IART - Integra LifeSciences: There's Value Here If They Can Stop The Unforced Errors

2023-10-27 11:29:18 ET

Summary

• Q3 results were impacted by customer returns related to the Boston facility recall, but the Codman Specialty Surgical business performed well.
• The reopening of the Boston facility is on track, but facility remediation can be a complicated process, and Integra isn't out of the woods yet.
• Wound care can deliver the mid-to-high single-digit growth that management targets, but competition is increasing and repeated execution issues over many years raise legitimate doubts.
• Expectations are low, and the shares appear to offer some value, but it will take time to rebuild investor confidence.

Opportunity without execution is just a recipe for frustration, and so it has continued to be with Integra LifeSciences ( IART ). I continue to believe that the company serves legitimately attractive markets, but I’m also starting to believe that after years of operational missteps and disappointments, maybe this is a business that will not thrive until it’s in the hands of a better operator and that can make more sweeping changes to how business is conducted.

Admittedly a fairly grim opener, but Integra LifeSciences is down another 35% or so since my last update , and again the main culprit is self-inflicted wounds (this time, the Boston facility recall and remediation). I do think the share price is now too low relative to the long-term opportunity, but my main hesitations in recommending Integra last time around were concerns about valuation and execution, and the execution issue remains a top-of-mind problem.

A Few Bright Spots In Q3, But The Recall Undermines The Story

Integra announced a slight revenue contraction on an organic basis for the third quarter, missing expectations by about 1%. All of the miss appears tied to incrementally higher customer returns related to the Boston facility recall; excluding the Boston issue, adjusted organic revenue was up a little more than 7%, but against a relatively easy comp (+3.5% org).

The Codman Specialty Surgical (or CSS) business performed fairly well this quarter, with revenue up more than 7% on 8% growth in the neurosurgery operations. Within that, monitoring and CSF management were up low double-digits, while dural access/repair was up high single-digits and advanced energy was down low single-digits. The instruments business grew 5% in the quarter.

The Tissue Technologies business is taking the brunt of the Boston facility impact, and revenue here declined 15% (up a little under 7% ex-Boston). Wound reconstruction product sales declined more than 15%, while private label sales were down around 14%. Even with those challenges, the company saw double-digit growth in products like MicroMatrix , Cytal , and Gentrix .

Adjusted gross margin declined 210bp in the quarter to 64.6%, missing Street expectations. Adjusted EBITDA declined 16% and adjusted operating income declined 17.5%, with respective margins down 430bp to 23% and 420bp to 20.5% - both also missing sell-side expectations (by 40bp and 150bp, respectively).

Management once again reduced guidance for the full year, with the mid-point dropping by about 1% - I’m not too concerned about this, as the revision was largely due to increased visibility on customer returns tied to the recalls (everything produced at the Boston facility since 2018 has been recalled).

The Boston Reopening Seems On Track, But There Is Still Risk

Management’s updates with the quarter suggest no meaningful changes to the timeline to get the Boston facility back online and shipping. The company has completed the interim external inspections and still plans to restart production by the end of Q4’23, with commercial distribution resuming in mid-to-late Q2 of 2024.

Whether management can meet that timeline is certainly a key near-term driver. The company announced the closure of the facility and recall of products back in May after years of high endotoxin levels and multiple FDA Form 483 observations (think of these a little like post-inspection report cards, with the FDA detailing things that need to be addressed). In fact, the facility had been operating under a warning letter since March of 2019, though no patient safety issues have thus far been noted.

Given that the recall was voluntary, and the FDA didn’t force the closure/remediation of the facility, my understanding is that the company does not need FDA approval to resume manufacturing or shipping. That helps, taking an uncontrollable variable out of the mix, but it remains to be seen if Integra will hit their own goals.

I’m skeptical that the company will resume shipping on the stated schedule – even for well-run companies with no past execution issues, this sort of remediation process typically has unexpected hiccups along the way that create delays. I would also note that this could impact the FDA approval of the company’s PMA for the breast recon indication for SurgiMend , as facility inspections are often necessary before getting FDA approval.

Competition Is Increasing And Growth Targets May Be Too Aggressive

Less than a month before the Boston facility recall was announced, management unveiled fairly ambitious multiyear targets at its early May investor day. Key among those targets was a long-term revenue growth rate of 5% to 7%, with growth accelerating from 5%-6% to 6%-7% around 2026/27 on the back of strength in new products like SurgiMend and Durasorb in breast recon and Aurora in deep brain tumors and intracranial hemorrhages, as well as expanded international sales.

I hate to keep using the word “execution”, but it’s a key gating aspect to this story. The CereLink ICP monitor was supposed to already be back on the market by now, but that timeline slipped to a Q1’24 re-launch, and there have been various other “challenges” at the product/business line level over the years.

I do think the underlying wound care market can support the sort of growth Integra is targeting, but whether they can reach that level is a different question. In addition to their own self-inflicted issues, competition in wound care has ramped up. Smith & Nephew ( SNN ) has made no secret of their focus on this area as a growth driver, and companies like Coloplast ( CLPBY ) and ConvaTec ( CNVVY ) have made their own mark with sizable M&A moves. With competition increasing, Integra will be under more pressure to keep their products top-of-mind with physicians.

The Outlook

I’m modeling 4% long-term revenue growth for Integra at this point, and while I do see annual revenue growth accelerating to over 5% in a few years, I think growth of 6% or more on a sustained basis is absolutely a “show me” story – possible, for sure, but absolutely not something I’m prepared to take as a given at this time .

I’m likewise taking a more skeptical line on margin improvement. The opportunity to do better is there, but I don’t see EBITDA margin breaking beyond the mid-20%’s over the next three to five years (management is targeting 28%-30% over the longer term). With that, I do expect free cash flow margins to get back to the mid/high-teens in a couple of years, but I need to see evidence of real margin improvement before I think 20% FCF margin is on the table.

Even with those expectations, 4% revenue growth and around 6%-7% long-term FCF growth supports a share price in the $40’s. Likewise, both mid-single-digit growth and mid-20%’s EBITDA support a forward revenue multiple of 3.5x that would get my fair value into the mid-$50’s. I’m using a 20% discount to that multiple (2.8x) to account for the ongoing operational challenges, but I freely admit that’s an arbitrary adjustment.

The Bottom Line

Integra doesn’t have much support on the sell side right now, and I’d argue that’s a good thing on balance. I do think expectations have been reset to a more achievable level, though I’ve seen other companies struggle in the past to surmount even the lowest of expectations. Whether or not Integra is fundamentally broken really can’t be answered now, but I don’t think it is – I think there are still multiple product/technology-driven opportunities here and real addressable market opportunities.

I would like to think that there’s not much downside left at this point, and this name has some appeal as a contrarian play. Even so, I’m not in a big rush to get more bullish just yet, as I think the Street will want a longer period of consistent, surprise-free performance before meaningfully rerating the name.

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