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  • Greatbatch: Competition And Debt To Drive The Stock Lower 0 comments
    Feb 7, 2014 3:35 PM | about stocks: ITGR

    Greatbatch, Inc. (GB) is a reputable company originally known for its pacemaker battery business. Wilson Greatbatch, co-inventor of the first successful implanted cardiac pacemaker, founded the company in 1970. He also invented a corrosion-free lithium battery to power the pacemaker he invented. A cardiac pacemaker is essentially a cardiac rhythm management ("CRM") tool that maintains the rhythm of millions of heartbeats. Subsequently Greatbatch, Inc. diversified its business in the areas of CRM, neuromodulation, vascular access, and orthopedics. After a meteoric rise last year, the shares of the company are currently hovering around $40. I believe that GB could have an immediate ~30% downside due largely to tough comps in the CRM and neuromodulation market in its Implantable Medical segment.

    Why Did the Stock Rise?

    1. Despite being a debt-laden company (over $200 million long-term debt against current market cap of $980 million), over the last eighteen months the stock price of Greatbatch more than doubled itself based on its organic growth prospects. In June last year Greatbatch management announced a strategic initiative to realign its businesses to achieve 5% organic growth by combining its two separate reportable segments, viz. Greatbatch Medical and Electrochem Solutions into a single sales & marketing and operating group. The Electrochem segment designs, manufactures, and distributes primary and rechargeable batteries, and battery packs for demanding applications in the portable medical, energy, environmental monitoring, and security markets. The company expected to generate an annual savings of $7.0 to $7.7 million, following the realignment plan and evaluating the short-term benefit from the plan it raised its adjusted EPS guidance range to $2.00 - $2.05 from the previous range of $1.90 - $2.00.

    2. The company sought to transform itself into a producer of complete medical devices for Original Equipment Manufacturers (OEMs) from being a supplier of batteries, capacitors, and components used in implantable medical devices, since almost 75% of its revenues are derived from medical devices companies.

    3. The Street expected GB to post solid revenue growth in the CRM and neuromodulation business along with a smart recovery in its lagging orthopedic business. However, it forgot to recognize how a debt-laden company like GB would fund its R&D expenses and face fierce competition from established players like Medtronic (NYSE:MDT), Johnson & Johnson (NYSE:JNJ), St. Jude Medical (NYSE:STJ) and Boston Scientific (NYSE:BSX), to name a few.

    Encouraged by Greatbatch's efforts to realign its businesses and to transform itself into a pure play medical devices company, the Street started to believe that GB is worthy of a premium valuation compared to its peers. This, coupled with an overall bullish market sentiment pushed the stock unreasonably higher.

    GB Chart

    GB data by YCharts

    Unfortunately, Greatbatch management was not as optimistic as the Street and the company insiders continued to sell their stake in the company as the stock continued to rise. In the last one year insiders net sold 200,831 shares and in the last three months they net sold 70,557 shares.

    What Happened Next?

    In the second quarter of 2013, Greatbatch posted an adjusted EPS (excluding one-time expenses) of 56 cents (40 cents on non-adjusted basis), up 30% y-o-y and 27% q-o-q, and revenue of $171.3 million, up 3% y-o-y and 15% q-o-q. In the third quarter, the company posted an adjusted EPS of 57 cents (46 cents on non-adjusted basis), up 30% y-o-y but flat q-o-q, and revenue of $167.7 million, up 5% y-o-y but down 2% q-o-q. In both the quarters, revenue growth was primarily driven by an average 6-7% growth in the company's CRM and neuromodulation business, which accounts for almost half of its revenues. Improvement in the underlying market was responsible for this revenue growth, rather than the company's efforts to drive sales.

    Orthopedic revenue remained more or less flat due to a weak economic scenario. Vascular Access sales remained soft primarily due to lower introducer sales. Electrochem business, which accounts for almost 25% of its revenues, continued to remain volatile.

    Valuation

    Let me share the good news first, Greatbatch has a consensus rating of "buy" and an average price target of $44 by sell side analysts. The stock achieved that target in January. I believe that sell side analysts upgraded the stock to "buy" based on Price to Sales multiple. In terms of P/S, GB appears cheap relative to its peers.

    GB PS Ratio (NYSE:<a href='http://seekingalpha.com/symbol/TTM' title='Tata Motors Limited'>TTM</a>) Chart

    GB PS Ratio (TTM) data by YCharts

    Now the bad news, on January 6 the executive vice president of the company Mauricio Arellano sold 24,198 shares of Greatbatch stock at an average price of $43.61, for a total value of $1,055,274.78. Following the completion of the transaction, he now directly owns 3,782 shares in the company, valued at approximately $151,280.

