In ways large and small, Orthofix’s management team has been beating expectations for the last 10 months. Here’s the record:
- Quarterly cash flows have risen sharply and consistently since early 2008.
- Debt, which was high following the purchase of Blackstone Medical, has begun to decline precipitously.
- A determined vulture capital attack (Ramius) was dismantled with surprising vengeance and effectiveness.
- New senior managers (a president of North American operations and a new chief financial officer) have not only melded well, but have already had an impact on operations.
Creating a Wealth-Producing Engine
One year ago, Orthofix was struggling with an underperforming spine division that had cost the firm $333 million ($330 million of which was debt) in 2006, a shrinking stock price, and bankers who had their own set of historically difficult problems.
In one of those “when you’re up to your ass in alligators, it’s hard to remember that your goal was to drain the swamp” moments, management didn’t talk much about creating a wealth-producing engine on its conference calls. Rather, managers talked about their Blackstone Spine division; the new Group President of North America and head of Blackstone Medical, Brad Mason; and negotiations with bankers.
From a high of $60 per share (about $1 billion in market value) in 2007, the value of Orthofix had hit bottom at $9 per share.
Then something very interesting happened. Orthofix’s management made a series of changes beginning late last year that today, 10 months later, looks like the emergence of a new Orthofix―one that increasingly resembles a wealth-producing engine.
Of course, most investors couldn’t spot a “wealth engine” if it walked up and said “howdy.” In the early 1980s Eugene Fama, Burton Malkiel and a group of brilliant economists from the Universities of Chicago, Pennsylvania (Wharton), Columbia and elsewhere tackled this question of defining and characterizing corporate wealth engines.
So Fama, in particular, put the earnings paradigm to the test. He measured the statistical link between company market values (stock prices) and all of these measures of corporate economic activity―earnings, sales, book value, you name it.
Earnings, he found, had a weak statistical connection to the value of a company (as measured by stock price movement). But cash flows (which were earnings but with all of the accounting accruals added back in) could predict reasonably well the direction of stock prices and company values.
Of course, boiled down to a simple truism, Fama’s observation was essentially that managers couldn’t spend accounting income, but they could spend cash flow. So cash flow trends were better statistical measures of managerial performance than reported income.
Recently Fama’s research was put to an updated test by a group of researchers from various universities around the world. In a paper titled “Earnings Quality and Stock Returns” (Chan K, Chan LKC, Jegadeesh N, Lakonishok J. Journal of Business. 2006;79(3):1041-1082. Available at http://www.fbe.hku.hk/~konanchan/research/JB_2006.pdf), the researchers looked at every company listed on the NYSE, AMEX and NASDAQ for the period from 1995 to 2005 and, in effect, repeated Fama’s research.
The results were the same. Cash flows are a stronger and more reliable measure of both the economic value of a company and the skills of the company’s managers.
Indeed, the researchers criticized Wall Street’s near obsession with earnings and accounting income, which led many investors to a consistent pattern of poor stock picks (the authors specifically cited investor enthusiasm for, at certain times, Enron, Tyco and Xerox).
Compared to earnings, said the authors, cash flows are less volatile and deliver greater predictive power to the investor. They asserted that relying on cash flows instead of accounting income gives investors a 2x increase in rates of return. “In one-way sorts by earnings-price ratios, the extreme deciles of stocks have differences in annual returns of about 3.9 percent over the subsequent year (Lakonishok J, Shleifer A, Vishny RW. Contrarian investment, extrapolation, and risk. Journal of Finance. 1994;49:1541-1578). When sorted by cash flow to price ratios, the return spreads are about 9.9 percent.”
So what does all this have to do with Orthofix?
Look at the two charts below. The first one shows Orthofix’s cash flow trend. The second is Orthofix’s year-over-year quarterly sales growth pattern.
Source: company documents
See how the two charts illustrate the diverging trends at Orthofix. Even as sales growth has been choppy at best, cash flows are rising and rising with increasing strength.
Those two diverging trends, lower sales and higher cash flows, are counter-intuitive for many professional investors. But, as Fama argued and as subsequent studies have confirmed, rising cash flows are in fact the single best predictor (better than earnings) of a company’s future value.
Even choppy sales growth, when combined with rising cash flows, is a strong positive since it is an excellent indicator of a management cleaning house and culling sub-performing businesses or products.
This beautiful pattern is the sign of a company that is getting focused on doing the right things, not just doing things right.
Source: company documents
With the bounce in cash flows, debt can be paid down (and, in fact, Orthofix has been accelerating its debt reduction). As debt is paid down and cash keeps building, then management can turn its attention to its profit stars and increase the investment in those businesses.
