Reflections on the Aircast Acquisition
BY JOHN MCCORMICK, NOVEMBER 22, 2004
Two weeks ago, Aircast announced that it will be acquired by $1.3 billion private equity fund Tailwind Capital Partners. By all measures, the deal looks and feels like a plain vanilla leveraged buyout. A substantial amount of debt is being issued to buy this Summit, N.J. family-owned company. While total transaction terms were not disclosed, the total debt outstanding at the end of the transaction according to Moody's is expected to be in the neighborhood of $100 million including $15 million of seller notes. Revenues are estimated to be in the neighborhood of $95 million.
G. W. Jim Johnson, III, the globetrotting son of Aircast's founder, Glenn W. Johnson, Jr., will assume the role of Chairman Emeritus while Thomas Crowley, who joined last year as President and Chief Operating Officer, is expected to continue on in his highly visible and active management role. This doesn't mean that Johnson gets to completely rest on his laurels, however. Selling shareholders are subject to an earnout provision that will be tied to certain minimum sales levels in the first three years after the acquisition.
Clearly Aircast has always had a special niche in the bracing industry due to its innovative products and branding. Rarely has a medical device manufacturer achieved the kind of patient recognition that Aircast has. According to the Company, one out of every five families has used an Aircast device.
This highly respected company was founded 30 years ago by orthopedic layman Glenn W. Johnson, Jr. who was fed up spending weeks in a conventional plaster cast waiting for a difficult fracture to heal. After some self-study Johnson invented a brace-like device with aircells which, to the surprise of his doctor, aided the fracture union. In the early years, Aircast's 'Pneumatic Walking Braces' were a homemade product even given away to friends. The rest of the story comes straight from the great American entrepreneurial playbook. A great company that revolutionized the management of ankle injuries was built, the son took over the business and sold it for a fortune to a highly sophisticated buyout firm. Obviously, that's not the whole story. It is common knowledge in the industry that the Company has been for sale on and off for years and the family could never quite get the price they were looking for until now it would seem. But that should not detract from the overall conclusion. From any perspective, the Aircast story is a great achievement.
Acquiring this jewel of the bracing industry must give great fulfillment to the psychic economy of Tailwind's partners whose ranks are filled with scholar athletes including CEO Thomas Weisel, a U.S. Ski Team alumnus and world record cyclist. From a financial point of view, the deal must also give great satisfaction to the Weisel team and their limited partners. According to Moody's, Tailwind is purchasing the Company at a 'multiple conservative for the industry' (our sources tell us in the neighborhood of 8x EBITDA) and the senior debt to EBITDA ratio is an orthodox 3.5:1 - a levelheaded number for this key credit market benchmark.
A few questions need to be asked before we pass out the cigars, however. After all, Aircast is a living breathing business in an industry with some subtle competitive dynamics.
The days of the Company's entrepreneurial family roots are now numbered and Weisel's Yale and Stanford educated denizens are ready to take over. The key question in our mind is can these philosopher kings get into the trenches to do battle with Aircast's competitors who happen to be savvy street fighting industry veterans? Can portfolio managers, no matter how credentialed, measure up to stalwarts like Charlie Federico and Brad Mason of Orthofix and BREG and DJO's Les Cross? We have heard cocktail chatter that Aircast was shopped widely and broadly to various strategic acquirers in the industry to no avail. In an industry where companies are routinely sold for multiples of revenue to strategic acquirers, why would such a profitable company and one-of-a-kind name like Aircast be declined as an acquisition candidate?
To 'Build Versus Buy' in Bracing
In 2003 we saw a similar deal go off. Royce, a fast growing and highly profitable bracing company, was extensively shopped, declined by the strategic acquirers and eventually sold for top dollar to Cortec - a New York based middle market buyout fund. The company, it would seem, was sold at a multiple that was too rich for the industry. The logic according to industry veterans was simple. Why buy a company at an outsize multiple when you can build your market share more cheaply through product development, disciplined sales and marketing and working through buyers such as Premiere? Perhaps a more sagacious reason not to pay a high multiple in bracing is that it is a low growth industry. The industry struggles to grow at 5% per year. Mature and profitable yes, but even Corporate Finance 101 tells us to buy cash cows on the cheap and not to pay for growth.
