Robin Young and John McCormick Discuss / Debate Credit Markets
BY EDITOR, OCTOBER 8, 2008
This article first appeared in the October 7, 2008 edition of Orthopedics This Week.
Robin: John, first of all, thank you so much for agreeing to discuss this unprecedented crisis in the capital markets. From my perspective, this is an extremely troubling series of poor decisions - from the poor risk management on Wall Street to the back and forth inWashington on a financing package. Hopefully, the central banks and government will figure out a way to get ahead of events soon and restore the credit markets to a position of trust and reliability. I'm not convinced as yet that this won't have some effect on the orthopedic markets. What's your view?
John: Robin, it's always a pleasure to have these types of exchanges with you especially on such serious topics. History tells us financial crises are more common than we think. Even so, this situation is unprecedented and everyone will be affected. So we are with you on the point of the potential effect on orthopedic markets. It is a question of degree, however. Taking the capital markets perspective, orthopedic stocks are nowhere near as badly shaken as the S&P 500 or - good grief - financials for that matter. Looking at some superficial fundamentals, in 1H:08 there has been encouraging revenue growth (currency gains notwithstanding) in the industry broadly. Importantly, the industry in aggregate is profitable and not leveraged. Without question, I'd rather be an employee of Zimmer versus Lehman Brothers right now. If we were going to check under the hood for problems, I would be concerned about how hospitals are doing. People's credit problems are forcing hospitals to go to collection agencies more. I would imagine that obtaining credit for a hospital is more difficult these days, and everyone knows that layoffs are sadly causing people to join the ranks of uninsured. All of this could withhold surgeries or change purchasing decisions. What do you think, Robin?
Robin: My #1 fear is the freeze in the credit markets - by far. This I believe is already affecting the entire range of vendors (metal suppliers, plastics suppliers, etc.) to orthopedic companies and then, on the other side of the ledger, customer receivables. Like you, John, these CFOs have portfolios of companies. As orthopedic company CFOs look at their respective vendor / customer lists, they must certainly be wondering how many will skate through with diminished bank revolving credit. This is not a weakness on the part of these firms, in my opinion. Until recently, perfectly healthy suppliers, clinics and hospitals used commercial bank credit as a standard element in their business model. But the game, I think, has changed. I would not be surprised if many of these vendor / customer companies are in urgent discussions with their banks for credit. How many will fail to obtain it? Or, how many will, as we just saw with Orthofix, pay as much as 300-400 basis points extra for a credit facility? The ripple effect and how orthopedic managers deal with it is, in my mind, the single most important challenge we all face during these difficult times. So, I guess my question back to you, John, is: Are you also concerned about the working capital effects of the credit freeze? And what, do you think, can the average Joe Six-Pack ortho company do about it?
John: I would agree with you that the industry must be extremely vigilant about the issue. These are unprecedented times for everyone. The good news is that even before the crisis began over a year ago up until 2Q:08, we saw the industry's working capital indicators such as accounts receivable days outstanding, inventory turns and accounts payable days outstanding remain remarkably stable. So the average ortho company has been collecting from customers on time (about 65 days) and paying its suppliers on time (about 60 days) like a Swiss watch for years. Earlier in the year, even when Bear Stearns imploded, equity analysts were sanguine about the risks of hospitals’ ability to finance. But that was then and this is now. The working capital data we have been reviewing here is only good up to 2Q:08, those analyst reports are old and now credit markets are more dysfunctional than ever.
So pointing out these risks to the average orthopedic company shows the usual bull's eye intuition you are known for, Robin. It will be interesting to test this assertion when companies report in the coming weeks. Our view is that the average orthopedic company should be closely examining customers and suppliers for signs of distress. Multiple sources of supply is a good way to go, but that doesn't happen overnight. For example, it is hard to diversify your supply base if you are dealing with complex inputs such as ceramics or the need for quality validation for FDA purposes. Paying burdened suppliers earlier might help, but that is hard to do if your customers are slowing payments. Fortunately the industry does not have a lot of customer concentration, but still with California stating flatly that it needs $7 billion from the federal government to keep the lights on, that can have a ripple effect in even small areas such as delaying workmen's comp to hospitals. There is a point of light here that the industry is not leveraged. Let's not lose sight of that. If a cash-constrained company is experiencing working capital disruptions, there are lenders out there, but - yes - they are expensive as you pointed out in the Orthofix example. What do you think? Is the industry on high ground? Will the house be completely submerged or is it a case of the basement being flooded?
Robin: I'm not convinced that this industry is on high ground, actually. There are clear vulnerabilities as the table below illustrates. Here are the numbers from the June quarter for the top 10 public orthopedic companies.
My takeaway from this table is:
1. The top 10 orthopedic companies added $13 billion in new debt this past year - that's a 28% increase.
2. Seven out of 10 of the top ortho companies saw their receivables net of payables decline in the past year.
3. Stryker and Synthes are the industry's cash cows. High cash balances, strong receivables less payables and total debt that, comparatively speaking, is low.
4. Only CONMED and Orthofix appear to be deleveraging.
5. The two most leveraged companies are Integra and Orthofix. The least leveraged companies are Stryker, Zimmer and Synthes.
6. My guess is that if vendors and customers find themselves caught in a credit squeeze, Stryker, Synthes and Zimmer will be in an excellent position to provide terms or even advance against purchases to keep their customers going.
So, John, at the end of the day, if the capital markets aren't prepared to support the rank and file vendors or customers or growth requirements of the orthopedic industry - a handful of orthopedic firms have the ability to use their balance sheets to further strengthen those ties that bind. It's almost as if we're back in the day of the true merchant banker. With that, would you mind taking the last word?
John: Even as we have been writing this, the global bank run has been worsening so I am afraid the last word is in the hands of the economic historians! To your question, the great investor Benjamin Graham would appreciate your "acid test" approach to these numbers, which is something few people use these days. The J&J increase in receivables (less payables) and overall debt is the most startling of this group. It is also the least applicable to the orthopedic industry given the wide range of consumer, pharma and other device businesses that J&J is engaged in. So if we strip out J&J and keep Medtronic (lots of other business lines, but the debt increase is related to the Kyphon acquisition), the remaining group looks better as a category.
The total debt increase (ex-J&J) is substantially less at about $3.3 billion and the net debt level (that is, after subtracting cash) is about $13.3 billion (again, ex-J&J). That $13.3 billion is supported by about $126 billion of combined equity market capitalization of the ex-J&J group of companies. So net debt to market cap is a little over 10%. That number falls to less than 7% when you remove Medtronic. If we insist on keeping J&J in the analysis, OK, but it is supported by nearly $190 billion of equity market capitalization and the net debt to market capitalization moves to a little over 13%. Compare that to General Electric which has (gulp!) roughly $535 billion in net debt supported by a $215 billion market capitalization. Net debt to market capitalization is a whopping 150% for GE!
Maybe GE is too dramatic of an example, but the pure play orthos are comparatively a pretty attractive bunch from a standpoint of leverage. Just to make sure we aren't drinking our own Kool-Aid here, your point about receivables (less payables) does mean increased working capital but, as you and I know, could also have negative implications. Growing receivables means fewer on-time payments by customers. Your point about vendors and customers being in a potential squeeze here is a good one for many reasons and - yes - Stryker, Zimmer and Synthes sure do look like good partners right about now. If I had to choose between supplying GE or Zimmer, I'd choose Zimmer any day.
But remain eternally vigilant . . . Thank you, Robin.
Robin: And you too, John. Excellent discussion. Thank you so much.
