Description

Business

Integra manufactures medical products used in neurological and wound-related surgeries

Segments include (1) Codman Specialty Surgical (CSS) (65% of Sales, 64% of Segment Profit) and (2) Tissue Technologies (TT) (35% of sales, 36% of Segment Profit). 

Codman (CSS) produces neurosurgical equipment that helps treat brain lesions, traumatic brain injury and hydrocephalus.  Products include regenerative tissues for dura mater, ablation systems, brain pressure monitors, endoscopes, and valves & catheters.  Additionally, Codman offers instruments that are used in various surgeries (primarily neuro and ear, nose and throat).  Codman was purchased in 2017 by Integra, nearly doubling its neurosurgery sub-segment.

Tissue Tech (TT) produces grafts that are used to help wounds heal, including chronic wounds and post-surgery wounds.  Additionally, the company provides collagen products on a private label basis in this segment. Raw materials used in the tissue segment include bovine collagen, bovine skin, porcine urinary bladder, human amniotic tissue and synthetic mesh.

Integra's brands are requested specifically by surgeons, because (1) its products perform better for certain specific use cases, and (2) physicians have an affinity and familiarity with its products given their tenured history in the market.  Hospitals ultimately purchase Integra’s products, but on the back of surgeons’ demands.

Surgeries in which the products are used are non-discretionary.  At best, surgeries can be deferred (at most for 60 to 90 days).  Surgeries are largely covered by health insurance (primarily commercial and Medicare insurance).

Products are largely recurring and relatively low-cost.  Recurring consumable products represent ~90% of sales.  Hospital capex-driven items are only ~6% of sales

Prices vary, but are relatively low-cost versus other hospital items.  For example, the most expensive Codman product is CUSA Tissue Ablation at $2,000, and the Tissue products range from $600 to $3,000 per single application

Sales reps manage relationships with surgeon customers for 70% of sales.  The remaining 30% of sales that are indirect go through distributors to international customers.

The company was founded in 1989 by Dr. Richard Caruso, and was the first to bring to market a tissue regeneration product (to treat burns and scars) approved by the FDA in 1996.  Integra grew largely through M&A under Dr. Stuart Essig PhD (CEO from 1997 to 2012), an ex Goldman Banker.  More recently, CEO Pete Arduini (CEO from 2012 to 2021) divested assets and focused the company on its 2 current core markets (i.e., neuro, tissue) in higher-margin, higher value-added products.

Manufacturing is done across 14 sites and distributed through 4 DCs.  HQ based in Princeton, NJ. Employee count is ~3,700.

Thesis

1. Well-positioned player in recession-resistant, MSD% growth end-markets.

Integra founded the regenerative tissue industry, and is a well-respected brand amongst customers.  Codman is also an early mover and leader in its space.  With strong, leading market-share brands, and technological/regulatory barriers to entry, Integra is favorably positioned to at least grow in-line with the industry.

We believe the company’s share is protected by its core competitive advantages, including:

(1) Brand name:  Integra founded the tissue regeneration space, and Codman is a 185-year-old brand (owned by Johnson & Johnson since the 1960s) with a well-recognized, high-quality brand name as well

(2) First-mover advantage:  Products are physician preference, creating sticky customer relationships that benefits the first mover

(3) Technological know-how:  Not only are there high technological barriers to entry, but once developed, the products must meet strict FDA standards given they could be fatal if not designed and manufactured correctly.  This provides a natural barrier to entry, and ensures that only ~3 or so players compete across most of Integra’s product areas

(4) Sales representatives:  Integra prides itself on staffing a market-leading neurosurgery sales team, which provides stronger customer relationships versus peers.  Competitors are focused on a broader product set than just neurological and tissue, or have smaller scale if they are focused on these products, and so their sales teams are not as deep in these product areas

Industry growth of MSD% is driven by price, population, technological innovation and increased diagnosis of chronic conditions such as diabetes, stroke, breast cancer, etc.  Integra’s guidance calls for market growth of ~4.5% to ~6.5%.

