K2M Group Holdings IPO Has Lots To Like But Plenty Of Reasons To Be Cautious

| About: K2M Group (KTWO)
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Summary

KTWO has shown a long history of innovation that has helped drive overall growth at the company.

KTWO's financials as a whole have great consistency and simply executing business as usual should be enough to meet FY expectations.

KTWO's unique sales cycle and the risks inherent to it add significant amounts of risk to a long position.

Who is K2M Group Holdings?

K2M Group Holdings, Inc. (NASDAQ:KTWO), a medical device company, focuses on designing, developing, and commercializing proprietary complex spine technologies and techniques in the United States and internationally. The company markets and sells implants, disposables, and instruments primarily to hospitals for use by spine surgeons to treat spinal pathologies, such as deformity, trauma, and tumor.

The K2M Group Holdings, Inc. IPO occurred May 8 and sold 8,825,000 shares at $15.00 share which was lower than the expected range of $16-18. The company's shares traded in a very tight first day range and closed at $15. Piper Jaffray and Barclays were the main underwriters handling the offering. The company plans to use the proceeds to pay down debt, to pay unpaid dividends, and for general corporate purposes.

What do they do and what does the market look like?

KTWO is a technology company who happens to have a specialty in the spinal medical device arena. Within the particular niche that they serve, KTWO further specializes in designing, developing and commercializing minimally invasive products although they also develop products for complex open access surgeries and for degenerative procedures as well. Their product line consists of implants and disposables. K2M has commercialized 57 products over the last ten years, including 34 in the past three years. They believe their wide-spectrum, multi-channel portfolio of products provides them certain strategic advantages and the ability to compete for market share in the $10 billion global spinal surgery market.

The global spinal surgery market has seen excellent historical CAGR rates and looks to grow by 40% over the next 5 years. Several factors will contribute to the general health of this market and to the expansion of the underlying opportunity. Those factors include technological innovations made in the medical and medical device fields (both in a procedural and a technological assistance within those procedures standpoint); the proliferation of minimally invasive devices and their abilities to treat a wider range of needs; several demographic factors including an aging population, increased life expectancies and increased quality of life expectancies from those in that demographic, and the demand for procedures with quicker recovery times; and the growth of the biomaterials market from an aggregate and scope standpoint. KTWO should have ample opportunity to continue to grow its financials and invest in defining their position as a market leader. I also expect KTWO to enter into several other general revenue channels within the surgical procedure arena in the near future, more on that later.

The company historically has focused on and derived a majority of its income from the US but has expanded its international presence as of late and is looking to take advantage of further growth in those markets going forward. Currently, KTWO sells their products in 29 countries, including the US. They market and sell their product lines through a hybrid sales organization which consists of direct sales employees, independent sales agencies and distributor partners. As of 12/31/2013, their U.S. sales force consisted of 114 direct sales employees and 48 independent sales agencies and their international distribution network consisted of 37 direct sales employees, five independent sales agencies and 15 independent distributorships. Currently, international sales represent 29% of revenues. Again, I expect aggregate sales to improve and international sales to be the largest contributor to short term gains.

KTWO's strategic advantages have been developed as a result of their focus on one market over the last decade. They believe they are the definitive leader in the spinal surgery device niche; that both their wide offering of products that serve multiple verticals within the general market and their strong IP portfolio help distinguish them from their competitors; that they have the largest global network of sales and referral sources; and that their extensive track record of innovation and forward looking vision has helped them build enough brand equity to establish a defensible leadership position. I would agree with all and think that their history of anticipating trends and product needs is their largest asset. These guys stay ahead of the curve and in many cases they have pushed the entire industry forward with their constantly evolving product base.

The following is a description of the products currently being offered at KTWO. The description is provided from the company and can be found in their S-1 filing:

KTWO's primary competitors include Medtronic Spine and Biologics, DePuy Synthes, Stryker, Globus Medical, NuVasive, Alphatec Spine, Biomet, LDR Holding Corporation, Orthofix and Zimmer.

What do the financials look like and what is the growth strategy?

The financials look fine but there are a few issues that need discussed. The company had $157.58 million in revenues in 2013 with $152.34 million in total expenses. They posted net operating losses of $44.92 million and a net loss of $37.91 million.

KTWO has showed a steady increase in revenues over the last three years, which is to be expected from a growth oriented company. Costs of revenues have not increased at a pace that is concerning in relation to the actual revenue growth and as a result of that gross profits have also seen a steady increase over the same duration, which is a healthy top line sign. These are all expected but positive signals.

Expenses have slowed considerably from 12'-13' after exponentiating from 11'-12'. The explosion was a result of the company scaling up their selling team and ramping into the current level of growth. The fact that expenses slowed as much as they have is encouraging from a selling cycle view and you can still see the effects of the ramp in the pace of top line growth, which is also good.

