Description

Description:

I believe Orthopediatrics Corp. “OP” (Nasdaq: KIDS) is a short. 

Orthopediatrics is a provider of orthopedic implants to juveniles for repair of trauma and deformity “t&d” and scoliosis. 

The short opportunity exists because the market believes KIDS is a unique orthopedic implants company that can compound growth in the 20%+ range for years to come and is operating around break even profitability already. The reality is KIDS is highly cash intensive business with decelerating organic trends and multiple accounting red flags. 

Today KIDS is the markets “favorite son”  trading at 9x trailing sales despite having a -40% FCF margin on revenue but over time once the market accurately ‘diagnoses’ the issues at the company its multiple will compress and the stock will trade meaningfully lower. 

While KIDS income statement looks great; I believe investors who carefully read the  “MRI scan” of KIDS’ balance sheet, cash flow statement, related party transactions and SEC filings may come to the conclusion that KIDS’ growth may not be as robust as it appears and is being aided by its largest shareholder, which in this analogy may be the protective parent, Squadron LLC. My belief is that true organic growth is likely less than reported for a variety of reasons and future growth and profitability expectations will disappoint the street at some point in the future or worse. 

History/Background: 

OP was founded in 2007 in Warsaw Indiana with the mission of being an orthopedic company dedicated to a specific call point, the pediatric orthopedist. KIDS came public in 2017 at $13/share and now trades around $40. Since coming public KIDS has conducted two follow on offerings in December of 2018 and 2019 at $27.00 and $36.50 respectively. 

At the time of the IPO Squadron Capital LLC a private investment firm was the majority shareholder. Squadron maintains ownership of 5.3m shares. Squadron is also KIDS balance sheet as they are the lender of the term loan, supplier of over 20% of KIDS cost of goods. Additionally Squadron lent KIDS money for the acquisition of Vilex, and even purchased from KIDS the part of Vilex that KIDS didn’t want in what I would describe as an unusual transaction. 

Business Oppty/Bull Case: 

According to the company’s 10-K there are only 268 hospitals that perform 62% of all pediatric t&d and scoliosis cases. The big orthopedic players like DePuy Synthes, Medtronic, Smith & Nephew all play in this call point and hold the majority of the market share. The bull case on OP is that doctors and hospitals would rather work with them than one of the big guys but as a private company KIDS was capital constrained and couldn’t provide enough instrument sets and trays to customers to grow their business. Since KIDS came public they have spent aggressively on set deployments to drive growth. 

To me it appears the return on this spend on sets may not be as high as initially hoped and the company is having to resort to acquisitions which are not disclosed in magnitude and potentially extending payment terms to customers or stocking distributors to grow revenues among other issues.  

Thesis: 

My high-level thesis is that KIDS is using various levers to inflate their income statement. I will lay out each red flag. 

1. Consistent growth in accounts receivable days sales outstanding 

2. Changes in revenue recognition methodology in 10-K 

3. Related party transactions 

4. Acquisitions inflate growth rate

5. Inventory and PPE growth indicate declining return on sets 

6. Significant gap between “adjusted EBITDA” and FCF 

7. Valuation is very high compared to other orthopedic companies with similar cash burn profile 

1. Consistent Growth in AR DSO: from 31 days to 80 days over past four years

KIDS DSO was up over 20 days Y/Y in Q4’19 reaching 80 days

Here is KIDS DSO compared to peers: 

KIDS has gone from below peer average to now well above peer levels which I believe is a concerning trend. 

To me this indicates changes in terms with customers, i.e. using payment terms to win business or worse. One company where I saw with similar consistent growth in DSO was Osiris Therapeutics (OSIR) which fell over 80% when they had to restate financials. 

2. Recent disclosure in 2019 10-K of changes in revenue recognition policy is a red flag: 

Outside of the United States, we primarily sell our products through independent stocking distributors. Generally, the distributors are allowed to return products, and some are thinly capitalized. Based on our history of collections and returns from international customers, prior to 2019, we concluded that collectibility was not reasonably assured at the time of delivery for certain customers who had not evidenced a consistent pattern of timely payment. Accordingly, in the past we did not recognize international revenue and associated cost of revenue at the time title transfers for these customers for whom collectibility had not been deemed probable based on the customer’s history and ability to pay, but rather when cash had been received. Until such payment, cost of revenue was recorded as inventories held by international distributors, net of adjustment for estimated unreturnable inventory, on our consolidated balance sheets. Following a review of our collection history, we deemed collectibility was probable for all international stocking distributors effective January 1, 2019. Based on a history of reliable collections, we have concluded that a contract exists and revenue should be recognized when we transfer control of our products to the customer, generally upon implantation or when title passes upon shipment.

What this means is that KIDS changed their revenue recognition with these aforementioned “thinly capitalized” international distributors to recognize revenue sooner. 

