Description

Integer (ITGR) is an acyclical “compounder” with unchanged post-Covid growth prospects that is down 30% since its February highs vs. the IWM which is up marginally.  The company makes highly engineered components & subassemblies that are used in medical devices.  This is not a contract manufacturer - the company has 20%+ EBITDA margins and has over 600 patents.  The stock trades at an attractive absolute valuation and a very large discount to many of its competitors who have been recently acquired.  In August, the CEO transacted his first buy in over 10 years as a public company executive.  A week ago, he bought more.

The opportunity exists because:

• 3 analysts covering it (Sidoti, Benchmark and Keybanc)

• No pure play public comps; private comparables taken out at several turns above ITGR’s valuation

• Poor execution by prior management led to underwhelming growth - this is now fixed

• Less than 2% hedge fund ownership and nearly 40% passive ownership

• Temporary weakness in its end markets that have returned to growth; ITGR recovers with a lag

• Long-cycle time to revenue;  customer design wins take 2 to 3 years (and sometimes longer) to result in material manufacturing revenue.

• An immaterial (but public) customer loss than is less than 3% of revs and of unclear magnitude, 3+ years away

We have two legs to our thesis.  The first leg should result in 30-45% upside over the next few months as the business returns to growth.  The second is that the company is well positioned in a structurally growing space and, with the upgraded management team in place, should be able to grow revenues high single digits with low teens EBITDA growth for a very long time with minimal macro risk.  In the second scenario, the stock has the potential to triple over the next several years. There is also a good chance the company is taken out before either scenario plays out, though we’d prefer the company to remain public and to participate in its growth as long-term shareholders.

We are structuring this write-up to quickly highlight the short-term opportunity, and go into more detail on the business and longer-term thesis in the second section for those interested in the longer term bet.

Basic business overview:

Integer makes a variety of highly engineered components that are used in the production of medical devices that largely support life saving medical procedures (roughly 75% of the business). The company breaks out the components it makes into 2 key areas:

Cardiac / Neuromodulation:  This business makes implantable batteries and pulse generators that are used in pacemakers, ICDs, CRTs, and other devices that are implanted in the body to support heart function.  You are going to be hard pressed to find another product that needs to work as reliably as these.  The batteries need to last years in the body (often 10+) without needing to be recharged, and the pulse generated directly supports and affects heart function.  The company makes capacitors, implantable batteries, lead systems, feedthroughs and enclosures - basically every electronic component needed to manufacture these devices.  They serve all the big 3 medical device companies and the vast majority of companies making implantable heart devices.  They also serve the fast growing Neuromodulation space, including companies like Nevro, Silk Medical, and Inspire Medical.  Although Integer has some very limited competition from other component outsourcers, their primary competition is in-house production at Abbott, Boston Scientific, and Medtronic.  Despite having some in-house capabilities due to patents and technical complexity, Integer manufacturers the majority of components for the medical device industry in these areas.

Cardio & Vascular: This business primarily makes medical devices used in procedures in blood vessels, components to full assemblies such as guidewires, catheters and introducers. The subassemblies / component work that Integer does are a small portion of total product COGS but critical pieces to deliver the therapy, creating further price insensitivity. For example, the guidewire is inserted through potentially multiple feet of blood vessels in vascular surgery to become the rail along which the entire primary device -- catheters,  coils,  etc -- can be navigated to the affected site. There is less IP in this business than CRM/Neuromodulation, but is replaced with an equal or greater amount of manufacturing and design know-how. In this business we have heard of unusually close customer relationships with R&D & go-to-market teams, in everything from intimate early-stage prototyping with R&D to helping go-to-market teams troubleshoot their in-house manufacturing issues -- a testament to the respect they command in this segment. Integer competes with a different set of tiny companies in each component, but the only competition at scale for component + sub-assembly work in this space is Creganna (TE Connectivity) and Vention (Nordson).