Its paramount to risk managing a position in KTWO that you understand the cyclical nature of their expenses growth to delayed top line growth as new products are launched. Costs are at their highest and sales are at their slowest during the launch phase of operations for new technologies. This is the main focus of the growth strategy in the next 12 months. Expenses see an uptick for obvious reasons of R&D, expansion of sales team, increased front end comp for the sales team, and costs of expanding the infrastructure to meet new demand. That being said, I expect net losses to grow, expenses to grow, and to see a marked slowing in revenues over the next 12 months at least and there's a good possibility the next implementation and launch phase could last several quarters after that. It's at that point that they should be seeing greater acceptance from surgeons (first one surgeon, then three, then 9, then 27, so on and so on) and revenues should start to catch up (quickly) with costs. Until they can gain traction and acceptance with enough surgeons, I expect margins to be negative on newer products and if they fail to gain traction on any particular idea the realized losses from the up-front spending will be large. This is an ongoing risk for the company going forward. I don't expect this sales cycle to be significantly changed for many years, if ever. Typically, only companies (in this field and sector) with the size and track record of multi-national, multi-billion dollar scale can gain front end traction that outpaces expenses. KTWO is a long ways from that. Watch this going forward. There is significant risk in launching product and KTWO means to do just that and in size in the immediate term.

This is the normal cyclical nature of KTWO's model and if successful will provide them with the top line growth to power the next product launch phase. The goal for KTWO is higher highs in both expenses and revenues until they reach the point of not needing as much CAPEX to hit their revenue goals, which again is not in the cards anytime soon. I just want to stress that there is nothing unplanned or unusual about the fluctuations in numbers, but you better be OK with that if you initiate a position.

Another issue to consider when looking at the financials and discussing the selling cycle is that if POD's, or physician-owned distributorships, continue to grow as a percentage of the spinal surgery market (of which KTWO currently does not sell product through), that would cause a material increase in costs of revenues and provide downward pressure on margins. That would materially affect the projections that the company and members of the investment community are basing their estimates on.

The final issue I would like to discuss while on the topic is that during the sales cycle and long into the launching phase the company is required to maintain high levels of inventory that may place high levels of risk on their books. For instance, should KTWO have just launched or plan to launch a product that has gained a significant level of traction and should immediately after launch or at the same time a more competitive product make their product irrelevant, KTWO would be forced to take an impairment charge on a significant amount of inventory. This is also a risk that won't go away until KTWO can realize the benefits of the economics of scale. They have a long history of innovating and launching new products and have not run into this issue to date but they will be growing at historic paces (hopefully) into the balance of 2014 and beyond and that will increase both the risks of this happening and the potential losses.

Understanding the selling cycle and the risks involved are should be the primary focus of a risk management strategy with the financials and growth strategies coming in closely behind. Again, KTWO has a long history of executing this cycle and using it to drive top line growth and there is no concern of high visibility on the horizon, just be aware of the potential speed bumps.

The growth strategy at KTWO is business as usual. They want to continue to invest heavily in R&D, expand their sales team and breadth of sales infrastructure, work on further diversifying their revenue streams globally, and actively look for best of breed solutions (read: acquisitions) that they feel can drive retention and growth. I don't have any problems with this strategy or the fact that it's a carry-over from the last several years. I like the path the company has charted and think they should continue to do what works. At some point, maybe two years from now, when they have the cash flow and hopefully net gains to take on more risk, they can make adjustments to their growth strategy that include higher reward options. For now, they need to avoid the road less traveled and they are.

Where's the trade?

KTWO has guided for the fiscal quarter ended 3/31/14 that their revenues will range from $41.5 million to $42.5 million and that their net loss will be between $14.6 million and $15.4 million. If those figures hold up that will be in-line with my projections for the Q and extrapolated for the FY14. That would give KTWO FY14 rev's of ~$165 million and net losses of ~$61 million, which would basically be flat-line revenues Y/Y and increased net losses of ~50%, not something to be extremely worried about if you have faith that they can produce future results of their selling cycle similar to historic results.

The estimated FY14 projections that I have listed could be accurate or not be accurate but historical data would suggest those figures aren't terribly off base. Without immediate traction of products launched (not likely) or significant down ticks in costs (also not likely) there shouldn't be any surprises to the upside form a margin standpoint. The choice to own or not own this stock will be made on if you think the market will reward the stock based on non-financial metrics like implied values of new products and surgeon sentiment of new products, and I'm not saying the market won't.

This story could take a while to play out and at this valuation I don't see myself initiating a long position, even one of small size. I could see the stock floating down a bit after not seeing much of a pop. I do like this company, I think they have a great future ahead, I trust that they'll continue to innovate and develop new products, and I think they'll have successful launch after successful launch. I just don't think there's much wiggle room for error at these prices and that I want to buy at the beginning of a long next year to year and a half of paying for future growth. If the market responds well and punishes me for being too risk averse here this is a trade I'll have to chalk up as an opportunity missed, but I'm willing to sit this one out for lower prices or a misstep that I can buy. If you decide to purchase shares make sure the funds making those purchases are coming from your long-term growth bucket so the potential volatility will be less of a shock to your overall strategy. Not a bad company, just not for me right now. Good luck to all.

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.