|Shares Out. (in M):||38||P/E||n/a||n/a|
|Market Cap (in $M):||348||P/FCF||n/a||n/a|
|Net Debt (in $M):||147||EBIT||0||0|
|TEV (in $M):||495||TEV/EBIT||n/a||n/a|
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Symmetry Surgical Spinoff from Symmetry Medical (SMA)
*Note – We apologize for posting so close to the vote of the deal (discussed below). We took a fair amount of time to get comfortable with the stand-alone costs, management etc. While the vote for the deal is tomorrow, 12/4/2014, the spin-off is not set to close until later in December providing some time.
Symmetry Surgical is a small (less than $75M) spinoff from Symmetry Medical (SMA)
SMA trades at roughly $9.25 ($347M), of which $7.50 will be distributed in cash (OEM business being sold to Tecomet) and the remaining stub represents the value of Symmetry Surgical (SSRG), roughly $67M
The vote to approve the deal is 12/4/2014. Prospective owners of Surgical have had to hold SMA with the risk of the deal not going through
Due to the nature of the cash pay-out and the spin, most prospective SSRG investors have likely been unable to own the amount they wish to as they have to by 5x the amount by purchasing SMA shares
Shareholder base has turned over; normal spinoff type selling appears unlikely. We expect demand for shares to increase as investors take their $7.50 distribution and re-invest a portion of this in SSRG.
Management has a fresh new equity compensation plan that highly incentivizes them to grow earnings. Management has to earn these shares and then they vest over 3 years.
SSRG is high margin, low capex and historically very cash flow generative (earnings hidden by large amortization costs)
Management has been clear, “singles and doubles” acquisitions are where they plan to play, they know the historical large deals haven’t done well
Currently valued at ~$67M, 2013 pro-forma EBITDA ~$10-$11M (2014 trending down slightly as discussed below, but we expect this to reverse)
Although we do not believe Management would try to affect this, in fact the CEO has worked with us through multiple issues, a lower price at the spin would result in a larger number of shares granted ($ amount of shares is fixed, not the number of shares themselves).
In August 2014, SMA announced plans to sell its OEM business to Tecomet, a private company owned by Genstar Capital for $450M, a portion of which is going to pay off debt while SMA shareholders receive $7.50/shr in cash. The remaining surgical instruments business will be spun off into a new company called Symmetry Surgical Inc. (SSRG) with no debt. The vote to approval the deal will be 12/4/2014. The spinoff should be completed by end of December.
SMA is a medical device company comprised of 2 business units, its OEM business and its Symmetry Surgical distribution business. The OEM business is much larger, generating 80% of the company’s revenues. This business unit focuses on the orthopedic device market, and more specifically on orthopedic implants and instruments used in the placement and removal of orthopedic implants. As detailed below, the company has entered into an agreement to sell this segment, so we will not spend very much time on it as it is ultimately not what we are buying.
The Symmetry Surgical distribution business, generates 20% of total revenues, sells over 20,000 surgical instruments directly to hospitals and other acute patient facilities. Symmetry Surgical has a small portion of its business that manufactures products they sell, but for the majority of its sales it acts as a marketer/distributor of products manufactured by other suppliers.
Symmetry Surgical Business:
The Symmetry Surgical business was formed through the combination of three separate acquisitions:
Specialty Surgical Instrumentation, Inc. was acquired in 2007 for $15.1M
Olsen Medical was acquired in August 2011 for ~$12M
Codman & Shurtleff, a JNJ sub, was acquired in late 2011 for $165M
One side note: Codman & Shurtleff (C&S) had a book value of $8.7M at the time of the acquisition, resulting in $150M+ of intangible assets (primarily Customer Relationships) added to SMA’s books. The amortization of these intangibles at a rate of ~$5M per year is one of the items masking the cash income this business generates.
Included in the C&S acquisition, JNJ provided transition services to SMA. The majority of these services terminated in September 2012, but international distribution services continued until mid-2013. As part of this transition, C&S customers had to migrate to a new internal ordering system under the Symmetry Surgical brand that affected thousands of products. According to management “this disruption caused multiple customers to review pricing and competitors’ offerings resulting in a loss of market share. This effect was most pronounced in the US during 2013 and internationally in the second half of 2013 and first half of 2014.” The decrease in revenues as a result of this transition can be seen below when looking at quarterly revenue figures for the Surgical segment:
Further compounding the issues, in 1H14 the company experienced problems sourcing products from a few suppliers. This resulted in the company delaying delivery to customers and having to pay higher prices to other suppliers to cover the disruption, resulting in a direct margin impact. The largest of these suppliers was New Wave, which was acquired by Covidien in April 2014 and subsequently ended its supply agreement with Symmetry in order to market the products directly.