2. Disrupted valuation due to exaggerated fears surrounding recent (1) recalls and (2) management changes.

Valuation has compressed from a P/E of ~20x+ to ~11x, due to a recent product recall (i.e., the Boston facility recall in May 2023).  Combined with a prior recall (i.e., the CereLink ICP Monitor recall in August 2022) and recent management changes (new CEO and recent CFO departure), the Boston recall caused existing investors to capitulate after a string of bad news.

We believe the causes underlying these recalls and management changes are not symptomatic of any larger structural issue at Integra, but instead represent self-contained, one-off challenges that will fade with time.  We believe the market’s short-term fears are creating a compelling long-term return opportunity.

Based on our field calls/primary research, we believe both recalls pass this framework suggesting limited long-term downside risk for the following reasons:

(1) Limited substitutes:  Expert network feedback on the Boston facility’s tissue products is that each product in the market addresses a unique patient scenario, which makes finding substitutes difficult.  PriMatrix, in particular, has nothing else that works remotely close to it; one surgeon said that he may be forced to amputate patient limbs because PriMatrix was not available.  It’s also difficult to find replacements for SurgiMend because of its unique thickness and biologics.  Replacements exist, but they are supposedly not ideal.  For the CereLink monitor, product substitution is less of an issue because customers are generally currently using the old iteration of the product.

(2) Strong brands:  Integra founded the regenerative tissue space, and so has a strong, well-respected brand according to our calls.  CereLink is under the Codman segment, which also has a long history in its markets and is well-perceived.  Product users said that Integra reached out to them quickly and has been a responsible actor in actually executing the recall.

(3) No injuries and swift outreach:  Both recalls did not lead to anyone being hurt, and Integra acted quickly to recall out of an abundance of caution.  Basically, the recall doesn’t seem to Integra in any way that could potentially damage its brand

(4) Recall is contained:  The Boston facility’s issues are rooted in it being 100+ years old, which makes it difficult to upgrade to modern standards without razing the site and building over.  All of Integra’s other manufacturing sites are modern, and Boston alone stood out as an antiquated facility.  Therefore, we believe the issue is contained to Boston, and not symptomatic of any larger issue at other facilities.  The CereLink monitor issue is very specific to that particular product, and did not represent any issue in Integra’s manufacturing or testing processes.  Experts suggest that all the proper testing had been conducted on the product prior to launch, and that finding the issue behind the recall during testing would have been nearly impossible due to the fact that the issue resulted from environmental interference at the hospital sites.  Thus, we believe this product recall is isolated, and not reflective of any larger issues.  

(5) Fixes are secured:  The Boston facility expects to launch commercially by late Q2 ’24, and our expert calls suggest that this timeline is feasible.  By 2025, the facility will be replaced by the newly built Braintree facility, which is a permanent fix.  Integra discovered a simpler fix for CereLink that involves just replacing 1 accessory on it, which will hasten the fix.  The relaunch in international markets has already started and will expand to the US in fourth quarter 2023, so the solution is relatively immediate.

The management turnover is justifiable, and doesn’t reflect anything pernicious at Integra’s core.  Carrie Anderson (prior CFO) was given the opportunity to become the CFO of Campbell Soup, a much larger (~$9bn in sales) and more high-profile company.  Pete Arduini (prior CEO) took up an offer to become the CEO of GE Healthcare, also a much larger (~$19bn in sales) company than Integra, instead of retiring according to his original plan.  Glenn Coleman (prior COO) left when he was passed over for the job of CEO, given he had been promoted to COO as part of succession planning under CEO Pete Arduini.

Just for context, here is some background on the Boston facility recall:

On 5/22/23, Integra (1) recalled all products manufactured in its Boston facility over the last ~5 years, and (2) halted all manufacturing at that same facility.  The Boston facility accounts for ~5% of Integra’s total revenues (i.e., ~$80mm in sales).  Primarily 2 products are produced at the facility, each accounting for ~50% of the facility’s revenues: SurgiMend and PriMatrix.  Both are bovine matrix tissue products.

