ENOV - Softer Guidance From Enovis Is A Drag But Ortho Growth Is Encouraging

Summary

• Enovis came up a little short with revenue and margins for both the fourth quarter of 2022 and guidance for 2023.
• The Reconstructive segment is performing well, with growth in U.S. hips, knees, and extremities that was well ahead of the group.
• The Prevention & Recovery business was lackluster, with what looked like volume declines that management tied to lower elective procedures in the third quarter.
• The momentum in the Reconstructive segment makes this a name to watch, but the valuation is not quite there, but better revenue growth and/or margins would be powerful drivers.

I don’t believe that slightly soft fourth quarter results and guidance from Enovis ( ENOV ) means anything like a return to square one, but it is disappointing for a company that has been showing some progress in its Reconstructive (orthopedics) business. Prior to the post-earnings sell-off the shares had been outperforming the broader med-tech space and other orthos like Smith & Nephew ( SNN ), Stryker ( SYK ), and Zimmer Biomet ( ZBH ) since my last update on bullishness around improving patient volumes, share growth, and margin leverage, and a lot of those themes are still in play.

Valuation is still an issue. If I thought there was a line of sight to 8% revenue growth, it would be easy to like this stock today, but I’m worried that the revenue growth and margin leverage just isn’t quite good enough, though I admit the valuation is not very demanding on a forward EV/revenue basis.

Mixed Trends To Close The Year

There was something for both bulls and bears in the fourth quarter, as Enovis came up a little short on revenue due to the Prevention & Recovery business, as well as a little short on margins, but delivered good growth and share gains in the Reconstructive business. Guidance for 2023 was a little below Street expectations, but only a little.

Revenue rose 5% in organic terms, but missed the average sell-side estimate by about 2%. Prevention & Recovery drove the miss, with just 1% growth (trailing rival Össur , which reported 5% growth). The Reconstructive business was strong, though, growing 14% with above-market growth in the hip/knee and extremities businesses.

Gross margin improved more than four points year-over-year and shrank about 10bp to 56.7% on a reported basis, while adjusted gross margin improved to 57.1%. EBITDA rose 21%, with margin up almost three points to 18.3%, coming in just a little short. Adjusted operating income declined 40%, with margin down 140bp to 2.1%.

Management guided to 5% to 6% organic growth for FY’23, below the Street target of 7.5%, while EBITDA guidance of 255M to 265M looked a touch light (about 2%), as did EPS, with a guidance range of $2.15-$2.30 versus an average sell-side estimate of $2.23 going into the quarter.

Recon Appears To Be Building On Its Strengths

Reconstructive growth of 14% compared well to the broader orthopedic sector this quarter. U.S. hip and knee growth of 14% was comfortably at the top of the table, with Zimmer Biomet achieving almost 11% growth and Johnson & Johnson ( JNJ ) at 10%, while Stryker came in at 9% and Smith & Nephew around 6%. Direct comps in extremities are more difficult, but 13% growth could well have come close to doubling market growth in the U.S., and the 16% growth at Mathys was likewise well above the group for OUS hips and knees.

Enovis continues to execute well in the ambulatory surgical center market despite increased marketing efforts from Stryker and Zimmer, and given that Enovis' EMPOWR3D knee implant targets younger, more active patients, it wouldn’t surprise me if they’re taking more share from Smith & Nephew, which also targets that market, but has had meaningful challenges, including inadequate supply of its Journey II implant.

In the extremity business I’m a little concerned whether Envois could see stronger competition in shoulders in the near-term, particularly in reverse shoulder where it has enjoyed leading share for a while. On the other hand, I think the foot/ankle business is performing well, and I think the new STAR PSI (Patient Specific Instrumentation) could be an invaluable offering, as it allows for 3D visualization of the joint, provides tibia and talus guides, and leads to reduced surgical time with improved outcomes.

An ongoing concern of mine in the recon business is whether Enovis will be hurt by its lack of a robotics system. Stryker and Zimmer are pushing hard with their systems and Smith & Nephew is placing a lot of its hopes on renewed strength in ortho on its Cori system, but Enovis doesn’t have a comparable system. It is possible that the Arvis system (augmented reality navigation for major joints) may be enough, but this is an item to watch.

Prevention & Recovery Is What It Is

I’ve never been bullish on this part of Enovis, and nothing has changed. Management didn’t explicitly discuss pricing this quarter, but pricing doesn’t tend to change too much quarter to quarter, and assuming that the 2% year-over-year pricing power carried over, volumes declined slightly. Management tied that to a decline in elective procedures from the third quarter, but I continue to believe that mid-single-digit growth is perhaps too aggressive of a growth target for this business.

The Outlook

I’m increasingly impressed with the performance of the Reconstructive segment and the company’s ability to take share in major joints. It’s unclear to me how much of that is coming at Smith & Nephew’s expense and whether improved supply and go-to-market efforts will stem those losses over the next year or two, but the company is more than holding its own in a business that rewards scale. Given a steady pace of competitive product development (cementless knees, knees with improved motion, and robot-exclusive implants), though, management cannot afford to drop the ball.

As management indicated on the call, further tuck-in M&A is likely. I’d prefer to see more of that on the Reconstructive side, and there are a lot of niche-type products in extremities that could make a difference to Enovis, as well as tech-driven products that could aid treatment planning and procedures.

I was a little more bullish than the Street on FY’23 revenue and have trimmed back my expectations by about 2%, but have otherwise not really changed much. Ongoing share gains in ortho could drive higher estimates down the road, but time will tell. On the margin side, I think management’s target of 50bp/year of EBITDA margin improvement could prove challenging, but I do think high-teens EBITDA margin over the next three-to-five years is achievable.

Valuation remains a little challenging. Revenue growth in the 6% to 7% range would be fine if Enovis were a large-cap med-tech, but single-digit revenue growth rates and small-cap med-tech don’t work as well together. I just don’t see enough revenue growth to drive a forward revenue multiple much beyond 2.1x, and that leaves me with a relatively lackluster fair value around $60. I could see a path to a 2.25x-2.5x multiple (powering a fair value closer to $70) on 8% revenue growth and/or more margin leverage, but we’re not there yet.

The Bottom Line

I don’t ignore the possibility that share gains in hips/knees and extremities could power upside and further rerating at Enovis, but I still have concerns that management expectations/guidance for Prevention and Recovery are too high. At this point, I don’t see enough upside to be bullish on the shares, but that momentum in orthopedics makes it a name worth following, particularly if the post-earnings sell-off drags out a bit.

To read my most recent articles on Smith & Nephew, Stryker, and Zimmer Biomet, please click here ( SNN ), here ( SYK ), and/or here ( ZBH ).

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