Clearly, the company has experienced execution issues that have impacted revenues. So why do we think performance will be different in the future? Neutralizing revenues for the New Wave impact, revenues in 2Q14 and 3Q14 were actually up sequentially. Two quarters aren’t exactly anything to write home about, but as outlined in the S-4, the Company has been able to build out the infrastructure for growth. Management has explained this infrastructure is the investments the company has made in its supply chain, distribution network, branding and sales team including:
Established a new global distribution center at the Nashville, TN headquarters
Implemented a new ERP system for order to cash and supply chain processing
Label changes for all acquired products to reference Symmetry brands
Establishment of global distributor network
Integration of an instrument quality and procurement facility in Germany
Integration of the Olsen Medical Louisville, KY instrument finishing and packaging facility
Initiation of cross training the direct selling force in the US
Established a global supply chain and international customer service center in Switzerland
Begun process of establishing country-specific regulatory approvals for legacy products which were historically not sold outside the US.
The question is whether or not the increased revenue/better infrastructure actually leads to cash flow generation. Management has discussed this on conference calls:
“We have a robust infrastructure in place in the US and abroad. And I don’t believe we’ll have to add any fixed cost in any way to take advantage of the increased sales opportunity. So we’d like to see revenue growth drop through the P&L at a rate faster than obviously revenue. We’d really like to see ourselves controlling SG&A at roughly half the rate of sales, so that you could see an additional drop through associated with that.” – Tom Sullivan, CEO, 2Q14 conference call.
Therefore, while the investments made in the surgical business have yet to show up in the numbers (beyond slight sequential growth in 2Q14 and 3Q14 when neutralized for the New Wave termination), it appears a platform for growth has been built and once the company reignites revenue growth, EBITDA growth will follow.
On top of these infrastructure investments, we have a management team that will now be 100% focused on this business, which was receiving much less attention under the larger company structure prior to the transaction.
Examining Management of the Spin-Off:We’ll address the following as we would for any spin:
Are any key members of the Parent management team moving to SpinCo?
Is new management going to be significantly compensated in stock of SpinCo?
What does management plan to do with the business post-spin?
SSRG Management Team - Short story is the whole senior management team of SMA (ex-CFO, which is a recent development) is going to move over and become the management team of SSRG. In a typical spinoff, a larger company is spinning off a smaller company while the larger company is going to remain an independent operation. This situation is a little different because the larger company is being bought out and so management would likely be out of a job without moving to SSRG.
Management Compensation – This is where things get more interesting. Below we have calculated the pre and post spin shares the top executives will have after factoring in conversions, vesting, severance payments, and the new equity incentive plan the company has put in place for the SSRG:
Please note that a recent 8-K filed noted that Fred Hite, SMA CFO, will no longer be going with SSRG and they are promoting Scott Kunkel to the CFO position. Mr. Kunkel’s shares, options, RSUs and equity incentive is not included in the below table, but if it is similar to Fred Hite’s economic interest, it would represent ~4% of the new company.
As one can see, management’s economic interest in the new SSRG is significantly increased compared to its interest in SMA. In addition, management will receive significant cash consideration for the OEM portion of the business associated with all shares listed above, except the SSRG Equity Incentive Plan shares. Most importantly, over two thirds of their new interest is directly a result of the equity incentive plan the company put in place to “encourage long-term growth.” It is important to note that we included the shares in the calculation above, but the officers need to earn the Equity Incentive Plan shares as they meet certain performance targets. The S-4 indicated that the primary performance target would be “adjusted EPS”, but management has confirmed that the targets have not yet been set by the board. Given that SSRG is also going to terminate the cash bonus program, we believe this equity grant program gives management significant incentive to meet performance targets. Furthermore, the company has done away with cash bonuses until at least 2018 and the management team is taking a 17% pay cut as they move to the new entity.
What Management Plans to Do with the Business Post-Spin – Management has stated that its goal is to get to $250M in revenues (from ~$80M today) and 50% gross margins (vs. mid to low 40s today). No timeline has been provided and we can assume this is a mixture of both purchased and organic growth. The company has spent 2 years revamping its ERP system, building an international supply chain, retraining its sales force, and establishing its brand. Now management is able to step away from the distractions of the OEM business and use the investments it has made to focus on growing this business. As discussed in the Risk Factors below, growth can often come at a cost to shareholders. However, management’s equity incentives likely being awarded on the grounds of earnings PER SHARE gives us some comfort that it will be smart when it conducts acquisitions. Here are a few quotes from the CEO describing their plans for acquisitions:
“As part of our expansion strategy, we will look to acquire and integrate new products and capabilities to enable our customers to have an even more comprehensive one-stop shop and partner for their ongoing surgical instrument needs.” – Tom Sullivan, CEO, 2Q14 conference call
“We expect this [spin-off] to put us in an excellent position to execute acquisitions to drive growth and to optimize our established sales channel and infrastructure.” – Tom Sullivan, CEO, 2Q14 conference call
“Our goal is to create a $250 million revenue medical company through organic growth and acquisition with 50% gross margins and consistent cash flow.” – Tom Sullivan, CEO, 2Q14 conference call
It should be noted that given the significant write-offs of goodwill that SMA has incurred in the past, there is not strong evidence that management is adept at performing large value-creating acquisitions. However, we believe that the poor integration of the very large C&S acquisition has taught management a lesson.
