K2M Group Holdings, Inc. went live on NASDAQ on May 8, 2014 and is trading under the symbol “KTWO.”
The company’s initial public offering (IPO) pricing was at $15 per share for approximately 8.8 million shares. According to a company announcement, the IPO was to net approximately $120 million. A few days after the listing, the stock was trading at around $15 per share with a market cap of $427 million. That compares to a $611 million market cap to another spine company that recently went public, LDR Holding Corporation.
The net proceeds from the offering are expected to be used to retire all indebtedness outstanding under the notes held by certain of its shareholders, to repay all of the outstanding borrowings under its asset-based revolving credit facility, to pay all accumulated and unpaid dividends on its Series A redeemable convertible preferred stock and its Series B redeemable convertible preferred stock, and for working capital and general corporate purposes.
Piper Jaffray & Co., Barclays Capital Inc. and Wells Fargo Securities, LLC are acting as joint book-running managers for the offering. William Blair & Company, L.L.C. and Cowen and Company, LLC are acting as co-managers.
The company was co-founded by K2M Chairman and Chief Medical Officer John Kostuik, M.D. and President and CEO Eric Major. Welsh, Carson, Anderson & Stowe acquired controlling interest in 2010. The company nearly $157.6 million in revenue last year, but also saw a $37.9 million loss. Welsh, Carson, Anderson & Stowe will continue to own a majority of shares in the company, according to a Washington Business Journal report.
Walter, as an investor in the medical device arena it’s important to dissect this a bit further and expand on the numbers that were disclosed in these two IPOs (KTWO and LDRH) which have a combined market value of $1B.
First, it’s important to note that both of these companies operate at extremely high profit margin levels ranging from 65-84% which would indicate that barrier to entry is minimal and the product is largely a commodity.
Second, it’s important to note that both of these companies spend 7-11% of revenue on research and development and thus it appears they aren’t in any growth mode as it relates to product offering.
Taking these two items into consideration, high gross margin and low spend on R&D, one would assume that these would be very profitable companies. The reality though is that they aren’t profitable at all and an investor must look to the “sales and marketing expense” line items to understand why.
Historically, spending significant amounts of precious capital on sales and marketing at the early stage of a company lifecycle as they prepare for a public offering is supported by a road map to top line revenue growth. However, in the instances of these two companies that doesn’t appear to be the case. Take LDRH for example. Their sales and marketing expense as a % of revenue increased from 54% in 2011 to 61% in 2013 during this growth period. However, the result of this increased spend hasn’t supported the traditional rationalization for increasing sales and marketing as their revenue actually declined from Q4 2013 to Q1 2014. It will be interesting to see if KTWO follows this same trend when they publish their next quarterly report.
As an investor in this space this would be pause for concern as something fundamentally wrong with the model of these companies. Why is so much precious capital being spent on sales and marketing – when there isn’t the revenue growth to support it.
Maybe the physicians in the industry, who are essentially the customers here, have the answers and maybe there are some new approaches to the sales distribution model that appear to be a necessity for this industry to operate in a profitable and reasonable environment.
There appears to be a real opportunity here for physicians to participate in this, not the aforementioned book-running managers on Wall Street.
Joe Sofio