SYK - Conmed: Sector Derating And A New Competitive Threat Shouldn't Overshadow A Solid Core Business

2023-10-28 04:42:30 ET

Summary

• Conmed posted another strong quarter, with low double-digit growth and operating margin leverage, as AirSeal and Buffalo Filter continue to grow well ahead of their markets.
• The company's smoke evacuation business, led by Buffalo Filter, has significant growth potential due to increasing mandates for smoke removal during surgical procedures.
• AirSeal, Conmed's valveless low-pressure insufflator, is another key growth driver, but faces oncoming competition from a new product targeting robotic procedures.
• Management has built a strong portfolio of growth products, and I believe the shares are undervalued today.

Not all that many medical technology stocks are working right now, and while CONMED ( CNMD ) (“Conmed”) enjoyed a great run into the summer, the last six months have seen the stock fall almost 20% in step with the broader medical device market. While the decline may be tied to nothing more than investors fleeing the med-tech space (for whatever reasons, including the overblown fear of GLP-1 drugs impacting a range of businesses), it’s also true that there is emerging competition for one of the company’s largest products, skepticism about double-digit revenue growth guidance for 2024, and a lot of leverage.

I’ve said in other recent articles that I’m not inclined to reach for falling knives in the med-tech space, but Conmed is more tempting than most. I am intrigued by the growth potential of the smoke evacuation business, and in my opinion management has skillfully used M&A to meaningfully improve the growth potential of the business beyond underlying growth rates in areas like soft tissue repair and general surgery.

Strong Revenue Despite Some Supply Challenges

Between improving procedure counts, product mix, and share gains, Conmed reported another quarter of good results. Supply shortages/constraints did still weigh some on revenue growth and margins, but not to a worrisome extent.

Revenue rose more than 11% in organic terms, beating by about 1%, with over 6% growth in the Orthopedic Surgery business and 16% growth in the General Surgery business. Demand for capital equipment was strong (up almost 19%), but single-use product sales growth was hardly bad at just under 11%. As far as specific drivers go, management called out both AirSeal and Buffalo Filter as growing 20%-plus in the quarter.

Gross margin was flat year over year and up 150bp sequentially to 55.9%, just missing sell-side expectations. Operating income rose 15%, with operating margin up 50bp to 14.6%. I saw two different sources reporting two different “consensus” estimates at this line, so Conmed either basically met expectations or posted a small (30bp) miss.

Management expects to have to still deal with some supply constraints in the legacy ortho business a little while longer, but is still targeting double-digit growth in Q4’23 and in 2024 (Street expectations aren’t not for double-digit growth in 2024 at this point).

Where There’s Smoke, There’s Money?

Perhaps the biggest key driver for Conmed in the near term is the Buffalo Filter smoke evacuation system.

Energy devices like electrocautery and ultrasonic tools and lasers and conventional powered tools like high-speed drills and saws generate smoke during their use, and state and national governments are starting to mandate the use of mechanical systems to remove this smoke from the operating field. This smoke is not only annoying and can hamper visibility (which is why many surgeons/hospitals use them without mandates), it can irritate the lungs and eyes and there is some evidence that long-term exposure is harmful to medical personnel (and it is also a potential vector for disease transmission).

Conmed’s Buffalo Filter is the market leader in smoke evacuation in open surgical procedures, with roughly 50% share of a market that is still quite small relative to its potential. Fourteen states representing about a third of U.S. hospital beds have already passed legislation mandating smoke evacuation and states representing roughly another third have legislation pending, and it is likely a matter of time before most markets in Western Europe, North America, and Japan have such legislation in place.

That could drive major market expansion for Conmed and Buffalo Filter . Research leads me to believe there are at least 25M-30M relevant surgical procedures each year in the U.S. alone which generate some amount of smoke. With a $20/procedure content from disposables, it’s not hard to get to a large potential number (about $0.5B-plus in this case) for smoke evacuation, and I’ve seen estimates that there are 300M to 400M surgical procedures worldwide. Of course there’s competition here, including well-established players in surgical equipment like Medtronic ( MDT ) and Stryker (SYK), but started off with leading market share is certainly a positive for Conmed.