The company also has a small non-medical (Electrochem) and more elective driven procedure business (AS&O), but both of these are immaterial and not worth discussion.

Thesis Leg 1: 30-45% upside, next 3-9 months:

The products Integer makes are typically acyclical - people who are suffering from life-threatening issues related to heart failure or vessel blockage come into the hospital.  For a short period, Covid changed that.  In Q2, the medical device industry declined over 30%.  Product categories for electives like spine products and hip implants declined more, but even mission critical medical devices (outside of respiratory) declined upwards of 20%.  Further, medical device companies were slow to reduce manufacturing as they did not believe that many of the critical medical devices they made would see a dip in demand.  This resulted in Integer outgrowing their end customers in Q1/Q2 as production exceeded demand, only to now lag their recovery in Q3 and Q4 as excess inventories bleed off.  Integer to its credit has actually explained this issue pretty clearly:

The company’s analysis matches up directionally with our own.  We looked at the company’s two main segments (Cardiac, Cardio & Vascular).  We then backed out a one-time revenue headwind related to Nuvectra and benchmarked Integer’s growth with their primary customers on a revenue weighted basis in those same categories.  The results are similar:

All these customers have guided flat-to-growing sales in Q4.  Despite their end markets recovering, ITGR is still working off the balance of inventory overbuild in the pandemic.  The company believes that this inventory will be worked off by Q4 and that they will return to industry growth levels in Q1 21.  Our view is that ITGR’s customers will overcorrect inventory post Q4, ending the year with less inventory by Q4 than they had pre-pandemic despite having a higher revenue base.  We think this may lead to Integer outgrowing the market in 2021 (assuming no share gains) as medical devices manufacturers rebuild inventory levels to normal. Below we calculate excess inventory / inventory shortage which based on guided industry growth suggests a modest inventory build will be necessary next year which should drive ITGR’s growth above industry levels, assuming no change in mkt share.

ITGR stock has materially underperformed its key customers* stock prices over the last several months as end customers have seen their business return to normal but ITGR is lagging in revenue recovery due to the issue described above.  As their revenue performance converges we expect stock performance to converge as well.

*Note we replace Abbott (a customer) with Edwards (an emerging customer) given Abbott’s stock price has benefited from their test business, whereas Edwards is pureplay med device. This chart is current as of 11/12/20.

Thesis Leg 2: 100%+ upside over next several years:

Over the next several years we expect ITGR to be seen as a “compounder” in a structurally growing space run by an excellent management team that can sustainably grow revenues single digits, low teens EBITDA growth and mid-teens EPS growth for a long time.  

Compounder is an overused-term. It increasingly involves paying an absurd price for a business that everyone thinks is good because the stock has gone up a lot and smart people own it.  Although many of these may (or at one point) actually fit the namesake, often a compounder is just a stock that went up a lot that people convinced themselves was a better business than it actually is.  If it is truly a compounder, the multiple ascribed today is often the highest it has ever been.

We define a compounder as a good business in a structurally growing market where we will get paid on consistent EPS / EBITDA growth over a long period of time, even without multiple expansion.  All else being equal, we’d greatly prefer to buy a stock that is not considered a compounder by any other public market participant, doesn’t screen as a compounder because prior growth has been poor, and can subsequently be bought at a lower multiple than many consensus compounders.  In addition to structural EPS growth, we can also make money on multiple expansion as our view becomes the consensus view.

