Description

Note: A number of pictures including deposition excerpts don't show up well on VIC -- a word version with pictures can be downloaded here: 

https://drive.google.com/file/d/0B6RZm3GPDn8nZHJZZk1vYzllRjg/view?usp=sharing

Globus Medical (GMED) makes commoditized implants used in spine surgeries. The spine industry is characterized by slow growth, intense competition, and low barriers to entry. GMED’s products are largely undifferentiated and overpriced and we believe its industry leading margins and ROICs are at risk given pressures on hospitals to reduce costs and potential reimbursement reform.

There are a number of questions around how ethically GMED’s products are marketed, the financial impact of a related party who constitutes 20% of COGS, GMEDs internal financial and regulatory controls, the CFO’s abrupt resignation, insider stock sale timing, etc. Finally, we believe management has been misleading investors and the sell-side about the health of the core business following a significant revenue guidance cut in the second quarter of 2014. The street has been led to believe organic pricing got 2-3% worse, we believe it actually got 5% worse (we “believe” because of sworn depositions we’ve found which are included in the appendix – it appears either management is misleading investors or the distributor is lying in a sworn statement about what his own sales are).    

Key Thesis Points (discussed below) – we’re going to focus first on the core business economics which we think are struggling, and at the end discuss a few of the ethics/credibility issues we find concerning 

1)      Spine is a slow growth industry with commoditized products

2)      GMED’s margins and ROICs are unsustainably high

3)      A change in industry structure is increasing pricing pressure on the business

4)      Large competitors are no longer market share donors in Spine

5)      There are quite a few questions surrounding management’s ethics

Catalysts:

·         Pushback from hospitals on GMEDs implant pricing

·         Potential reimbursement reform

·         Intensifying competition

·         Legal remedies

·         Investors realizing the core business declines are much worse than they’ve been lead to believe 

Valuation:

At 24x consensus 2015 earnings for at best low double-digit EPS growth in the bull case, we think this is an attractive entry point for a short position. If pricing pressure continues, we think GMED could earn $0.85 in 2016 (25% below consensus) which at 15x would be a <$13 stock, down 47%.

Business Overview

GMED makes hardware including screws, rods, and spacers used in spine surgery. They are the 5^th largest player in the global spine industry with 5% market share. GMED designs and engineers the implants, outsources manufacturing to 3^rd parties, and then distributes their products using both a direct sales force and external distributors. 90% of sales today are in the US.

“A pedicle screw is the same across all vendors. We don’t care who it’s from at all…There is nothing unique about Globus’s products” – Orthopedic Surgeon

“A typical pedicle screw costs us $80 to make and we sell it for anywhere from $600 to $2,600” – A new competitor in spinal implants

“We experienced an uptick in pricing pressure during the quarter increasing from the low to mid single-digits to the mid single-digits…Hospitals continue to aggressively manage implant costs through contract negotiations. We are able to mitigate this pressure to some extent by shifting the mix towards new and better technology, but the decline in prices negatively impacts our results” – Dave Demski, GMED President, 2q14 Earnings Call

“Historical design methodology and testing practices may challenge your ethics…[GMED] hasn’t gone through the regulatory revamp many bigger companies had to. Someday a serious product event with legal ramifications will occur, practices will be exposed…” – Glassdoor review from a former employee

1)      Spine is a slow growth industry with commoditized products and low barriers to entry

·         The $10bn global market for spinal implants has been flat over the past few years as low single digit pricing declines offset modest procedure growth

·         Doctors confirm that products are commoditized with very little differentiation among vendors – screws are pretty much all the same, as you might expect. Some companies in the space (we’ve heard NUVA for example) bring innovative solutions to doctors. Nearly every doctor we’ve spoken with says Globus’s products are basic and commoditized. Globus’s own distributors will tell you the same thing

·         Barriers to entry are relatively low. Patents exist but mainly on unique feature such as a screw cap and many of these can be worked around. GMED itself was founded when the current CEO left Synthes’ spine division in 2003 and copied Synthes’ product portfolio  

·         There are 2 types of approvals for new products in spine

1) a PMA application

2) a 510(k) clearance

Most products in spine are approved via a 510(k) clearance, which is granted if you can demonstrate your product is “substantially equivalent” to a previously cleared device. 510(k) approvals only take 3 to 12 months

