OFIX - Orthofix: SeaSpine Transaction Not Pulling Its Economic Weight Reiterate Hold

2023-09-10 04:58:56 ET

Summary

• Orthofix Medical has failed to gain traction and remains within its FY'23 range.
• Looking at the Q2 FY'23 insights show that SeaSpine integration has not been economically beneficial for OFIX.
• Market-generated data is inconclusive and the price structure of OFIX's stock appears compressed.
• Reiterate hold.

Investment briefing

Since the June publication, Orthofix Medical Inc. (NASDAQ: OFIX ) has failed to catch a bid and sells in line with its FY'23 range. As seen in Figure 1, it has backed and filled across the YTD, with no changes in price structure.

The latest investment findings also corroborate that OFIX is a hold in my view. A lack of catalysts, challenged fundamentals, and zero economic leverage on capital deployed are the critical facts outlined here today. Market-generated data is equally indecisive. This report will unpack the company's latest numbers, and the economics of its SeaSpine integration, and link this back to the broader thesis. Net-net, reiterate hold.

Figure 1. OFIX Weekly price evolution, 2022–date

Critical facts to reiterate hold thesis

Q2 FY'23 insights—SeaSpine not pulling its economic weight

OFIX put up $187mm in sales for Q2, up 58% YoY on adj. EBITDA of ~$10mm, down ~$1.5mm from last year. Growth was underscored by its 145% gain in implants, biologics, and enabling technologies sales, plus the 10% growth in its bone growth therapies ("BGT") segment. It pulled this to gross of 63.9%, a sharp decrease from the 73.2% recorded in Q2 FY'22, all related to merger and integration costs.

Still, management revised up its FY'23 projections and now forecasts $752mm—$758mm at the top line, equating to 7% on a pro forma basis (i.e., what its revenues would have been with SeaSpine included in 2022). It has done ~45% of this in H1 and therefore expects strong momentum into the backend of the year.

Crucially, these forecasts are inclusive of the newly-structured company, that folds SeaSpine into the mix. The company is eyeing >$50mm in annualized COGS and OpEx synergies by FY'25, higher than the $40mm estimated previously. Nearly $30mm of these synergies are expected to be achieved by the end of FY'23.

This would be important in my view. The reason being—that profitability, already thin for OFIX, has taken another hit. Figure 2 outlines the gross profitability produced on assets employed by OFIX to run its business on a rolling TTM basis. The SeaSpine transaction is clearly observed. Prior to this, it was churning out ~$0.7—$0.75 in gross for each $1 in assets. This year, it's back to $0.40–$0.47. For reference, anything about $0.7 is exceptional here. The trailing $0.47 is still high, and so we'll need more time to see what value this creates for shareholders. Point being, there's been a hit to profitability on resources employed to OFIX's operations.

This has spilled over to marginal and efficiency headwinds as well. Figure 3 shows the company's rolling TTM inventory turns, adj. operating margin, and rate on cost. Rate on cost is the variable costs as a percentage of revenues. A reduction in this number implies a gain in leverage on variable costs. An increase implies the opposite. Whereas the adj. operating margin is the reported operating profit adjusted for 100% of R&D investment and recorded as a function of total revenues each rolling period.

Since bringing SeaSpine into the business, all three of these measures have taken a hit. Variable costs as a percentage of revenues are up 5 percentage points, whereas margins are negative, and inventory turns are <1x. I'd repeat what I said in the last publication—that OFIX has a large effort ahead of itself to prove the value of the SeaSpine transaction.

Back to the quarter, the divisional highlights from the quarter were as follows:

1. Critically, global revenues in the spinal implants and biologics, and enabling technologies business expanded rapidly and grew 145% YoY to $105.3mm.
2. The company successfully placed six 7D units in the quarter, the majority deployed in the U.S. This brings 8 installations of 7D units placed via earn-out, generating annual commitments of $4.8mm in sales.
3. Global orthopedics were up 640bps YoY and booked $29mm, whereas the spine channel was up 74% YoY to $158mm via the cross-selling opportunities through its SeaSpine distribution channel, combined with procedural volumes in complex spine surgeries. The Medicare-approved rate increase was >6% in '23 which helped things as well.

Market generated data

OFIX's price structure and corresponding trend action are intriguing. The daily and weekly cloud charts below exemplify this well.

On the daily (that looks to the coming weeks), you've got OFIX backing and filling in a wide range but pushing farther into congestion. The price and lagging lines just broke the cloud base as of September—a critical juncture if you ask me. These sharp reversals have been seen before, with snap-back rallies in response—but nothing of new heights. This is a neutral setup in my view, with limited price visibility downstream.

Figure 4.

The weekly chart (looking to the coming months) is no more telling. You've got the stock pushing well into the cloud, clearly a neutral indicator. Most important is the lagging line's position beneath the cloud. You'd need a break of this line above the cloud top to imply a bullish reversal. This would be at the $24.00 share level by the end of October on this chart.

Figure 5.

What's interesting about the above points is that we do have upsides to this level on the P&F studies below. Upside targets are to $24.50 and were thrown off in July. I'd proceed with a sense of caution on these, however. P&F studies are the best at objectively identifying price structure and removing intra-trend volatility. But the recent downside sees OFIX testing the lower resistance line shown, and there's no saying it couldn't break this point. What I'm saying is, you need a break to the upside to really 'activate' the $24.50 objective. Without this supporting price action, I am hesitant to consider this mark as a directive just yet. Again, this is a neutral factor.

Figure 6.

Valuation and conclusion

The stock sells at ~1x forward sales and has created marginal value above its net asset value ($1.12 for every $1 invested, to be precise). Investors have priced the company at just 1.12x the capital required to run the business. This is unattractive in my eyes. You need a high EV/IC ratio to suggest the market expects a firm's capital will produce, stable, predictable, and reasonably high earnings + cash flows into the future. A ratio of 1.12x indicates basically no growth expectations. This too supports a neutral rating—I'm not betting against the market here.

In short, OFIX has plenty of heavy lifting to do in order to say it's an investment grade company. For now, there are multiple challenges to advocating a buy rating. Chiefly:

1. Productivity, profitability, and efficiency are all tight, and have not seen any short-term accretion post-SeaSpine.
2. Related to (1), the SeaSpine transaction is not yet pulling its economic weight.
3. Market-generated data isn't conclusive, and the price structure on OFIX's equity stock looks compressed.
4. A lack of identifiable catalysts to see these issues reverse, and the company catches a bid at these levels.

These factors all corroborate a neutral posture in my view. As such, reiterate OFIX stock as a hold.

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