In recent presentations, the CEO noted acquisitions will likely come in the form of “singles” and “doubles”. The focus of these acquisitions will be to locate great products that are being underutilized and then distribute them out through SSRG’s global distribution network. For example, take a product that is limited geographically to one area of the US and push it out through sales reps across the country and into Europe.
“I was at the American College of Surgery this week out in San Francisco, and I was really excited by the number of companies that I saw with innovative technologies that I think could bring both a clinical and an economic value to hospitals. But there are companies that had no powerful sales force behind them. They had a handful of 1099s. They had relationships with a scattered group of independents across the country. I really believe that there's a lot of those smaller technologies, some that are already established, plenty that had already FDA approval for sale in the U.S. is either a 510(k) or is a Class 1 and yet they have no infrastructure behind them. And I think one of our competitive advantages in Symmetry Surgical is our sales force here in the U.S. then the global regulatory and quality capabilities we have along with our distribution network outside the U.S. And we look forward to finding those little companies and starting to fold them in to our portfolio that's already strong in so many clinical specialties to really round us out, and we think bring more value to our customers.” – Tom Sullivan, CEO 3Q14 conference call
While the company is going to be coming public with no cash and no debt, the company generates a significant amount of cash flow and will have a revolver in place to finance small deals and for working capital purposes. IR has indicated that revolver capacity would likely be in the 3-4x EBITDA range, which leads to $30-40M of initial borrowing capacity. From conversations with management, it appears that “singles” and “doubles” likely mean acquisitions in the sub $15M range and that we shouldn’t expect any kind of massive acquisition similar to the C&S acquisition described above.
Other Spin-Off Considerations – Having the OEM business associated with Symmetry Surgical, limited the markets that the Surgical company could pursue because it had to be very sensitive about entering the same product lines as the OEM’s customers. Post-spin, while management has stated they don’t directly intend to pursue stealing market share from OEM customers, they clearly are not going to worry about it as much and are going to use their established distribution network to expand their product offering. For example, on the Q2 call the CEO noted “We do believe that there will be greater opportunities for us to augment our sales bag and to really leverage the infrastructure that we have in place over our broader selling base if we are no longer in an environment where we’re very sensitized to not competing with any division of any of our OEM customers.”
When looking at the valuation of SSRG, we need to look at it on both an absolute and relative basis. The most important measure of value to us is the cash that a business generates, and therefore we tend to focus on free cash flow. Given that SSRG will have no debt on the spin and will have a higher overhead burden as a result of being an independent company, we are going to use pro-forma EBITDA-Capex as a proxy for FCF. The company pays very little in cash taxes as a result of the tax shield coming from the amortization of customer relationships in the C&S acquisition. Working capital may build as they grow but should net out over time. Pro-forma EBITDA for 2013 excluding New Wave impact and adjusted for expected cost savings was $10.9M. Pro-forma capex as outlined in the S-4 is $500K. Therefore, 2013 EBITDA-Capex is $10.4M.
With a current implied market cap of $67M, the SSRG stub is trading for <7x EBITDA-Capex. 2014 EBITDA should be down slightly; however we don’t have great visibility into how much. As mentioned above, given the new management focus, already established platform for growth, and lack of sensitivity to pursuing new product lines that compete with OEM customers, we believe EBITDA will grow in 2015. On an absolute basis, given the high capital efficiency of this business, and recurring cash flows that are poised to grow, we believe this business is worth at least 12x EBITDA-Capex, which would be ~$125M, or approximately 85% upside from the implied value of the spinoff. This is somewhat corroborated by the fact that the company paid ~$192M for these businesses a number of years ago, and while the top line numbers have deteriorated, the cash flow remains strong.
From a relative valuation perspective, there really aren’t any great comps. In an effort to provide some industry color though, we tried to locate medical/dental distribution businesses. HSIC and PDCO are distribution businesses not manufacturing businesses, and therefore we used them as the primary comps below. Most med device companies, similar to SMA pre-spin, have both manufacturing and distribution integrated into one company. The proxy discloses divisions of CFN and IART as the closest competitors to SSRG, but we do not have individual valuation metrics for those divisions, only for the companies as a whole, which is not an apples to apples comparison (we included them in the table below purely for reference). Both HSIC and PDCO are significantly larger companies, with revenues growing in the high single digits. But these companies also boast gross margins in the 27-30% range rather than the 44% level for SSRG and convert a much lower percentage of their sales and their EBITDA to cash flow. Given this higher conversion, one would think SSRG deserves a higher multiple of sales and higher multiple of EBITDA. But to be conservative, we will assume that SSRG won’t trade to the same type of multiple as HSIC/PDCO given its size. But as SSRG begins to return to revenue growth, we do expect the relative valuation gap to narrow and believe this relative valuation easily supports our $125M valuation at 12x FCF (which would still be less than half the valuation multiple HSIC/PDCO).
