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The last twelve to eighteen months have not been easy on NuVasive (NASDAQ:NUVA). Once a darling of growth-oriented investors in the med-tech space, NuVasive got knocked off stride by a combination of sluggish growth in its core spine market, increasing competition, an IP litigation loss to Medtronic (NYSE:MDT), a questionable acquisition, and just a generalized ennui on the part of investors frustrated with the pace of progress at this small-cap orthopedics company.

The good news is that a lot of these issues are starting to clear up. The spine care market seems to be re-accelerating (and NuVasive is growing faster than the market), investors have gotten more comfortable with the Impulse Monitoring deal, final resolution of the Medtronic royalties should be near, and sentiment seems to be shifting more to what NuVasive could do as opposed to what they so far have not done. All of that said, investors have to be willing to give the company some benefit of the doubt for this stock to look meaningfully undervalued today.

Still A Leader, But The Edge May Be Narrowing

Within a broadly-defined spinal care market worth about $7 billion to $9 billion a year in revenue, NuVasive is more narrowly focused on minimally invasive surgery and related products/services like monitoring and biologics.

In particular, the company has focused on tools and technologies for less invasive spinal fusion procedures, where the company has roughly 40% market share. By focusing on this faster-growing market segment, NuVasive has been able to post double-digit growth at a time when many established players like Medtronic, Johnson & Johnson (NYSE:JNJ), and Stryker (NYSE:SYK) are struggling to grow much if at all. Unfortunately, most of NuVasive's rivals now have less-invasive lateral systems of their own and the question is whether NuVasive can maintain enough of an edge to grow its overall spinal market share out of the single digits on a global basis.

There are still reasons for optimism. NuVasive is just getting started in Japan (the second-largest spine market) and new products like AttraX (a synthetic biologic), the PCM cervical disc, and expanded XLIF and MaXcess offerings should help preserve at least some of the sales momentum. That said, there was a sequential deceleration in lumbar fusion growth, and the reimbursement environment is a lot less friendly than it was just a few years ago.

Can NuVasive Build Up The Profitability?

Part of the attraction of med-tech is the above-average profitability of the industry, but NuVasive has yet to really join that party. While it may not be fair to compare NuVasive straight up to a company like Medtronic, Stryker, or Integra LifeSciences (NASDAQ:IART) due to issues of scale and whatnot, the lower profitability vis a vis newly-public Globus Medical (NYSE:GMED) takes a little more explaining.

Even if Globus gets a benefit to its cost of goods from the fact that some of its manufacturing is handled by companies partly owned by the CEO and VP of Operations, and a benefit to SG&A from the fact that some customers are also shareholders, it doesn't explain all of the difference. What seems to be the case, then, is that NuVasive is not running this company for maximum near-term profitability - spending more money on policy lobbying, celebrity spokespeople, physician training and so on as part of a plan to build a larger business for the long term.

I can understand if this frustrates investors or even pushes them to the sidelines, but it's hard to win share against the likes of Medtronic, Stryker, and JNJ's DePuy by scrimping and saving on SG&A.

Litigation Tide May Be Turning

NuVasive has not done especially well in court over the last year, but the news may be at a turning point. While the company's appeal of Medtronic's IP victory has been temporarily sidelined, a final ruling on the royalties owed to Medtronic (likely to be in 1H'2013) should clear up some of the uncertainty regarding the company's new margin run-rate.

NuVasive currently accrues royalties at a rate of 2% for the Helix ACP Cervical Plate, 3% for MaXcess retractors, and 10% for CoRoent XL implants. Those aren't crushing royalties, and so as long as the verdict doesn't substantially increase them (which would be counter to current expectations), the damage ought to be containable and is certainly better than the prior worst-case possibility of an injunction barring the sale of the products. What's more, the company is appealing, though I don't think investors ought to count on a successful outcome there.

Elsewhere, the company was granted a new trial in its Neurovision trademark case. While the district judge had found in favor of Neurovision Medical and awarded a $60 million judgment against NuVasive, the appeals court not only granted the motion for a new trial, but criticized the conduct of the original judge pretty sharply.

The Bottom Line

To be sure, NuVasive has plenty of challenges left on its plate. Competitors large (Medtronic/JNJ) and small (Globus) represent threats to its market share and growth, while the new 2.3% excise tax on U.S. medical device sales will take some steam out of the margins.

The real question for investors is just how much improvement they believe NuVasive can attain in margins and free cash flow. If NuVasive ends the next decade with a free cash flow margin of 12.5% and a decade-long average of 8.5% (along with mid-to-high single-digit revenue growth), the shares would be worth something in the mid-$20s. Boost that decade-end margin closer to the industry-norm, though, and the fair value moves closer to $30.

NuVasive's profitability in 2022 may well be a moot point anyway. It would not surprise me in the slightest if NuVasive got (and accepted) a buyout bid, and were a deal to materialize over the next year, the premium could very well range from 30% to 60% of today's price.

Source: NuVasive Could Do Better, But Will It?