Extremities are the highest-growth area in orthopedics today, but Tornier (TRNX) has been on the outside looking in for the last few quarters. Large companies like Johnson & Johnson (JNJ), Biomet, and Stryker (SYK) are paying more attention to these markets as a way of augmenting slower growing hip, knee, and spine markets, but Tornier's problems are largely self-inflicted by way of its sales restructuring.
Tornier doesn't believe it is going to return to torrid growth in 2014, but the market seems to be willing to look past these issues and forward to a strong multiyear extremities market growth story. It also certainly does not hurt that large med-tech companies have started opening their wallets again and Tornier would be an attractive target for multiple companies. Tornier's intrinsic DCF-based valuation isn't so impressive at these levels, but by the EV/revenue method that is often favored in med-tech there still would seem to be worthwhile potential.
Fourth Quarter Is More Relief Than Rebound
Tornier had previously announced revenue for the fourth quarter, but investors still liked what they saw in terms of the final results and the company's guide for the next year.
Revenue rose 5.5% as reported (and 4.4% in constant currency), which was a 10% beat relative to the expectations at the time. While that is of course better than the alternative (another sizable miss), I would remind readers that expectations for the fourth quarter were running around $86 million at mid-year 2013, so it is not as though everything is fine again.
Tornier's core extremities business saw 5% growth this quarter, with upper extremity growth of 5% and lower extremity growth of 10% offset by an 11% decline in the tiny (5% of sales) sports medicine / biologics business. Tornier's France-centric large joint recon business was up 7% this quarter.
Gross margin improved almost nine points from the year-ago level, but selling expenses were up 22% as the company continues working through a conversion process back to a dedicated sales effort for upper and lower extremities. Reporting operating income was negative, while adjusted EBITDA fell 16%.
Guidance Offers Some Reassurance That The Worst Has Passed
Tornier's guidance for 2014 isn't really commensurate with the underlying opportunities in shoulders, ankles, and other extremity products. What it is, though, is a sign of stabilization in what has been a wildly unpredictable business. Although management did guide to a 4% sequential decline in Q1 sales, the midpoint of the full-year guide was pretty much on target with the existing sell-side expectation (suggesting flat performance from 2013). The guidance for adjusted EBITDA was a hair below the prior average estimate ($25 million versus $26 million), but there was a lot of uncertainty in how Tornier would guide this quarter.
The Rep Conversion / Transition Marches On
As a reminder, Tornier is in the middle of converting its sales reps back to a model where they are dedicated to selling either upper extremity products (shoulders, elbows, wrist/hand) or lower extremity (food/ankle) products. To say that this process has not been smooth or seamless would be an understatement, but the company is making progress. Of the company's total revenue, 85% was generated by reps where there are agreements in place (meaning they have been dedicated/committed to one or the other), while 55% of the company's U.S. revenue came from committed reps.
Why does this matter? Consider the following - while 55% of the U.S. revenue came from those reps, they are only about one-third (145 out of 400) of the total base. I would be careful about extrapolating from this point, as I would expect the company to have focused on handling its most valuable and productive reps first, but I believe the point stands that completing this conversion process quickly and efficiently is important for revenue productivity.
Tornier's Focus Should Draw Attention
Med-tech companies are stepping back into the M&A ring. Smith & Nephew (SNN) decided to expand its sports medicine business by buying ArthroCare (ARTC), and before that Stryker acquired MAKO Surgical for its robotic major joint surgical system.
Extremities have become the hot area in orthopedics right now, as aging but active Boomers are demanding better solutions for problems with their shoulders, elbows, ankles, and so on. True growth rates are hard to come by, as most large players like Biomet, Stryker, and Johnson & Johnson typically consolidate extremities with trauma and/or sports medicine, but procedure data suggests growth in the neighborhood of the high single digits to low double digits depending upon the market. With a total market of about $3 billion (and likely to grow due to emerging markets), that is enough to get the attention of bigger players.
Johnson & Johnson would probably have to divest some upper extremity products to do a deal but they could still be interested, and Tornier could make sense for Zimmer (ZMH), Biomet, and Stryker. I also wonder if Medtronic (MDT) would consider it - the company has had some setbacks lately in its growth plans and orthopedics wouldn't be wholly new to the company (as it has a large spine business).
The Bottom Line
The M&A appeal of extremity companies is not lost on the market, as these stocks have already been pretty strong (even with Tornier's iffy growth, the shares are up almost 30% from their early November crater). With that, Tornier doesn't look like much of a bargain on a DCF basis even if you assume double-digit revenue growth for the long term.
Med-tech stocks are by no means beholden to DCF-based valuations, though, and that is particularly true of cases like Tornier where M&A is a valid option. Given the above-average growth potential of Tornier's extremities business, I would go to a 4.0x sales multiple (below the 6.0x to 8.0x range of med-tech growth stocks, as this is still orthopedics we're talking about) and that works out to a $26 target on the basis of management's guidance for 2014 revenue.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article. (More...)
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