Integra LifeSciences (IART) announced a small divestment. This transaction and the fact that this stock is undercovered on this platform are enough of a reason to create an investment thesis on the stock. This reveals quite modest valuations given the activities of the underlying business, organic growth and valuation multiples. A drawback is the large and consistent gap between reported and adjusted earnings.
Integra claims to be a leader in neurosurgery, holding leading positions in plastics and reconstructive surgery, including regenerative and wound care markets. The company generated $1.5 billion in sales from these markets, split across a roughly 2/3 of revenue contribution from Codman Specialty Surgical and the remainder from the Orthopedics & Tissue Technologies.
The company’s largest Codman unit generated just shy of $1 billion in sales in 2019, with the vast majority coming from neurosurgery, complemented by precision tools and instruments. Growth is driven by new product introductions, solid organic growth of the market and potential M&A to drive the addressable market even larger. The orthopedics business generates half a billion dollars in sales, with just above half of sales derived from wound reconstruction, complemented by private label and extreme orthopedics products.
The company has some great long-term ambitions on the back of focus on R&D, new products and international expansion. Long-term goals include 5-7% organic growth targets, greater than 70% gross margins, 30% EBITDA margin targets and double-digit earnings per share growth.
In February of this year, the company reported its 2019 results. Sales rose 3% last year to $1.52 billion with organic growth pegged at 4.8%. The company reported adjusted earnings of $2.74 per share, or $237 million in actual dollar terms. Net earnings only came in at $50 million, with the large discrepancy largely explained by acquisition and integration charges, as well as amortization expenses.
The 87 million shares of the company traded at $57 at the start of the year, giving the company a market valuation of just around $5.0 billion as net debt of $1 billion translates into a $6.0 billion enterprise value. Debt was a bit on the higher side with EBITDA running at $369 million, for a 2.7 times leverage ratio. While far from shocking, lack of GAAP earnings and recurring charges limit the deleveraging pace, although the organic growth of the business makes leverage more manageable.
The company guided for organic sales growth of around 5% for 2020, with adjusted earnings set to increase to $3.00 per share. Based on these multiples, shares traded at a reasonable 4 times sales multiple, 16 times EBITDA, with equity exchanging hands at 21 times adjusted earnings.
Since early 2017, shares have been stagnant around the $40-50 mark as the investment thesis has been dominated since the February 2017 purchase of the Codman neurosurgery business from Johnson & Johnson (JNJ). That $1.04 billion deal was quite substantial, adding about $370 million in sales and roughly $115 million in EBITDA as the multiples looked compelling. This deal was important in creating the current Integra, including the built-out of the international operations. Hence, the growth profile of the business has been improving, as was evident in the original 2020 outlook, with Covid-19 obviously having a big impact on the business as well.
While first-quarter sales were rather flattish, second-quarter sales fell off a cliff with sales down more than 30%. The company reported a flat GAAP profit number, with adjusted earnings still trending at just over a dollar per share on an annualised basis. The fall in sales is obviously the result of fewer procedures having taken place amidst the Covid-19 pandemic.
Net debt has been cut to $789 million, and while the decline in absolute leverage ratios is compelling, relative ratios have been shooting higher. Quarterly EBITDA fell to just $52 million, which annualised works down to a 3.8 times leverage ratio. Note that debt could have been cut further if not for the fact that nearly 2 million shares were repurchased by the company, with the share count dropping to 85 million shares.
Trading at $47 per share at this moment the equity valuation has dropped to exactly $4.0 billion, for an $4.8 billion enterprise value. The company actually sold some of this business, as it has divested its Extremity Orthopedics Business to Smith & Nephew (NYSE:SNN) in a $240 million cash deal. The business unit generated $90 million in sales in 2019, translating into a 2.7 times sales multiple.
This looks rather reasonable with the entire business now trading at around 3.2 times sales based on the 2019 revenue base. Unfortunately, $41 million of the net proceeds will be payable to the Consortium of Focused Orthopedics upon closure of the deal. It should be said that the unit has been off to a soft start with annualised sales in the first six months of the year down 28%, much worse than Integra’s 1% drop in sales in the first quarter and the 32% drop in second-quarter revenues.
Needless to say, the deal will tackle debt in a way in which any remaining debt overhang is addressed, yet with 6% of the 2019 revenue base leaving the door, earnings might probably see a bit of dilution, not even taking into account the fact that 2020 is set to become a very soft year for obvious reasons.
Under normal conditions the company would be trading at around 15-16 times expected earnings, which looks very reasonable as leverage is under control amidst cash flow generation so far in 2020 and the recent divestment, yet the multiples are based on adjusted earnings and not reported GAAP earnings.
While a great deal stems from non-cash charges, the reconciliation between GAAP and adjusted earnings is being explained by some cash charges. With shares here at $46 still down $15 from the 52-week-high, and up just $10 from the absolute low in March, the stock has been underperforming the sector and the wider market (obviously).
I like the low valuation as the company operates in a structurally compelling industry, yet I am really not too comfortable about the large and continued discrepancy between adjusted and reported earnings.
Here and now I am happy that I stumbled upon this interesting business; while I have some reservations, I see the potential of the company and its stock as well at the same time. Given this I am initiating a small position, mostly with a goal to have some kind of watch list function, as I lack conviction to initiate a position in size. I look forward to narrowing differences between the earnings metrics, continued organic growth and over time valuation multiple inflation to potential M&A action (perhaps even on the sell side).
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Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in IART over the next 72 hours. 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.