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There was no shortage of skeptics regarding Integra LifeSciences' (Nasdaq: IART) aggressive build-by-acquisition strategy during the past decade, myself included. To management's credit, while the company has quite a lot of debt for a med-tech, it has emerged as an appealing niche player in attractive markets in orthopedics and neurosurgery. While the company is currently suffering from the same sluggish markets that have stalled out bigger rivals like Johnson & Johnson (NYSE: JNJ), Stryker (NYSE: SYK), and Medtronic (NYSE: MDT), this is an interesting stock to watch for investors who want to go a little deeper than the well-known big-cap names.

Reality Bites Into The Third Quarter

In an orthopedics world where hip, knee, and spine competitors like Biomet, JNJ, Medtronic, Stryker, Zimmer (NYSE: ZMH), and Smith & Nephew (NYSE: SNN) largely seem to be spinning their wheels, Integra had looked pretty good with a growing spine, orthobiologics, and extremities business. Unfortunately, it looks like the ortho malaise is spreading to the extremities.

Revenue in the third quarter rose 8% as reported, 7% in constant currency terms, and probably somewhere in the neighborhood of 2-3% on an organic basis. Orthopedics led the way with 18% reported growth, much of that a byproduct of acquisitions, and extremities soften to below double-digit growth. Neuro was up 4% and the instruments business was down 1%. That seems like a surprisingly weak result given the equipment and instrument results posted at Stryker, Covidien (NYSE: COV), and Hill-Rom (NYSE: HRC).

Profitability was likewise not so spectacular. Gross margin dropped almost two points and reported operating income fell by a third. Looking at the adjusted EBITDA (including stock comp expense), though, profits were about flat.

Well-Positioned But Still Subject To The Same Realities

Integra has built an appealing business for itself and continues to make sound and savvy acquisitions. SeaSpine will boost the company's spine care business, while the acquisition of Ascension Orthopedics expands the company's offerings in upper extremities (like shoulders) and brings in the interesting PyroCarbon technology.

Still, this is ortho, and ortho is not doing well. Worries about government investigations into reimbursement have led many hospitals to pull back on ortho procedures. What's more, overall patient volumes are down across the board and ortho procedures are no exception. And now this malaise seems to be spreading into extremities and companies like Tornier (Nasdaq: TRNX) and Wright (Nasdaq: WMGI) as well as spine companies like Nuvasive (Nasdaq: NUVA).

The Good, Bad, And Unknown

Although Integra arguably has too little overseas exposure (U.S. sales are about three-quarters of the total), it does at least have the advantage of serving fragmented markets and actually leading many of its markets (especially in the neurosciences business). All in all, this would be an attractive acquisition candidate for a number of companies - but perhaps most of all for Stryker, given this company's recent expansion into neurology.

But it's not all sunshine and roses. The company has some issues to resolve with the FDA concerning its collagen facility - a facility that produces a rather substantial amount of the company's revenue. That high debt load could also become a bigger issue if end markets stay stagnant for too long - at a minimum, it could restrain the company's ability to expand marketing, sales, and R&D efforts.

Can Integra continue to find complimentary acquisitions? Probably. Can Integra show better internal growth? Maybe. Investors should realize, though, that organic growth is not necessarily as important in med-tech as they might think - many of the biggest names in the space end up buying a large portion of their growth.

The Bottom Line

Even subtracting all of the company's net debt from the valuation leaves the shares looking undervalued on the basis of only mid-single digit revenue growth and below-average free cash flow margins. Looking at conventional metrics like EV/EBITDA and EV/revenue likewise has Integra looking too cheap relative to its prospects and market positions. The ongoing malaise in orthopedics may keep these shares cheap for a while, though, so new buyers should not expect a fast rebound here unless a buyer or two emerges.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

Source: Integra Hitting That Same Ortho Wall