·         The real barrier here is the sales rep’s relationship with the doctor. The rep is in the operating room during the surgeries and is often very close with the doctor. As discussed in more detail below, we believe Globus had historically established and grown its business by being more aggressive in their consulting arrangements with doctors (and in many cases actually giving doctors GMED stock to use the products). Regulation has cracked down on this “pay to play” type of arrangement which we believe will make it increasingly difficult for Globus to grow

·         Also, sales reps and distributors are loyal to whichever vendor pays the highest commissions

2)      Margins and ROICs are unsustainably high

·         GMED does 77% gross margins (discussed below why that could be artificially inflated by a related party supplier) and 35% EBITDA margins. ROIC in 2013 (pre-tax EBIT / invested capital) was 68% and if we exclude the goodwill from deals they have done, ROIC was 85%

·         We’ve heard from hospitals and surgeons that GMED’s list pricing is well above competitors and we estimate GMED prices are ~20% higher than peers, although we heard up to 75% in some specific cases

·         Given the lack of R&D and capital to create a new product and the high margins, we’ve heard of some 3^rd party manufacturers who have decided to cut out the Globus’s of the world and partner directly with 3^rd party distributors to sell their products. It’s not a huge piece of the thesis here, but the threat of new/unbranded entrants seems to be in the very early innings. We spoke with one specific 3^rd party manufacturer who used to supply to Medtronic and Depuy-Synthes but has recently started forming his own relationships with distributors because the economics are so compelling

3)      Pricing pressure will erode returns

Shelf pricing models significantly hurt implant vendors

·         Historically, spine vendors have negotiated separate rates with hospitals which has resulted in Hospital A paying a different price per screw than Hospital B. And even within Hospital A, a Globus screw can be a very different price than a MDT or NUVA screw. We heard up to 100% difference from one hospital

·         But hospitals are moving to a shelf-pricing model where all vendors must meet a price ceiling to be used. Essentially the hospital goes to all of the vendors and says “we will pay $500 per screw, take it or leave it.” Given the substitutability across vendors, this is an effective approach by hospitals. We estimate only ~25% of hospitals have moved to a model like this so far and the trend is accelerating

·         Given that GMED is on the higher end of pricing, they have a long way to fall as hospitals implement shelf-pricing

Reimbursement reform could accelerate pricing pressure

·         Today, Medicaid/insurers write two separate checks to reimburse a spine surgery: one to the doctor and one to the hospital. The doctor gets paid the same amount no matter what the cost of the implants are as the hospital pays for the implants out of its reimbursement check. Thus the doctor is price insensitive

·         Obamacare is testing a bundled reimbursement model where hospitals and doctors receive one bundled payment that will be used to reimburse doctors, vendors, etc. This forces hospitals and doctors to work together and reduce costs and will squeeze the implant vendors

·         Previous trials of bundled pricing in cardiac and joints have confirmed that implant vendors feel a lot of pressure when the model changes

·         Current ACA programs are still in trial phase now and we haven’t gotten any conviction on if this will play out

·         Additionally, spine surgeries are very lucrative for hospitals and surgeons. We think hospitals make 30% - 50% more on a spine surgery than they do on a joint surgery after the cost of implants. Thus spine is also a target for Medicare / insurers.  While we don’t have any visibility on this, it seems logical that in a world of rising healthcare costs spine could face sweeping cuts

Pricing pressure is starting to impact the business, yet the market does not seem concerned 

·         Pricing pressure has intensified in the last 2 quarters for Globus and some of their peers

·         For Globus, pricing had been down low to mid-single digits throughout 2013 and in Q1 14 (Most device companies give pricing qualitatively and quote it on a same product basis, so excluding the impact of any new higher priced products). On the Q2 2014 call in August, GMED President David Demski said:

o   “We experienced an uptick in pricing pressure during the quarter increasing from the low to mid single-digits to the mid single-digits.”…“Hospitals continue to aggressively manage implant costs through contract negotiations. We are able to mitigate this pressure to some extent by shifting the mix towards new and better technology, but the decline in prices negatively impacts our results”

·         JNJ has reported similar pressure recently:

