Would Stryker Buy NuVasive?

Slow overall procedure growth combined with an increasing concentration of vendors at the hospital level may well be laying the foundation for a consolidation of spine manufacturers. That is the opinion of senior Wells Fargo analyst Larry Biegelsen as described in his July 9 report titled “Is the Spine Market Finally Ready for Consolidation?”

The most likely candidates to be acquired, hypothesizes Biegelsen, are NuVasive, Inc. and Globus Medical, Inc. Noticeably absent from the senior analyst’s list were Alphatec Spine, Inc. and Baxano, Inc.. In his view, Alphatec and Baxano were “less attractive to potential buyers due to their lack of size and scale.” But, in reality, Biegelsen’s exclusion of these two companies (as well as such private firms as K2M, Inc., LDR, Lanx, Inc., Paradigm Spine, LLC or SI BONE, Inc.) reflects the prevailing opinion on Wall Street of spine—that it is now a commodity industry. In commodity industries, M&A (merger and acquisition) activity is usually driven by the need to build size and scale—and only NuVasive or Globus seem capable of delivering that to Biegelsen’s list of larger prospective buyers.

The Buyers

And who might be the buyers in a possible wave of consolidation?

Three companies, says Biegelsen, have the means and the motivation to step up. They are; Stryker Corporation, Biomet, Inc. and Zimmer Holdings, Inc.

DePuy, having purchased Synthes, Inc. for $20 billion last year, is still digesting that mammoth company and would not be shopping for anything large. Medtronic, Inc., with the largest market share in spine and having recently acquired the large Chinese spine and orthopedics company Kanghui, also seems to be satiated.

Survey Says

The same week as Biegelsen’s report, Bob Hopkins, research analyst with Bank of America (BofA) Merrill Lynch, released a survey of leading spine surgeons that seemed to support the same view of the spine industry that led Biegelsen to make his consolidation call.

That view is that the spine industry is growing slowly—about 1% per year—and continued pricing pressures and a lack of innovation has changed the industry from an innovation driven, rapidly expanding industry to a commodity industry.

Hopkins surveyed 75 U.S. spine surgeons (57% orthopedic surgeons, 43% neurosurgeons) from 24 different states. Here are the main conclusions:

• Vendor consolidation is increasing: When Hopkins asked surgeons about vendor consolidation, 44% responded saying that their hospitals were actively reducing the number of spinal implant manufacturers supplying product. Furthermore, respondents said that, on average, their hospitals would likely reduce the number of vendors by 39% over the coming two years. Fifty-six percent of the respondents said that their hospitals would likely increase the number of vendors over the coming two years—although not by much. Overall, on a weighted average basis, the conclusion of the 75 respondents is that their hospitals would be using 19% fewer vendors over the coming two years.
• Innovation is essentially non-existent: By far the most definitive result of Hopkins’ survey was the nearly unanimous opinion that innovation is dead in spine. When asked this question: “Do you see any innovation coming to market in the next two years that could allow one manufacturer to take significant share of the spine fusion market?”, 95% said “NO.”
• Insurance Coverage is worsening: No matter how the question is asked, surgeons surveyed were clear in their answer—insurance companies are increasingly dis-inclined to pay for spine fusion surgery. Sixty percent of the survey’s respondents said that willingness of payors to pay for either spine fusion or degenerative disc disease cases has worsened in the last several months.
• Procedure volumes are flat to slightly up: 75% of the respondents said that spine fusion volumes have been flat to slight up so far this year. Here is the chart from the BofA Merrill Lynch Survey:

What Is Driving the Urge to Merge?

Like the surgeons in Hopkins’ survey, Wells Fargo’s Biegelsen noted in his analysis an increase in vendor consolidation and pricing pressures which are major contributing factors to prospective M&A activity. He also added three other conditions that, in his view, set the stage for purchases. Those are:

1. Spine market stabilization. Year-over-year growth rates have fallen significantly but recently seem to have stabilized. In Biegelsen’s view, growth rates may be slow going forward, but they are stable growth rates. That de-risks purchases of the larger spine manufacturers quite a bit.
2. DePuy/Synthes combination changed the competitive dynamic. As much as competitors may hope for DePuy/Synthes to stumble with regards to consolidation, the reality is that this, in Biegelsen’s words: “altered the competitive dynamic of the spine market” and “established DePuy Synthes Companies as a formidable competitor to the market leader, MDT [Medtronic].”
3. Spine valuations remain reasonable. To quote Biegelsen: “Spine companies continue to trade at a discount to the large orthopedic companies on an EV/Sales basis which suggest that the spine companies remain relatively inexpensive on this metric. …spine valuations are at a level that could be appealing to both buyers and sellers, in our view, if the buyers can generate cost synergies.”

As a result, says Biegelsen, the buyers’ prospective motivations are clear. By stepping up the M&A activity, companies like Stryker or Biomet or Zimmer can:

1. Acquire size and scale in spine.
2. Put their large stores of cash to strategic use. Stryker, for example, ended the first quarter with $4.5 billion of cash and equivalents. Zimmer ended this past March quarter with $1.2 billion in cash and Biomet reported $217 million for the February 2013 quarter.
3. Take advantage of the low cost debt markets. Low cost debt makes buy-outs financially attractive—particularly when the target firm has such strong cash flows (i.e., Globus Medical’s 30% profit margins).
4. Boost growth rates—top and bottom line. While buying a firm certainly adds to the sales line, consolidating accounting and other administrative functions can also add to profit growth.

And, why would, for example, NuVasive entertain such a possibility? Biegelsen sees three basic motivations which could prompt a seller:

1. Valuations are up. Which means that the timing for a sale may well be especially good right now. Given FDA uncertainties and the ACA (Affordable Care Act) implementation, valuations may retreat in 2014 and beyond. So the time to sell is now.
2. Exit strategy.
3. Various trends favor larger spine companies. Hospitals are reducing the number of vendors. Pricing pressures across the board favor the manufacturers with the largest scale and, presumably, lowest per implant cost of manufacturing.

What If??

What if these top analysts are correct and the spine industry is entering a period of accelerated merger and acquisition activity? What might any one of these combinations look like from a purely financial point of view?

In Biegelsen’s report, he analyzed the hypothetical combinations of Stryker + NuVasive, Stryker + Globus, Zimmer + NuVasive and Zimmer + Globus. Interestingly, the most favorable combination of all was the Zimmer + Globus combination.

Here are the pro-forma numbers as calculated by Biegelsen and his team at Wells Fargo.

The Only Constant Is Change

It is very hard to accurately predict who could potentially buy whom. But the spinal implant business is certainly changing. DePuy’s acquisition of Synthes did, indeed, change the strategic landscape. And as Hopkins’ survey made clear, the nature of spinal care at the surgeon and hospital level is also shape shifting. Something may have to give. Logic would support larger companies, larger hospitals and a standardization of spinal care. But, to take the contrarian’s view, how often is the conventional wisdom correct.