Did Wright Medical Make The Right Move?

question mark Did Wright Medical Make The Right Move? (SeekingAlpha)

Summary

Wright Medical Group announced a merger with Tornier to create a major player in the higher-growth extremities segment of orthopedics.
Wright Medical also announced the receipt of an approvable letter from the FDA for its much-harried orthobiologic product Augment.
With the potential for Wright Medical and Tornier to become a $2 billion company with leading share in upper and lower extremities, Wright Medical looks undervalued below the high $30s.

Four months ago, I fretted that Stryker‘s (NYSE:SYK) acquisition of SBi reduced the pool of eligible buyers to acquire Wright Medical Group(NASDAQ:WMGI) and/or Tornier (NASDAQ:TRNX). A lot of bullishness on these companies was based on their attractiveness as M&A targets for larger ortho companies, but the two companies have instead decided to come together to create a leading enterprise in the fast-growing extremities segment.

I have mixed feelings on this move as a Wright Medical Group shareholder. Wright Medical’s somewhat disappointing third quarter sales result suggests that there’s still more self-improvement to be done and Tornier has been working through sales restructuring efforts of its own. That said, Wright Medical CEO Bob Palmisano is a proven leader in the med-tech space and the prospects of a company with leading technology in both upper and lower extremities is appealing, not to mention the fact that the impending approval of Augment brings hundreds of millions of potential revenue into play.

A Busy Day

Investors were given a lot to digest on Monday, as Wright Medical not only gave investors an early look at third quarter revenue, but also announced that the FDA had issued an approvable letter for the Augment Bone Graft and that the company would be merging with rival extremities peer Tornier in an all-stock deal.

Taking the least significant item (from a long-term perspective) first, Wright Medical announced that third quarter revenue rose 24% to about $71 million, missing expectations by close to 7%. This is two straight revenue misses for Wright Medical, with management citing sales execution issues in the U.S. foot/ankle business and shortfalls in the international operations (related to inventory/sales channel mismatches) as the cause. While management did lower full-year expectations, the company’s growth is still solid in the wider context of the extremities market and orthopedics in general.

Success At Last For Augment?

I have written repeatedly on Wright Medical’s battles with the FDA to get the orthobiologic product Augment to market. While I can sympathize to some extent with the FDA’s concerns given its embarrassment over the Medtronic(NYSE:MDT) Infuse debacle, the reality is that Wright Medical has consistently demonstrated that Augment is safe and effective as a bone graft substitute.

It’s worth noting that what Wright Medical received from the FDA was an approvable letter, not an actual approval. Final approval will be contingent on a few additional steps, most significant being facility inspections, but these should be routine and Augment should be on the market in 2015.

I continue to believe that Augment can be a $200 million to $300 million product on the basis of its on-label indications and that off-label use could generate a similar amount of sales. That latter number is riskier, though, as I would expect the FDA to pay very careful attention to off-label use in the wake of the problems with Infuse. As is, though, Augment will be a unique product with a large market to address. If initial market acceptance is strong, I would not be surprised to see management revive/reinvigorate the prior R&D efforts of BioMimetic Therapeutics (the company Wright Medical bought to obtain Augment) and look for expanded applications of the technology.

Merging With Tornier Creates A Pure-Play Ortho Growth Company

The decision for Wright Medical to merge with Tornier is a bold one, but not without some appeal. I believe most Wright Medical shareholders were expecting a company like Johnson & Johnson (NYSE:JNJ), Medtronic, or Smith & Nephew (NYSE:SNN) to acquire the company for its solid lower extremity business and orthobiologicals upside, particularly after the company sold its large joint operations and deprioritized upper extremities. To that end, I will be curious to see if the merger prospectus details any such discussions between Wright Medical and potential suitors prior to this merger with Tornier.

Together, these two companies will be a force in extremities. Wright Medical is primarily a lower extremity (62% of sales) and biologics (25% of sales) company, while Tornier is primarily an upper extremity (59% of sales) company with solid share in the shoulder market and new products (Ascend Flex, Simpliciti) poised to generate more revenue. Together the companies will largely dominate the total ankle market (50%-plus share), a market which is still early in development (about 85% to 90% of patients get fusions instead of joint replacements), and will be a significant player in shoulders, wrist, and biologic products.

Deals like this always carry risks. There will be revenue dysynergies at first (there almost always are when ortho companies combine), and almost certainly disruptions to the sales effort as the two sales forces are combined and the sales approaches are harmonized. There is also some risk that regulators could force some divestments in the total ankle business – though it remains to be seen whether regulators will consider the share of Wright Medical + Tornier in the context of the totality of the foot/ankle market. Last and not least is the question of what the combined company does with Tornier’s large joint business – a cash-cow business with significant (around 50%) share in France.

There are also opportunities for synergy. Duplicate back-office expenses can be eliminated, duplicate sales reps can be eliminated, and there is the potential for manufacturing efficiency improvements (Tornier outsources the manufacturing of most of its lower extremity products, while Wright Medical has surplus capacity).

Combined, this is a company that should be able to grow at a double-digit average rate for the next decade, with free cash flow margins in the high teens to low 20%’s. What’s more, it should be a formidable player against Johnson & Johnson, Stryker, Zimmer (NYSE:ZMH), and others, with both strong product/R&D technology and a solid sales effort. Add in the upside of Augment (and the potential to introduce it into sports medicine and upper extremity indications) and this combined entity could be a $2 billion company with 20%+ free cash flow margins in a decade.

The Bottom Line

Combining into one will make both Tornier and Wright Medical more viable as a stand-alone entity, though at the cost of desirability as an M&A target. Regulators likely wouldn’t allow Stryker to buy the combined company (unless there were major divestments in the lower extremity business) and Johnson & Johnson likewise probably could not get clearance because of the upper extremity share implications. That would leave Medtronic and perhaps Smith & Nephew as the only probable suitors down the road (unless a company not currently involved in orthopedics wished to make that move).

I do believe Wright Medical is paying a lot for this – the terms of the agreement mean that Tornier shareholders are getting a 28% premium and the transaction is taxable for Wright Medical shareholders. Even with the premium, though, I see the deal as no worse than a breakeven for Wright Medical unless the integration goes badly wrong (something I do not expect given Palmisano’s experience).

As things stand today, Wright Medical continues to look undervalued to me, though the underpinning of potential M&A is now greatly reduced. Wright Medical’s CVRs (NASDAQ:WMGIZ) have shot up in response to the approvable letter, but still offer reasonable potential relative to a maximum total payout of $6.50. Wright Medical, too, still looks interesting with a fair value in the high $30s on the basis of 5x the combined entity’s revenue potential in 2015.