Description

RTI Surgical (RTIX)

Investment Overview

RTI Surgical is a company with a market cap of $217m and an EV of $383mm ($167m net debt).  It is in the process of doing a very large divestiture of its OEM business for $440m.  After the divestiture, we estimate that shareholders will be left with $147.5m in net cash and RTI’s spine business which will cost about $68m at today’s valuation.  The stub business will have about 68% of its market cap in cash in addition to the spine business which we believe is significantly undervalued.  Even with the cash drag, which offers substantial downside protection, we believe the upside from the spine business can offer a total return of at least 30% in less than one year.

Note – We assume the preferreds will fully convert to 15.2m shares due to expected price appreciation.

Business Overview

RTI Surgical will be selling off the vast majority of is business and it will be a very different business after the sale.  We will only offer a brief description of their spine business rather than the OEM business because that is what will remain. However, it is worth noting that RTI is selling its OEM business for 12.5x+ our estimated pre-COVID EBITDA and 14.5x+ our estimated pre-COVID EBITDA-capex.

Within their spine business, RTI manufacturers and distributes surgical implants, instruments and biologics used in the treatment of spinal conditions.  Their implant offerings include components such as spine screws and rods, spacers, and plates to promote spinal fusion.  The spine business generated about $119m in sales in 2019 at a 75% gross margin for $89m of gross profits.

RTI has targeted LT growth for Spine to be “well beyond 10%”.  We spoke with an independent industry consultant who knows RTI well and he spoke very highly of RTI assets and of CEO Camille Farhat.  He said we should feel comfortable that they will achieve what they expect to do. We spoke with the company and they highlighted a comprehensive plan to accelerate growth and profitability for their spine business. Finally, we spoke with other industry participates who confirmed the opportunity.

Deal History

Beginning in 2018, RTI Surgical announced new strategic initiatives and that they were planning to reduce the complexity of their organization by divesting non-core assets.  In January 2020, they announced that they had struck a deal to sell their OEM business to the PE firm Montagu for $480m in cash plus $10m in other consideration.

On March 16, 2020, the company filed an 8-K stating that they had filed for an extension for the release of the 10K due to an internal investigation of current and prior period matters relating to the timing of revenue recognition.  At the time, we were concerned about the accounting investigation thought that it may jeopardize the sale to Montagu.   However, the investigation revealed that the accounting issues were not especially serious and RTI sometimes recognized revenue too early, after binding orders were placed by before orders were shipped. The company must still file its 10K (and eventually its Q1 10Q) although we believe these will be complete within the next few weeks and are unlikely to contain any material surprises.

On April 29^th, the company put out another press release announcing that the deal with Montagu was still on, but they purchase price was reduced from $490m to $440m.  Additionally, the outside date for closing the transaction was pushed back to August 31, 2020.  We believe the deal is highly likely to go through as Montagu was willing to renegotiate the deal during the COVID pandemic and after RTI announced they will be issuing an accounting restatement.

Valuation

Montagu is now purchasing the OEM business for $440m in total consideration.  Prior to re-negotiating the deal, RTI stated in a press release that they expected pro forma net cash balance to be $175m to $200m after accounting for taxes and transaction costs.  The merger consideration was reduced by $50m so we reduce the pro forma cash balance by $40m, assuming a smaller tax liability.

On a pro forma basis, RTI will have 68% of its market cap in cash.  To value the spine business, we look at the EV/gross profit ratios for the closest comps.

The company disclosed that Spine is estimated to have generated $119m in sales and $89m in gross profits in 2019.  The independent orthopedics consultant told us that Seaspine, Alphatec, and Globus are the closest comps.

Even if we use the most unflattering multiples from SeaSpine (1.1x sales and 1.8x GP), we still get a value of $131m and $161m for the Spine business which only costs $69m.  Even with the significant cash drag, we still estimate 28% and 42% upside to the equity respectively. If we use Alphatech’s multiples we get returns in excess of 100%. Both are attractive returns in a short time period that we feel are very reasonable given we are benchmarking against the lowest comps. Further, these two comps have both struggled with growth and profitability over the past 5 years so we believe they are a good base case.  They also both burn cash every year, while RTI has said they expect to be cash flow positive within 12 months of closing the OEM transaction.

In closing, we expect the OEM deal to close by the end of the summer and that RTI stock will re-rate as a pure play high-growth spine growth business, creating substantial value for shareholders.

Risks

The biggest risk of course is that the deal falls through.  Though we think this is very unlikely given that Montagu re-negotiated in the middle of the pandemic and after RTI declared they are doing an accounting statement prior to the renegotiation.

Another major risk we see is that the company will be left with a large chest of cash if they are able to see the deal through.  Although we have heard very positive things about RTI’s CEO, he still may make poor acquisitions.  We expect if they do start to acquire, they will start off with small businesses as they had in the past, but this is a risk to the thesis.

The last risk we foresee is that they burn a larger than expected amount of cash before they close the deal.  We don’t have great visibility into this because they are delayed in reporting their 2019 and their 1Q20 filings but there is a large cushion still with PF cash being 68% of market cap.

Catalyst

Near term - Sale of OEM business to Montagu during the summer

Longer term - Once RTIX is a pure-play, Spine stub starts generating cash and is seen as at least comparable to SeaSpine, if not better