There’s a saying in the markets that there’s always a bull market somewhere. Along similar lines, it’s almost always possible to find areas of growth in otherwise stagnant med-tech markets. While the overall performance of the orthopedic market has been pretty uninspiring of late, the extremities sub-sectors (upper and lower extremities) have been notable exceptions.
Growing share in lower extremities is not the only positive factor at work in pushing Wright Medical (NSDQ:WMGI) to new highs. After years of pursuing what I believe to have been an unrealistic business model and a scandal tied to the industry-wide practice of improper payments to surgeons to use their implants, CEO Bob Palmisano has the company on the right track again. Two years into his tenure as CEO, there’s still ground to cover in terms of margins, but the company’s sales strategy for recon, its growth in extremities, and the assets acquired from BioMimetic Therapeutics make this a name to watch in the sleepy ortho sector.
The wrong products, sold the wrong way, and at the wrong time
While recon sales (hip and knee implants and related products and tools) are still more than half of sales, this has been a challenging business for Wright Medical for some time. It takes a lot of money to compete with Johnson & Johnson (NYSE:JNJ), Stryker (NYSE:SYK), and the high fixed cost structure was very adverse for Wright Medical’s profits.
Making matters worse, Wright Medical found itself subject to basically the same criminal complaints regarding kickbacks to surgeons that swept across the orthopedics industry about four years ago. Even here, though, the company managed to find a way to make it a little bit worse – acting in such a way that the U.S. Attorney’s office accused the company of willfully violating the deferred prosecution agreement only about seven months after signing it.
The long and short of these missteps was that it cost several executives their jobs (including the CEO at the time, Gary Henley) and it cost the company significant amounts of money in incremental compliance costs. And all of this for a company that holds just 2% of the global recon market (and didn’t hold all that much more prior to the scandals).
So, to summarize, we had a company that couldn’t design particularly compelling hip and knee products (at least not compelling enough to gain real market share), couldn’t keep its nose clean from a legal standpoint, and couldn’t break into the double-digits for operating margin.
What was wrong is now right for Wright, or at least a lot better
Since Palmisano took on the task of turning around Wright Medical, a lot of meaningful improvements have been made.
First, the company has transitioned from a distributor-based sales model for its extremity products to a direct sales model. Not only is this good for margins (distributors have to get their cut, too) over the long term, but it also allows the company to have, well, more direct control over the sales process.
Given that the extremities market is growing at a high single-digit/low double-digit rate and Wright Medical actually has meaningful share here (#4 overall, with more than 10% share), this is no minor development. In fact, Wright continues to execute well here – foot and ankle sales were up 20% on an adjusted basis for the first quarter, roughly doubling the reported adjusted sales at Tornier (NSDQ:TRNX) – the market leader with approximately 30% share in lower extremities.
Wright is also getting more realistic about its opportunities in the recon space. The company has launched the Wright Direct program – a so-called turnkey solution for hospitals wherein Wright Medical will sell hip and knee implants at significantly reduced costs (15% or more) in exchange for the hospitals taking on the inventory management requirements and accepting essentially lower service levels.
As hospitals are increasingly looking to cut costs and go with capitation, this could make Wright’s implants more attractive. Now, it’s only going to be relevant to a small percentage of hospitals initially, probably something in the range of 10%. But longer term, this could be part of an effort to position the company as a value-priced implant player, and that may be the company’s best hope of competing with much larger and better-heeled rivals.
Augment is the wildcard
While I’ve followed Wright Medical for years as part of my regular med-tech “beat”, my interest got considerably more personal when the company acquired BioMimetic Therapeutics – a biomaterials company in which I owned shares. I was quite optimistic about the potential of BioMimetic’s lead product, Augment, and I believe it could have a significant impact on Wright Medical’s sales growth and market share in the coming years.
Augment is a recombinant orthobiological product designed to replace autograft bone in foot and ankle fusion procedures. While the FDA has been on ultra-high alert regarding biologics ever since the Medtronic (NYSE:MDT) InFuse debacle, studies of Augment have shown it to be safe and effective in fusion procedures.
