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Business Description

Greatbatch (NYSE:GB) is a designer and manufacturer of custom parts and technologies for implantable devices and within the commercial battery industry (mostly for oil and gas applications). This is specialty power. GB's legacy emerges from a private battery company that transformed itself to a public company in 2000  providing implantable batteries for cardiac medical devices.

Relevant History and Strategic Course

Current CEO Thomas Hook, elected in 2004, drastically rationalized the manufacturing facilities at GB. He consolidated 16 facilities into just 4. Sales and profitability grew dramatically.

However, GB had an enormous concentration of customers - by 2005, Boston Scientific (NYSE:BSX), Medtronic (NYSE:MDT) and St Jude Medical (NYSE:STJ) accounted for 70% sales. By 2007, these customers still provided 67% of sales and as implantables for these customers (pacemakers, ICDs) slowed, so did GB's revenues.

In mid-2007, GB made a dramatic strategic shift, buying seven very small companies to enable GB to enter into new markets such as neuro-stimulation, orthopedics and vascular markets. Post acquisitions CRM now accounts for 50% of revenue. GB is transitioning from being a manufacturer of parts to providing sub-assemblies and full assemblies in important new markets such as neuro-stimulation and orthopedics. This will offer a 2x revenue opportunity.

Focus in 2008

As a result of the acquisitions, GB was left with 29 manufacturing locations. The goal in the next three years is to lower that to nine. This would mean a 250bp increase each year from efficiency on the consolidations alone. GB, at its low, had an operating margin of 10%, which should expand to 17.5% if the efficiencies can be sustained.

Growth and Defendability

The greatest growth opportunity for GB is in neuro-stimulation. Management has expressed a desire that it become a $100m business in two to three years. This is due to the fact that it is an open nascent field and GB has been asked by smaller companies to make the assemblies for them. This represents a tremendous shift in which GB is not limited to the leads or sub-assembly but can provide the whole design.

For 2008, management has given midpoint guidance of $510m in revenue and EPS of $1.20 to $1.50. It is divided into:

$250m in CRM and Neuro (growing at 5%)
$75m in commercial (growing 7%)
$75m therapy delivery i.e. vascular (growing 12%+)
$110m orthopedics (growing at 10%)

In Q2 2008, GB delivered an earnings surprise via a $15m beat on the top-line (see conference call transcript). Most of this was in the orthopedic unit via some low hanging fruit and the ability to get products moving much quicker than expected.

Longer Term Model

Gross margins for GB have typically been low to mid 40%. In 2005/6, they declined to mid 30% and rebounded in 2007 to 40% as facilities were automated. Many of the 2007 acquisitions are low gross margin businesses based on small volumes. This is the challenge for GB - building up these new businesses and harnessing the talent and design at these acquisition sites.

There is tremendous leverage in the model and any incremental good news affecting the growth rate in the CRM segment, which has been riddled with recall and medical problems outside of GB's control, would be hugely positive.

Assuming a top line growth rate of 10% in 2009 and 14% in 2010 would place revenue at $655m. Delivering on the promised expansion of operating margin as a function of efficiencies would mean a 14% operating margin. This would deliver an operating income of 92m or an EPS of $2.42.

Typically, small cap medical device companies trade at 24x EPS. Applying a 20x multiple to GB would give a price of $48.

Debt

As of Q2 2008, GB had debt of $358m. Interest Expense for the quarter was $4m. They generated 24m in cash flow from operations.

$241 of the debt is the function of two convertible notes at 2.25% per annum due in 2013 and convertible at $40.29. The other $115m is a line of credit underpinned by GB's non-realty assets.

Risks

  1. Acquisitions were too expensive or not integrated well. Cost cutting is not linear so quarters may slip.
  2. Continued sluggishness in the CRM market. In Q2 2008, sales in this category declined 2% due to a recall of leads on Medtronics' Fidelis product.
  3. GB has historically been a highly acquisitive company, but bouts of acquisitions tend to be followed by periods of integration. GB has stated no further acquisitions for 2009.

Valuation Metrics

Stock Price: 21
Shares O/S: 24m
Mkt Cap: 500m
Cash: 20m
Debt: 358m
Enterprise Value: 818

EPS 2008: $1.20
EPS 2009E: $1.90 (11x)

Sales 2008: 520
Sales 2009E: 580

Disclosure: Author holds a long position in GB

Source: The Long Case for Greatbatch