Wright Medical’s (WMGI) deal for Tornier was well-timed – not because it has driven amazing synergies by combining strong lower and upper orthopedic extremity franchises but because the growth in Tornier’s strong shoulder product line-up has offset surprising and disappointing weakness in Wright’s core lower extremity business. It looks there are some signs of life in the lower extremity business, though, and ongoing maturation of the expanded sales force and new product introductions should drive better results throughout the year.
Wright Medical shares look a little undervalued now, but the company’s performance hasn’t really built up much trust with investors. The potential FDA approval of an injectable form of Augment could still be on the way, and Wright still has M&A takeout potential, but inconsistent performance has been the rule for here for a little while.
Shouldering The Load
Wright Medical offered a welcome and much-needed beat versus expectations with its first quarter results. Revenue rose 12% as reported and a little more than 9% on a constant currency basis. Growth continues to be driven by the very strong upper extremity business (shoulder implants in particular), as sales here rose 20% from last year. Lower extremity sales were also a little better than expected and up 2% from last year. Biologics (down 2%) remains frustratingly weak.
Gross margin improved about 30bp and modestly exceeded expectations. Wright Medical is still in a loss position at the operating line, but adjusted EBITDA (which adds back SOE among other costs) rose 47% from last year.
While this was a good quarter relative to expectations, management elected to maintain guidance for the year (instead of raising it). Given Wright Medical’s recent track record of disappointment, “under-promise and over-deliver” may not be such a bad strategy, though the pessimist in me does worry that some of this guidance may be tied to expectations for increased competitive pressure as the year goes on.
Can The Shoulder Business Maintain This Pace?
Wright Medical saw better than 23% growth in its U.S. shoulder business in the first quarter. While its very successful share-gaining Simpliciti stemless shoulder continues to perform well, the company is also benefiting from its Blueprint planning software and last year’s introduction of the Perform reversed implant. Simpliciti and Perform should both continue to generate good share gains in 2018, but the comps are going to get a lot more challenging later in the year.
I’m also incrementally concerned about competition. Management didn’t sound all that worried about Zimmer Biomet’s (ZBH) Sidus stemless shoulder launch, but Exactech recently got approval for its Equinoxe stemless shoulder. The reason this concerns me is that Exactech was able to use the 510(k) pathway for approval while Wright Medical and Zimmer both went through the IDE route. The 510(k) is a simpler, faster process, and if this is now the precedent, rivals like Johnson & Johnson (JNJ) (historically, the market leader in shoulders and the biggest “donor” of market share to Wright Medical recently), Stryker (SYK), Arthrex, and Integra (IART) could get stemless products to market much faster. Granted, getting FDA approval is only part of the battle in successfully launching a new device (product design certainly matters), but it is still an incremental risk.
Still Waiting On The Lower Business
Having added 100 sales reps, Wright Medical is working toward rebuilding growth momentum in the lower extremity business. While the company continues to do okay in total ankle (up 14% yoy), this business has been slowing too. Some of this could be a byproduct of the challenges in growing the total ankle replacement market (it is still a relatively uncommon procedure), but I am still worried about the competitive pressure from Stryker. I’d also note that Wright Medical’s legacy foot/ankle business continues to struggle.
New product introductions should continue to help this business. Products like Ortholoc and the Salvation limb salvage system should continue to help rebuild the momentum in this business as 2018 rolls on.
Augment Looks A Little Sluggish
Wright Medical’s biologics business has been a weak spot for a while, but I’m increasingly concerned about the growth trajectory of the company’s Augment product. Trailing twelve-month sales through April 1st were up 17% year over year, but up only slightly since the end of 2017. I believe the sluggishness in Wright Medical’s underlying foot/ankle business is playing a significant role here, and the company could really use the FDA approval of an injectable form of Augment to reignite momentum here.
As it pertains to the BioMimetic CVRs (WMGIZ), then, I think there is a good chance that Augment sales will reach the $40 million trailing sales trigger for a $1.50 payment, but the second $1.50 payment (tied to $70 million in trailing revenue) appears out of reach.
The Opportunity
With a favorable settlement with an insurer and an expanded loan agreement, I think Wright Medical’s liquidity situation is okay. The company does have a significant debt load and modest free cash flow prospects over the next two years, but FCF should start scaling up meaningfully in 2020.
I haven’t changed much about my model. As a result, I’m still looking for long-term revenue growth over 8% a year (annualized) with growth closer to 10% over the next five years. I do believe that improving margins can drive FCF generation to over 15% of revenue in 2022 and over 20% in 2027.
The Bottom Line
Based upon the discounted cash flows and revenue growth I expected from Wright Medical, I believe fair value is in the mid-$20s. Accordingly, I think Wright Medical is slightly undervalued and could perhaps be poised for beat-and-raise quarters as the lower extremity business reignites and if/when the FDA approves injectable Augment, but it is not a clear-cut must-own, even though a sale of the company could fetch more than $30/share.