4)      Large competitors are no longer market share donors in Spine

·         In April 2011, JNJ (21% market share in Spine) announced that they would be buying Depuy-Synthes and the transaction closed in June 2012. The merger of two of the largest salesforce in spine created a lot of disruption as most mergers involving large salesforces do. GMED benefited extraordinarily from this (management acknowledges this) as the GMED CEO, David Paul, came from Synthes. JNJ/Synthes was a massive share donor in Spine in 2012 and 2013, and finally returned to growth in 4Q14:

·         Commentary from other competitors like Stryker, Zimmer, and even Medtronic suggest they are all re-investing in their Spine businesses and launching new products to gain back market share

5)      There are a number of questions surrounding the company’s ethics

Globus is a controlled company exempt from normal corporate governance and where the founder and CEO David Paul controls 79% of the voting power. This list is by no means exhaustive, we continue to discover more information that makes us question the company and management team, but as a start:

·         Surgeon ownership – Multiple surgeons (usually through their wives), distributors, and their family members owned stock in the company pre-IPO. This is very concerning and we believe could be a key reason why Globus has been able to outgrow its peers in the past. See Exhibit 1 below for more detail

·         Aggressive selling tactics – We have heard from surgeons that Globus has been one of the more aggressive players in terms of pushing consulting agreements to get their products used. To be fair, this all seems within the legal boundaries and the latest Sunshine Act data (released September 2014 and is supposed to show all payments from vendors to doctors) does not show an outsized amount of payments from Globus to doctors in 2013. We hypothesize regulation like this has forced Globus to clean up its act which has partially contributed to the recent slowdown but also understand a lot of this still goes unreported

·         Ethical complaints from former employees– While you can never expect glowing reviews from ex-employees, the reviews on Globus are overwhelmingly negative (more so than their peers) and strikingly consistent in their complaints of unethical behavior and nepotism.

o   From an ex-Globus engineer on working at Globus: “Globus can be a good place to work if you can keep your moral compass in line while you’re there. But after that you can’t go to Synthes, Depuy, or any other reputable company…Globus is a real taint on your resume.”

o   The glassdoor.com reviews are a good place to start to get a flavor and http://spineblogger.blogspot.com/ is an industry blog that gives some interesting commentary on the space and Globus’s actions over the years. Clearly all opinions/biased but former employees independently referred us to this blog for more color on what goes on at the company 

·         Related party supplier – 20% of COGS come from a supplier that is 47% owned collectively by David Paul’s wife (GMED Founder, Chairman, and CEO), David Davidar’s wife (SVP Operations), and David Demski (President and COO). David Paul was the CEO of the supplier until March 2009 and was a director of the supplier until February 2010. David Davidar served as secretary, treasurer, and director of the supplier until February 2010. David Demski was also a director of the supplier until February 2009. Today, David Paul and David Davidar’s wives still serve as directors of the supplier

o   The disclosure of the related party relationship has been a source of tension between the SEC and GMED as GMED has been reluctant to include all of the appropriate disclosures. It is worth going back through the SEC correspondence. In the original 2012 10-K GMED did not include the ownership detail of the related party. The SEC then instructed them to and GMED filed an amended 10K with the appropriate disclosures (Item 13 in the amended 10K)

o   What is puzzling here is that while pricing is down ~5%, gross profit margins have held up. Upon closer look, the COGS from the related party supplier have declined on a dollar basis in 4 of the past 5 quarters. See exhibit 2 for more detail

·         Insider selling…ahead of a weak quarter/material event – Q2 2014 was an objectively bad quarter for Globus as the pricing pressure got worse and they lost a distributor. The CFO exercised and sold $735k worth of options on May 2, 2014. The stock was down 18% on the announcement yet Globus claims they did not believe this was material

o   From the 8/12/14 report by William Blair after traveling around with the GMED management team: “We believe Mr. Baron was genuinely unhappy with the perception that he executed his small stock sale knowing that second-quarter results were soft; he insists that he did not know that the quarter was developing poorly.”

o   We now know that the lost distributor was Vortex Spine LLC, and court documents reveal Globus sent the distributor an official termination notice on April 18, 2014…

·         Abrupt CFO Departure – Along with the (good) 3^rd quarter results on October 30^th, Globus announced that CFO Rick Baron would be stepping down as CFO. This came out of left field and Rick is officially no longer the CFO just 3 days later on November 3^rd. David Demski the current President and COO will step up as interim CFO. From the call, it does not sound like Rick is retiring but will be looking for another job.

