GMED - NuVasive: Critical Factors Unchanged Reiterate Hold

2023-06-07 03:37:58 ET

Summary

• NuVasive's announced merger with Globus Medical has been approved by shareholders, indicating confidence in the deal.
• NUVA's exposure to the cervical disc treatment market, which is expected to grow at an 18.5% CAGR into FY'30, could be a key differentiator for the company.
• The company is currently trading at 18x forward earnings, which is in line with the broad indices and a discount to the sector's 19x multiple.

Investment Summary

With NUVA, Inc. ( NUVA ) equity stock trading near my previous target range of $49 it was prudent to re-examine the investment debate for any potential mispricings. Most notably, the big change in the story is the announced merger with Globus Medical (NYSE: GMED ), that shareholders have already approved at whim, indicating the confidence in the deal, set to be closed in Q3 this year.

There is a terrific overview of the merger conducted by Seeking Alpha analyst James Long [ see it here]. I would encourage you to read this to get a unique and in-dept analysis on the whole thing. Personally, I am long GMED, and have enjoyed its journey thus far. The question is if the deal makes sense, which James does well at answering in the analysis, which saw him rate both names a hold.

This report will look at NUVA's prospect outside of the merger lens. In that vein, investors can make a more informed decision on their own in what to do with NUVA on its own merit. Findings show there are multiple headwinds to consider, most prominently the firm's returns on capital. Investors would be wise to consider these facts, especially given the universe of selective investment opportunities abundantly found beneath our eyes. Net-net, reiterate hold.

Figure 1.

Critical Factors:

1. Q1 earnings: complete breakdown

It is prudent to completely unpack the company's latest numbers to get a sense of where we are headed over the next 12-18 months, and gauge what the market has and hasn't discounted in NUVA's share price.

Top-line analysis

1. NUVA clipped Q1 net sales of $307.7mm, a 5.8% YoY growth rate. Growth was underlined by increased procedure volumes and a burgeoning demand for NUVA's innovative product portfolio. In terms of revenue drivers, I believe NUVA's core offering (excluding the Globus integration) offers its competitive advantages, being involved in cervical disc treatment markets, (discussed later). This is a unique value proposition and NUVA could establish leading position within the market. Further to this, the cervical segment has delivered 6 straight quarters of 20% sequential revenue growth, something to think about. This was backed by $65mm in quarterly surgeon support sales. Hence, I am looking to the cervical offering as a potential differentiator here.
2. Business Segments: NUVA's US division did ~ 9% growth, underscored by upsides in its funnel hardware sales, but again, the spectacle is the 20% growth in the cervical segment for the 6th consecutive quarter for U.S. sales. Meanwhile, growth in its international business was encouraging, with an 8.3% YoY gain. Core spine sales (cervical, thoracolumbar, and lumbar) in Europe, and solid growth in APAC were instrumental in driving this performance.

Moving down the P&L, adj. gross margin came in at 71.9% of net sales, a compression of 110bps YoY. Management note the delta primarily resulted from increased reserves for excess and obsolete inventory. But I'd still be keeping a close eye on this going forward, we don't want any inventory issues. Now, more so than in the last 5-10 years, I'm finding that a firm's cost structure has far more impact to long-term profitability, given the inflation and rates situation. In my view, NUVA must diligently address the excess inventory issue to restore that gross.

And to that point, you can see the reasons why in Figure 2. Here, the gross capital productivity is calculated as the rolling TTM gross profit divided by gross assets each quarter. You can see the firm produces $0.40 on the dollar from its operating capital, up from $0.28 around 2-years ago. This is a good sign in my opinion, and demonstrates the incremental profitability that fills one line of my investment criteria. Hence, it needs that margin to loosen up back to the 72-73% range, in my opinion.

Figure 2.

Capital efficiency, profitability

On the topic of investment criteria, there is a key point that must be addressed here. Looking to the firm's returns on capital, in my view, they are sub-par for a company doing just $1.2Bn in turnover, and must be improved. For example, in Figure 3, it shows the rolling return on capital, defined as the net operating profit after tax ("NOPAT") divided by the total capital provided to the company (debt, equity). Ideally, you'd expect the company to be investing at a rate that is above the market as 1) companies typically have more and more lucrative investment opportunities that investors, and 2) that is a fundamental reason to attract equity investment into its stock in the first place.

I've benchmarked the ROIC against a 12% hurdle rate, as shown below, and you can see NUVA hasn't nudged past this point once over the past 2-3 years. It has remained within a 6-8% range, touching 11% last year. This is a tad concerning to me, especially in order to overcome a hold rating. For one, the firm's economic earnings, those profits earned above the specified cost of capital, are actually economic losses, and therefore tell me that recent uses of investor capital haven't generated a meaningful return (at least what investors could have got elsewhere). In terms of attracting a higher market value, I find it difficult to foresee investors allocating droves of capital to NUVA, when capital is typically more valuable in their hands, than in the company's.