The real subtlety as to why it may be better to build than buy in bracing lies in the bracing industry's comparatively weak intellectual property structure and, to an extent, the reduced FDA burden. Barriers to entry in bracing are comparatively low and the industry is fragmented. To develop a new brace, you don't need to invest millions in R&D to develop ground breaking technologies nor fund a sophisticated PMA process with the FDA. Orthopedic companies like Spine Next, which specializes in dynamic stabilization of the spine, command substantial buy-out sums because they have meaningful patents and potentially paradigm shifting technologies. ArthroCare's acquisition of Opus is another great example of when and why to pay up. Opus took great strides to achieve bulletproof intellectual property protection. On that note, we are under the distinct impression that the strategics (and even the little mom and pops) in bracing have been salivating lately over the fact that key Aircast patents have expired. Building rather than buying is especially lucrative in that case.
Branding in Bracing
But doesn't Aircast have a phenomenal brand? Yes they do and their brand is laudable especially in the tough bracing industry. You don't want a brace unless you need it and your need is likely to be one-time-purchase decision. Without constant repeat customers, branding is generally next to impossible. Case in point: how many air ambulance companies can you name? Probably none - You'll only need a Lear Jet to fly you out of Timbuktu maybe once in your life. DJO and BREG have done much to overcome this obstacle by identifying doctors, therapists and coaches as the repeat customer.
To Aircast's credit, they have achieved outstanding mindshare in the marketplace among both doctors and incredibly... patients. Ask any longsuffering soccer Mom about how her kid felt 'cool' to be seen walking around in an Aircast. The brand name is a formidable strength and going after their ankle stirrup isn't going to be easy. On the other hand that is not going to stop anyone either because patents not branding is the real key to dissuading competition. Brand extension for Aircast may also be limited due to the name. But doctor... I thought this 'brace' is for my osteoarthritis, I don't have a broken bone. Why do I need a 'cast'? Extending out into DJO's, BREG's, and Gen-II's markets will certainly meet stiff resistance from these entrenched and seasoned competitors. We're not holding our breath for Aircast dental floss either.
Despite the strength of branding, intellectual property in orthopedics is where its at. Wanna come play in the orthopedics neighborhood? Better have patents. Wanna get bought for an outrageous multiple? Better have patents. Brand name is nice, but it is not going to stop a tidal wave of comparable products from competitors looking gain precious share in this slow growth space.
Onshore vs. Offshore Manufacturing in Bracing
Frost and Sullivan has reported that trying to achieve price increases in bracing unambiguously stinks. First, the others concur with our observation that competition for market share is fierce in this low growth market. Second, payors don't like to pay for braces of any kind, the exception being osteoarthritis braces which seem to have a value proposition in forestalling expensive knee replacement surgery. Guess what' DJO moved their manufacturing offshore last year to Mexico. In fact, DJO has increased their profit margins so handsomely as a result of this move they have just been able to afford a revamped Mexican facility. BREG is offshore and Royce has been moving their facilities to China. Aircast still manufactures in New Jersey, however.
We see two scenarios here: First, Tailwind can move Aircast's manufacturing offshore. Manufacturing Aircast braces is not rocket science and a move like this could add points to the Company's gross margin line. The problem with this is that Aircast is going to be saddled with lots of interest and amortizing term debt which means a potentially large portion of earnings may have to be used to service debt. A capital expenditure of the kind required to undertake a manufacturing transition may be difficult to come up with without scrutiny from the bankers. Second, Tailwind can keep Aircast manufacturing onshore. It does concern us that such on-shore manufacturing leaves the company at a competitive disadvantage compared to others in the bracing industry who have moved their manufacturing to lower cost environs. In scholar-speak, the situation reminds of Ulysses navigating the dangerous straits between the Scylla and Charybdis.
What are they Thinking?
Tailwind, an extremely sophisticated private equity firm, is buying Aircast - a company whose competitors have seen on the block for years, but have declined to buy. On the face of it, leveraging a Company that is already at a competitive disadvantage due to limited intellectual property and onshore manufacturing would tell us that Tailwind sees something the industry does not. Much can be done with companies that have strong brands and strong profits. We may also conjecture that Tailwind has an idea the industry hasn't thought of. Are they planning to position Aircast away from traditional bracing and more in the consumer products area? Perhaps prophylactic braces for worried soccer Moms? A consumer driven approach might an interesting avenue that the strategic buyers don't have the same resources to bring to bear. Another possible scenario is that Weisel rides it for a few years, pays down debt, sells it to another buyout group and gets a modest return. Whatever the strategy is, we hope it works given the standard exit venue of 'selling to the industry' does not seem to be available here.
