Before expanding on the topic at hand, praise to Urologix (OTCPK:ULGX) management for being bold and exiting the Wall Street earnings numbers game (see my article dated April 23). At least investors and management will not be distracted by sell-side analysts asking non-value added questions about tax related adjustments to the CFO’s financial model and other short sighted nonsense. Since I am doling out compliments, it was welcoming hearing Blueline Partners (the California-based hedge fund that owns 8% of ULGX common stock at about $3.88 per share) participate on the call.
Now to the ongoing chatter. For a while, ULGX onlookers have been mentioning, perhaps hoping for, a takeover. Rightfully so, in my opinion. Given that last month Boston Scientific (NYSE:BSX) completed a $60 million purchase of a competing prostate treatment product line, Prolieve, from Celsion Corporation (CLN), there is added economic pressure for ULGX to join forces with another company. Granted, prior to the purchase, BSX was the exclusive distributor of Prolieve, and, in fact, owned about 8% of CLN’s common stock. So, it is not exactly a new competitor to the sector, just a more formidable one.
Provided below is a high-level financial comparison of Prolieve and Urologix.
Due to assumptions of overhead application by Celsion, operating margins have been excluded. However, it is likely that if Prolieve were assessed as a stand alone entity, it would have generated operating margin losses exceeding those of Urologix’s.
As highlighted in the above table, there is a significant gap in valuation multiples, which can be interpreted several ways. One interpretation is that ULGX is trading at a steep discount as an asset for a strategic buyer. More precisely, it is trading at less than one sixth the revenue multiple paid a couple of weeks ago to a directly comparable competitor, Prolieve. Notable, too, is that Prolieve produced sluggish revenue growth and lower gross margins. Nonetheless, even if a buyer paid the same dollar amount BSX paid for Prolieve, it would receive nearly double the revenue base and fatter gross margins.
One element to the valuation gap is overhead synergies, specifically concerning SG&A. ULGX has been trying to reduce costs by restructuring its direct sales force (laying-off staff). Despite this effort, its total SG&A remains high at 51% of revenues, versus that of BSX’s 37% and American Medical Systems Holding’s (NASDAQ:AMMD) 44%. Accordingly, by combining ULGX with a more productive, scaleable infrastructure, its value will be unleashed. It is clearly worth a lot more as ‘part of a whole,’ than just a stand alone ‘part.’
That said, even though there are several high quality potential acquirors, at the moment I will only comment on the company that has appeared most often in chatter as a potential acquiror: Rochester Medical Corporation (NASDAQ:ROCM). I believe some of the reasons ROCM is often mentioned as a potential suitor are (a) it is described as a urological care company, (b) it has the financial wherewithal to consummate a transaction, and (c) geographic proximity: it is located about a two-hours drive from Urologix’s headquarters.
A brief review of ROCM as a potential suitor of ULGX follows:
It is not the most conventional fit, at least from a topical perspective. Although they both make catheters and are healthcare companies, their sectors are quite unique. ROCM produces low-tech, consumer oriented, external catheters used to transport urine to a holding bag, which it also produces, among other accessories.
In contrast, ULGX primarily produces higher-tech internal (minimally invasive) catheters and microwave equipment used by physicians to treat enlarged prostates. Additionally, these are FDA regulated devices and require highly trained professionals to use them. And, the most needed synergies of SG&A might not be leveraged as well between these companies, since the selling and distribution process and regulatory requirements are fairly different.
Nevertheless, ROCM has two primary expansion alternatives: external, disposable, consumer-oriented products (diapers, pads, etc.), and treatment oriented, minimally invasive devices. As such, if ROCM truly wants to expand its product portfolio into a more device-oriented segment, then ULGX is a viable, and perhaps attractive, option.
To this end, since AMMD provides both types of products (it acquired two ULGX competitors), ULGX and ROCM both appear vulnerable as stand alone, pure play companies.
It is attractive from a growth and gross margin perspective.
To justify its premium stock valuation, ROCM needs to maintain a high growth rate. Recently, its stock has pulled back 50% from its 52-week high, and has a lot of short interest pressure. If it were to buy ULGX, it would nearly double its revenues from about $28 million to more than $50 million, although it would incur some net income per share dilution (assuming no overhead synergies, which is highly unlikely – see SG&A below).
Regardless, Wall Street would salivate at the notion of an 80% year-over-year, profitable growth rate (this doesn’t include ROCM’s current organic growth, either).
After factoring in a premium, ROCM would likely need to pay roughly $35 million to acquire ULGX (net of ULGX cash, and excluding transaction related costs). Again, note that this is half the amount BSX paid for the much smaller Prolieve, illustrating the deep discount at which ULGX trades (as a strategic acquisition). Clearly, ROCM has more than that amount in hard cash. And, it also has a richly valued currency (stock). So, more than likely, it could offer 50% cash, 50% stock and still retain $20 million cash on its balance sheet.
Whether ROCM or a larger strategic-buyer pursues ULGX, the company is trading at a significant relative discount to the Prolieve precedent transaction and similar assets acquired a couple of years ago. Keeping in mind that it is the board of directors fiduciary duty to maximize shareholder value, the question to the Board is this: Will a fair relative value be reflected before a takeover, or after (within a new entity)?