Can Synovis Soar Again After Its Pegasus Acquisition?

When Synovis Life Technologies (SYNO) (15.72, $181mm market cap) reported in late May, I thought I had let a great opportunity slip away. I had recently added this pure-play in biological materials used in surgery to my watchlist, as it is a member of an elite group of companies in the Med-Tech space with gross margins above 60% and little or no exposure to capital spending. I have written about a couple of others, including Somanetics (SMTS) last week and Volcano (VOLC) earlier this summer. SYNO reported a great quarter, yet again, but it announced that it was going to be hiring salespeople. I mistakenly took this long-term bullish but short-term costly action as a possible catalyst for the stock to pullback even further than it already had. Instead, it ran from its close of 14.24 to a high of almost 20 in the next few days and a peak of almost 22 five weeks later. As you can see in the chart below (click to enlarge), it looked like I had let a great one get away:

Well, just a few days later, the company announced that it had won an auction of a company in bankruptcy, Pegasus Biologics. Investors reacted extremely negatively to the news, hitting the stock hard for the next week and driving it back to the gap in the mid-14s that had been left when they reported earnings. You can see that action in the up-to-date chart below (click to enlarge):

The deal closed, the market has been rallying and SYNO has been locked in a tight holding pattern since they announced the deal and trashed the stock. I expect that what had investors so excited in late May will be evident yet again when the company reports Q3 on September 2nd.

As I mentioned, I had been trying to get up to speed on this tiny company before it blasted off. I was attracted to the gross margins in the mid-60s, the strong top-line growth (19% through the first 1/2 of the year, all organic, and expected to grow 18% this quarter) and the overall theme of biological materials. While it is a competitive space, with much larger companies than SYNO, this is a very underpenetrated market. The value proposition is the triple-win I like to see in Healthcare, where the 3 "Ps", the patient, physician and payor, are all happy. Instead of harvesting tissue from the patient, a timely process with potential adverse side effects, the doctor uses products such as those provided by SYNO. These materials tend to come from cows, pigs or horses. In the case of Synovis, the company offers both products as well as surgical tools. The products are used to reinforce staples as well as to repair soft tissue. Some applications include bariatric, thoracic, cardiac, vascular and other surgeries.

I view these guys as a potential take-out candidate, so I was surprised to hear about the Pegasus transaction. I shouldn't have been, as they had hired Tim Floeder in May, 2008 specifically to explore opportunities and even spell out parameters on their website. I tuned into the call to discuss the buy and even got to ask questions. I was curious about how much due dilligence the company had done primarily. I followed up with a discussion with the CEO a few days later.

Here is my take on Pegasus: Little downside, likely success, possible grand-slam. Pegasus was enjoying similar growth to Synovis, but they got caught up in the financial crisis. Unlike SYNO's pristine balance sheet, Pegasus had a lot of debt and was forced to shut its doors abruptly in May. SYNO was familiar with the company but didn't consider acquiring them as a going concern due to its being more expensive than its focus (the company had raised over $40mm). I agree with the company that it would have been worth in excess of $30mm. Instead, SYNO picked up 2 products on the market and an additional recently approved one, for $12mm (1.33X 2008 sales). Of course, the company had ceased operations, so SYNO assumed the cost and risk of restarting operations. Not surprisingly, it hasn't been too hard in this market to get back key employees. When the company announced the buy, the indicated that the deal would be dilutive initially as it re-started the company, which is being run initially as a separate subsidiary. They estimate a loss in 2010 of up to $5mm after a 4th quarter loss of $1-2mm for this new division.

The Pegasus buy could be a flop - the CEO assures me that they won't throw additional resources at it if that proves to be the case. It is likely, however, to work out just fine, possibly spectacularly. I believe that the company could make this happen quicker than they initially expected. The acquisition gets them products that would have been costly and time-consuming to develop internally and in front of a potential FDA rules change that makes it more difficult for Medical Device companies to gain approval. The only unfortunate aspect of the transaction is that the focus areas of Pegasus aren't the same as Synovis, with products geared towards sports medicine and chronic wounds, so there is no sales synergy. Ultimately, if successful, the company will be able to consolidate manufacturing into its Minnesota factory, so there could be synergy in that regard.

Even after the buy, SYNO is rich with cash and will still be quite profitable despite the burden of the additional expense. Without making heroic assumptions about Pegasus sales ($4mm over the next 3 quarters), I estimate that the company can get their annualized sales to $74mm a year from now. I believe tha the EV/S multiple can expand to 3X. Assuming what I expect to be cash of $52mm (excluding LT cash tied up in ARS), I get a target of 24 a year from now. Alternatively, I get 24 by using a PE target of 22X and adding back in the cash. Below is a longer-term valuation view (click to enlarge). I put in a line for my price target, which coincidentally was the high in 2007 and 2008 (and the company has grown since then!). Also, my key valuation metric of EV/Sales of 3.0 looks reasonable. The current PE is off of depressed earnings (Pegasus dilution, salesforce expansion) - the thesis is that EPS can grow to .90 or so over the next year (implying a PE of 26.5, or unchanged).

So, why the huge negative reaction to the deal? It seems to me that the shareholders were not happy about the dilution, which may prove to be a lot less than the company indicated. As CEO Kramp explained to me, the company had been consistently producing record EPS, and this will no longer be the case, at least in the near-term. The whole thing is amazing to me, as the company is committing less than $20mm to the transaction (purchase price plus assumed initial losses), yet investors wiped 1/4 of the market cap out - about $60mm. In an optimistic case, this new division could add $15mm in sales (or more) in fiscal 2010 (though I assume much less). That level is probably a reasonable conservative estimate for fiscal 2011. In that is the case, the company will most likely have created at least $25mm of value (rather than destroyed $60mm). And who says markets are efficient!

I am betting that SYNO's bid for Pegasus will prove to be a great anecdote for the Great Recession, where a well capitalized company was able to take advantage of a good company that had a challenged capital structure. I own it in a portfolio I manage as well as in my Top 20 Model Portfolio (7/15 at 15.34), which is up 46% YTD. Even if Pegasus doesn't pan out, I believe that the company will keep growing sales and earnings even if the economy continues to struggle.

Disclosure: Long SYNO

Comments

[User 475551:]

Well done report. Thanks.

Aug 23 11:16 AM

[Alan Brochs...:]

Ouch. The company had a 6% sales short-fall on the same competitive issue from the previous quarter and kaboom. There was a big seller yesterday in front of the number, and today is a massacre. I still like the story - the $12.90 price seems like a steal to me. The Pegasus integration seems on track, and the short-fall, which was confined to one area, seems likely to resolve within a couple of quarters.

Sep 02 12:44 PM