American medical device companies are supposed to buy Chinese med-tech companies and not the other way around, right? Not anymore.
Apparently MicroPort and Wright Medical (NSDQ:WMGI) didn't get the memo – American med-tech companies are supposed to buy Chinese med-tech companies and not the other way around. But in a surprising announcement Wednesday night, the two companies revealed that MicroPort has reached an agreement to acquire Wright Medical's OrthoRecon business for $290 million in cash.
This is a bold move for both parties. It not only brings MicroPort into the global hip and knee market, but also establishes a meaningful presence for the company in the U.S. For Wright Medical, it removes a significant amount of execution risk, and makes the company a pure-play on the much faster-growing markets for orthopedic extremities and biologics.
Going The Other Way For A Change
Until recently, all of the major trans-Pacific M&A went in one direction – American companies bought Chinese med-tech firms to gain access to this huge market, as well as manufacturing facilities and product lines that could expand the company's options in lower-cost markets. Medtronic (NYSE:MDT) bought Kanghui in November of 2012, PerkinElmer Inc. (NYSE:PKI) bought Haoyuan in that same month, Zimmer (NYSE:ZMH) bought Montagne a month later, and Stryker (NYSE:SYK) bought Trauson in March of this year.
This isn't the first meaningful acquisition in the U.S. by a Chinese med-tech company (that would be the announcement earlier this month of Mindray's (NYSE:MR) acquisition of Zonare), but suffice it to say this is not the norm. While the U.S. market is large, it's not growing that much anymore, the cost of regulatory compliance is high, and not that many Chinese med-techs are large enough to afford to acquire an American company with significant operating scale.
A Win-Win Proposition?
Adding a further level of “... well, that's a little odd” to the deal is that MicroPort isn't really an active player in the Chinese orthopedics market. While the company does have a spine business, it is rather more like Medtronic or Abbott (NYSE:ABT) in some respects, with a sizable vascular device business (including significant drug-eluting stent market share in China) and operations in diabetes and electrophysiology.
In any case, MicroPort is paying $290 million in cash for a business that generated about $270 million in revenue in 2012. At about 1.1 times sales, that is a sharp discount to the average forward multiple for both U.S. orthopedic companies (nearly 3x) and Chinese med-tech companies (almost 5x). The reason for that discount is not too hard to find, though – Wright Medical has tiny share in the global hip and knee markets (2% overall), sub-optimal profitability, and the company was facing a risky transition to a new sales model.
Even so, this deal could work out for MicroPort. The company is getting the existing manufacturing and logistics facilities in Tennessee, and will use them as its new global headquarters for orthopedics. There's also a good opportunity for synergies – MicroPort has a strong existing salesforce and Wright Medical's hip and knee products are already approved in China, so expanding their market share shouldn't be quite as challenging.
Increasing The Risk-Reward For Wright Medical
The “win” for MicroPort is that it gives the company a credible starting point for a global orthopedics business at a very affordable price, as well as a starting point to potentially begin developing and selling products in the U.S. market.
For Wright Medical, the “win” is in paring down the business to a faster-growing, higher-margin opportunity. Even in better days, the margins for the OrthoRecon business were about two-thirds to three-quarters of the peer group, and the company really wasn't getting any traction against market leaders like Johnson & Johnson (NYSE: JNJ), Stryker (NYSE: SYK), or Zimmer (NYSE: ZMH).
What's more, there was substantial execution risk in the company's new Wright Direct program. Although I liked the idea of offering what amounted to value-priced recon implants to hospitals, the company was going to have an uphill climb in selling hospitals on the program and realigning the business to produce acceptable margins. With this deal, those execution risks evaporate.
Post-sale, Wright Medical is a company purely focused on extremities and biologics – two of the strongest growth markets in orthopedics, and one where the company has enjoyed significantly better margins. Even so, Wright Medical isn't getting a great price. About 10% to 15% of the sales proceeds of OrthoRecon are going to go to establishing a new headquarters and otherwise paying for the transition, and the “net-net” multiple for the deal drops to about 0.85x sales. But such were the prospects for OrthoRecon that, even at such a low net multiple, the cash Wright Medical is getting (and the opportunity to reinvest it in the extremities/biologics business) is actually worth more on a discounted cash flow basis.
Augment Needs To Come Through
While there were certainly risks involved in the company's plan to improve OrthoRecon, this sale too creates its own set of risks. In particular, Wright Medical has to get the FDA's approval of Augment, as sales of this promising orthobiologic represent more than 20% of my post-deal prospective 2014 revenue for Wright Medical and more than 40% of 2017 revenue. Now I may be underestimating the growth potential of the extremities business, but the point stands that Augment is now a much bigger part of the company's future – and the FDA has already shown that it is, at a minimum, nervous about approving Augment despite solid efficacy and safety data.
On the extremities side, management is still targeting a goal of generating $1 million in revenue per rep in 2014, and that would most certainly improve margins. At the same time, though, the company will need to keep up with its R&D (not to mention M&A) to maintain share and/or close the gap with Johnson & Johnson and Tornier (Nasdaq: TRNX) in extremities. As an aside, though, selling the hip and knee business could also greatly facilitate the sale of Wright Medical itself – Zimmer, Biomet, or Stryker could all look at Wright as an attractive, growth-boosting acquisition now that the OrthoRecon business is gone.
The Bottom Line
For this deal to work for MicroPort, the company definitely has to be more effective in selling Wright Medical's hips and knees in China than Wright Medical was. I don't think that's an especially challenging target, and I think MicroPort is getting a credible “turnkey” business at a price that strips away a lot of execution risk – so long as they don't screw up the business in the U.S., it will likely be no worse than a net-neutral deal.
For Wright Medical, though, this looks the start of a new chapter. Not only does the sale of OrthoRecon boost the company's long-term revenue growth rate (on a like-for-like basis, of course), but it also significantly boosts its prospective free cash flow margin. All told, my model suggests that this deal adds about $3 per share to the fair value of the business. With that, Wright Medical looks like one of the more interesting investment prospects in the ortho and overall med-tech sector today.
Disclosure – As of this writing, the author owns shares of Wright Medical, as well as Wright Medical Contingent Value Rights (WMGIZ).
Stephen Simpson CFA is a former sell-side and buy-side analyst who focuses most of his professional attention on financial and investment writing. In addition to a decade of work as an analyst, Mr. Simpson has worked as a wet-bench biomedical researcher and a consultant in the med-tech industry, as well as writing on a freelance basis for over 10 years. He can be reached via email at firstname.lastname@example.org.