Wright Medical Has The Right Stuff, But Isn't Cheap

| About: Wright Medical (WMGI)
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Extremities remain a popular growth market within orthopedics and med-tech, and that has kept Wright Medical Group (NASDAQ:WMGI) a pretty popular stock. With mostly solid fourth quarter results and guidance, and growing expectations for more M&A in the space, I don't think Wall Street is in a hurry to jump off this name just yet. The valuation doesn't really look a huge bargain, though, so investors buying into Wright Medical should realize that any interruptions in growth could bring swift and severe punishment for the market.

Lower Extremities, Higher Revenue

Wright Medical reported 16% growth for the fourth quarter, with organic growth coming in at 11%. That was quite a bit better than rival extremities company Tornier (NASDAQ:TRNX), but closer to expectations as Wright Medical beat by "only" 4% this time. Foot and ankle sales were up 19% for the quarter, while upper extremities rose by 14% and biologics rose by 5%.

Margins remain mixed. Gross margin slipped 60bp on an adjusted basis, but remain at an overall attractive level (76.6%). Leveraging operating expenses is very much a work in progress; operating expenses were inflated by costs related to past transactions with the OrthoRecon and BioMimetic businesses, but a nearly $11 million operating loss is not exactly "super" either.

A Share Gainer In A Growing Space

Benchmarking Wright Medical is not as easy as you might like. Biomet, Stryker (NYSE:SYK), Zimmer (ZMH) and other large orthopedic companies have meaningful presences in the extremities markets, but they seldom break out their results in a way that allows for direct comparisons. More specifically, these companies will often combine extremities, trauma, and sports medicine into one line item.

Even so, Wright Medical nearly doubled up Tornier's 10% growth in lower extremities this quarter. What's more, due diligence calls around the space suggest overall lower extremity growth in the very high single digits or very low double digits, so I feel comfortable that Wright Medical is gaining share within a growing market due to platforms like the Inbone Total Ankle.

Guidance Is Okay

Wright Medical guided for core revenue growth of 13% to 15% for 2014, with recent acquisitions Solana and OrthoPro kicking in a meaningful contribution as well. On a like-for-like basis this was a little light. Management also guided for higher SG&A spending (including maintaining over $10 million in expenses tied to Augment) and the stock's valuation doesn't really permit for spotty guidance.

On a more encouraging note, sales rep productivity continues to improve. Wright Medical reps generated an average of $820,000 in revenue this quarter, up from $780,000 in the third quarter. With that, management's goal of $1 million per rep per quarter seems attainable late in 2014.

Augment Gets Its Last Chance

Wright Medical had previously announced that it was appealing the FDA's decision to reject Augment, the recombinant bone growth biological it acquired when it bought out BioMimetic. The FDA has scheduled an appeals panel meeting for May 19, 2014, which is pretty quick relative to past appeals. The odds are still very much against Wright Medical, but two of the seven prior appeals did go in favor of the appellant, so there is at least a fighting chance. Should the FDA uphold its rejection, it would be unlikely that Wright Medical would move forward, though I suppose there is a theoretical middle ground scenario where explicit guidance from the FDA (akin to a special protocol assessment for drug trials/applications) and reasonable demands could make a follow-on study viable.

Recent Deals Build Up The Bag

Wright Medical has not been shy about using its cash to bulk up its offerings in the lower extremity market. The company announced two deals at the end of January, paying $90 million for Solana Surgical and $36 million for OrthoPro.

Solana brings the SolaFix Twist Screw System (a screw system that reduces soft tissue damage), the Hemi Phalangeal Implant, and the TenFUSE allograft for hammertoe procedures. OrthoPro is likewise focused more on toes, with the Cannulated Hammertoe Gap Filler and Metal Hemi Great Toe implant. Solana in particular

With the two businesses expected to contribute about $36 million in 2014 revenue, Wright Medical paid a pretty reasonable premium (about 3.5x) for these businesses. Solana in particular was a company I'd heard of before, as surgeons have been speaking pretty highly of their products.

Multiple Avenues For Growth

I do not expect Augment to be approved on appeal, so that product plays no factor in my model at this point in time. Even without this product, Wright Medical has several avenues to maintain, augment, and accelerate growth. The company is still under-exposed to foreign markets and growing this business in key foreign markets is a definite long-term priority.

Wright Medical also still has the opportunity to grow meaningfully through business expansion - pursuing additional tuck-in deals like Solana/OrthoPro and Biotech Intl for particular products or market exposures. Longer-term, I also would not be surprised if Wright Medical chose to bulk up its upper extremities business. I believe that this company is being run today with an aim toward being a very attractive lower extremity business (making it easier to acquire), but if a deal doesn't come it will likely make sense to diversify outside of lower extremities.

I'm looking for nearly 12% long-term revenue growth for Wright Medical as the company continues to gain share in foot/ankle procedures and add capabilities/products. I'm also expecting extremities to remain a faster-growing segment within orthopedics as R&D capabilities and consumer demand for higher quality of life combine to expand the extremities market segment. I believe that Wright Medical can be highly profitable down the line, with FCF margins in the high teens to low 20%'s.

The Bottom Line

Like many growth med-techs, Wright Medical is not cheap at all by discounted cash flow. Looking at the more commonly-used price/revenue metric, a 4x multiple on 2014 sales suggests a fair value of about $33 after factoring in the net cash from the MicroPort transaction. Neither DCF nor revenue multiples suggest that Wright Medical is a bargain, and the market clearly did not like the slight revenue guidance shortfall, but I believe the stock will remain relatively popular so long as revenue growth stays in the teens.

Disclosure: I am long WMGI. 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.