Going forward, my numbers have the company to produce a range of 6-8% return on capital into FY'25, suggesting these trends would continue. In that vein, if this were to happen, NUVA would not be creating value for its shareholders. Serious thought would have to go into company growth or growing shareholders valuation (free cash flow, owner earnings), it couldn't do both. Whereas if the returns on capital were high, it would afford this luxury in my view.

Figure 3.

2. Insulating factor - cervical disc treatment market

As noted earlier one key differentiator in NUVA compared to other spinal orthopaedics players is its exposure to the cervical segment. In my view, this is tremendously important. The global cervical disc treatment market may grow tremendously in the coming years if estimates prove to be correct. According to recent projections, numbers as high as 18.5% CAGR into FY'30 are being thrown around. Several critical factors, including the increasing prevalence of cervical disc disorders, and advancements in medical technology, underpin the attractive growth.

Importantly, this is an underserved segment of the overall spinal treatment market, given the complexity of the cervical spine, and the cervical disc injury.

A cervical disc injury refers to damage or pathology affecting the discs between the vertebrae in the cervical spine, which is the upper portion of the neck region. The cervical spine consists of seven cervical vertebrae ("C1-C7"), numbered from the base of the skull to the thoracic vertebrae, which is where your shoulders start. The cervical discs are cushions between the vertebrae, providing flexibility and mobility to the neck. Typically, pathology occurs in the upper regions of the cervical spine, predominantly due to biomechanical factors.

For context, the composition of a cervical disc includes an inner nucleus pulposus , a gel-like substance composed of mucoproteins, and an outer annulus fibrosus, a fibrous ring-like structure. Think the situation of a gel pack inside of a car tyre. This composition allows for shock absorption and the distribution of forces within the cervical spine. However, with certain stressors, in particular, poor posture (as in computers, gaming, work situations) or traumatic injury, the inner nucleus can sometimes bulge and even protrude out of the outer ring, just as if the gel pack was being squeezed out of the tyre. This impacts on the surrounding nerves, causing immense pain and dysfunction. Oftentimes, this doesn't heal on its own, requiring surgery.

As it relates to market for treatments, including surgery, etc.:

1. The growing incidence of cervical disc disorders, such as herniated discs and degenerative disc diseases, is a crucial driver for the cervical disc treatment market. Incidence rates of herniation, the most serious form of cervical disc injury, are thought to be as high as 42% ( Weller & Benzel, 2005 ). Factors such as sedentary lifestyles, poor posture (think computers, gaming), and the aging population contribute to the rise in these conditions. As a result, the demand for effective treatment options is expected to propel market growth.
2. Advancements in medical technology have revolutionized the treatment landscape for cervical disc disorders. Minimally invasive surgical techniques, artificial disc replacements, and improved diagnostic tools have enhanced patient outcomes and recovery times. The benefit here is that more patients can be treated in the same time frame, notwithstanding the shorter recovery times.

Whilst this critical factor is certainly a differentiator, the question is how much NUVA can recycle capital from growth investments into additional profits in the segment. To date, revenue growth has been exceptional, slightly outpacing the sector. This tells me it could be capturing market share. I'll be looking to the growth rate going forward, and if the market is pushing a 18-19% delta, I'd be looking to NUVA to rest above this in its cervical segment growth.

3. Valuation

Following recent price action investors have priced the stock at 18x forward earnings, in-line with the broad indices, and a discount to the sector's 19x multiple. In my view, this discount is warranted, and the market certainly agrees. It is difficult to justify the company compounding its intrinsic valuation when its returns on new and existing capital are behind the hurdle rate (12% in this instance). Investors are unlikely to reward a company with those business economics in my view. I am in the same boat, and believe 18x is a fair multiple.

Assigning this to the consensus FY'23 earnings of $2.17 you get to $39, a shade above the market price as I write, suggesting there's nigh a mispricing in my view. I believe this could be correct given the factors discussed in this report, especially that, propping up NUVA's investment case, aside from the potential benefits in its GMED merger, is the growth trends forecast for the cervical market.

These findings are supported objectively by the quant system . It too has found NUVA weak on valuation, along with growth and revisions. These are consistent with my findings, adding confidence to the data. Collectively, there isn't sufficient evidence the firm is ready to attract a premium or trade higher above the current 18x multiple. That already is a stretch in my view.

Figure. 4

In short

There isn't sufficient investment data to suggest NUVA is undervalued in my opinion. Instead, I believe the market may have it correctly priced at the moment. NUVA is attracting 18x earnings, and investors may not be interested in paying more than that with the economic losses discussed in this report. One thing that keeps an investor interested is the cervical market, however. It appears to be a high-growth sector and investors may benefit from positioning against it, in which case NUVA could be the offering of choice. I'll be looking at that closely the next 3-6 months. Net-net, reiterate hold.

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