Description

Business Description

Alphatec Holdings, Inc. (NASDAQ: ATEC) is a medical technology company focusing on the design, development, and marketing of products for surgical treatments of spinal disorders. ATEC generates its revenues through the utilization of its products in spine surgery procedures. Currently at $12.96 a share ($1.56B FD market cap), ATEC is up 322% in the past 5 years mostly due to tremendous growth in its top line. In the past four years ATEC experienced a ~37% TTM CAGR resulting in analyst price targets as high as $22.50 per share (see Cowen Jan. 26, 2023, Equity Research report), representing a $2.75B FD market cap. We see many issues with the company including:

1)     Excessive growth at the cost of profitability  

2)     Products that face material uncertainty.

3)     A management team that does not believe in the company they are leading

In addition, management has recently stated that the goal is to become EBITDA profitable or breakeven for 2023, but for a company that hasn’t seen profitability in more than a decade, valuation may revert once the goals laid out are not achieved. Also, Patrick Miles, the Chairman and CEO, who sold 360K shares in the month of Jan. 2023 (% of stock).

Revenue at the Cost of Profitability

As previously mentioned, ATEC’s story has always revolved around immense revenue expansion, and it has been able to achieve that with revenues growing from ~$108M FY2018 to ~$319M Sept-LTM at a ~37% TTM CAGR in the past four years. Most recently however, the narrative has shifted towards not only maintaining this revenue growth but also becoming EBITDA profitable/breakeven by 2023. Most recently in Q3’22 earnings, management went on to say:

“So as we talked about at our Investor Day, our focus is $555 million in 2025” and “[…] trajectory sets up very nicely going into next year and achieving our commitment of being adjusted EBITDA breakeven into next year”

While analysts are fully buying into this narrative:

“ATEC affirmed its commitment to achieve AEBITDA profitability in 2023 so the stopper will be in the bottom of the tub, while the water will continue to flow. That is truly good news for investors” – Brooks O’Neil from Lake Street Capital Markets, Jan. 12, 2023, Equity Research report

“We are encouraged by ATEC’s decision to execute on these transactions and expect they will support the company’s objectives of reaching positive adjusted EBITDA in 2023, $80M in adjusted EBITDA in 2025, and cash flow positivity in 2025.” – Cowen Analysts, Jan. 26, 2023, Equity Research report

This would require current Sept-LTM revenues to continue growing at a ~20% annualized rate until 2025, and for a company that has reported a net loss every year in the past 15 years, this goal is highly unlikely to be met. Historically, the revenue growth has not supported bottom line improvement. Gross margins are in line with other peers in the space, but operating expenses continue to be an unsustainable % of revenue with TTM operating expenses hovering ~113% of revenue. This represents a 10% increase from FY18 when operating expenses were 110% of revenue. Most of the operating expenses can be attributed to SG&A expenses that in the TTM were ~89% of revenue, which is flat from where it was three years ago in FY19 at ~90% of revenue. Although ATEC has been able to aggressively grow their topline, the quality of revenue is low and such growth is not reflected positively in the bottom line. Digging further into historical SG&A spend, the average SG&A cost from FY14-FY18 was 66% of revenue, which declined at a 12% annualized rate during the same time period. Then, in Oct. 2017, Patrick Miles was appointed as Executive Chairman and subsequently CEO in Mar. 2018; from that point on, Miles was able to lead the company to its moderate double digit revenue growth, but it wasn’t without any downsides. Average SG&A spend as % of revenue in FY19-Sept-TTM shot up to 91%, a 25% increase from the 66% during the FY14-FY18 period. Further diligence into NuVasive’s lawsuit against Patrick Miles, ATEC and certain distributors show evidence that independent ATEC distributors were generating higher revenues on the basis of being paid much higher commissions, all the while actually losing business with some of their biggest clients (see the below filing from the Misty Deck Amended Expert Report dated March 15, 2021 – Exhibit D-10 in NuVasive, Inc. v. Day).

As it appears, sales post-switching from NuVasic to Alphatec dropped sales by ~57% from ~$950K per quarter to just ~$540K per quarter.

In further court filings, the Paul Dopp Expert Report dated January 30, 2020 (pg. 14-15) details Absolute Medical Systems sales dropping ~50% from $8.0M/$5.5M per annum in 2016/2017 to $2.6M/$2.8M in 2018/2019:

Considering all of this, ATEC’s largest driver of pricing in growth may ultimately prove to be the result of artificially inflating sales through heavily incentivizing distributors. So it would seem extremely unlikely for the scenario that ATEC can maintain its tremendous revenue growth that comes off the back of higher commissions while trying to achieve profitability. There then remains the question of why these “independent” distributors would choose to sell a subpar product for ATEC that erodes their sales if not for more financial gain than just higher commissions.