·         Disregard for FDA approval processes – Globus launched their first biologics product in 2007, called “NuBone” (bone graft product). According to the FDA, NuBone was never approved

o   In March 2008, the FDA notified Globus it must seek a 510(k) clearance for NuBone

o   Globus waiting until January 2009 to submit their 510(k) to the FDA, and the FDA declined to clear the product

o   In December 2009, the FDA sent a letter to Globus demanding that Globus stops selling NuBone

o   Globus ignored the letter and continued illegally selling NuBone

o   In an FDA inspection of Globus in September 2010, investigators learned Globus continued selling NuBone and Globus finally discontinued it

o   The FDA fined Globus $1m including a $450k fine for David Paul, and the product finally got taken off the market. See the FDA release here (court documents on Pacer are also enlightening):  http://www.fda.gov/NewsEvents/Newsroom/PressAnnouncements/ucm293745.htm

·         Questionable founding circumstances – Globus founder and CEO David Paul left Synthes in 2003 to start Globus and according to Synthes, copied a number of key patented products. So far Globus has been ordered to pay $16m to Synthes for the infringement.

o   GMED claims this judgment will not impact future results but we are not so sure. From GMED’s June 17, 2013 press release following the verdict that GMED’s products do indeed infringe upon Synthes’ patents: “Globus Medical does not expect the verdict to impact its ability to conduct its business or to have any impact on its future revenues. As this lawsuit involved only three products that are no longer part of Globus Medical’s product portfolio, this verdict will not impair the company’s ability to sell any of its current products and will not require any royalty payments to Synthes based on current or future sales.”

o   However, after the judgment, Synthes filed for an injunction against Globus claiming they are still selling these 3 products. These products specifically are “COALITION”, “INDEPENDENCE”, and “INTERCONTINENTAL” which you can see are currently still listed on the product section of Globus’s website as well

o   According to Globus’s 2012 Prospectus, COALITION alone represented 11% of sales

o   This may sound like your typical IP dispute, but people in the industry including doctors and ex-employees say this was a particularly unsettling event that left a bad taste in many people’s mouths

The most disturbing example is that Globus appears to be misleading investors about the size of a lost distributor to mask the pressures in the core business

Background / management’s story:

·         Q2 2014 was an objectively weak quarter for Globus as sales grew 6%, well below the historical double digit levels and below expectations. On the call, management cited 2 reasons for the slowdown:

o   “Domestic sales growth in the quarter was below our historical standards. This was primarily the result of two factors. First, early in the quarter, we made the decision not to renew our existing contract with a significant U.S. distributor, negatively impacting our sales. Second, we experienced an uptick in pricing pressure during the quarter increasing from the low to mid single-digits to the mid single-digits.” - GMED President Dave Demski

·         As a result, Globus took down their FY14 revenue guidance by $20m. On the call, Globus refused to give any detail about the size of this lost distributor. The sell-side’s math was that if US pricing has deteriorated ~2-3% more than anticipated (‘low-mid single digits’ to ‘mid single digits’) that would be $6-9m over the remaining 9 months of the year.  Which would means the distributor accounted for $11-14m of the reduction in guidance over 9 months, or would be $15-19m in annual revenue. We understand that in conversations with investors and sell-siders following the quarter, management hasn’t given the number outright, but has implicitly blessed this math that the distributor was between $15m - $20m of annual revenue with comments like “closer to the $15m end of the range.”

·         Published sell-side notes following GMED’s Q2 earnings mostly reference the $15-$20m of annual revenue lost from the distributor and multiple sell siders have told us they feel confident that is the right range.  They have told us it is clear from management discussions that it is not much lower, if the number did prove to be as low as $7m that would be significant, and would indicate a real credibility problem

o   Brean Capital recently initiated on GMED with a buy. Presumably after speaking extensively with management, they said the distributor was $16-$18m in annual sales: “Early in 2Q14, the company decided to end a relationship with one of its Gulf Coast distributors, and as two year non-competes have become industry standard, replacing that distributor will take time forcing the company to lower its estimates for F2014 by $12 million ($20 million including a price drop)—implying an $16-18 million annualized impact”

o   After hosting the GMED management on Nov 7^th, BAMLs upgraded and believes the distributor loss was very material. Their piece said: “GMED's Q3 was stronger than it looked, in our view. GMED grew revs 10% in Q3 (up from 6% in Q2) despite what we think was about $2mm less revenue sequentially from the lost distributor.

