Synergetics USA, Inc. (SURG) supplies surgical devices used in ophthalmology and neurosurgery, including disposable and reusable devices, and surgical equipment.
On March 12, 2013, after market closing, the company reported $1.4 million in net losses for 2Q 2013. Revenues for the quarter declined 6.8% y-o-y. Gross profit margin was 36.8% due to a $2.0 million pre-tax inventory write-off vs. 59.5% in 2Q 2012.
Following the announcement, the stock dropped some 30%. Should investors expect a quick rebound in the price of the stock?
This article reviews the performance of the firm in terms of fundamental value metrics, such as ROIC, growth, and the cost of capital. It provides a diagnosis and discusses a possible avenue to unlock shareholder value.
Value Metrics Definition
- ROIC (Return on Invested Capital) = NOPAT / Operating Capital
- NOPAT (Net Operating Profit after Taxes) = EBIT (1- Tax Rate)
- OC (Operating Capital) = NOWC (Net Operating Working Capital) + OLTA (Operating Long-Term Assets)
- WACC (Weighted Average Cost of Capital)
- EVA (Economic Value Added) = (ROIC - WACC) OC
- FCF (Free Cash Flow) = NOPAT - (Changes in OC)
- EV (Enterprise Value) = PV of prospective FCF, growing at g; discounted by WACC
ROIC and Growth
- ROIC is below WACC
ROIC for the last four fiscal years, ending on July 31, is as follows: 4% (2009), 8% (2010), 10% (2011), 10% (2012). ROIC for 2Q 13 is minus 14% (annualized). Deferred Revenues are excluded from the computation of Operating Capital under the rationale that the cause behind Deferred Revenues is not inherent in the ordinary operation of the business (even if Deferred Revenues are included in the OC computation, the argument stands).
ROIC, a sticky financial attribute, results from two basic conditions; industry structure, where rational pricing allows reasonable economic returns to economically viable participants; and the firm's unique competitive advantages among participants. In the case of SURG, persistently weak ROIC indicates industry conditions which are unfavorable to the firm and/or weakness in the firm's competitiveness.
Investing in a business that produces returns below WACC (estimated at 11% to 12%) is a questionable proposition for investors, particularly when the path to improvement is unclear.
- Growth is slow
In the three-year period, from FYE 7/09 ($53.0 million) to FYE 7/12 ($60.0 million), revenues grew $7.0 million, or an annual average of 4% . In 2Q 13 revenues declined 6.8% y-o-y.
Modest revenue growth is recorded even after recognition of Deferred Revenues due to the Alcon settlement, which began in FYE 7/10. In 2Q 13 $0.32 million was recognized from Deferred Revenues; equal to the amount recognized in 2Q 12.
Operating capital as percentage of revenues is high. In FYE 7/12, the firm required 71 cents in OC for each $1 of revenue. If we exclude Deferred Revenues in the computation of OC, the OC requirement increases; every Dollar of revenue requires one Dollar of OC.
Such heavy capital content requires a commensurate higher NOPAT to reach an ROIC that exceeds WACC. This is not happening in the firm. Further, high OC requirements make any goal of free cash flow (FCF) an almost insurmountable challenge.
High capital intensity is caused by a production-sales cycle that is complex and/or expensive in relation to the resulting NOPAT (in September, 2001, the firm transitioned inside plastic injection molding to an outside vendor).
As part of the production-sales cycle, the firm has marketing partner agreements with Codman, an affiliate of Johnson & Johnson (JNJ), and with Stryker (SYK). Dependency on external distribution channels represents significant risk, notwithstanding multi-year agreements. Furthermore, the firm is in a disadvantageous negotiating position given the larger size and market clout of the marketing partners, and in consideration of the magnitude of a loss that the firm could suffer if distribution was discontinued. Revenue concentration is major - 34% of revenues in 2Q 13; 21.1% Codman, and 12.9% Stryker.
The point is that the firm's operations are excessively capital intensive; and operationally entail significant risk. These attributes engender low NOPAT and volatile revenues and increase the difficulty in achieving ROIC that exceeds WACC. Concomitantly, WACC raises with volatility as investors require greater expected gains to compensate for risk.