Will AirSeal Spring A Leak?

AirSeal , Conmed’s valveless low-pressure insufflator is another key growth driver for the company. This product likely generates more than 15% of company revenue (and at good margins) and about 60% of Intuitive Surgical ( ISRG ) robots also have AirSeal s, and management has estimated their system is used in more than a third of all robotic procedures.

Insufflators are key equipment for laparoscopic procedures. Readers may be generally aware that these are less-invasive surgeries done through small ports (holes) in the patient’s body, with the surgeon using a camera and other tools to conduct the surgery. What not all readers may realize is that there’s another part in the process – to make the procedures easier, the space is inflated with air. AirSeal does this, and does it with much lower pressures than competing insufflators, and also allows for valve-less access to the surgical field (which simplifies the procedure), as well as integrated smoke evacuation.

The threat here is that Novanta ( NOVT ) has announced its intention to launch a new insufflation and smoke evacuation product with a “major” robotic platform. The Street has generally assumed that this means Intuitive Surgical, and that’s a clear threat to Conmed. As far as I can tell, the Novanta system will operate at standard pressures and is not valveless, so I think AirSeal will still stack up as a superior product, but I don’t know how much Intuitive will push the Novanta offering. I’d also note that the AirSeal is the only insufflator on the market clinically-proven superior outcomes (less pain and fewer complications after surgery).

The Outlook

There are other growth drivers worth following at Conmed. The company acquired its way into the attractive foot/ankle extremity market with the 2022 In2Bones deal, and while I haven’t seen clinical data on the Quantum Total Ankle , the CoLink Carbon Fiber plating system appears to offer superior outcomes versus incumbent titanium systems; I’d also note the gross margins in this business are over 80%.

I’m also intrigued by the potential of the BioBrace product platform that the company acquired in the Biorez deal. With a broad label (“reinforcement of soft tissue where weakness exists”), this bio-inductive implant encourages tissue growth and helps reduce the risk of re-tears in rotator cuffs, ACLs, and so on as well as the risk of revision/repeat repair procedures. Used at the time of the initial surgery, this basically helps make for a stronger, more durable repair to the torn tissue.

I’m bullish on the suite of major growth drivers that Conmed offers today. I think Buffalo Filter has a significant opportunity to leverage new mandates and thrive on growth in smoke evacuation, and I think the threat to AirSeal is manageable. I’m also bullish on the BioTrace and In2Bones opportunities, and while it’s true that all of these businesses/products compete with large rivals ( Johnson & Johnson (JNJ), Medtronic, Smith & Nephew (SNN), Stryker, et al), that’s nothing new for Conmed and the sales infrastructure is in place.

I’m expecting around 9% long-term revenue growth, which is a marked acceleration from the past decade and directly tied to the ongoing success of those aforementioned growth drivers. On margins, I believe the growth of these higher-margin growth drivers will have a meaningful positive impact on overall company margins, taking EBITDA margin to the mid-20%’s over the next five years and operating margin to and beyond 20%. At the free cash flow line, I expect fairly quick acceleration toward mid-teens FCF margins and then slower progress into the high teens, driving high single-digit adjusted FCF growth.

Discounted cash flow suggests the shares are undervalued, as does a growth/margin-driven EV/revenue process. Given that the company does have a large amount of debt (unusual for smaller med-tech), a discount to what would otherwise be “fair” seems warranted, and I’m using a 3.75x multiple where the company’s growth rate would otherwise argue for 4.5x, and this gives me a $132 fair value.

I should note, too, that I’m using longer-term valuation norms and not the more aggressive valuation standards that have applied in recent years (I think this is warranted given the derating going on now).

The Bottom Line

As much as buying into med-tech now feels like playing chicken with a train, Conmed is an interesting stock here. Maybe the smoke evacuation market won’t grow as much as I expect, or the company will be gapped by rivals, maybe AirSeal will lose more of its robotics business than I expect, and maybe newer additions like In2Bones and Biorez won’t pan out. There are always reasons not to buy a stock, but I think on balance this is an interesting name to consider.

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