It hasn’t been easy or smooth sailing, though. The FDA originally rejected the filing for Augment and wanted a re-reading of CT scans (to confirm fusion) and a redefinition of what constituted “failure” – including screw removals or screw fractures unrelated to the material. Fortunately for the company, the re-analysis of the data still showed Augment to be safe and effective, and it is now down to waiting to see whether the FDA will grant final approval.
Strict on-label usage of Augment could be worth upwards of $300 million to $400 million in sales just in the foot and ankle market, with related (but off-label) usages more than doubling that. As Augment is cheaper to manufacture than InFuse, it can be priced quite competitively and still be profitable – leading to potential target revenue (again, mostly off-label) of perhaps $1 billion.
I do not expect or model in $1 billion in Augment sales, nor do I believe Augment will go from zero to $300 million right out of the gates. Though it flummoxes and frustrates investors, surgeons don’t always care about the primary beneficial aspect of Augment – the reduction in pain and discomfort to the patient in not having to harvest autograft bone. Moreover, companies like Stryker and Johnson & Johnson will almost certainly market aggressively against it.
I nevertheless believe that the benefits of Augment are significant (and the quality of autograft bone is an under-appreciated negative factor that favors Augment adoption) and that sales will approach $250 million by 2017 (making up perhaps 30% of company sales). Likewise, I think Augment will drive greater adoption of Wright Medical implants and devices, leading to better overall revenue and margins. It’s also worth noting that there are other potential uses and forms of Augment, including an injectable form that could be used in sports medicine and/or spinal cases.
Conservative numbers still offer solid potential
Overall, I’m modeling nearly 9% long-term compound revenue growth for Wright Medical, with Augment responsible for nearly half of it. I’m somewhat more conservative with my margin assumptions, as though I believe Augment will be very good for margins, Wright Medical still lacks operating scale in a fiercely competitive industry. Consequently, I’m looking for free cash flow margins in the very low teens by 2017 and the mid-teens by 2022, which is still good for over 13% free cash flow growth (albeit off a low base).
That all works out to around $28 per share in fair value, but with upside to both implant/device revenue and revenue/margin upside from Augment. It’s also not unthinkable that Wright Medical could be an acquisition target. Palmisano has a history of selling the companies he runs, and Wright Medical could be attractive for both its lower extremities business as well as Augment. I’d also note that companies like Medtronic and Stryker have been buying companies in China with attractive “value-priced” implant businesses and if Wright Direct succeeds, perhaps that will make it all the more attractive for a company that wants to address both ends of the implant market.
Last and not least, there is also the matter of the Wright Medical Group Contingent Value Rights. This was part of the payout for BioMimetic, and it entitles the owner to certain cash payments for various Augment-related milestones. These milestones include $3.50/share in cash for FDA approval, and potentially $3/share more for certain sales milestones ($40 million and $70 million). The math here involves assigning odds to each milestone and factoring in the time value of money, but I value these contingent rights at $4.18/share on the basis of 80% approval odds, and 75% and 65% odds, respectively, of hitting the sales milestones.
The bottom line
I’ll freely admit that Wright Medical Group shares do not look exceptionally cheap on the basis of my assumptions. That said, they do appear to be cheaper than most other med-tech stocks (including Stryker, Johnson & Johnson, and Medtronic), and I believe my assumptions are relatively conservative at a time when most analysts are getting more aggressive with numbers on the larger companies.
Wright Medical has a lot left to prove. Can it effectively sell its recon products? Can it can share in extremities? Can it gain approval and then effectively market Augment? Can it hit its cost-cutting/margin-improving milestones? Though the answers are not certain, I think the odds favor “yes”, and I think Wright Medical is still a name worth buying in med-tech.
Disclosure – As of the time of publication, the author owns shares of Wright Medical and Wright Medical Contingent Value Rights (WMGIZ).