3. Squadron Capital is KIDS largest shareholder. As mentioned above they are also KIDS lender on their debt and credit agreement and mortgage, supplier and acquirer of segments of Vilex. 

1. One of Squadron’s portfolio companies is a significant supplier. Structure Medical, LLC owned by Squadron is supplying anywhere between 22-37% of KIDS COGS over the past 3 years. Perhaps this is perfectly innocuous, but I wonder HOW DOES STRUCTURE MEDICAL SET PRICES TO KIDS?  Is it possible that the private structure medical could be absorbing costs that might in a normal transaction be born on Orthopediatrics income statement? 

2. Vilex Transaction: On June 5th 2019 KIDS announced the acquisition of Vilex in Tennessee, Inc. (Vilex) and Orthex, LLC collectively Vilex an external fixation company for $60m. [For simplicity I will refer to the part of Vilex transaction that KIDS kept as Orthex and divested part as Vilex but its not quite this simple].  Squadron was there to lend additional money for this acquisition: 

In conjunction with the acquisition of Vilex and Orthex, the Company entered into a new $30,000 short- term loan facility with Squadron in addition to the existing $20,000 term loan facility and $15,000 revolving credit facility previously established. 

Subsequently we learned that Squadron had actually purchased the part of the acquisition “Vilex” that KIDS didn’t want back from KIDS on 12/31/2019 for $25m. 

On December 31, 2019, the Company divested Vilex for $25,000 to an affiliate of Squadron -2019 10-K 

On the Q4’19 call the details of the transaction were announced: 

As consideration for the Vilex Adult Business and the Orthex adult license, the amount we owed under our Term Note B payable to Squadron Capital was reduced by $25 million. 

Here is where things start to get interesting: 

I also wanted to highlight a new line on the balance sheet called deferred revenue. This consists of the unearned portion of the exclusive license arrangement to allow the new owner of Vilex the ability to sell products using the Orthex technology to non-pediatric accounts. This deferred revenue will be recognized on a proportional basis across the term of the agreement, effectively recognizing royalty revenue and income over time. The remaining $12.5 million of the total $25 million purchase price went against the Vilex assets sold.

What this means is that instead of a typical sale of an asset which doesn’t result in revenue generation, KIDS structured this deal with Squadron so they will be able to recognize half of the divestiture proceeds through their income statement over time despite receiving the cash upfront. 

KIDS can now start recognizing $12.5m in revenue and profit on their income statement over time due to the sale of this asset. To me this is odd and I think the divestiture should have been allocated purely to assets sold. Why should you be able to buy a business and then sell part of it to a related party in a transaction that will result in you recognizing revenue and profit on half of the proceeds of the sale? 

At minimum any respectable financial analyst should subtract any declines in deferred revenue from revenue and EBITDA. I believe this transaction exemplifies managements attempts to show revenue on their income statement but it isn’t truly a revenue generating transaction from my admittedly uneducated perspective. 

4. Orthex revenue recognized in 2019 (the real revenue not the non cash revenue discussed above from the divestiture of some assets to Squadron) contribution inflated growth and management has gone through great lengths not to disclose the impact. KIDS likely would have missed their original 2019 guidance without the acquisition impact

When asked about the contribution of Vilex to revenue on the Q2 call management refused to answer: 

Fred won't let me disclose much about that unless he has a change of heart here at this moment because of your persuasive question, Rick. But I think we can safely say that there was a very limited contribution of Orthex in June. And from that standpoint, it was not a significant contributor to the growth of the company. – Mark Thordahl Q2 CC

On the Q3 call analysts asked again only to be rejected. 

Michael Stephen Matson Needham & Company

Okay. So I mean, I guess, if we're estimating that the deals added $750,000 -- deal -- I'm sorry, not deals, I mean, is that a reasonable assumption? 

Fred L. Hite CFO & Director

We're not going to break out specifically what it is. The overall business, the growth is steady with or without the -- with Orthex. 

So you might be asking- what was acquisition contribution? 

The answer is we don’t know. However, piecing together disclosures we know the business they bought did $12m in revenue in 2018  (see image of 8-K below) and likely grew some in 2019 so let’s estimate $12.5-13m in revenue in 2019 full year proforma. 

We know they owned the asset for 7 months or 58% of the year which would imply approximately 7.25m of revenue during the period of time in which KIDS owned the business. 

We know that KIDS considered the part they divested “Vilex” as discontinued operations from the time the purchased it and during the time they owned it generated $3m in revenue that was not reported on the income statement (see snip from 10-K below) which would imply KIDS likely reported around $4-4.5m on their income statement during 2019 primarily in the second half of the year. 

