10% followed by a downward revision to 2013 adjusted EPS guidance from $3.18 to $2.55.  This is Arduini’s second earnings preannouncement for disappointing results and lowered guidance since becoming CEO in December 2011; the first occurred in January 2012 for Q411 results from weakness across all three businesses, particularly Instruments, which appears a potential “bath” to be taken such that he could set a low bar for 2012 guidance.

We did not predict a product recall, but its symptom reflects the underlying quality control problems Integra faced leading up to the recall with the three FDA warning letters, an issue that also proved problematic for the new CEO at his prior employer.  For the time being sell-side analysts have given a “free pass” to Integra for the product recall, assuming it’s an aberration whereby everything returns to normal with growth on the horizon in 2014.  We disagree, as our field research indicates this type of interruption often causes permanently lost market share.

Furthermore, Integra appears to have tripped its total leverage covenant of 3.75x in Q113, with leverage of over almost 3.9x after being in compliance as of Q412 with leverage of 3.25x.  The agreement enables certain “non-recurring” add-backs and inclusion of balance sheet cash above $40 MM, which our analysis has accounted for.  Given the Duragen recall and reduced 2013 guidance, IART will only increasingly violate the leverage covenant throughout the year.

The capital structure is as follows:

Key Risks:

• Integra continues to receive a free pass by investors and sell-side analysts for its “non-recurring” expenses.

Business Overview & Competitive Landscape

• U.S. Extremities (15% of 2012 Sales): Extremities includes foot/ankle plating and screws as well as upper extremities products for shoulder replacements and other procedures.  Extremities is the fastest growing orthopedic industry in the 10% to 12% range, and IART has focused its M&A attention on this business in hopes of grabbing share, most recently with the acquisition of Ascension in September 2011.  However, IART doesn’t have the requisite product portfolio to recruit decent sales reps having acquiring commodity products.  The Company faces larger and more formidable players in terms of product offerings and sale force capabilities.  In foot/ankle, Wright Medical, Stryker, Zimmer and Small Bone Innovations are competitors with superior product offerings and/or sales forces.  Exactech is also a competitor but is not as strong as the others.  In terms of upper extremities, primarily shoulder, competition is also formidable and includes Tornier, Zimmer, Stryker and Biomet, all of which have product niche positions and/or sales force capabilities that are superior to Integra’s.

• U.S. Spine (23% of 2012 Sales) & Neuro (20% of 2012 Sales):  Spine includes implants and regenerative bone and skin products made from human origins while Neuro is mostly DuraGen regenerative skin along with other biologics and capital equipment used in the OR.  Integra is built on its Neuro business, particularly DuraGen and other regenerative skin products.  Neuro is a decent business with MSD growth rates, primarily from pricing power, but Spine is an industry declining in the LSD rate from hospital pricing pressure and commoditization.  The sales force for Neuro is unique, as is Spine and Extremities, where each sells to a different surgeon base, so there is no shared sales force scale or leverage from combining product portfolios amongst any of Integra’s business units.  Both Neuro and Spine are saturated markets without much innovation and with a lot of competition from larger orthopedic and medical devices companies.  Medtronic, Johnson & Johnson, Stryker, Zimmer, and Biomet are all competitors with similar products but larger sales forces.

• Instruments (20% of 2012 Sales):  Instruments includes basic surgical tools including procedural tool sets for the OR (think scalpels) to head lamps.  As much or more so than Spine and Neuro, the Instruments industry is highly commoditized and is a flat to LSD growth business.  The market is saturated without any meaningful innovation along with heavy competition from a number of major medical devices companies. 

• International (22% of 2012 Sales):  IART started reporting International as one consolidated line item in Q113, whereas previously International was broken out separately within each product segment, another red flag.  Neuro is the biggest contributor at almost 60% of International sales, based on historically disclosed numbers.

Sales Force:  As a side note, our field calls consistently suggest IART pays at the low end of the industry to its sales force and has a high churn rate as a result, letting highly paid reps go while bringing in junior, less expensive reps as replacements.  Customer relationships are very sticky in this industry with strong surgeon loyalty, such that once the sales rep leaves Integra, generally so does the business, and trying to win back market share with new reps is difficult and time consuming.

M&A:  M&A activity has long been prevalent throughout the industry.  Large medical devices players do not want to dedicate R&D dollars to projects that have low success rates, largely leaving the innovation to targeted, smaller companies that undertake the risks of FDA approval, market acceptance and reimbursement eligibility.  Those who are successful generally monetize at large premiums selling to the big players with the sales force capabilities to leverage the products into existing channels and product portfolios and extract substantial selling expense synergies.  Extremities, Integra’s targeted growth business, is the most highly targeted orthopedic industry given its outsized growth rate of 8% to 12%.  Recent M&A has focused on Biologics, with WMGI acquiring BMTI and SNN acquiring Healthpoint Therapeutics.  This has caused some to speculate Integra would be a takeover target in the past, but our field research indicates there is little interest from big orthopedic and other device companies in IART’s product portfolios with the exception of Neuro.

Earnings Power:

Integra has reset its guidance from the DuraGen recall, which is going to hamper future earnings and cash flow, and when combined with IART’s considerable leverage (5.5x net leverage), the Company is unable to make future acquisitions and disguise organic growth, which is in the LSD range.

The bridge between IART’s adjusted EBITDA and real economic EBITDA for 2012 and 2013 are below:

True EBITDA generation power for Integra is at most between $100 MM and $110 MM.  The numbers below reflect our adjustments to GAAP numbers, not Integra’s.  See the 2014E projections and commentary below for more details on our assumptions behind expected EBITDA power.

• 2012A EBITDA: $120 MM
  • Sales = $831 MM (organic growth = 2%)
  • Gross margin = 62%
  • SG&A margin = 45%

• 2013E EBITDA: $80 MM
  • Sales = $840 MM (organic growth = 1%)
  • Gross margin = 61%
  • SG&A margin = 48%

• 2014E EBITDA:  $107 MM
  • Sales = $855 MM (organic growth = 2%)
  • Gross margin = 62%
  • SG&A margin = 48%

2014E EBITDA assumes gross margins return to 2012 levels, which is actually overstated.  See margin commentary below:

• COGS: 2012 included no medical devices tax, which represents an additional expense of $13 MM to the “adjusted” COGS of $290 MM in 2012, although the Company capitalizes any amounts payable in inventory even if the related sales occur in-period.  This is a permanent reset to gross margins.

• SG&A:  2014E EBITDA assumes SG&A margins remain at 2013 levels.  Integra expects to pay elevated sales commission rates indefinitely starting in Q213 to its neuro reps in order to hang onto them following the DuraGen recall.  Unfortunately this is not quantifiable but should be noted as a headwind that is unlikely to subside.

In summary, assuming IART gets back to ~$100 MM of EBITDA and investors stop accepting management’s “adjusted” numbers, the stock should trade at most in line with its “big ortho” peers, including (ZMH, SYK, SNN) at 8x EBITDA.  The equity is then worth less than $14/sh, downside of 60%.  If the market start to recognize true earnings power in 2013, the stock could trade as low as $6/share, downside of 80%+, based on 2013E EBITDA of $80 MM and an EBITDA multiple of 8x.

Catalyst