The distributor actually does $7m in annual sales, not $15-20m, which indicates organic growth has gotten much worse than management is leading investors to believe:

·         The lost distributor is a company called Vortex Spine LLC. Court documents from the lawsuit between Globus and Vortex show that Vortex’s is a tiny distributor in New Orleans with annual revenue of only $7m and only 4 total sales reps. The distributor relationship was terminated on April 18^th, 2014 (so the BAML math of $2m of lost sales in those 18 days would imply Vortex did $40m of sales annually)

·         See Exhibit 3 for the relevant excerpts from the court documents.  In a deposition taken from the owner of Vortex spine, he clearly states his revenue was about $7m in each of 2011, 2012 and 2013. The case also makes it very clear that Vortex had only 4 total sales reps

·         It is important to note here that while the sellside is aware of the lawsuit between Globus and Vortex, they have not discovered these publicly available documents and continue to believe management’s story

·         $7m is materially different than the $15-20m annualized investors were led to believe, which speaks to the credibility and intentions of this management team, and means organic revenue declines behind the revenue guidance are significantly worse than investors were lead to believe 

·         If the distributor actually only does $7m in annual revenue as per the court documents (or $5.25m for 9mo of the year), that means that $15m of the $20m rev cut was “organic / price” pressure, which means price pressure really increased by 5% in the US when they cut guidance (not 2-3% as management says).  That, or there is some other material worsening of the organic business management has decided not to discuss

Implications / Questions:

·         Why is management misleading investors about a clear factual question?

·         What is actually going on in the core biz that caused it to deteriorate much worse than management has discussed? 

Risks to the short

·         Capital deployment – Healthy balance sheet with $350m ($3.60/share) in net cash

·         Takeout – The broader device industry is consolidating. We would argue that spine is not an attractive space within devices, the large players are currently busy integrating recent acquisitions, GMED doesn’t have many unique products to offer bigger players who are already in Spine, and given the number of questions surrounding GMED’s ethics we think it is unlikely any legitimate company would want to buy them

·         PODs (Physician Owned Distributors) – Spine is a dirty industry in general and GMED is not the only one who is aggressive. PODs (Physician Owned Distributors) are distributors owned by the doctors that use the products.  The doctor can get wholesale products with a different SKU number (though substantially similar to other products), he can demand to use this SKU, which is only available from his distributor at a high price.  Since the device is reimbursed separately from the doctor, he or she can make more money per surgery by also taking a markup on the device.  PODs are estimated to be 10-15% of the market and some efforts have already been taken by the OIG and hospitals to ban these, but there could be more market share up for grabs as PODs get shut down

o   We take some comfort from the DOJ initiative on PODs being over a year old, HCA banned PODs a year ago, so the impact of potential market share coming up for grabs as PODs are phased out should already be reflected in growth (which is slowing)

·         Large addressable market – GMED competes in a large TAM, though that TAM is not growing. GMED has increased market share from <3% in 2009 to 5% today, and is still only doing 475m of rev in the $9bn spine market

·         International expansion – GMED’s international business is only 10% of revenues but grew 25% last year. There could be more opportunities to expand their TAM internationally

Exhibit 1 – Historical surgeon and distributor ownership in Globus is concerning:

From the Aug 2012 GMED prospectus:

You can also download the 2007 GMED Voting Agreement here, which includes a more comprehensive shareholder list. This list is fraught with surgeons and distributors:

http://www.sec.gov/Archives/edgar/data/1237831/000119312512216517/d319036dex102.htm

Exhibit 2 – Recent economics leave unanswered questions which do not sit well with us given management’s history, the related party supplier, and the abrupt resignation of the CFO:

Notes / Questions

1)      Pricing pressure – has gotten worse. Now down mid-single digits versus low to mid single-digits, according to Globus

2)      2013 Gross Profit – was dragged down 170bps due to the medical device excise tax

3)      2014 Gross Profit – How is GP in 2014 holding relatively stable when we know pricing is down mid-single digits?