Most of the time prior to the close of a merger agreement, the major risk is that the deal is going to fall through. While we recognize this risk, we think the risk of the deal falling through is low. Our reasons are:
Our checks indicate that financing for the buyer has been locked up
Our checks indicate that very few meaningful shareholders are against the deal (in fact we believe most of the larger shareholders pre-announcement have moved on and now shares are largely owned by special situation funds)
The company has already received its Hart-Scott-Rodino clearance from the FTC,
Management is significantly incentivized to close this deal as it results in significant cash compensation to them, in addition to large upside in the new entity.
Large Unfavorable Acquisition: There is risk that management seeks to build an empire and destroy value for shareholders through a large unfavorable acquisition post-spin. As discussed above, management has stated it is only going to do small accretive acquisitions where it can push new products through its pipeline, this risk remains as it is hard to see how the company will get to $250M in revenues in 3-5 years without some meaningful acquisitions.
Higher Than Expected Costs as Independent Entity: It is our understanding based on conversations with management and reading of the S-4 that to develop the company’s adjusted EBITDA for SSRG for 2013 of $10.9M, the company took segment EBITDA, added back all of the overhead costs it would need to incur as an independent company (board fees, full allocation of executive pay, IT systems, etc.) and then looked for ways that it could cut those costs. Initial estimates by the company were $3.2M of costs that it would be able to cut, however in the 8-K reported the evening before Thanksgiving, the company lowered its expected cost savings to $2.4M. While we believe that management has included a full independent corporate allocation of overhead in those estimates, if cost savings are less than expected or other material costs appear, it could provide downward pressure on the valuation.
Loss of Relationships: This is almost entirely a relationship business driven by the company’s sales force. If key members of the salesforce were to leave, we believe this could result in a deterioration of the business. This is mitigated by minimal concentration in the company’s customer base.
Why You Buy SMA Now Rather than SSRG Post-Spin:
Cash Consideration Will Be Reinvested: Given that the remaining stub is only 21% of the total SMA stock price today, portfolio managers would need to take a position nearly 5x the size to achieve their desired allocation. For example, a PM that wants a 5% position in SSRG, needs to invest nearly 25% of his fund into SMA to get a 5% position exposure to SSRG. This size of position is much too big for most fund managers as they don’t want to take on the risk that the deal falls through on that size of position. In addition it may be beyond some managers’ investment mandates, or some managers may simply not have the excess cash nor want to lock up the cash Therefore, we expect many investors/managers to use the cash consideration received from the closing of the merger to buy shares in SSRG to increase percentage allocations to SSRG. For example, a PM who wants a 3% position, may currently carry it at a 5% position, which turns into a 1% position post-close where the PM then reinvests 2% into SSRG. This should result in significant demand for the shares post spin.
Management Wants the Stock Price to Be Lower Pre-Spin: Senior management’s change of control bonus and equity compensation plan for the new company is set in dollars rather than shares. The number of shares will be determined by the trading price of the stock on the first 5 days after the spinoff. If you are management, you want the stock to be as low as possible when it spins. A $0.50 difference in the price of SMA translates to approximately an additional 140K shares after the spinoff.
Shouldn’t Have Post-Spin Selling Overhang: In a typical spinoff, SpinCo gets routinely sold by the index funds, mutual funds and big hedge funds that own the parent and don’t want to own the spinoff. We believe that with cash consideration set at $7.50/shr and the SSRG spin being too small for most large funds to hold a meaningful position, larger funds holding the stock have already sold their shares and moved on. Large holders at the time of the announcement, such as Ariel Investments and Frontier Asset Management, have already completely sold out of their shares as reflected in the 13F filings. The volume in the shares since the announcement indicates that all of the shares have already turned over. In addition, smaller event driven funds, such as Moab Capital Partners, have moved in to take the positions of these larger funds who are exiting. These event driven special situation funds are likely suffering from underexposure as described above and will likely be reinvesting merger consideration into SSRG.
In summary, you have a business that was bought 2-3 years ago for a combined $192M, with a newly focused management team, heavily incentivized to reach performance targets, trading at less than 7x EBITDA-Capex. With peers trading at over 28x FCF, an expected return to revenue growth should cause an upward revaluation in the value of SSRG. We believe 12x FCF is a fair valuation for this business, giving us 85% upside from current levels.
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