When this cash flow cylce starts, it can set in motion a wealth-producing cycle.
The Conditions for Change
Orthofix was always a bit of a diamond in the rough. It has more than 560 direct sales people globally plus 290 distributors, the majority of which are outside the U.S. Orthofix has solid distribution in Europe, Asia, Latin America, the Middle East, and Australia. The only other orthopedic firms with comparable distribution networks have market values of between $8 billion and $15 billion (Orthofix is presently trading at under $500 million). But with a headquarters in the Netherlands Antilles and no particular stars or brand names in the product line, OFIX was a platform waiting for something.
Blackstone Medical’s spinal implant product line and its Trinity brand stem cell product line were the “something.”
The purchase of Blackstone Medical in 2006 for $330 million put Orthofix’s stock on an upward trajectory―for a while. Unfortunately, the promise of Blackstone did not meet up with reality. Doing the right thing, in this case, was not backed up with doing things right. Within one year, most of the key managers who’d built Blackstone were gone. The replacements left a year later.
When sales didn’t meet pre-acquisition expectations, the debt incurred to pay for Blackstone began to drag Orthofix down. When the overall credit crisis hit in 2008, banks began to pressure Orthofix in new and painful ways. A new CFO came and went. Orthofix’s stock price finally hit bottom the week of October 20, 2008.
The conditions for either a change or capitulation were in place. More than one institutional analyst was questioning the ability of the company to survive without divesting Blackstone―even at a discount.
But no towel came from the OFIX corner.
Instead a gentleman named Brad Mason, the founder of DJ Orthopedics and later Breg (one of Orthofix’s divisions) took over as President of North American Operations and President of the troubled Blackstone Spine division.
Robert Vaters,
CFO and EVPA couple of months later, Robert Vaters joined Orthofix as the firm’s new Chief Financial Officer and Executive Vice President.
A month later, in mid-December while the market was trying to forget an awful 2008 and look ahead to, hopefully, a rebounding market under a new U.S. president, this announcement was made: “Orthofix International to Make Partial Debt Repayment Ahead of Schedule.” The company’s new CFO was quoted as saying that he thought it was probably a good time to start deleveraging the balance sheet. That was unexpected.
Then Blackstone’s offices in New Jersey and Massachusetts were closed and consolidated in the McKinney, Texas, operation.
On December 2, a letter arrived at Orthofix from well-known corporate raider and vulture capitalist hedge fund, Ramius Corporation. In a nutshell, the letter accused Orthofix’s board of directors and management of failing to build shareholder value, recommended that certain members of the board be replaced, and suggested that the assets of the company be reviewed for possible divestiture or re-organization.
Orthofix responded with a vengeance. One press release after another attacked Ramius, its principals and its board nominees…again and again and again.
January 20, 2009: Orthofix issues a press release accusing Ramius of using misleading and inaccurate information.
January 28, 2009: Orthofix accuses Ramius of nominating unqualified candidates for the board.
February 9, 2009: Orthofix attacks the qualifications of yet another Ramius board candidate.
February 19, 2009: Former Orthofix Chairman, Robert Gaines Cooper, writes an open letter opposing Ramius.
March 2, 9, 11, and 21: Orthofix sends four sharply worded letters opposing Ramius to its shareholders.
March 18: An independent proxy advisor rejects Ramius’s bid.
March 19: Orthofix accuses Ramius of egregious errors in its shareholder letters.
March 31: Orthofix forces Ramius to retract false statements.
At the shareholders’ meeting on April 2 the vote wasn’t even close. Every Ramius candidate was crushed.
The New Orthofix
Alan Milinazzo, President and CEOLast week Orthofix President and CEO Alan Milinazzo provided a comment about his company’s quarter: “I’m very pleased to report a strong quarter. These favorable results were consistent across all of our core business segments. This included our spinal implant business, which continued to gain momentum in the second quarter as sales grew 12% led by the recent launches of our Firebird™ pedicle screw system, Pillar™ SA interbody device and Trinity® Evolution™ stem cell-based allograft. Additionally, our improved cash flow has allowed us to make a total of $20 million in debt payments ahead of their scheduled maturities so far this year, including a $5 million payment this month. Based on our results for the first half of 2009 we are reaffirming our full-year guidance.”
While there is no discernible swagger among Orthofix’s managers, there is gritty determination. This team has been through the valley of the shadow and emerged stronger than perhaps even they expected. From where we sit, and after more than 25 years analyzing companies, we recognize this pattern. We see a wealth-producting engine in the making. The future for Orthofix is so bright right now that both managers and shareholders will need sunglasses.
