Description

Short: OMI Equity

Note: Probably too small a market cap with not enough of a borrow for most funds, so I'm recommending as a PA idea. 

Investment Overview: 

Owens & Minor (OMI) is a manufacturer & distributor of hospital products that has come under significant pressure over the last 12 months due to poor capital allocation decisions, overpaying for a leveraging acquisition, and a deterioration in industry fundamentals. 

After originally trying to evaluate the company as a potential long given the consensus hate for the name and weak trading activity, I ended up coming to view OMI stock as a short, with the potential to go to $0 over the next few years, and bonds as a possible short from here as well (contingent on what the company does to address front-end maturities, as discussed below). I do think this company has a long runway / no near-term catalysts to the short, so it may take a while to pan out, but it is challenged nonetheless. 

Capitalization: 

The company is significantly leveraged today, and with results likely going lower from here, leverage will continue to tick up. 

Industry / Business Overview:

Owens & Minor operates in two structurally challenged segments, and I discuss both below. 

Global Solutions Segment: 

The Global Solutions segment is a subscale distributor of hospital products, which involves being the middle-man between manufacturers of surgical gloves, gowns, medical devices, drapes, etc. and the Group Purchasing Organizations of hospital systems. 

This segment formed the vast majority of revenues & EBITDA prior to a transformative acquisition in 2018 and represented the company’s core business since the 1960s. OMI & 2 other players, Cardinal Health (CAH) & Medline (privately held), became the most prominent market participants (CAH / OMI were distributors for a long time, and Medline was a hospital products manufacturer that became a distributor). These three players represent 95%+ of the hospital products distribution market, with Cardinal at ~40-45%, OMI around 30%, and Medline the smallest today at around 20-25%. There are a few small regional players (Seneca is an example), but the large nationals have all merged into the 3 major players as of 2006 (last transaction was McKesson selling their MedSurg distribution assets to OMI then). 

Despite being an oligopolistic market, this industry has faced significant price competition for decades, which was exacerbated over the last few years as other players have made aggressive share grabs and become more vertically integrated at the same time as customers have consolidated & faced reimbursement pressures to lower costs. 

Competition: 

Price competition has mainly stemmed from the fact that Cardinal & Medline are vertically integrated, in that they both manufacture & distribute product. Cardinal spent over $10B acquiring a variety of hospital products businesses, and Medline actually began as a products business out of Chicago before building out its distribution service. 

Today, roughly 40% of Cardinal’s product offering is private label / manufactured in-house, and industry consultants estimate that over 50% of Medline’s business is private label. This compares to low-single digits for legacy OMI, which had one private label brand in-house for commoditized surgical equipment prior to 2018. 

What competitors have begun doing is offering distribution services for 0-1% margins as a way to subsidize their product sales to hospitals, which has the secondary effect of winning business away from OMI it comes off contract. 

Competition / price pressure has been amplified by the fact that customers have become increasingly difficult to sell to. Providers / hospitals have banded together to form a number of Integrated Delivery Networks (IDNs), and IDNs are in turn part of Group Purchasing Organizations (GPOs). IDNs contract directly with the distributors that GPOs have partnerships with. The consolidation of customers has put significant pressure on the industry, as the negotiating power of distributors has declined and they often recut rates upon. Additionally, while switching costs for an individual hospital system can be material, distributors have begun to offer product across the entire spectrum of manufacturers (eg. OMI distributes Cardinal & Medline private label products and vice versa) – so if a hospital system switches distributors, no real impacts to product availability occur. 

Separately, hospitals continue to face reimbursement pressure from payers to provide acute care as cheaply as possible through a shift to value-based care in the acute setting, which has had the secondary effect of annually reducing budgets for hospital purchasing departments. Discussions with IDN purchasing managers indicates that the first place providers look to cut is the cost of equipment, both on the distribution & manufacturing side. Put differently, reimbursement pressure directly increases pressure on distributors & manufacturers to provide cheaper service. 

As far as industry participant behavior, some channel checks imply that Medline is pricing distribution as a service at up to a 2% discount vs. OMI, which is obviously meaningful in a business that does 1.8% margins. Medline’s website boasts of being fully self funded by cash flow (with no debt), and has a reputation for being aggressive share takers in this segment as well as other pieces of the hospital value chain. Cardinal’s behavior has been aggressive as well, pricing at a 50-100bps discount to OMI nationwide. 

Purchasing contracts are typically 3-5 years long, so the decline / loss of customers is felt gradually as existing contracts are either lost or repriced. Indeed, OMI’s reported EBITDA for this segment declines ~10% per annum, despite some acquisitions to offset the issues. 

Operating Issues: 

Compounding the issues for the company are the fact that OMI created a bunch of self-inflicted wounds over the last few years, none of which have any near-term abatement likely. Previous CEO Cody Phipps implemented a significant cost cutting plan, identifying $150MM of costs to cut. 

