The performance of mid-cap medical device company Enovis (NYSE:ENOV) is getting harder and harder for me to understand. As I’ve said in past articles, I’ve never really loved this business, and I’ve found some of management’s projections to be overly optimistic, but I do think there is a solid orthopedic device business here, and I find the stock’s behavior relative to underlying performance to be stranger and stranger.
Since my last update, Enovis shares are down around 12%, worse than the mid-teens appreciation for the overall medical device sector, and worse as well than major ortho players like Stryker (SYK), Smith & Nephew (SNN), and Zimmer Biomet (ZBH). A distaste on the part of investors for smaller ortho names could, perhaps, explain it though, as SI-BONE (SIBN) and Paragon 28 (FNA) have done even worse over that time period.
Given that I think Enovis should be trading somewhere around the mid-$60’s, this name is getting more and more interesting. With opportunities to gain more share in ortho, particularly in ambulatory surgical centers (or ASCs) and extremities, as well as leverage synergies from the Lima acquisition, this is a name to consider.
A Slight Step Back In The Last Quarter
As far as bad news goes, while Enovis beat sell-side expectations with first quarter results, there were some areas of weakness. Prevention & Recovery only grew a little more than 3% in the quarter, and this is a business where I’ve long thought management growth expectations are too high, even granting opportunities to grow the business overseas.
The Reconstructive business grew 7% in organic terms in the same quarter, and that’s on the low side of the high single-digit that bulls want from this business. The hip and knee business was particularly weak, with just 1% year-over-year growth. Yes, the year-ago comp was tough (up 22%), but the larger players managed 6% yoy growth against tough comps (up 10% for hips and 16% for knees). Growth in the U.S. extremities business of 8% was okay, but here too not exactly exceptional when compared to large rivals like Stryker.
Margins were also fine, with gross margin up 70bp to 58.7% and operating margin up 190bp to 10.9%.
Q2 Results Will Likely Be Similar
I’m expecting that upcoming second quarter results will largely resemble first quarter results, with organic revenue growth in the low-5% range, including around 7% recon growth as the company faces another tough set of comps (hips/knees were up 22% last year and extremities were up 15%). I expect some incremental progress in margins, with gross margin up around a quarter-point sequentially and operating margin up a stronger point-plus (to around 12%) as the company starts reaping some synergies from the Lima deal.
In terms of what could change the tone around the stock, a return to double-digit growth in U.S. extremities would certainly help, as would better growth in hips and knees more in line with sector growth (I’m expecting around 5% for hips and 8% for knees for the large players).
Enovis Should Have What It Needs To Compete
One of the debates around Enovis concerns just how much the company may miss out in its business by not having a robotic surgical system. Stryker and Zimmer both have robotic systems for knee and hip procedures (the MAKO and Rosa, respectively) and both are looking to also leverage those systems in shoulder surgeries.
There’s no question that MAKO has been an important driver for Stryker and a driver of market share gains, as the system can help surgeons more easily achieve more consistent results and with better patient outcomes as well. The impact on Zimmer’s business has been less significant, but both Johnson & Johnson (JNJ) and Smith & Nephew have lost share in U.S. knees in recent years, and the lack of a robotic offering is likely at least partly responsible.
Enovis is not completely helpless here. The company continues to ramp its Arvis augmented reality system, and while it’s not a robot, it does offer at least some of the advantages of a robotic system (namely navigation guidance) with a much smaller price tag and footprint. Still, it’s understandable that investors might be nervous about the prospect of Enovis seeing itself pushed out of hip and knee accounts in favor of a rival with a robotic system, and if robots start making inroads into the shoulder business, it will threaten a major driver of growth.
I don’t dismiss the long-term competitive threat from robotics. Even so, I think there are still opportunities for Enovis to grow share. The company already has strong share in ASCs and more and more knee procedures are moving to ASCs. Better still, robotic systems are less likely to be as important in the ASC setting; Stryker and Zimmer are certainly targeting the market, but space and capex constraints are more pressing relative to hospitals.
I’d also note that Enovis has a product well-suited to ASC knee replacements – the Empowr knee line, including the Empowr3D. The Empowr is the only dual-pivot knee on the market, and this gives a more natural range of motion across various tasks (walking, squatting, et al.). As this is better for younger, more active patients, and younger, more active patients are more likely to go to an ASC, I think this should continue to be a share growth driver for Enovis.
The Lima acquisition should also boost Enovis’ prospects. The business not only gives Enovis a stronger presence in Europe, but also creates cross-selling and product development opportunities. Lima’s trabecular titanium technology is well-regarded for 3D printing of custom implants, and the company also has a good revision product for shoulders.
The Outlook
There are valid concerns about whether Enovis can generate the long-term high single-digit growth it needs to hit management targets, as that growth demands further share gains against established ortho players. Likewise, successfully integrating the Lima deal and maximizing the cross-selling opportunity is a must-do; Enovis has experience with smaller tuck-in deals, but this is a much larger and more complicated business to integrate.
I don’t think my expectations for Enovis are all that bullish. I’m slightly below the low end of the Street range for FY’24 (although estimates are tightly bunched, so that means less), and I’m likewise below Street estimates out at three and five years, and I’m looking for three-year growth a bit below 7% (and longer-term adjusted growth of around 6%).
On the margin side, I’m looking for EBITDA margin to improve from 15.8% last year to almost 18% this year, almost 19% in FY’25, and 20% in FY’27. With that, I expect cash flow margins to improve into the low double-digits, supporting adjusted free cash flow growth in the low teens.
Discount that all back and I get a fair value around $63; $58.50 if I want to be more conservative and use a higher discount rate to “punish” the company for its lack of a robotics system and the risk of losing share in markets like shoulder because of it.
I also value med-techs by growth and margin-driven EV/revenue approaches, and Enovis trades well below the revenue multiple that roughly 7% three-year growth would normally get. Allowing that the margins are lower than many of its rivals, a margin-driven model still gets me to a fair value in the mid-$60’s.
The Bottom Line
Maybe smaller-cap ortho is just out of favor now, in addition to SI-BONE and Paragon 28, Alphatec (ATEC), a smaller player in spine, has likewise been underperforming. In any case, while I do still have some issues with Enovis, it’s harder for me to understand the valuation in the context of financial performance that’s at least decent if not good.
Maybe there is something obvious that I’m missing – yes, GLP-1 drugs may reduce the need/demand for hip and knee replacements, but that’s a long way off and not exclusive to smaller orthos. Whatever the case, though, these shares are getting more interesting as the valuation gap widens.
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