As a BioMimetic Therapeutics (BMTI) shareholder, I have long regarded a buy-out as the overwhelmingly logical end game for the company. While I would have initially preferred to see one of the ortho giants like Johnson & Johnson (JNJ), Stryker (SYK), or Zimmer (ZMH) make the bid, the combination with Wright Medical Group (WMGI) could ultimately prove a lot more powerful for both companies than the Street currently seems to believe.
CVRs Arguably The Fairest Way Forward
Unfortunately for BMTI shareholders, the bid that Wright Medical made last week is heavy on contingent value, as the initial bid offered $6.75 in upfront value to shareholders and another $6.50 in future payments tied to the approval and sales of BioMimetic's Augment recombinant biologic.
While I have no doubt that shareholders would have much preferred to have $12 or so in cash upfront, that was not going to happen. The FDA has made it abundantly clear that it has real concerns with this product category in the wake of Medtronic's (MDT) problems with InFuse, and while the two products are quite different, the FDA has been difficult and skeptical at every step. That significantly increases the risk of a bid for BioMimetic at this point, as any buyer could be buying into another rejection and/or a protracted process of getting approval for Augment.
All in all, then, this was a balanced way for BioMimetic to de-risk the FDA process - if the company had waited to sell itself and the FDA had rejected the Augment application again, there's a good chance that the stock would have seen $2 (or less). While BioMimetic is not getting top dollar on a discounted cash flow basis, it's a good mix of risk and reward.
The Deal May Not Be Done
Investors in both BioMimetic and Wright Medical should realize that this deal may not be fait accompli. The transaction included asymmetrical break-up fees that obligate BioMimetic to pay about $8 million if they kill the deal, while Wright Medical has to pay $30 million to walk away (including if the FDA rejects Augment before the anticipated deal close).
This is not a trivial detail in my mind. There's a small, but non-zero, chance that the FDA could issue an approval or rejection before this deal closes in the first or second quarter of 2013. While I think an FDA decision is more likely to come in the second half of 2013, investors should realize that an approval before then could prompt a competitive bid, while a rejection could prompt Wright to write that $30 million check and move on.
Potentially A Major Deal For Wright Medical
Such is the skepticism about Augment that the announced deal added all of about $1 to Wright Medical's stock price. I believe this could be an overly conservative reaction to the deal, particularly as I'm not sure any other orthopedic company has as much to gain from a successful Augment launch.
While Wright Medical gets over 50% of its revenue from hip and knee reconstruction, where it is not terribly competitive with Stryker, Biomet, JNJ's DePuy, or Zimmer, one-quarter of the company's revenue comes from extremities reconstruction, particularly foot and ankle. In addition, about 15% of Wright Medical's 2011 revenue came from biologics.
As a recombinant growth product designed to assist in foot and ankle fusions, Augment could be a powerfully leveragable asset for Wright Medical. Not only will Wright Medical have one of the most interesting biologics on the market, but it should be synergistic in creating more business for Wright's fixation and reconstruction products (Augment procedures require other fixation products).
I've seen a variety of estimates out there, but I think Augment is targeting an initial market (foot/ankle) worth about $400 million to $500 million a year, and I think there's a good chance that Wright can get up to 50% of that market in time. I know that's a very aggressive estimate, but I believe once surgeons and patients find out about the benefits of Augment relative to other options (including the painful and potentially risky process of harvesting bone from the patient's hip), it will win a lot of converts.
If Augment can deliver $200 million in revenue to Wright Medical in five years' time, and using the margins of prior biologics as a guide, a successful Augment could be worth $10 per Wright share in today's dollars, even after factoring in the contingent value payments to BioMimetic shareholders.
BioMimetic Shareholders Can Gain Over The Long-Term As Well
I imagine that more than a few BioMimetic shareholders were discouraged with the deal as announced. After all, I thought BioMimetic was conservatively worth $10 to $12 per share, and that was without including much, if any, value for follow-on applications of Augment in areas like trauma, spine (probably another $1 billion in addressable market), and sports medicine, to say nothing of the potential of an injectable form of the product (which is in clinical development).
What's more, Wright Medical is not the prettiest property in the med-tech world. While the company's stock has done pretty well this year and investors are gaining confidence in the turnaround plan (which has included shifting the extremities business to a direct sales force), the fact remains that the baseline orthopedic industry is still struggling and Wright's competitive position in hips and knees is hardly certain.
But I think there are some reason for BioMimetic shareholders to consider hanging on to their Wright shares in this transaction. First, the extremities business is growing well (up double-digits in the third quarter) and holds very good market share, and I believe this is a growth business over the long term. What's more, I think CEO Bob Palmisano has a common sense plan to turn around Wright Medical and make it a leaner, better competitor as something of a niche player in orthopedics.
And then there's Augment. If Augment gets FDA approval, it could further Wright's leadership in the extremities, and open up more potential in markets like sports medicine and trauma. It's also well worth noting that Palmisano has sold two of the companies he's run before (IntraLase to Abbott (ABT) and ev3 to Covidien (COV)) and if Augment lives up to its potential as a biologic, Wright Medical could be the next company he sells to a large bidder.
The Bottom Line
If investors include a 10% risk that FDA rejection comes before the deal's close and that Wright Medical walks away (leaving the stock at around $2), today's valuation implies only a one-third chance that BioMimetic shareholders get that $3.50 contingent payment for Augment approval. While that kind of skepticism is understandable given FDA communications that have, in some cases, read like "over our dead body", I believe the odds of approval are better than that and at this point I do believe Augment approval is a "when, not if" proposition.
For Wright Medical, this was a bold and aggressive move to get arguably the highest risk/reward opportunity on the ortho market today. Absent Augment approval and revenue contributions, Wright Medical looks more or less fairly valued unless you believe the turnaround plan can ultimately vault free cash flow margins into the mid teens. With Augment's success, though, the stock today looks a lot more interesting (if significantly riskier).
For BioMimetic, it's an interesting opportunity. Wright Medical may not be the biggest ortho company today, but it just may be the best partner for what is initially a food/ankle product. With the market currently giving long odds to Augment approval and almost no odds that Augment becomes a meaningful contributor to Wright Medical, I'd say there's more than enough value here for BioMimetic shareholders to sit tight.
Disclosure: I am long BMTI.