Description

Capitalization

Market Capitalization = $67mm (33.5mm Fully Diluted Shares x $2.00 per share)       

Net Cash of $13.7mm (Cash & Marketable Securities of $40.6mm less Total Debt of $27.0mm)

Enterprise Value of roughly $54mm

Theragenics has two lines of business:

Brachytherapy:  TGX sells radioactive "seeds" for the treatment of cancer.  The seeds (roughly the size of a grain of rice) are implanted into a prostate tumor and deliver radiation over time.  This is a well established and effective procedure that has been around for decades. 

Due to the emergence of other methods of treating prostate cancer (IMRT and robotic surgery), as well as disadvantageous reimbursement, prostate brachytherapy has been in decline.  TGX's brachy sales peaked in 2005 at $35.8mm and have since declined to $22.3mm in 2010.  There are signs that the decline has meaningfully slowed and evidence that TGX is arriving at a new and permanently lower run-rate of sales and operating income ($3.7mm in 2010).

Surgical Products:  TGX manufactures and sells surgical products with applications in a variety of medical practice areas.  The products are generally focused on wound closure (sutures), vascular access (sheathes, guide wires, etc), and specialty needles (broad variety of needle types).  In 2010 this division did $59mm in sales and was roughly breakeven on an Operating Income basis. 

TGX entered Surgical Products via three acquisitions.  They did so with the stated objective of diversifying away from Brachytherapy once it became clear that the competitive/reimbursement environment for brachy was deteriorating.   A couple of thoughts on the deals:

• - First, TGX paid in excess of 2.5x revs on average for their three acquisitions to enter surgical products. Their total investment to date is about $110mm ($100mm of acquisitions + $10mm of capex). For this amount, on a TTM basis they did $59mm in revs (1.9x) and did not generate any operating income. Based on comps, it would be a stretch to turn around and sell these businesses for $110mm - thus, in our opinion they overpaid and this was a poor use of capital
• - Second, when will management team realize that investors have many ways to diversify their portfolios? We do not need management teams entering new, unrelated lines of business in the name of diversification. All mgt did was to diversify their jobs. The fact that the stock market is according the entire company a value of $55mm tells you what the market thinks of management's diversification efforts. (we'll get more into mgt/governance factors later)

Valuation - How do we value these two businesses?

Brachytherapy:  We see the brachy division as being worth $20mm to $40mm.  The low end of this range is treating brachy as a standalone company - roughly 1.0x revs and 5.5x EBIT seems fair.  However, there is significant strategic value in this division to a potential acquirer.  With roughly 50% gross margins (and even higher cash flow margins ex depreciation), a strategic acquirer (already in brachytherapy) could potentially realize significant synergies if they acquired this business.  This is not idle speculation; there is an unsolicited offer on the table for $2.20 to acquire TGX in its entirety.  The potential acquirer is a German company with a brachytherapy division.  They specifically state in their offer letter:

..."We believe this proposed combination provides superior value to our respective shareholders and will enable us to offer better products, better services and innovation to our customers," said Dr. Andreas Eckert, CEO of Eckert & Ziegler and Chairman of the Board of IBt Bebig.

"With this planned acquisition we would move one step forward, as we would re-enter in the United States, the largest brachytherapy market. We are the best strategic partner to expand the potential of Theragenics and together broaden the product portfolio with our SmartSeed® and MultiSource® Afterloader", commented Dr. Edgar Löffler Managing Director of IBt Bebig.

"We have great respect for Theragenics, one of the leading Brachytherapy companies in the US. We have known them a long time, since IBt was founded in 1996 by a few former Theragenics Executives. We have the same vision, that Brachytherapy is a well tolerated treatment option to cure cancer and aligned to patient requirements. Our combined company will be uniquely positioned to further promote this efficient and economical treatment option worldwide", commented Dr. Gunnar Mann, Managing Director of IBt Bebig.

The buyout offer is for the whole company but the strategic rationale is around the brachytherapy division - this validates our thinking about the value of this business unit to a potential acquirer.  In this case, with all the strategic benefits associated with such a deal, we think a $40mm value is more realistic.  This is closer to 2.0x revenues and some reasonable multiple on EBIT post synergies.