The recall was due to the facility’s endotoxin testing process basically being deemed unreliable by the FDA.  The issue was not that the FDA found higher-than-permitted endotoxin levels, but instead that this could result from the inconsistent testing process.  Endotoxins, at their worse, cause a fever, presenting a relatively benign risk.  There have been no actual product complaints related to endotoxin levels.

Integra acquired this facility as a part of its TEI Biosciences acquisition in 2015.

Integra had been investing to address issues raised by the FDA at the Boston facility over the last 4+ years, but issues continued to pop up (one expert likened it to playing “whack-a-mole”).  The fundamental problem with the facility is that it is over 100 years old which makes it difficult to bring up to modern standards.  Here’s a regulatory history of the Boston facility: March 2019: the Boston facility received a warning letter from the FDA (after an inspection in Oct/Nov 2018), largely referencing corrective actions required for its endotoxin testing process; Oct/Nov 2021: FDA inspects the Boston facility again, and issues a Form 483 (which states that the company “may” have violated FDA laws, but can’t say so with finality); March 2023: FDA inspected the facility again; H1 '23: to address the FDA’s continued concerns, Integra stepped up its investment to upgrade the Boston facility; May 2023: FDA issued a Form 483, leading to Integra's recall.

A 3rd party firm has been hired to conduct an audit of the facility once changes are made, to assess whether the facility should restart.  It is important to note that Integra does not need FDA approval before restarting production at the Boston facility.  Restarting commercial production at Boston is entirely up to Integra upon receiving a satisfactory audit finding by the third party.

Timeline for reopening is: Manufacturing restart in late Q4 '23; Outside expert audit report at end of Q1 '24; Commercial distribution restart in mid-to-late Q2 '24

Integra is building a new facility (in Braintree, MA) that will replace & expand the Boston facility’s current capacity, at which point it will shut down the Boston plant. The new Braintree plant is slated to come online in 2025, and will cost ~$50mm

Just for context, here is some background on the CereLink recall:

On 8/18/22, Integra recalled its CereLink intracranial pressure (ICP) monitor system.  This product accounted for ~1% of sales (i.e., ~$13mm), and had an installed base of 1,200.  CereLink ICP is a new version of an old product, and was only launched ~1 year prior to the recall (launched in October 2021).  The new product had an upgraded user interface and analytics capabilities

The recall was due to customer reports that the pressure readings were out of range.  The issue turned out to be that there was outside electrical interference that disrupted the readings.  Customer reports were at a limited number of sites, with an incidence rate of only 1.5%.

Integra has engineered a simple fix to the problem that will be relatively lower cost to execute.  The solution only requires sending an accessory (a cable) to customers, which makes it easier to fix.

The relaunch date is now set for Q4 ’23 in US markets, and has already relaunched in international markets starting in Q3’23.  This relaunch date is one quarter later than the original relaunch date, given Integra just recently discovered this easier fix, which necessitated restarting validation/verification testing.

During the recall period, Integra has provided loaners to customers of the prior generation of monitors.

3. Integra has transformed over the last ten years, positioning itself for growth and margin upside that is above and beyond our base case.

Between 2012 and 2021, the company has consolidated ERP systems, facilities, divisional structures, and operating processes.  Additionally, non-core assets were sold so that Integra could focus on its highest-growth and margin assets.

The aforementioned efforts are foundational to its long-range plan of driving significant new product introductions, expanding internationally, and achieving 70-72% gross margins and 28-30% EBITDA margins, versus current levels of ~67% and ~25%, respectively

We do not give the company credit for achieving these growth and margin goals in our base case, and given its disrupted valuation, we believe the market is giving the company no such credit either.  Nonetheless, we believe Integra is particularly well-positioned for upside potential. 

Catalyst

Relaunch of recalled products