We believe this business fits our ideal setup given the following characteristics:

1. High quality business, indicated by both our own differentiated opinion and prices that others are willing to pay

1. Business fundamentals create a highly sticky, low risk business due to long-tenured customer relationships, high switching costs, substantial barriers to entry, and focus on supplier execution vs. price

2. Private market valuations further suggest high business quality and growth potential

2. Strong structural growth

1. Structurally growing med device end markets

2. Structural trend towards outsourcing driving natural growth above med device end markets

3. Opportunity exists because the company does not screen like a compounder, despite substantial evidence that it is one (due to long business cycle and previous mgmt missteps)

1a) Why we believe this is a high quality business

When we say outsourcing, it’s important to clarify what that means.  This is not a contract manufacturing or “build to print” business.  The big EMS players like Jabil, Flextronics, and Plexus make simple medical products, assemble the printed circuit board, and/or do final device assembly - this area is growing but is generally a much lower margin business with substantial competition.  While Integer has a small amount of this type of business (~15%), they specialized in making highly engineered components and technology that is a core part of the device design, function, and regulatory approval. ITGR typically works hand in hand with folks in R&D on product design, prototyping, FDA approval, and scaling manufacturing.  This process can take from 3-10 years to material revenue depending on the medical device and when Integer wins the business.  There are much fewer competitors in this market.  Most importantly, the decision maker involved in awarding this business (typically R&D) is very different from the one awarding assembly business (procurement).  Having invested in many contract manufacturers over time, the discrepancy in how procurement and customers talked about their relationship with Integer is night and day vs. typical contract manufacturing.  

A few examples:

1. Customers are focused on speed to market more than price.  Being first to market is very important and someone who slows you down / creates delays is going to cost you much more than  the notional amount you may save working with them.  Engineers / project managers are hesitant to switch away from suppliers that have been reliable unless the supplier messes up.

2. Customers almost never dual source products. Because acceptable device failure rates are zero in this industry, OEMs need to spend considerable testing and development resources in ramping a single supplier. Setting up a second supplier significantly slows time to market and increases manufacturing complexity. Further, relatively low manufacturing volumes means concentrating volume in a single outsourcer is important for price. Many customers have tried unsuccessfully over the years to dual source supply. “Dual sourced” supply today typically has a primary supplier with 80-100% of volumes and a backup supplier with little to no volume.

3. These are 70-80% gross margin products for Integer’s customers vs. much of contract manufacturing which supports products with gross margins in the 20s-30s - which means price is just less relevant.  Further, instead of providing a commoditized service (assembly), Integer provides hard to manufacture components with patented IP that are critical to these devices functioning properly.

4. Although it is possible to lose a new product generation, it’s almost unheard of for a supplier to insource an existing product line or switching suppliers while the product is on market.  Engineering resources are limited and are always more valued working on the “next big thing” than doing the engineering work to transfer production and get regulatory approval.  Many of these products have 10-20yr lifecycles which creates a very sticky revenue stream.

5. Effective “buyer” concentration is quite low.  Even though ITGR has 3 big customers that account for slightly over 50% of revenues, they make hundreds of products. The “buying” decision to use a particular manufacturing resource (insource or outsource) is made at local / product level and is actually quite difficult for upper management to change on a structural basis.  We believe that there is only one product that is 3% of revenue, and a handful of products that are 2% of revenue.  Additionally, Integer is usually making multiple components for each product. 

1b) Rich M&A valuations show we are not alone in thinking this is a high quality business:

The business quality we highlight is also well-appreciated by others in the market.  

Many of Integer’s direct competitors have been acquired in recent years for the reasons highlighted previously.   Nordson & TE Connectivity have both been strategics active in acquisitions in recent years and have bought several of the Integer’s primary competitors, especially in the Cardio & Vascular space.  All deals were done at 14-15x EBITDA, with some rumored even higher. We also note that deals of similar financial profile in the highly analogous pharma CDMO space (similar regulatory life-of-product lock-ins, emphasis on speed/reliability to market, etc) have also changed hands in the 12-16x EBITDA range.

Historical transaction multiples for Integer’s current business are around 13x -- including Integer’s own acquisition of Lake Region in 2015 and the take-private of ITGR’s legacy Cardio & Vascular business (Lake Region / Accellent) in 2005. We also point out that Integer trades materially below the divestiture multiple of its inferior-quality AS&O business at 11.5x in 2017.

Meanwhile, ITGR sits dislocated today at ~10x normalized EBITDA today and a 7.5% FCF yield.