Surgical Products:  We value this division based on public trading comparables.  Since it does not generate significant operating income, we focus on EV/Revs multiples.  We note that at the current scale (and even with decent growth), this division is subscale and will not optimize profit and valuation on a standalone basis. 

We ask, what would this division be worth to a larger company selling similar products?  We think this is largely a function of the gross profit contribution that TGX business would bring a buyer.  There are a host of potential comps but for simplicity sake we look at Medical Action Industries (MDCI) and Merit Medical Systems (MMSI).  These two companies represent the different ends of the 'revenue multiple' / 'revenue quality' spectrum.

• - MDCI is a pretty imperfect comp as a lot of what they sell is lower tech (gloves, masks, etc). But, they also make procedure kits and some wound care products. They trade at about 0.7x revs and generate roughly 20% gross margins.
• - MMSI is a better comp. They produce catheters, guide wires, valves, procedure trays, etc. This product set is closer to what TGX produces. In fact, we think MMSI would make a great acquirer of TGX's Surgical Products business. MMSI trades at 2.2x revs and generates about 42% gross margins

So, what is TGX's $59mm in revs (growing at 10%) with 35% gross margins worth?  We think the high end of the range would be something approaching MMSI's multiple and the low end of the range as 1.0x. (Note: based on our conversation with people in the space - 1.0x is probably excessively conservative.  But, we use it to anchor the low end valuation.  TGX revs are significantly more valuable than MDCI's given the meaningfully higher gross margin profile).  The range would imply that the TGX Surgical Product business is worth anywhere from $60mm to $120mm

On a combined basis this places a low-end value of $93mm ($20mm brachy, $60mm surgical, $13mm cash) up to $173mm ($40mm brachy, $120mm surgical, $13mm cash).  This would imply a stock price of $2.75 to $5.15 - either end of the range represents a healthy premium to the current stock price (37.5% to 150% premium).

Also, it is worth noting that adjusted EBITDA for 2010 was $11.6mm - thus, at the current price an investor is only paying 4.7x TTM EBITDA.

What's Holding the Price Back?

With the intrinsic value of the operations worth significantly more than the current stock price, and with a low-ball offer on the table for roughly 10% higher than the current value - one would think the stock would trade meaningfully higher.  It raises the question - what is holding the stock price down? 

Our belief is the discount is a function of a general concern amongst potential shareholders about mgt/governance factors.  We think this concern is justified for a number of reasons:

• 1. Management pays themselves very handsomely (see P13 of proxy filed on 4/1). We'd argue that CEO compensation of $1.2mm in 2010, and $1.3mm in 2009 is rather high for a company this size
• 2. Given the valuations management paid during their diversification initiative - shareholders are right to question whether TGX leaders are good allocators of capital
• 3. In the case of the recent offer for the company, per the public comments of the potential acquirer, TGX BOD vetoed an offer at a 38% premium without making shareholders aware of the offer. This further fuels suspicions that management and the BOD are not acting in shareholders' interests (even if the $2.20 offer is not a adequate price)

Nevertheless...

Our belief is that the recent offer for the company (and related potential lawsuit from a law firm - see 3/18 headline) may force the company into a strategic alternatives process.  If so we believe there are a number of potential buyers for each piece of the business that would result in a meaningfully higher valuation - easily 50% to 100% upside.  We believe this is the value optimizing outcome for the company.  The company is simply too small to be optimized on a standalone basis. 

But, what if there is no sale of the company?  The stock may languish but ultimately we feel there is sufficient valuation support from:

• - The deep discount to the intrinsic value of the assets
• - Paying under 5.0x EBITDA
• - $8mm to $10mm in 2011 FCF = well in excess of 10% FCF yield

Therefore, we see asymmetric risk, meaningful upside and limited downside.  It may take some time to play out - perhaps all of 2011 - but we ultimately like the risk/reward of a long position in TGX.

Catalyst