We can stipulate the baseline that the problem facing the firm refers to value drivers that extend beyond the short term, beyond last period's financial results. The problem is not transactional - a specific sale which closed a few days after the close of last quarter, or an unhappy supplier, or a fluke, or a team which missed a productivity mark.
The problem facing the firm is recurrent, having to do with operating sustainability; competitive advantages, cost structure, and general health of the commercial cycle. The problem concerns strategic issues; the core business, operational risk, and technology. Suggestions for quick fixes would not stand scrutiny under the light of history - past results, initiatives undertaken, changes made, and projects completed.
In a scenario of ROIC below WACC, any growth actually lowers value, as a negative EVA worsens from larger OC [EVA = OC (ROIC - WACC)]. Further, coupling rapid revenue growth with high OC requirements not only preempts FCF, but rapidly increases the need for bank debt.
How can the firm's business model be reconfigured into a sustainable combination of attractive risk-adjusted returns to shareholders, products that add value to clients, and effective management? What should be the response to low ROIC, high capital intensity, and slow growth?
These are loaded questions involving a complex problem that presumptively can be resolved by means of unbiased analysis, thoughtful consideration, deliberate decision-making, and persistent execution.
Enhancing shareholder value is a guiding principle in the search of a strategic solution.
A possible solution considers potential owners (potential buyers) who have relevant attributes of knowledge, resources, scale, and linkages in the industry (and with the firm's stakeholders) which represent potential avenues for adding value.
The attributes of potential owners are critical as a foundation to the core activities of the firm in discovering synergy. The firm's activities can be piggybacked into the potential owners' process, costs, and products.
An obvious avenue of value is distribution. A potential owner with an established distribution network can use it for the products of the firm. The firm's marketing partners come to mind as potential owners. An analysis of logistics, volumes, costs, would give a sense of the savings involved.
Studying manufacturing, outsourcing, R&D, and other activities, from the perspective of the potential owner, can also point to potential savings.
Potential owners (with expansive market coverage) who have industry insight can foresee growth opportunities; new products, expanding products to a new class of users, expanded users, etc. They can also add value in the relationships with the firm's stakeholders, including governments, regulators; and by means of improved governance.
Ultimately, a potential owner is motivated to make the acquisition when (A) the acquisition price paid (sum of the price of the stock plus any premium to shareholders to motivate them to sell) is no greater than (B) the value of the firm to the potential owner (sum of intrinsic value of the firm, as it is, plus the present value of the improvements made after the acquisition).
Inherent in the intrinsic value of the firm is its unique core competence (not easily duplicated elsewhere). Influencing the acquisition price are the priority avenues of value and related magnitudes of potential savings and potential gains.
Nothing in this discussion detracts from the improvement sought by the firm's current initiatives, including improvement in production and distribution, expense control, and new product introductions. No doubt these are well-meaning and well-intentioned actions that connote improvement. However, they do not zero in, front and center, on the causes behind unfavorable value metrics - capital intensity, low ROIC, slow growth.
Any reasonable man would anticipate an unchanged operating mode to yield the same performance in the future as it has in the past.
The solution to firm's problem resides in the domain of core competency, entails strategy, involves the foundation in operations, and is rooted in value. It can entail as many combinations and mode of cooperation with different potential partners as there are avenues of value. The potential owner perspective discussed earlier is just one alternative.
Solutions are not single announcements, or single decisions or actions. Solutions take the form of a process that attacks the cause(s) behind unfavorable metrics. It starts with analysis, decisions and actions that drive (improved) outcomes, which turn into (improved) value metrics and revised (higher) expectations that drive (higher) enterprise value and eventually move the price of the stock. The process takes time and outcomes are uncertain.
How the problem is defined, the diagnosis and the medication prescribed and taken, and the follow-up, all determine outcomes. In multi-period horizons, outcomes are studied and suitable modifications and adjustments are incorporated into the next business period, and so on.
What is the motivation to tackle such a tough problem?
The motivation is shareholder value; to take the shareholders into a sustainable value-creation state of attractive risk-adjusted ROIC and rapid revenue growth. The challenge of transformation falls within the jurisdiction of the board of directors; to be addressed in collaboration with the management of the firm.
Should investors expect a quick rebound in the price of the stock?
There is no way of knowing what the market will do. However, in my opinion, the current operating mode supports an intrinsic value estimate no higher than the current price of the stock.