2a) Structurally Growing End-Markets

The medical device industry historically and going forward is expected to grow mid-single digits (see pg 13 in this BSX investor deck for a sense of industry estimates by end market: https://investors.bostonscientific.com/~/media/Files/B/Boston-Scientific-IR-V3/reports-and-presentations/bsx-2020-jpm-presentation-final.pdf)

Integer’s integral role in two structurally growing categories - Neuromodulation & Cardio/Vascular -  allow them to participate in market growth.  In neuromodulation, Integer serves many of the largest emerging growth stories in the industry.  In addition to serving the large existing neuromodulation players, Integer also serves more nascent companies like Nevro ($5B cap), Inspire Medical ($3B+ cap), Silk Medical ($2B+ cap) and others projected to grow at fast rates for a long time.  The company has recently begun to give more disclosure around their pipeline and we are optimistic that the company will continue to provide more information like the below as time goes on (presented for the first time in their last earnings presentation).

2b) Structural Trend towards Outsourcing

Across many industries, large technology companies are increasingly becoming design houses and moving away from the physical product production.  While this trend has existed and spread throughout most consumer products, the concept is still in its early days in higher reliability / change resistant industries (namely aerospace, defense, and healthcare).  This has slowly been changing for years and has many more years ahead of it.  Customers and competitors we have spoken to believe this trend should add 2-5% to growth above med device end markets in med device outsource manufacturers (like ITGR) over time. Many of ITGR’s competitors are in fact growing 10%+ today.  There are a few drivers behind this trend:

1. OEM core competency is not manufacturing - outsource manufacturing has long been accepted in multiple industries as having a variety of benefits. Healthcare is no longer an exception. Med device OEMs are refocusing on their core competencies in design and marketing, not manufacturing. 

2. External manufacturers support R&D better than internal resources - in large organizations, production managers are often incented based on reducing cost and producing the products that today generate the most revenue. If I am in R&D or launching a new product, it’s hard for me to get much prototyping / manufacturing support from internal resources before my product is generating a lot of revenue.  Since engineering is compensated and evaluated on new product development and progressing to launch, their incentives are different than their internal manufacturing partners. Internal manufacturing is often structurally unsupportive for product development - thus leading to business being often outsourced.  To get a company to agree to do the early stage engineering / prototyping / development work, that same customer also is awarded the eventual manufacturing contract should the product go to market.

3. Top outsource manufacturers’ know-how and IP creates superior execution over internal manufacturing - these components / subassemblies are highly technical and specialized with a zero tolerance for failure, since death often is the consequence. They are often being inserted in the body, sometimes staying there for years.  Integer has substantial IP and manufacturing know-how it has developed over a long time to serve these markets. Many industry participants point to Integer’s superior reliability, resource availability, and bundling capability that makes life for the project & R&D managers much easier in the go-to-market process. Given the risk averse nature of med device companies combined with Integer’s reputation and experience level, they are in a prime position to grow with their customers.  New competitors struggle to make inroads especially in these more specialized / critical component applications.

3) Why the opportunity exists (why the future is brighter than the past)

Integer does not look like a compounder in large part because of mis-steps, primarily in the Cardiac business, that have hampered growth in recent years.  Prior to 2017, Integer was run by a long tenured founder/CEO who aggressively grew the business through acquisitions.  Management also increasingly upset customers in its Cardiac segment as it grew, namely by launching their own medical device business (Nuvectra) that was competitive with their customers’ products.  We heard during this time that Integer was blacklisted for new business by Medtronic and that Abbott built their own battery factory (10 years in the works) to try to move away from their reliance on Integer.

In 2017, Joe Dziedzic became CEO of the business, and subsequently has refreshed the entire management team.  Feedback from customers and formers have been universally positive.  Customer relationships are the best they have ever been and Integer has seen its new product pipeline grow at the same time it has seen lost programs due to prior customer dissatisfaction fade.  Joe and his team have a target to return the business to growth 2% above the medical device end-markets. This bar seems unheroic given it is set substantially below its private peers, which are growing 5%+ over the med device industry.  That said, growth the past couple years has remained at or modestly below the market, leading to this growth target being seen as aspirational more than realistic.

