As a shareholder, I'm pleased to see that Wright Medical (NASDAQ:WMGI) shares have done well since my last update after third quarter earnings. Management continues to do a good job running this business and there may well be legitimate underappreciated opportunities to outperform on the top line (new product introductions, share gains) and bottom line (better expense leverage) in the next few years.
Even so, it looks as though the Street is moving back to a "what if they get bought out?" sort of mentality, as the shares do seem to be factoring in quite a bit of growth and margin improvement from here. I don't like to bet against good management teams and good product stories, so I'm still content to hold tight with my position in Wright Medical, but I'd be a little more cautious about buying in on the assumption that a big M&A payday is right around the corner.
Another Solid Result
Wright Medical came through with another good quarter as it continues to integrate Tornier and gain share in multiple orthopedic extremity markets.
Revenue from continuing ops rose 16%, or 12% on an adjusted pro forma basis. The shoulder business did quite well, growing 22% (constant currency), with 14% growth in the U.S. business. The lower extremity business suffered from more pronounced dis-synergy headwinds and growth here was 9%, though the U.S. total ankle business continues to perform very well (up 23%). Biologics revenue was up 30%, fueled by the ongoing ramp of Augment, while Sports Medicine was up 12%.
Gross margin was a little weaker than expected, falling a little more than a point on an adjusted basis, but the company spent less on SG&A. All told, Wright came in better than expected on both the top and bottom line for the quarter, and management's guidance for the next year was comfortably ahead of expectations (with the low end of the ranges for revenue and EBITDA above the prior sell-side average estimates).
The Product Story
With 30 new products on the way, Wright Medical has a better story to tell with respect to organic growth than some may realize. While it is true that the extremities market remains a growth business as patients seek out better options to preserve mobility later into life, Wright is outgrowing the likes of Johnson & Johnson (NYSE:JNJ), Zimmer Biomet (NYSE:ZBH), and Stryker (NYSE:SYK) in large part because of the innovative products it is bringing to market.
Wright should have a new reversed shoulder product on the market in the first half of this year (the Perform), and improving its offerings here is a good move as reversed procedures are about 45% of the market (and growing). Wright will also be launching its new 3-D planning software this year; products like planning software and cutting guides don't seem to get much acknowledgment or respect from individual investors, but they make meaningful differences in procedure times and outcomes, and they can be meaningful drivers of product adoption/use.
On the lower extremity side, Wright will be looking to introduce two new products in the second half of the year - the Ortholoc ankle fracture system and the Invision total ankle revision system. I've mentioned in this past, but I believe the Invision revision product could be a bigger deal than people realize. Total ankle replacements are still relatively uncommon (20% or less of eligible procedures in the U.S.), and part of the reason why is that many surgeons are reluctant to do these procedures without a good revision system (basically, revision systems are bail-out options when a total joint procedure isn't successful).
The story around Augment is a little more nuanced. Wright continues to report trailing 12-month sales on a monthly basis, but it looks as though adoption has slowed some. I'm not too surprised; this was never going to have a pharmaceutical-like ramp because once the initial adopters were all onboard (surgeons that were in the trials or are inclined to be early adopters of new tech), then it was going to transition to a more drawn out process as Wright Medical has to work through hospital value analysis committees to get them to sign off on Augment.
I still believe this product will meet or exceed expectations, and I would note that the company filed a PMA supplement earlier this year for an injectable version. It was always expected that Wright would try to get approval of this version, and the company is looking for the same label that it currently has with Augment (with the main attraction being an easier/different route of administration). Based on past performance, I would expect the FDA to take around 10 months to review this, so investors should know more in the fall. If the FDA gives the go-ahead without any drama (something that has not historically been true with Augment), I could see the company possibly being willing to go forward with new clinical studies designed to expand the range of labeled indications (and the revenue potential).
The Operational Story
While a lot of attention is given to Wright Medical's leverage to the fast-growing extremities market, perhaps not enough is given to its operational successes. Management has done a good job of driving improved sales force productivity in lower extremities and the integration/synergies with Tornier are ahead of schedule.
Management is going to add 85 "carrying" reps in the U.S., with most of those being promotions of existing associate reps. The company has done well with the lower extremity business and its reps are annualizing at around $1.2 million in sales. At that level, it is hard for existing reps to capture new sales opportunities (competitive takeaways, new volumes, etc.), and so adding more reps should boost growth. On the subject of reps, though, I think there's still a lot of room for improvement - the upper extremity reps are only about half as productive as the lower extremity reps, but new product introductions (and good sales execution) could have Wright taking over Johnson & Johnson's #2 position in shoulders this year and more seriously challenging Zimmer's upper-20%s market share.
I also believe there is solid internal leverage potential. Management has been making this case a little more forcefully lately (at sell-side presentations and so on), but the basic idea is that Wright's operating infrastructure was built to support a larger business and the sale of the large joint business led to under-utilized infrastructure. Now, between Tornier and organic growth, more of that slack is being taken up and it sounds as though management believes it will only need to spend on G&A (so, not sales and marketing) at roughly the rate of inflation to support growth for several years.
Zimmer is a strong rival in upper extremities, but I believe Johnson & Johnson's lack of reinvestment in extremities creates an opportunity for Wright. With lower extremities, I don't dismiss Stryker or Integra (NASDAQ:IART), but Wright staked itself out to a big lead in total ankles and I think the follow-up product introductions will further establish its leadership in the foot. Augment is more of a "who knows?" to me; the range of revenue-generating opportunities for this product is appealing, but Wright management is taking a conservative approach, so it could be a slow-building opportunity.
I mentioned M&A earlier and I want to come back to it. Wright's valuation suggests that investors are coming back to the idea of Wright as an attractive target. In some respects, why not? Extremities are growing at a high single-digit rate and are likely to continue to do so for several more years. Take good market share, a strong pipeline, and meaningful potential operating synergies and I can see the appeal. What I can't see is the buyer. Johnson & Johnson would potentially have antitrust issues with upper extremities and seems to prefer to shrink, not build, its device business. Zimmer would likewise be problematic given its share in upper extremities, while Stryker would have the same issue in lower extremities.
I don't know enough about privately-held Arthrex to know if it has the resources, but Smith & Nephew (NYSE:SNN) is at least a theoretical possibility. I would also note that given that Hologic (NASDAQ:HOLX) recently went "off script" and announced its intention to acquire Cynosure (NASDAQ:CYNO), a buyer like Medtronic (NYSE:MDT) may not be completely ludicrous to contemplate for Wright.
Still, I'm not expecting a bid for Wright Medical in the near future (which probably means one will be announced this coming Monday...). Instead, I look for Wright to generate double-digit revenue growth over the next five years and high single-digit growth over the next decade, with long-term FCF margin potential in the 20%s. That supports a fair value of about $26.50 by DCF today, and a roughly similar fair value by my EV/rev methodology (my fair value by this method has increased given a better margin outlook).
The Bottom Line
I don't like to call it a day too soon on stocks/companies that are performing well, and I believe Wright Medical is not only doing well now, but has the seeds planted to continue to do well for a little while yet. The valuation isn't so compelling here, but I think most long-term investors can agree that they've seen how the market will overpay for quality growth stories. Accordingly, I'm content to sit tight but would suggest new investors really do their due diligence and make sure they're comfortable with the price/growth/value tradeoffs.
Disclosure: I am/we are long WMGI, WMGIZ.
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.