KIDS original guidance was for a midpoint of 22% revenue growth off of 2018 full year revenue of $57.5m. This would imply guidance midpoint of $70.15m for 2019. KIDS full year 2019 revenue ended up being $72.6m which means if Orthex contributed around $4m that KIDS actually missed original guidance by over $2m which is significant for a high growth high multiple stock known for perceived “conservative” guidance. 

Additionally this arithmetic implies a significant organic deceleration in KIDS largest business line, trauma and deformity. 

Trauma and deformity represent roughly 70% of KIDS revenues and averaged 21% annual growth in the three years 2016-2018. However, if we assume Orthex acquired revenue contributed $3.6m to T&D segment revenues in 2H’19 that would imply that T&D segment growth organically was 15% in the 2H’19 period a significant step down from the golden 20% level the company’s valuation is based on. 

This math calls into question what CFO Hite meant by “growth is steady without Orthex”

See supports below from 8K and 10-K respectively. 

5. KIDS is seeing deteriorating returns on the set investments they have been making since coming public which calls into question their strategy and quality of their business model. 

KIDS has seen consistent growth in inventory over the past few years in relationship to revenue meaning which implies declining returns on set investments or worse improper treatment of costs. 

When we combine inventory and PPE to fully capture the set investments then the picture does not look any better: 

Inventory and PPE combined as a percentage of revenue were 313% of Q4 revenues up from prior year 263% of revenue. This shows that each dollar of sets out there is incrementally driving less revenue. 

To me this is a red flag because it means that the incremental revenue per incremental dollar of set deployment is deteriorating rapidly which calls into question KIDS ability to continue to drive growth through set deployments. 

A corollary many in this industry can related to: at some point no matter how low interest rates go it wont stimulate demand during a coronavirus recession and on some level no matter how much inventory KIDS puts out in the field it won’t mean incremental revenue. 

Additionally, we can see that KIDS has nearly twice as much inventory in relationship to cost of goods as their peer group and has nearly doubled that metric over time: 

PP&E is also well above peer levels but not by same order of magnitude as inventory. However, the significant growth in PPE % of Revenue demonstrates deteriorating returns on capital and unit economics of set deployment. 

VI: KIDS is valued as a break even EBITDA company and investors may not be aware of their serial cash burning and equity raising ways. 

For example its apparent analyst on calls are focused on EBITDA but really they should be focused on cash flow: 

Kaila Paige Krum

That's really helpful. That's great color. And then just on EBITDA. And thanks, Fred, for your comments there on the quarter. I'm sorry if I missed this, but can you just give us a sense for any items that you view as sort of more onetime in nature? And then how we should think about go-forward spending? So should we still be modeling EBITDA profitability in the coming quarters? Just want to understand sort of the puts and takes there.

Here is a table that shows adjusted EBITDA because every kid learns in school a picture is worth a thousand words: 

In reality KIDS burned $30m in FCF in 2019 and over $20m in 2018 roughly 41% of revenue in 2019 and 37% of revenue in 2018. 

Looked at in this light KIDS profitability is getting worse not better and EBITDA is not the right way to look at the business profitability given the significant Cap X and working capital movements going on. 

Additionally the securities and exchange commission (SEC) went out of its way to call out KIDS in correspondence for their aggressive definitions of Adjusted EBITDA. See correspondence below. 

VII: Despite all red flags surrounding KIDS they still trade at a significant premium to orthopedic peers which means there is significant room for the stock to re-rate lower. 

If KIDS were to trade at any of the revenue or gross profit ratios of its peers there would be considerable downside. 

Conclusion: 

There are a multitude of red flags surrounding KIDS as I have laid out. Growth appears to be decelerating organically in the T&D segment which is 70% of revenue. Cash flow is significantly diverging from EBITDA. Related party transactions abound and the stock trades at a full multiple. I see potentially significant downside to the equity. 

Risks: 

1. KIDS starts converting their newly created deferred revenue balance into revenue and profit and the sell side and bulls cheer along and don’t care or want to know where the revenue is coming from 

2. The first half of 2020 will feature an inorganic contribution from Orthex acquisition that will muddy the growth rate. Investors may not realize or care and drive stock up. 

3. KIDS could issue more equity and buy more things which will make organic growth calculations difficult 

4. Any med tech company can be acquired at any time although my guess is given product isn’t really that unique in my opinion and valuation is full I don’t see an acquisition as particularly likely 

Disclaimer: 

This write up contains certain opinions of the author as of the date written. Before investing do your own work. The author or his employer may or may not hold positions in the Security noted in this article. These parties may trade at any time, without notification to this community, and will not disclose this information to this community. The author and his employer disclaim any liability for investment losses that you may incur under any circumstances.

Catalyst

- Lapping Orthex inorganic contribution

- Continued cash burn

- Follow the balance sheet and cash flow metrics