4)      Related party COGS – Is it a coincidence that the COGS from the supplier in which the wives of David Paul (Founder, CEO), David Demski (President, COO, Interim CFO) and David Davidar (Senior VP Operations) sit on the board and own 47% declined in 4 out of the past 5 quarters?

a.       Potentially a private related party manufacturer could lower prices to GMED, shifting profit out of the private company into the public company that has to report and guide to earnings

5)      SG&A­ – How are SG&A dollars roughly flat when sales are growing? (the majority of SG&A is commissions to sales reps and distributors). Is GMED kicking the can down the road by reducing commissions in order to save profitability today?

When slashing revenue guidance 4% in 2Q14, GMED maintained earnings guidance, which is unusual.  We are concerned GMED could be using short-term levers in sales and marketing or related party COGS to prop up earnings, potentially to the detriment of the business going forward. 

Related Party disclosure from 2012 Prospectus:

Since 2005, we have contracted with a third-party supplier that manufactures certain products for us. The supplier previously supplied us with certain products pursuant to a Supplier Quality Agreement dated November 10, 2005. In September 2010, we entered into a new three-year Supplier Quality Agreement on an arm’s-length basis, pursuant to which we purchase products and services from the supplier from time to time. During 2009, 2010, 2011, and the first three months of 2012, respectively, we purchased $13.6 million, $12.0 million, $17.7 million and $4.6 million of products and services from the supplier.

As of March 31, 2012, David C. Paul’s wife, David D. Davidar’s wife, and David M. Demski collectively owned approximately 47% of the outstanding stock of the supplier. In addition, until February 2009, Mr. Demski served as a director of the supplier. Mr. Paul served as the president and chief executive officer of the supplier until March 2009 and as a director of the supplier until February 2010. Mr. Davidar served as the secretary and treasurer and as a director of the supplier until February 2010. Since February 2010, Mr. Paul’s wife and Mr. Davidar’s wife have served and continue to serve as directors of the supplier.

Exhibit 3 – Court documents reveal that the lost distributor in 2Q14, Vortex Spine LLC, contributed only $7m of annual revenue, materially lower than the $15-$20m that management has led investors to believe

You can download all of the court documents from the case at this site. The most relevant documents is:

·         21-1: Memorandum of Law in Support of Plaintiff’s Motion for Sanctions

http://www.lawsuitdata.com/lawsuit-data/natures-of-suit/contract-lawsuits/other-contract/pennsylvania-eastern-district-court/0000644768/globus-medical-inc-v-vortex-spine-llc-et-al/officially-filed-court-documents/

Highlights:

I)                   pdf page 18 of document 21-1. Testimony of James Long, owner of Vortex Spine LLC, in which he clearly states that Vortex did $7m in annual sales in each of 2011, 2012, and 2013              

II)                 pdf page 120-121 of document 21-1. Testimony by Vortex’s office manager Vanessa Lirette who says Vortex employed 3 reps (in addition to the founder James Long). At its peak Vortex only had 5 total employees including the office manager. The last time Globus disclosed their rep count was for 2011 when they had 336 total reps in the U.S. (including distributor reps). With $311m of annual U.S. Revenue in 2011, that implies the average rep did <$1m in revenue. Thus it makes sense that a 3-5 rep operation would only do $7m in sales, not $15 - $20m as management wants people to believe

III)              pdf page 300 of document 21-1. The interrogatory of James Long in which he was required to list all individuals associated with him and his business.  Again, only 3 employees/contractors listed – Pat O’Hara, David Cliburn, William (Wes) Schaeffer.  Again, it is inconceivable that a 4 employee distributor (these 3 plus the founder James long) could do more than the $7m in sales he testified to.

IV)              Document 1-0 (Globus’s complaint against Vortex). This document clearly states that the distributor agreement was terminated on April 18^th

Catalyst

Continues industry pressure, renewed pressure from competitors no longer donating share

Potential related party problems

Organic growth is less than perceived -- will become clear this year when phony distributor explanation laps, or may cause real credibility problem earlier if inconsistencies between mgmt's explanation and the sworn deposition we found come to light.