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Morningstar | Integra Runs Into Some Growing Pains, but Sell-Off Appears Overdone; Maintaining $58 FVE

Narrow-moat Integra reported a disappointing quarter, with revenue, adjusted gross margin, and adjusted EBITDA falling below our and consensus forecasts. We intend to make some adjustments to our model, but we don't expect a meaningful change to our fair value estimate of $58 per share, or a little over 20 times estimated adjusted 2019 earnings. Management reduced guidance for the year and hinted that 2019 may see lighter organic growth than we think investors were anticipating. While our full-year 2018 organic growth numbers were already in line with management's now lower guidance of 4%, its updated adjusted gross margin target falls 100 basis points short of our forecast. In our view, organic growth and gross margin are the two most important metrics for investors, and weakness on both fronts has left shares down roughly 15%.

The poor results stem from two main areas--the firm's extremity orthopedics business that we believe is subscale relative to the firm's other moaty franchises, and in international markets, where the operations acquired in the Codman transaction have yet to fully transition to Integra's commercial team. While the orthopedics and tissue technologies segment reported strong organic growth of 11.5%, even with ortho posting a 5% decline, we'd caution that this was off negative 1% organic growth in the year-ago quarter. We've mentioned that we think management is likely to bulk up its ortho presence via acquisitions as its balance sheet has deleveraged and it remains an area of competitive weakness, and we continue to believe tuck-in transactions remain likely.

On the other hand, we're struck by the size of the implied decline in the 10% of acquired Codman revenue represented by international countries with indirect sales channels that Integra won’t have control over until the second quarter of 2019. While a small portion of the overall business, we estimate that the declines in this area are annualizing near a 25% rate.

It'll be critical to monitor this subsegment into next year to determine whether management can stem the bleeding once the businesses are transitioned. While only a $2 million shortfall in the quarter, and frankly immaterial to our valuation, management expects this to accelerate into the fourth quarter.

Our full-year organic growth rates for the business were already mostly in line with management's updated outlook of 2.5% growth out of the surgical segment and 6%-7% growth in the ortho and tissue technologies segment. This is down from expectations of 3% and 8%-10% growth from each segment, respectively. That said, we think investors are more concerned with the discussion around 2019 that indicated the business is more likely to grow near the low end of management's maintained long-run organic growth projections of 5%-7% annually. We were expecting more along the lines of 6.5% as much of the Codman integration and commercial reorganization efforts undertaken during 2018 should be complete. While management may simply be tamping down initial expectations for next year, we think the share price decline after the earnings report suggests investors remain skeptical.

Encouragingly, however, operating and free cash flow is set to come in above our initial forecasts for the year, which we believe is critical given the plethora of add-backs in management's adjusted figures. As a result, the company's cash flow conversion metric is set to increase modestly from initial expectations, but we're hopeful that 2019 brings much improved earnings quality--our forecast implies free cash conversion closer to 75%-80% next year versus approximately 55% for 2018.