Nobel Biocare Has Gotten Its Teeth Kicked In

| About: Nobel Biocare (NBHGY)
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How unpopular is Swiss dental device company Nobel Biocare (OTCPK:NBHGY)? The stock was down 30% in 2012 and is down 75% over the past three years, but the stock still carries an overwhelming number of "Sell" recommendations. While Nobel has seen some significant negative developments in its core dental implants market, it's still worth asking whether this stock may not carry some value for risk-tolerant deep-value turnaround investors.

Focused On Better Smiles

While Nobel Biocare does offer a wide array of products including prosthetics like crowns and bridges and the NobelProcera CAD/CAM system, the business is very much built around its dental implants. As the name might suggest, dental implants are basically implantable products that are drilled/anchored into the jaw and replace lost teeth.

This makes Nobel Biocare (and its fellow Swiss implant rival Straumann) relatively focused plays in the larger dental industry. While companies like Danaher (NYSE:DHR) and Dentsply (NASDAQ:XRAY) do have some involvement in the implant business, they sell a much wider variety of tools and equipment into the dental care marketplace. In comparison 3M (NYSE:MMM) is not very active in implants, while other implant players like Biomet and Zimmer (ZMH) do not compete in the wider dental equipment/supplies market.

For Nobel, this focus has come with a cost. Dental implants were once a hot, hot space - orthopedics companies were hungry for new avenues of growth, and analysts dutifully built models pointing to aging populations in North America and Western Europe, plus rising healthcare spending in emerging markets, as major drivers for the space.

Unfortunately, dental implant procedures run about $3,000 to $5,000 (with the implant often making up about 10%-15% of the cost). While there are reportedly over 150 million Americans missing a tooth, upwards of 60% of them earn less than $25,000 a year. That's problematic given that dental insurance is not always included in health insurance, and many dental insurance programs either exclude implants or demand very high co-payments. Couple the recent challenges in employment and consumer confidence with much tighter consumer credit availability (a common source of funds for dental procedures five years ago), and Nobel has a demand problem in North America.

Other markets have their own challenges. Europe's national payer systems have led to much higher dental implant penetration rates (2x in Germany relative to the U.S., 3-4x in countries like Spain), but also smaller available patient populations, while countries like China and Brazil are more concerned with providing better levels of basic care as opposed to expensive restorative procedures. Add to this, too, that European healthcare systems are facing shrinking budgets, and value-priced competitors are gaining on Nobel.

Trying To Rebuild From A Solid Base

From a peak of EUR 666 million in revenue in 2007, Nobel has seen steady erosion down to about EUR 570 million, with basically flat revenue from 2009 up to present. At the same time, the operating margin has plunged from more than 32% to about 13% and returns on invested capital are about one-third of their former levels.

For all of that badness, it's worth noting that analysts believe Nobel still holds approximately 24% share of the U.S. implant market. Straumann is second with 18%, Dentsply third with 14% (after its AstraTech deal with AstraZeneca (AZN)), and Zimmer fourth. On a global basis, Straumann claims the top spot (19% versus 18% for Nobel), with the other shares broadly similar to the U.S. market.

It's also worth noting that missing teeth don't grow back; business that Nobel lost due to the recession and subsequent changes in consumer credit is still potentially available. Dentures and bridges don't feel natural, and while I don't want to overstate the benefits of dental implants, most people who have a choice seem to choose the implants. The dental implant business has very definitely stagnated in the U.S. (apart, at least, from value-priced entrants), but the long-term growth rate still looks as though it could fall in the 4%-5% range.

In order to rebuild its business, Nobel has chosen to start directing more assets (money, in other words) toward R&D and marketing. While these are logical steps, they're not quick fixes - it takes a med-tech rep about nine to 18 months to really hit stride, and med-tech R&D can take years to produce returns.

At the same time, the company has done itself no favors in terms of credibility by initially claiming that the steep margin declines 2010 were reversible. Likewise, the introduction of NobelProcera took longer than expected, has had a worse-than-expected impact on margins, and hasn't really boosted the overall business much at all from my point of view.

Could Nobel Be Somebody Else's Prize?

As a modestly-sized company (roughly $1B in market cap) with a focused product line-up, Nobel would be a logical acquisition target. To that end, deal rumors (including LBOs and private equity) have dogged Nobel throughout the shares' prolonged decline.

A deal could make sense, but the number of bidders may be relatively limited outside of private buyers. I don't believe Danaher wants to get any bigger in healthcare right now, and I don't think the premium dental implant space is where it would go. Dentsply likely doesn't have the balance sheet flexibility, assuming that regulators would okay the deal. What's more, I don't see Zimmer or Biomet as likely buyers, particularly with Biomet considering a spin-out of its 3i dental business.

That may leave Johnson & Johnson (NYSE:JNJ) and 3M as possible bidders. JNJ does have an oral care business, but it's pretty much an OTC business, and I'm not sure there'd be much synergy with the DePuy orthopedics business.

3M is a more interesting story. Prior to the change in CEO and an apparent change in strategy toward more aggressive/growth-oriented goals (like the deal for Ceradyne), I would have thought Nobel would be a very logical (if dull) tuck-in deal for 3M. That could still very well be the case, but I have to wonder if 3M management would be wary of the optics of buying a struggling company with high European exposure in an industry/market that many analysts and investors have soured on.

The Bottom Line

I am cautiously optimistic about Nobel. I do believe that it is possible for the company to regain much (though likely not all) of the margin leverage it lost. I also believe that there will come a time again when companies (and investors) want to own healthcare businesses with meaningful discretionary/self-pay components. The problem is that I don't know how much longer Nobel will struggle in the meantime.

I believe Nobel can grow revenue at a long-term rate of about 3%-4%, with growth in emerging markets and North America offsetting some of the risk of greater value-priced penetration. I'm also taking a conservative view on free cash flow margins, assuming that the company can regain the mid-teens levels of good med-tech companies, but not the 20%+ levels of superior companies. That works out to about 6% free cash flow growth over the long term and a fair value between EUR 10 and EUR 11 (or about $6 for the ADRs).

I don't want to dismiss the threat of low-cost competition in implants and abutments, nor the risk that Nobel's management simply doesn't have what it takes to regain the great margins of yesterday. That said, and while acknowledging that this isn't the easiest stock for American investors to buy or follow, the stock could be an interesting rebound play from here.

Disclosure: I am long MMM. 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.