    Why the company EVP sold his stake at $43.61 is completely understandable. From a discounted cash flow angle, a 15% CAGR cash flow growth for the next five years followed by a 5% CAGR perpetual growth discounted back at 11% would justify an intrinsic value of roughly $44. With huge debt on GB's balance sheet and fierce competitive pressure (I will discuss competition in the following paragraphs) I believe this kind of visibility is not there in Greatbatch's business. I would be comfortable with a 10% CAGR cash flow growth for the next three years, followed by a 4% CAGR long-term growth. If I discount it back at 11%, I get $27.85 as GB's immediate target price.

    In terms of Price to FCF, GB is trading at 52x, which represents a huge premium compared to its competitors. At $27.85, it would trade at a Price/FCF of 36x, which is still a premium valuation but maybe acceptable given the size of the company.

    GB Price to Free Cash Flow (<a href='http://seekingalpha.com/symbol/TTM' title='Tata Motors Limited'>TTM</a>) Chart

    GB Price to Free Cash Flow (TTM) data by YCharts

    Competitive Landscape

    Greatbatch's CRM and neuromodulation business accounts for almost half of its revenues and Electrochem business accounts for approximately 25% of its revenues. CRM consists of three key areas:

    • Pacing systems
    • Implantable cardiac defibrillators (ICDs)
    • Automatic external defibrillators (AEDs)

    Initially the CRM products were primarily developed and marketed by a handful of global players for treating arrhythmias, specifically supraventricular arrhythmias ("SVA") and ventricular arrhythmias ("VA"). However, today a lot of companies develop these products aside from Greatbatch, such as Medtronic, St. Jude Medical, Boston Scientific, and Altera (NASDAQ:ALTR), to name a few that are listed and many others that are privately held. As a result, competition is intensifying.

    The different types of SVA are premature atrial contractions ("PAC"), supraventricular tachycardia ("SVT"), sick sinus syndrome ("SSS"), atrial fibrillation ("AFib") and atrial flutter ("AFL"). The different types of VA are premature ventricular complex ("PVC"), ventricular tachycardia ("VT") and ventricular fibrillation ("VF"). Greatbatch's broad range of CRM products is used in multiple applications that cover almost all types of SVA and VA. The company has a huge product line including catheters, leads, introducers, adapters, and delivery system products that are intended to be sold through the major OEM companies as additions to their product lines in the markets of CRM and neuromodulation. However, I feel that the company would lose significant market share going forward due to growing competition for its current products. Moreover, new product launches by major OEM companies are expected to render its existing product line partially invalid.

    Medtronic enjoys a leadership position in the $18 billion CRM market with 30% market share, which is well below its historical market share of 55% in 2008 due to growing competition. Let me illustrate the role of competition with an example. ICDs constitute a significant part of the CRM market and going forward growth in ICD sales is expected to be driven by the launch of new advanced Subcutaneous-ICDs (S-ICDs), which do not require a transvenous lead to connect ICD to the heart and are expected to replace conventional ICDs over the next couple of years. Boston Scientific has already launched the device in the United States leaving Medtronic behind and it has seen a strong traction. I believe that it's a matter of time Medtronic and St. Jude Medical will also join the S-ICD bandwagon.

    In October last year, St. Jude acquired Nanostim, the owner of the only leadless cardiac pacemaker to hit the market so far. Nanostim's leadless pacemaker just obtained a CE mark approval and started its trial for FDA approval. The deal has put St. Jude well ahead of its competitors, Medtronic and Boston Scientific, who are trying to catch up with similar products. But can Greatbatch also catch up with such innovation? How would it face this kind of competitive pressure with a monster debt on its balance sheet? How would it fund its R&D? I think these questions are needed to be answered before attaching a premium valuation to the company's stock.

    Greatbatch's Electrochem business is also reeling under competitive pressure and seeing weak environmental and military product sales due to reduced government funding on certain military and environmental projects.

    Catalysts to Drive the Stock Lower

    Based on the analysis presented above, I believe GB will see a significant drop in its stock price going ahead triggered be the following catalysts:

    • I believe that the most intense catalyst would be new product launches by competitors, because it would unnerve the Street and as a result the stock would fall.
    • Further insider selling of the company's stock could also trigger a sell-off in GB.
    • There is a strong chance that Greatbatch's fourth quarter 2013 earnings slated to be released later this month would disappoint investors and as a result the stock would correct.

    A Word of Caution

    The only risk associated with the bear thesis is that the company could be an acquisition target by a large corporation. In that case the stock may rise further.

    Conclusion

    Competition in the med-tech space is fierce and if a company fails to innovate, eventually it will be punished by investors. Everybody knows that Wilson Greatbatch was a great innovator, and I expect that his company will start innovating soon. Until that happens, the stock is a "sell" to me.

    Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

    Stocks: ITGR
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