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Morningstar | Merit Acquires Privately Held Cianna Medical; Interesting Transaction, but Maintaining FVE

Merit Medical announced its intent to purchase privately owned Cianna Medical after market close on Oct. 1. The deal is structured as $135 million in cash paid upfront, with earnouts of $15 million tied to achieving supply chain metrics and $50 million associated with sales-based milestones. We don't plan to change our fair value estimate for no-moat Merit, as we already incorporate the financial impact of ongoing acquisitions as management's primary avenue for capital deployment. Interestingly, while the terms and economics of this specific deal vary modestly from our projections, we weren't all that far off. Cianna is expected to generate $50 million to $56 million in revenue in 2019 implying an all-in valuation of 3.8 times sales, or 2.5 times excluding the associated earnout liability. Management indicated the company's GAAP gross margin profile should be between 55% and 65% in 2019 and that the transaction will be dilutive to GAAP earnings per share but roughly $0.08 to $0.13 accretive on a non-GAAP basis.

The addition of Cianna brings another end market and procedure type to Merit's continuously expanding portfolio. Specifically, Cianna has FDA approved and commercialized products used in pre-surgical preparation and post-surgical radiation therapy for patients diagnosed with early stage breast cancer. Merit's interventional oncology portfolio remains a rather small contributor to overall results, but the contribution from Cianna is a potentially interesting growth opportunity should it prove additive to the company's broader biopsy lineup. With 2018 revenue that imply roughly 5% market share of the pre-surgical tumor localization market, Merit has a sizable opportunity to expand product penetration within breast cancer and into other soft-tissue areas over time. That said, the transaction comes on the heels of Hologic's $125 million acquisition of Focal Therapeutics, which markets a competing device to Cianna's SCOUT platform.

While management is moving into a potentially attractive, but competitive, market with this deal, we're encouraged that it intends to keep the Cianna sales team and research and development organization largely intact following integration. One of our key criticisms of management's acquisition strategy has been poor post-integration sales performance, largely due to cost-cutting and salesforce attrition associated with a handful of transactions completed over the years. However, management's commentary surrounding potential cost synergies and its indication that Cianna will be broken out as a separate operating segment suggest this time might be a little different.

Overall, we think the success of the transaction will come down to what the economic benefit to hospitals and surgeons ultimately turns out to be. While there's only been a handful of smaller studies completed thus far, it appears that the benefits associated with the device are limited to operating room scheduling efficiencies and a better patient experience versus wire localization standard of care--studies don't appear to show significant differences in surgical outcomes. While it's not unreasonable to assume scheduling benefits and a better patient experience justify the product's $50,000 price tag, we're somewhat skeptical as to how sustainable the business' 30%-40% revenue growth trajectory will be over the long run.

Merit intends to finance the transaction with its existing line of credit, which we estimate has ample capacity following its roughly $200 million secondary equity issuance over the summer. Incorporating both the equity raise and the upfront payment for Cianna, we estimate the company will likely maintain a gross leverage ratio just north of 2 times following the close of the transaction expected in the fourth quarter.