Integra LifeSciences: Paring To Hold On Recall Uncertainties

Integra LifeSciences: Paring To Hold On Recall Uncertainties

Summary

• Integra LifeSciences’ recent product recall has led to a change in market expectations and factors into the investment debate.
• The recall has impacted the company’s fundamentals, sentiment, and valuation, leading to a revised position of “hold” for IART.
• Further clarity on FY’23 guidance, Boston operations, and potential future issues is needed before the market can regain confidence in IART.

Matteo Colombo

Matteo Colombo

Investment Summary

Since the December publication covering the investment credentials of Integra LifeSciences Holdings Corporation (NASDAQ:IART), there’s been a meaningful change to the investment debate. As will be discussed here, the company’s recent decisions relating to its Boston manufacturing facility have resulted in a change to expectations, both from the market and internally.

With the broad market fundamentals in their current shape, it is critical for firms to be in tip-top shape in order to attract investment. Looking at the benchmark indices, market breadth is narrow, market internals are weak, and macro-factors continue to dominate the landscape. Hence, with the latest fundamental changes, and without at least some clarity on IART’s future cash flows, it is difficult to advocate buying IART at this time. On factors of earnings growth, valuation, and market technicals, I am revising my position on IART to hold.

Figure 1. IART Price Evolution, 2015-date

Critical Factors

There is a new chapter emerging in IART’s story. The major update – the company initiated a voluntary global recall on all products manufactured at its Boston facility, from the dates March 1, 2018-May 22, 2023, around 5-years of production.

Consequently, the market (along with myself), has revised its expectations on IART. Thinking in first principles, the critical issues now are:

1. The decision follows an internal investigation and consultation with the FDA. Investigations revealed deviations in endotoxin testing, which could lead to the release of products with higher levels of endotoxins than permitted by the product specifications. Not good at all.
2. The market has reacted violently as a result, pushing the firm’s market value off the $50/share cliff, sinking to c.$39 as I write.
3. IART reported $380mm in Q1 top-line revenue with $92mm in adj. EBITDA, and called for the guidance of $1.6Bn in turnover for FY’23.
4. It has pared this back following the recall, however, and there’s less certainty on growth or predictability of cash flows going forward.
5. The market has also revised its expectations for the company downstream at the compressed market valuations.

These critical factors have a meaningful impact to the IART investment debate in my view. Certain adjustments must be made to my outlook given the new data, and this report runs through the crux of these. Specifically, there are notable changes to the company’s fundamental, sentiment, and valuation factors. Since these are required to outperform the market in my opinion, their absence has me agnostic to the growth prospects of IART without obtaining further clarity on the critical issues raised above.

Recent catalysts to investment thesis

Fundamental

As a result of the recall, the company expects to incur an impairment charge of ~$22mm ($0.27/share) in the June quarter, thus impeding future earnings by that amount. That, and the temporary halt in operations, which is an unknown (and likely stranded) opportunity cost. In that respect, there are undeniable implications to the IART investment debate following the decision, that must be discussed in detail in order to develop an informed opinion.

Investment Implications

1. Bold move could pay off down the line

• Starting with the positives. The decision to recall was the right one, and undoubtedly wasn’t the easiest to stomach. At least some credit must go to the firm’s prompt action in proactively initiating the call. Down the line, this may or may not have benefits, but there’s still merit in the company ‘doing the right thing’ so to speak.

2. Financial Implications

• One shouldn’t discount the potential for this recall to have significant financial implications for IART, notwithstanding the pull-through to investors.
• Thankfully, the $22mm impairment charge reflects the write-off of affected inventories, net of costs, it will just remain stranded.
• However, and more importantly, it is the opportunity cost, that is the true cost in this instance. The temporary halt in operations will impact the company’s revenue and earnings profile into FY’23 in my view, such that the market expects a 10 percentage point change in IART’s forward growth rates (discussed later).
• IART expects to report revenues of $372mm-$376mm in Q2 on adj. earnings of ~$0.60. This would call for a run rate of $1.5Bn, including Q1 turnover. I would immediately say, however, that FY’23 guidance remains quite uncertain now with the impairment. More so with the halt in manufacturing.
• If it persists, management project a ~$60mm headwind to revenues (375bps of projected turnover) and a $0.35 decrease in adj. earnings from previous guidance.

Collectively, these changes may have meaningful impacts down the line, and in that vein, it is the uncertainty that has major implications here, i.e., less predictability of future cash flows.

Sentiment

The market’s reaction to the news was swift and violent. Evidence of the change in sentiment is observed analyst, pricing and money flow factors. In particular, money outflows from IART’s equity have been large in the near term, and pricing has been re-evaluated by the market completely.

• Analyst factors
  • Sell-side ratings and price targets have been slashed.
  • Both Citi and JP Morgan immediately downgraded their ratings. Citi to sell from hold, pushing to a $39 price target, JP Morgan to underweight from neutral as well, $43 price target.
  • Further, in the last 3-months, there have been 12 EPS down revisions, and 9 revisions to the downside for projected revenue.
  • As a result, forward earnings targets have been revised lower in each year out to FY’26 [Figure 2].

Figure 2.

• Price generated data
  • You can see in Figure 2 the gap down after the announcement, wiping tremendous value from the firm’s market cap in doing so. Note, the large red volume bar in the bottom frame of Figure 2, indicating the high-volume selling that occurred.
  • There’s a chance that savvy investors could enter at these depressed prices, depending on the outlook. But one thing’s for certain, if the market is trying to reflect its change of expectations of IART in its share price, then it would appear expectations are now low. Two things to consider from this:
    1. You’ve now got the market paying no more than 12-13x forward earnings and 12-13x forward EBIT to buy IART (discussed later). Is this a mispricing, or is this where the company is fairly valued now?
    2. If investors are comfortable valuing IART at these multiples, what does this say for the prospects of valuation upside going forward?