In short, we believe the company will hit their target within the next 1-2 years, as new business signed since new management’s arrival begins to generate material revenue.  Although Integer sometimes begins a customer relationship 6-10 years before launch and revenue, it most commonly gets involved about 2-3 years before product launch.  Integer does prototyping, designs custom components in tandem with customer engineers, supports the FDA approval process, and ramps to customer launch.  In exchange for this early engineering work, which has minimal revenue contribution typically on a cost-plus basis, Integer is given the manufacturing contract for when the product reaches volume production.  Based on conversations with customers and the company, we believe that Integer is on track to hit these targets even though you can’t see it in their numbers today.

We think Lake Region, now the Cardio & Vascular business, has maintained excellent customer relationships and growth since its acquisition in 2015.  We estimate the business has grown organically at a 6% CAGR, roughly inline or slightly above end-market growth.  Cardiac/Neuro, on the other hand, has grown at a sub 1% revenue CAGR.  We believe the Neuromodulation business with emerging customers has grown from $15 to $50M over this time-frame, implying the core cardiac business has declined low to mid single digits vs. low to mid single digits industry growth.  We expect a combination of improved customer relationships, increasingly pipeline, and end market growth should allow this business to return to growth more in line with the industry.

We would call out 3 tangible sources of incremental revenue that we think will be meaningful towards getting the company closer and above industry growth rates:

1. In the Q3 earnings slide referenced earlier, the company has called out 5 customers that are in the product-launch phase.  The one customer who has already launched is Nevro, who generates roughly $30M in revenue to ITGR today.  On top of that, the other 5 companies are expected to generate 20M in revenue, growing to $40M in 2022 and doubling thereafter.  All else being equal this should add 1-2% to ITGR’s growth over the next several years

2. Based on industry diligence we believe Integer is now working with Edwards Lifesciences on new component outsourcing opportunities.  Edwards did $3.6B in Cardio & Vascular revenues in 2019.  We estimate based on penetration at its top 3 customers that ITGR can eventually capture about 7% of Edward’s product COGS.  This would represent a $75M opportunity for ITGR over the next several years that is purely incremental to its existing business today.  We expect the company to eventually disclose more pipeline metrics to make opportunities like these that are already “baked in” clearer to investors.

3. The sense we have gotten from talking to each of ITGR’s top 3 customers is that the relationship is in a substantially better place than it was 3 years ago, and that this has and will result in greater capture of share within these customers over the next several years.  

Valuation / framing long-term upside:

In the short term, we are playing for ITGR’s underperformance vs. customers to correct itself, representing 30-45% upside.

Longer-term, we expect ITGR to grow topline 6-7%, with EBITDA growth about 1.5x that number and EPS growth about 2x that number.  Assuming the multiple stays the same, we expect to clip about 15% a year in appreciation just from earnings growth.  We see EPS of $4.80 next year and the stock is trading ~14x that number.

What is a high quality, acyclical business that can grow EPS in the mid-teens for a long time worth?

At current consensus multiples (19x consensus 2021 EPS estimates of $3.60/sh), we would realize nearly 100% upside and ~20% IRR on pure business performance. If you layer in modest multiple expansion back to historical ranges (when ITGR screened significantly lower growth and higher leverage than we expect going forward), we get potential returns of ~2.5x.

DISCLAIMER

As of the publication date of this report, the author has long positions in ITGR and stands to realize gains in the event the stock increases. Following publication of the report, the author may transact in securities of ITGR herein without notice. All content in this report represents the opinions of the author. 

Catalyst

Leg 1 - closing gap of underperformance vs customers, leg 2 - demonstrated revenue growth with positive operating leverage over time