NuVasive Riding A New Wave Of Optimism

Turbulence In The Spine Market Isn’t Going Away Soon

In talking to spine surgeons, I get a definite sense that they don’t believe there is all that much innovation in the market right now. Sales and usage trends have become more about the level of service that the vendor can provide, and I expect that to lead to some choppy reported results from companies like Johnson & Johnson, Medtronic, Stryker (SYK), NuVasive, and Globus (GMED) as these spine players trade market share.

Reimbursement is still getting plenty of attention, particularly the recent pushback against cervical cages as “not medically necessary”. I would suggest that investors should get used to this as the “new normal” in the device space, as hospitals, payers, and ACOs all have incentives to take a harder line on prices (particularly in the wake of relatively less innovation coming to the market).

There are also still some headwinds attributable to physician-owned distributors (POD). These organizations now hold somewhere in the neighborhood of 15% share in the spine market (and closer to 20% in fusion), but the larger vendors won’t deal with them. Now the Office of Inspector General is investigating PODs for fraud. The OIG is exploring claims that these organizations not only do not results in lower costs for hospitals (as they claim) but also seem to encourage a higher number of procedures than may be medically necessary, not to mention fostering conflicts of interest.

All told, while I do not believe the spine market is going to be logging great growth right away, this could still create an opportunity for NuVasive. The combined spine business of Johnson & Johnson and Synthes has seen some disruption since the merger and Medtronic is still trying to figure out its post-Infuse strategy.

Bold Goals Of Addressing Key Issues

During NuVasive’s November investor day, management laid out what I believe to be bold but necessary goals for the business over the next five years.

International sales are only about 10% of the company’s revenue mix today, and management is looking to OUS sales as a major growth driver. Given that the company’s share in Japan is in the low single digits (against around 10% in the U.S.) and the XLIF just hit the market early in 2013, this could be a good growth market for the company, as could markets like China and Brazil.

It’s worth remembering that minimally-invasive procedures hold nearly one-third share in the U.S., but less than 10% outside the U.S. That suggests meaningfully growth potential to me. That potential has to be set aside execution challenges, though, as NuVasive lacks the same level of global infrastructure as Medtronic and Johnson & Johnson. Pricing could also prove to be challenging in many of these markets; if payers in the U.S. are balking, markets like China and Brazil could prove tricky.

The other major target for NuVasive is operating leverage. While NuVasive has consistently had strong gross margins, the company’s operating margins have never been very good as the company is still spending large sums on its sales and marketing efforts. Management is looking at multiple paths to improving margins, including leveraging its scale overseas (more sales through existing channels), improving its inventory management, and improving its sales force productivity. That latter one could be tricky, though, as I wonder how “better productivity” will compete with the high-touch model that surgeons apparently want today.

NuVasive is also looking to move more manufacturing in-house, with a target of tripling its in-house COGS from about 15% to 45%. The company can also look forward to lower royalty payments in 2015, as the key Medtronic patent that is tied to about 80% of the royalties expires early in 2015. All in all, management is look to operate with gross margins in the mid-70%s and operating margins in the low 20%s.

A Good Chance Of Logging Industry-Leading Growth

Even though the spine surgeons I spoke to talked of a disappointing level of innovation in the market today, NuVasive is seeing a lot of benefit from its own suite of relatively new offerings. U.S. lumbar sales growth rose 12% in the third quarter, helped by the mid-2013 launch of MAS PLIF and good sales of the Precept posterior fixation system, which has helped the company shore up a traditionally weak market. Other products like Bendini, which the company believes can reduce surgical times by 30%, are also likely to contribute.

All told, I’m looking for NuVasive to log long-term revenue growth of over 7%, which implies steady share growth through the next decade. I’m also willing to give the company the benefit of the doubt that they will hit their low 20%s operating margin goal, leading to a FCF margin in the mid teens (comparable to what Stryker achieved with low 20%s operating margins). Those numbers work out to a free cash flow growth forecast of nearly 14% and a discounted fair value of a little over $34.

The Bottom Line

The market has already bid these shares over that $34 level, and I believe some of that can be attributed to growing expectations of M&A in the ortho space, even though larger ortho acquisitions have a dicey valuation-creation record. As an aside, every extra 1% of long-term revenue growth works out to about $2 of fair value, so it appears that NuVasive needs to grow at a 10% clip for the next decade to justify a $40 target unless you assume even better margin leverage or use a lower discount rate.

NuVasive has always been a volatile stock, and I would be a little nervous given the valuation. Given the company’s recent growth rates, though, I am not expecting the Street to worry about valuation unless those growth rates start to disappoint.