Low Quality Products

ATEC prides itself on a broad portfolio of products that constantly have new additions, with 18 new products in 2019, 9 new products in 2020 and 13 new products in 2021. One of its core products, the SafeOp Neural InformatiX System, was developed with electromyography (“EMG”) and somatosensory evoked potentials (“SSEP”) to deliver real-time, actionable information pertaining to the location as well as the health of nerves at risk during surgery. There was a graduate paper published in 2018 titled “Evaluation of Perioperative Peripheral Nerve Injury in Cardiac Surgery Using a Novel Automated SSEP Monitoring Deice” that details technical problems arising from the use of the Neural InformatiX System. It was reported that ATEC’s product only had an 11% specificity rate, indicating a high probability of false positives. This rate of detection is detrimental to a process defined to provide actionable information; to give ATEC some benefit of the doubt, the study was published two months before FDA approval of the product so there is the unlikely possibility ATEC made incredible improvements after the study.

Moreover, FDA filings in Q2’21 (that ATEC has not reported in its own SEC filings) showed 29 products with class II recalls pertaining to its Insignia Anterior Cervical Plate System that was brought to market only a year ago. Within these filings, ATEC cited a “potential for the screw blocking mechanism on the anterior cervical plate system to disassociate intraoperatively/postoperatively or unlock postoperatively”.

These recalls were later terminated in Nov. 2022, taking more than a year and a half following the initial recall date in Apr. 2021. Despite the termination however, a search on FDA’s Manufacturer and User Facility Device Experience (“MAUDE”) database shows that a similar problem still occurred recently in Dec. 2022.

This report is in addition to the 411 other reports citing adverse effects from ATEC’s products that have been sent into MAUDE since Jan. 01, 2018. Here are some further reports point to ATEC’s products’ ineptitude:  

ATEC’s products have exhibited a pattern of low quality and a questionable safety profile time and time again with no improvement, which raises the question of what exactly is driving this level of revenue growth?

Management Problems

ATEC’s current executives have found their way in and out of their roles in a peculiar way. Patrick Miles, current Chairman and CEO of ATEC was previously an ex-executive at NuVasive before joining ATEC in Oct. 2017. This eventually led to multiple lawsuits, including one against Miles for violating his non-competition and non-solicitation obligations to NuVasive. Additional legal action was then taken against certain disbtributors (mentioned more in detail later) for allegedly breaching contract and displacing the distribution of NuVasive products with ATEC’s. What is more interesting is that during his tenure at NuVasive, Miles strongly turned down the opportunity to acquire ATEC with court filings revealing his thoughts on potential acquisition (see exerpts below):

“[…] waste of time as far as I am concerned” while referring to ATEC as an “aged, undifferentiated portfolio”. – Sourced from NuVasive, Inc. vs. Patrick Miles court document

This calls into question whether Miles believed in ATEC’s future or if he had only joined the company for short term financial gain. Most recently, the sign of the times has come as Miles begin to sell his shares, with ~$4.8M worth of shares sold in the month of Jan. 2023 alone. The last time that Miles sold ~$2.4M worth of shares in May 2022, ATEC dropped ~22% within a month and a half.

Furthermore, ATEC has swapped between three different auditors now, with the first change in Aug. 2017 replacing Ernst & Young with Mayer Hoffman McCann and then in Apr. 2021 switching over to Deloitte. Apr. 2021 also happened to be the month that former CFO Jeffrey Black resigned from ATEC. This happens to coincide with the month of ATEC’s unreported recalls of its Insignia Anterior Cervical Plate System that will be detailed below (sourced from FDA Medical Device Recalls Database).

Risks to the Bear Case

The obvious risk to the bear case is that growth continues, there is marginal improvement in EBITDA because there is easy wood to chop.  Growth continues to outshine profitability for the investor base as the narrative shifts back and forth. 

Conclusion

With all things considered, ATEC products have shown time and time again to be defective, and despite the high revenue growth that may be driving the stock price up, bottom line profitability remains a major concern. ATEC will need to actively compete alongside bigger players such as Johnson & Johnson, Medtronic, as well as NuVasive, all the while trying to reduce costs without applying a major shock to revenues. With its current business model however, ATEC seems to be stuck in a vicious cycle of burning through cash to prop up revenue metrics only to require more cash (see ATEC’s new term loan for $100M in Jan. 2023, leaving them at ~$206M cash balance). In due time, ATEC will burn through more cash than they can raise and without a history of ever being profitable, there are no indications that it has the ability to successfully reduce cash burn through organic growth. 

Catalyst

- Earnings revision