Description

MDXG: More Than Just a Restatement Play

BACKGROUND: MiMedx is a biopharmaceutical company that develops biologics using placental allografts. During the JPM healthcare conference of 2018, short seller Marc Cohodes confronted the management team over the company’s sales practices, launching the opening salvos of what would end up being a very public and successful short campaign centered on the claim that the company was a massive fraud. In June of that year, the company announced a financial restatement and the firing of the CEO/founder and the launch of an internal investigation into sales practices which led to an eventual delisting. In December, they fired 25% of their work force. Each hit drove the stock price lower till it reached $1 (after $18 earlier in the year). In January, Prescience Capital put out a bullish report (see here) that brought attention back to the story. In the months since, Prescience began an activist campaign that helped spur the company to hire a new CEO and auditor and reconstitute the board. Since the beginning of the year, many of the key outstanding issues that existed have been resolved in a manner that has been favorable for the share-holders. The two remaining ones – a restatement and a re-listing - look achievable by year end.

THESIS: Once the financials are fully re-stated and the company is relisted, the stock which trades at $4.25 a share should comfortably re-rate to 3x sales (+$10 a share) but the real multi-bagger potential here lies in the newer indications.

KEY POINTS:

1. The internal investigation has concluded and revealed transgressions that were limited in scope and well short of what the shorts had claimed.

2.  The financial position is now secure with a $75mm debt financing, which takes all near term liquidity concerns off the table.

3. The company has brought on experienced new board members as well as a new CEO and auditor.

4. Third party sales data reveal that sales have rebounded aggressively since February and are now annualizing at over $300mm a year.

5. The recent acquisition of Osiris for 5x revenue proves out the attractiveness of the market.

6. The company has an unappreciated portfolio of biologic assets.

1)     Independent investigation revealed limited transgressions.

The short thesis was built on the claim that the independent investigation would be interminable and would reveal evidence of fraudulent revenue as well as doctor kick-backs. The shorts were heartened by the fact that the audit committee had every incentive to bring to light negative behavior on the part of the prior management team in order to justify their decision to abruptly fire said management team and keep the prior CEO Parker Petit from returning to the board.

The auditor KPMG and the law firm King and Spalding subsequently spent 15 months (and likely over +$70mm in fees) reviewing 1.5mm documents and 2,750 hours of video tapes. The central conclusion of this very thorough investigation was that there was indeed some timing issues with regards to the recognition of revenue for their largest distributor and that Petit did engage in various aggressive and inappropriate behavior.

However, the most important finding was the one that they did not make – they did not find evidence of fake sales or doctor kick-backs or bribing or round tripping of cash or any of the other myriad claims that the shorts had lobbed at the company. Needless to say that moving revenue around to beat a quarter is a dismissible offense but it represents a very different sort of offense then lying about the existence of revenue. The basic premise of the whole short thesis (MDXG is a thorough fraud) was proven wrong by the outcomes of this third party investigation.

2)     The company secured non-dilutive financing.

On April 11th, the company announced that they would seek a capital raise, which caused the stock price to fall from the low $4s to mid $2s. The market was concerned that the company would run out of cash as a result of the ongoing investigation costs and be forced to do either a dilutive equity offering or worse. Rather than do an equity offering, the company on June 11, 2019 was able to secure a three year term loan facility deal with Blue Torch for $75mm.

The filing indicated that the company would have $99mm in cash at the end of this $75mm capital raise. The company’s last cash balance as of 12/31/2017 showed a cash balance of $33mm – meaning that the company burned roughly $9mm over the course of the 15 month investigation. If you assume the investigation cost +$70mm in fees – then that indicates that the underlying business was significantly free cash flow generative during this time period (at least $60mm in FCF).  

3)     A new, motivated team is coming into place.

Since the firing of Petit, the company has been managed by ad hoc with a restructuring specialist brought in to run the company on an interim basis and some war time internal promotions. Much of the focus of the management team has been on the internal investigation rather than offensively growing the company. Many decisions have been made that were in retrospect counterproductive like laying off almost 20% of the sales force. 

The company has finally hired a full time CEO in Tim Wright who was previously the head of business development at Teva. More importantly the board has been re-constituted with several high caliber nominees from the biotech world – folks with lots of opportunity cost who would not be entering the fray here if they believed that this had any potential of being an actual fraud as the shorts purport and did not have the potential to be a very compelling turn around opportunity.

Richard Barry is a biotech investor who has served as a director Elcelyx Therapeutics and Sarepta where he is a beneficial owner of over 3mm shares worth over $350mm. He has been buying shares of MDXG in the open market and owns 3.5mm shares personally. Why would Richard Barry a man worth several hundred million dollars go risk his reputation to join a “fraud”?

Dr. Kathleen Wilsey serves as the chairman of the board of Sarepta. She has been a venture investor for much of her career and has served on the boards of Amylin and Abgenix. During her tenure at the helm of Sarepta, the stock price moved from $12 a share in 2015 to over $125 today.

Todd Newton is the current CEO of APEN but more importantly was previously the CFO of Arthrocare Corporation. Newton was brought into Arthrocare in 2009. The company had fallen from $40 in 2008 to $3 in 2009. The company like MDXG had been accused of channel stuffing and various other forms of fraud and was the subject of an SEC investigation and a de-listing. Newton led the company through a convertible raise and a restatement – the company was eventually sold for $48.25 in 2014 – again a 10 bagger.

These are leading leaders from the bio-pharma community with a substantial amount of opportunity cost who would not be willing to devote time to MDXG unless there was an opportunity for a multi-bagger turn around.

4)     Sales are inflecting.

