Allograft: Whacked Again
BY JOHN MCCORMICK, MAY 16, 2005
The allograft industry is a curious phenomenon. Companies in this segment of the orthopedic industry are stand alone processors of human cadaveric musculoskeletal tissue for surgical implantation. Companies are stand alone because it seems that the metal benders in Warsaw, Indiana are reluctant to become tissue processors themselves. The allograft segment, therefore, is mainly a subset of industry suppliers such as Regeneration Technologies, Tutogen, Allosource and non-profit service organizations such as MTF.
Large firms in the industry such as Medtronic Sofamor Danek and Zimmer tend to keep allograft at a distance, "private label" the tissue processing and farm out the risks, such as disease transmission and quality control. To investors in the public market, valuations for allograft suppliers trade at a discount because their distribution structure tends to create customer concentration which, in turn, creates a risk of revenue, gross margin and inventory volatility. Last but not least, their supplier status means lower gross margins and therefore suboptimal operating leverage due to high fixed costs.
Last week, these issues came home to roost at Regeneration Technologies, Inc. (NasdaqNM: RTIX) when the Company announced that it was (i) disbanding its effort to sell the Company (ii) announced a $0.05 per share loss versus analyst expectations of a $0.07 per share profit and (iii) has decided to stop sharing revenue projections with Wall Street. As a result, Regeneration Technologies' market capitalization was whacked by over 30% last Tuesday. Although the shares began to climb back, the week's overall value impairment was 23% or over $50 million of shareholder wealth.
Revenue and Earnings Crushed
On Tuesday, the Company announced that net revenues had declined on a year-over-year basis by over 36%. 1Q:05 revenues were $15.0 million, compared to $23.6 million for 1Q:04. For 1Q:05 the Company recorded net loss of $1.3 million and EPS of ($0.05), compared to net income of $1.4 million and net income per diluted share of $0.05. Combine the bad revenue and earnings results with an announcement that you were inconclusively concluding an "exploration of strategic alternatives" (e.g. selling the company) and you get toxic stock syndrome.
What happened?
Below, we give a quick synopsis of Regeneration Technologies' 1Q:05 revenue breakdown compared to 1Q:04.
The principal decline in revenue was a "delay of orders" to Medtronic Sofamor Danek, the Company's principal customer. In fact, Regeneration Technologies' sales to Medtronic Sofamor Danek were off nearly 50% and the Company's quarterly spine product sales were down to about $8.0 million from $15.9 million a year ago. Unit volume was down a notable 43%.
How does this happen when the (i) market for spinal machined bone is growing at nearly 10% per year especially when (ii) your key customer is the leader in spine and (iii) your key customer is, in fact, growing? According to management, delays in customer ordering patterns were greater than anticipated. According to nefarious rumors, revenues could have been stuffed into the 4Q:04 in anticipation of finding a strategic buyer. According to us, Regeneration Technologies' continued woes are the symptom of a diseased business model: being a supplier with over half of your revenues dedicated to one customer. This situation is no different to us than a small supplier to General Motors or Wal-Mart that gets whipsawed every time the big guy sneezes.
We also note that when Regeneration Technologies reported their 1Q:04 results a year ago, they surprised the Street by announcing greater than expected revenues. Why? A surprise rebound in sales to Medtronic. I guess we should be prepared to be surprised with this Company every single quarter until it diversifies its customer base.
Management is acutely aware of the Company's problems, has now officially given up putting out revenue guidance to wean investors off of a quarter-to-quarter mindset and has stressed new R&D initiatives. These are helpful tactics and the management team are excellent business operators, but much needs to be done to address a flawed industrial economics paradigm.
The Allograft Market: Points of Light?
That being said we don't think the allograft paradigm itself is at risk. In fact, we believe the market will continue to grow. The market, largely driven by spinal fusions, stands at over $525 million today and is growing at about 8% to 10% per annum
Source: Millennium Research, Medtech Insight, MedMarket Diligence, HealthpointCapital
Allograft: Spine Segment
According to Millenium Research, this $370 million market is a growth market clipping along at nearly 10% per year. Although the growth in allograft is projected to fade thanks to new technologies such as motion preservation in spine, the off-label use of INFUSE with allograft may have already encouraged more allograft use. There are also clinical arguments that better fusion outcomes in allograft are achievable when compared to devices like metal cages. One interesting tidbit we have been encouraged to look for is the decline in PLIF allograft implants in favor of TLIF due to cost containment pressures among hospital customers.
Allograft: Soft Tissue
Other areas of allograft include meniscal repairs, tendons, ligaments and the like. These segments are growing as fast as 15% (faster than spine), but the growth numbers are working off a smaller base and we expect the growth rate to decline in future years.
Conclusions
In the long term, allograft is demonstrating resilience as a medical technology and we think continued surgeon use is inevitable. In addition, we think that being at the back end of the supply chain is no place to be for the faint of heart unless you can withstand significant quarter-to-quarter revenue, earnings and inventory swings.