Figure 2.

• Money Outflows
  • Note the heavy outflows both leading up to and following the announcement in Figure 3. You can see the depth at which these occurred subsequent to. These are the largest daily outflows in 2-months and reflect the current sentiment shown in the IART share price.
  • It is unsurprising to see the correlation in liquidity to price sentiment in this instance. In my view, the selloff and large outflow of equity were absolutely spurred by IART’s announcement.
  • Again, this can either set up a contrarian’s dream, or the market will continue punishing IART on the back of the new data. Difficult to call what the projection of money flow’s will be from here, nevertheless, liquidity to the downside is predominately guiding price visibility down the line, and looking to the order book, it is heavily biased on the short account.

Figure 3.

Data: Updata

Data: Updata

To illustrate the magnitude of this recent investment activity to IART’s equity stock, I’ve run an interesting visual exercise, observed in Figure 4. This is a very long chart, showing quarterly price returns dating back to 1998 (The corresponding line chart below it is the same albeit with a log scale, which is more appropriate, although less visually effective in this instance). That is to say, each candle represents one quarter. It is fruitful to sometimes look at charts in this sense to get a better sense of the long-term context. For one thing, starting on the left of the page, you can see the value IART has created for investors up until its all-time highs. But of course, the investor of today doesn’t benefit from yesterday’s results.

Which is important to know, because we can now clearly see IART now trading back at a 2016 range, meaning the company has wiped out c.7 years of gains in market capitalization since its peak in June 2021. You can also see the buying levels in Figure 4 exhibited by the volume histogram. You can see the major buying volume occurred back in 2016-’18, and hasn’t matched this range since.

In fact, you can observe the 6 consecutive quarters of heavy, and increasing selling volume across 2021-’22, and selling volume in the June quarter (6 days in mind you) has already surpassed these levels. This is telling. If there’s one gauge of sentiment, it could be described as the composite of price, money flows and volume buying/selling in my opinion. For IART, the picture is quite somber in all 3 categories, thereby supporting a revision to hold on sentiment grounds as well.

Figure 4. IART Price Evolution, Quarterly bars

[Price Evolution in Log Scale]

Valuation

On relative standing, IART is now very attractively priced at a c.38% discount to the sector priced at 12x forward earnings. Those managers who are mandated to a benchmark or index in this space may find value in this relative discount, in addition to it trading at 12x forward EBIT and 1.9x book value. Looking to various analyses on IART, I believe the market is valuing the company on a combination of forward earnings and EBIT, so these multiples would be relevant.

The issue I have with these relative discounts is there’s all the reason to believe they may be correctly marked for IART at this point in time given the change in circumstances. Or, at least until we have further clarifications on the company’s future cash flows. Looking at it from an expectations-based framework, at the firm’s current market cap of $3.2Bn, and a 12% discount rate (upper range of long-term market averages), it would imply the following:

1. Looking out to a certain horizon, the market expects $385mm in pre-tax earnings from IART (385/0.12 = $3,208);
2. On the TTM EBIT of $270mm, the market expects 12.5% geometric growth in earnings from the company over the next 3-years (270x(1+0.125)^3/0.12 = $3,203);
3. Comparatively, immediately prior to the selloff, at the $4.15Bn market value, the expectations were for $498mm in pre-tax earnings, and 22.6% CAGR over the 3-years.

Figure 5.

Data: Author, Market Data

Data: Author, Market Data

Alas, the revised expectations are equally as telling, suggesting the market now foresees a $113mm (29%) impact to the company’s future cash flows and 10.1 percentage point (44%) decrease in projected growth rates [Figure 5].

I wouldn’t suggest these are numbers to ignore. For one, the changes are statistically meaningful. Second, it confirms to me there has been a change in fundamentals, sentiment, and now, valuation, thereby warranting the revision to a hold.

Furthermore, the revision to hold on a valuation front is supported objectively in the data via the quant system. You can choose to ignore these ratings, but at your own peril in my experience. That IART has been rated to a ‘hold’ under the quant system weighs heavily on my revised investment thesis.

Figure 6.

In short

Net-net, the critical facts have changed in the IART investment debate and therefore so too has my investment thesis on the company. I have pared back my rating to a hold. This is well supported by the fact there have been notable downside changes to:

1. Fundamentals (impairment, temporary halt in operations at Boston);
2. Sentiment (exhibited by price action, money flows and volume selling); and
3. Valuation (the market now expects ~$113mm less in future cash flows and ~45% less geometric growth from IART in my view).

Combined, changes to these three critical factors, which were essential to forming my buy thesis in the first place, are conducive to a hold rating. Looking forward, there is key information we need to obtain. Critically, this includes:

• Clarifications on FY’23 guidance, the long-term impact of the temporary halt at Boston.
• When we can expect to see Boston operations live once again, and what the FDA’s expectations will be going forward.
• If this will have resolved the issue for good, and all future potential reoccurrences are nullified (it won’t happen again).
• What this means for investment factors such as free cash flow, earnings growth and the balance sheet.

Once there’s clarity on this, I believe the market will have confidence again and regain strength in its hands to hold IART. This will require some parsing out by management, and I look forward to seeing what the next plan of action is in order to see where IART rests for my clients. I cannot recommend buying the stock right now. There are too many uncertainties and risks that may not yet be baked into its market price. Net-net, revise to hold until further guidance on the above points.

This article was written by

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