One of the concerns raised by the 8k filing for the credit agreement was the fall off in EBITDA as seen below.

The simple explanation for this is that the company due to the concerns around the ongoing costs of the investigation fired a good chunk of the work force in December, which affected their sales the following quarter and also led to increased severance costs and the like. The general negative cadence here would be concerning were it not for two facts – we can already see the sales inflecting in the third party data feeds (February was the low as seen below) and the company has the cash where withal now to begin investing in their sales force as the investigation is over and they have raised financing. This third party data feed referenced below has been within +/- 4% of accuracy in predicting revenue in the past.

5)     The recent acquisition of Osiris proves out the value of the graft market

Smith and Nephew acquired Osiris in March for $660mm or roughly 5x revenue. Smith and Nephew along with Acelity are the two largest players in the wound management space but are seeing flat revenue growth right now. Allografts represent the best avenue for growth –

The U.S. skin substitute segment is currently worth $900 million per year and is growing 7%. Within that, the subsegment of human tissue derived products known as allografts is growing faster at 9% and there Osiris is the #2 player. (Smith & Nephew M&A Call March 12, 2019 10:30 AM)

The #1 player is obviously MiMedx whose EpiFix product not only sells the most but also generates the best outcomes. That can be seen in this published article on the NIH website (see here) or more simply in this representation below. It generates almost 100% wound closure versus 30-76% for its comps.

There are over 3mm Americans with chronic wounds and that costs the healthcare system roughly $25 billion a year and EpiFix has proven itself over and over again to be the superior product in the space.

6)     The opportunity for Amniofix in the OA knee indication is enormous and completely unrecognized.

Two very successful biotech investors who have been a part of a multi-billion success story like Sarepta don’t join the board of a troubled company with a sub $500mm market cap simply to make a quick double off a successful restatement and relisting. They join if the product and science is interesting enough to engender multiple upside.

The injectable market for joints is roughly $12 billion and there are various indications for which Amniofix may eventually play a role (here, here, here, and here). More effort needs to go into developing data for each of these and with a $100mm cash balance such efforts can start to now be made.

But all of that is an aside to the enormous potential of osteoarthritis in the knee. Kris Alden – an MD/PhD Knee specialist at Hinsdale Orthopedics – treated over a one hundred patients on AmnioFix with below results (see here in Geriatric Medicine).   

He found that 85% of patients experienced significant improvement scores and that “many patients did so well that they didn’t need arthroscopic surgery.”

Why OA is important? More than 14mm Americans suffer from knee OA – knee OA specifically costs the US healthcare system $27 billion annually. A global aging population will see more degenerative joint disease in general. Right now the treatment options are basically pharmaceuticals such as opioids and steroids that are either toxic or habit forming.

Just as the company was falling apart in the spring of 2018, MDXG received an FDA RMAT designation for OA of knee. The FDA rejects most RMAT designations and has only given out 28 (see here). Such a designation is for therapies that address an unmet need and allow for a fast tracked and accelerated approval of the therapy.

A phase 2b trial was designed that will be coming to a close in August of this year. It will be a double blind controlled trial of an Amniofix injection compared to a saline placebo and will involve multiple centers with roughly 318 patients. The primary end point will be a mean change in a VAS core and a WOMAC score and adverse incidences with a secondary endpoint of the KOOS function.

The TAM here would be enormous – OA costs hospitals alone roughly $16 billion a year.

The amazing thing is that virtually no one is aware of the potential for Amniofix in the knee and we have data coming out presumably within the next few months that is not even at all remotely priced into the stock. If this was a biotech with a pivotal data result coming out for a therapy that had a potential TAM of +$10 billion – the company would be worth multiples of the current share price just on the probability of success for a product that could have huge addressable TAM.

VALUATION

This is just a simple model based on our third party sales data – the sales bottom in early 2019 and then rebound in 2020 as they hire back the sales force.

On a restatement/relisting the stock re-rates to the $11-14 range by next year as they trade closer to their comps.

The bigger question is what is the future upside from there and the answer to that lies in the ortho indications. This is much harder to tease out – its safe to say that it would be multiples and multiples higher than where the current stock price is.

According to GrandView Research, the market size for pharma drugs for OA for the knee was $5,987mm in 2018 growing to $10,327mm in 2025. Below is a rough estimate of what sales could look like as a % of that total market with some basic estimates of patient population size and cost per injection which is roughly in line with what other injections currently cost.

The market will have a much better idea of the probability of success after the results come out from the phase 2b study but the salient point here is that 1) none of this being incorporated into the stock price (this is presumably a driving reason for why big biotech investors are coming onto the board ) 2) there is no discussion on this at all by the part of the management team because they are still sorting through other issues.

CONCLUSION

The short thesis on MiMedx has drifted a considerable amount since the start of their campaign. The company is a fraud thesis has been disproven first by the fact that they have continued to generate cash flow and remain solvent during the course of this very expensive internal investigation conducted by third parties. The results of the independent investigation which while finding channel stuffing found no evidence of outright revenue fraud or doctor kickbacks. The resolution of said investigation as well as the introduction of a real CEO and world class board members shows that the story should begin to turn away from the hyperbolic shorts. While the company is still a mess and very damaged by this short campaign, the new board should effectively begin to turn around the morale and bring back order to the core business of wound care and complete a restatement and a re-listing in short order, which should be good enough for a double/triple from here. The beauty of this investment is that you are getting the relatively simple restatement and re-listing upside with enormous optional upside on the OA knee indication for free.

Catalyst

- Earnings restatement in 2nd half of 2019

- Relisting by early 2020

- Data from Phase 2b in OA for the Knee by Q4 2019