Integra LifeSciences Looks More Interesting Now

I have generally liked the strategic changes that Integra LifeSciences (NASDAQ:IART) management has made over the last few years, including selling its extremities business to Smith & Nephew (SNN), but when I last wrote about the stock I didn’t like the valuation relative to the ongoing execution challenges.

Down more than 20% since then (a little worse than the average med-tech), the investment argument is more interesting. Tying so much of the company’s growth targets to the Tissue Technologies business is risky, but I do also see some products that could achieve real differentiation and drive good growth. I still don’t see enough undervaluation relative to the execution risks to be outright bullish, but this is a name worth watching more closely now.

Lackluster Results To Close The Year

Integra didn’t perform poorly relative to sell-side expectations, and management had previously guided that it would take some time before growth accelerated to the mid-to-high single-digit range that management has targeted for the long term, but the results were still pretty “meh” on balance.

Revenue rose 3% in organic terms, which ends up looking fairly lackluster next to the 4% growth at Medtronic (MDT), the 5% med-tech growth at Johnson & Johnson (JNJ), the double-digit growth at Stryker (SYK) and so on. Still, it was in-line with expectations.

Codman Specialty Surgical (neurosurgery) revenue rose 2%, with neurosurgery slightly weaker (up 1.7%) on declines in the monitoring business (the CereLink recall) and dural access/repair, offset by low single-digit growth in Advanced Energy and low double-digit growth in CSF management driven by programmable valves. Precision tool sales rose a little more than 2%.

The Tissue Technologies business grew 5%, with wound reconstruction sales up more than 8% on double-digit growth in ACell, while private label sales declined about 4%.

Gross margin remains problematic, even though the company has achieved lower costs than expected on the CereLink recall. Gross margin declined 60bp yoy and 40bp qoq, missing by 130bp. Operating income rose 5% (with margin up 170bp to 25.1%) and beat by 2%, with the company doing a good job on SG&A cost containment.

Guidance wasn’t dramatic in either direction, with a revenue and EPS guide just a bit below expectations. Even though this wasn’t a big revision, it does put a little more distance between where the company is today (revenue up 4.6% org at the midpoint in 2023) and the story management has been trying to sell to the Street regarding acceleration. Again, I want to emphasize that management has been pretty clear that 2023 would be another year of investment/re-investment, but the Street often only cares that you’re not growing fast enough, not why you’re not growing fast enough.

The Good

As critical as I may sound of management at places in this article, there are positives worth following at Integra. In particular, I’m very interested in some new products that could end up being highly differentiated and drive that targeted revenue acceleration.

The neurosurgery market isn’t really a growth market (around 3% to 5% long-term growth), but monitoring should outgrow the market and the CereLink ICP (intracranial pressure) monitor should be back on the market in mid-2023 after a recall in 2022. I don’t get the sense that this recall did much damage to the perception around the product or the company, and management has reacted quickly.

What excites me more is the Aurora Surgiscope. First off, it’s a disposable endoscope that can plug into existing imaging and monitoring equipment, and that’s not common. This product is going to target minimally invasive surgery for deep brain tumors (a roughly $600M addressable market); these tumors are currently addressed by open surgery. Integra is also targeting opportunities in intracranial hemorrhages. This is a $400M to $500M opportunity and one where there aren’t good treatment options today (only about 20% of patients ever regain full function); getting to patients fast enough will be an issue, but a minimally invasive approach could drive better outcomes.

In the Tissue business I’m certainly interested in the ongoing growth of ACell. I had some issues with how the company integrated this business (it led to sales relationship disruptions and sales disappointments), but it seems to be on track now.

I’m more interested in the opportunities in breast recon and nerve repair. An FDA panel voted against the implant-based breast recon indication for the SurgiMend matrix in 2022 in a close vote where the main negative argument was that the benefits didn’t clearly outweigh the risks (even though the safety vote was in favor of the device). With a $600M addressable market growing at a double-digit rate, management isn’t abandoning this product and intends to submit an amended PMA in August of this year that will hopefully lead to an approval in 2024.

The company doubled down on matrices for breast recon late in December when it paid $140M (including earn-outs) for DuraSorb and its resorbable synthetic matrix. The company has an IDE study underway and is looking for approval for breast recon in 2025/26. There are no surgical matrices currently approved specifically for breast recon, and DuraSorb gives the company a synthetic option to complement the xenograft-based SurgiMend. Both synthetic and xenograft matrices are cheaper than human-derived matrices (30% for xenograft, 60% for synthetic).

I’m also interested in the potential of Integra’s new nerve repair product, NeuraGen 3D, for short/mid-gap nerve repair. Management thinks this is a $600M addressable market growing double-digits, and I’ve been bullish on nerve repair (though my call on AxoGen (AXGN) hasn’t really worked out).

The Bad

Integra still has a lot of work to do to get to a point where meaningful rerating seems likely. Since my last update there has been further turnover in the top ranks of management, with both the COO and CFO leaving. While both departures make sense (the COO leaving since he wasn’t chosen as the new CEO, the CFO leaving to become CFO at Campbell Soup (CPB), a much larger company), it can still be disruptive.

Execution has also been an ongoing challenge. While many companies have struggled with input costs and supply chain issues, I’d have liked to have seen better from Integra, and while Tissue Technologies appears to be on better footing now, it took some time to get there.

While not necessarily “bad”, I would also note that a lot of the potential growth drivers I’m excited about could prove to be “missionary” sales efforts, where the sales force will have to work a little harder to convince surgeons that changing their practices is worthwhile. No device sells itself and investors should keep in mind that surgeons (and physicians in general) can be surprisingly resistant to change – if they didn’t learn it in residency, some seem to believe, then they don’t need to know it.

The Outlook

For all of my criticisms of Integra, I’m actually more bullish than most of the Street. My expectations over the next three years are more or less in-line, but I do expect revenue acceleration beyond that and 5% to 6% long-term growth. Management’s targets are higher, and maybe they’ll get there, but I think more evidence is needed first.

On the margin side, I’m looking for flattish EBITDA margin in FY’23, but improvement in FY’24 and FY’25 (about 125bp relative to FY’22) and further improvement toward 30% over the next five years. At the free cash flow line I expect margin to improve into the high-teens over time, driving high single-digit FCF growth.

Integra doesn’t look all that cheap on discounted cash flow, which is pretty typical for med-tech. The margin and growth-driven EV/revenue valuation is more interesting. The shares aren’t all that undervalued on the basis of what the company is likely to do over the next 12 months, but if you credit them with the growth and margin improvement I expect, I could argue for a fair value in the low $70’s (a 4.5x forward multiple). Splitting the difference would give me a mid-$60’s fair value.

The Bottom Line

I’ve liked the improvements I’ve seen in the Tissue business, and I think Integra has a good portfolio there. I also like those growth opportunities I mentioned above, even if they are risky and uncertain. I’m tempted to turn bullish now, even with 2023 being a reinvestment year, but I’d really prefer to see a little more evidence of improved execution. The shares are already up more than a third from their 52-week low, though, so there very well may be a cost to waiting for that added security.