In the process of cutting costs, a big step the company made was to shut down all of the regional service centers that allowed for direct sales & relationship access to local hospitals / GPOs. While this had the immediate impact of improving EBITDA margins, customer relationships soured and service capabilities fell apart, and a number of contracts were lost to Cardinal & Medline given their price advantage. OMI, priced at a premium already, was previously valued for its high touch service aspects & long-standing customer relationships, all of which were lost upon the sales office consolidation…leaving little reason to continue using OMI vs. cheaper priced alternatives. Customers I have spoken with seem to imply that they don’t really mind if OMI goes away due to competitive pressures just given the diminished levels of customer service levels & elevated price. 

The company also suffered from a brain drain of sorts during this transition, as while they tried to relocate sales talent to a centralized location, not all of their trained salespeople moved. Separately, they found liquidity squeezed during 2018, so were unable to hire people to fulfill new staffing needs in a wage inflationary environment. Existing employees had to work significant amounts of overtime to make up for the understaffing which continued the vicious staffing cycle. 

Industry participants suggest Phipps as a high-flying ex-consultant who was out of touch with customers & the operating business, which foots with this narrative. While new management seems to be re-engaged on these issues, it appears to be too little, too late. 

Outlook: 

I model this segment as likely to continue losing contracts & revenues to decline at an LSD pace (including a big contract loss that management has already guided to for the end of this year) as I view it as unable to hold volumes against competitors who are effectively giving away this service for free. There is a strong home health business in here OMI purchased in 2017 that offsets some of the decline, which prevents it from being faster than I have modeled. Pricing in my model drives EBITDA lower as well, and I have margins declining gradually from 1.5% to 1% (still at a premium to market) over the next 3-4 years. I view new management positively and think they have some ability to offset the issues by re-engaging customer relationships, but the industry pressures are unlikely to abate in the near-term. 

Global Products Segment: 

As a natural response to competitors driving private label penetration by offering distribution product for free, OMI decided to counter by buying their own products business, which makes all the sense in the world. Unfortunately, however, they paid 7.5x EBITDA for a commoditized Surgical & Infection Products Business from Halyard Health which has had to deal with EBITDA falling off a cliff due to a number of macro and micro issues. 

HYH S&IP Acquisition: 

Would note that beethoven does a pretty good job of describing S&IP & its issues in his HYH short writeup in 2015, so I would encourage those interested to read his synopsis / history of this business as well, but basically S&IP was part of HYH (formerly part of Kimberly-Clark) in the late 90s after KMB acquired a surgical gloves company. 

Long story short, this segment produces significantly commoditized surgical gowns & drapes, medical exam gloves & masks, sterilization wraps, and a few other ancillary products. It is probably fair to think about all of those categories as equal contributors to revenues, with similar drivers. 

As beethoven outlines, price pressure is the biggest driver of share in this space, followed by innovation. When S&IP was part of HYH, the big competitors (Sempermed, Medline, Cardinal) had done most of the innovation of these products over time and priced them at a significant discount to S&IP. Industry participants suggest that HYH was usually rushing to plug holes and innovate around existing IP of Medline / Cardinal as opposed to trying to create their own new product and would usually just find some way to copy what competitors were already offering. Customers talk about all of these products as interchangeable and indicate that GPOs only want to purchase what they can source the most cheaply due to the lack of differentiation. 

Additionally, the acquisition of S&IP in 2018 by the distribution business should have brought back office synergies and created the opportunity for revenue synergies given customer overlap in the GPOs, but ironically as distribution business lost customers due to its late entry into manufacturing, it has simultaneously taken a big chunk out of whatever private label / in-house manufacturing sales it had prior to acquiring S&IP. 

To add to the perfect storm for this company, input raw materials have been a huge headwind, as nitrol & polypropylene prices have increased 20%+ since 2016, and they do not show any real signs of reversing the long-term trend. 

Since acquisition in April 2018, EBITDA for Global Products has declined from $125MM to $77MM today (albeit with some one-time negative impacts of about $10-15MM). 

Outlook: 

I model this segment to continue declining at a rate of MSD per annum (which I admit might be slightly punitive), although I do view margins as jumping back to a higher level than the LTM period (the company was impacted by some one-time issues in the first half that drove absurdly low EBITDA margins). Volumes will continue to be impacted by the share gains of competitors and collapse of the legacy products business as it declines with the distribution segment. 

Path Forward: 

Before discussing valuation, I think that a relevant topic is the path forward, which is fairly murky for this company – on one hand, results continue to be challenged, and there are near-term debt maturities that the company must figure out how to deal with. But on the other hand, to their benefit, the company does generate cash today and has sufficient liquidity and runway before 2021 bonds come due in 2 years, and debt securities trade at 9%, which implies that they could be refinanced at a higher coupon. 

The company also has the ability to easily separate the two segments and raise money via asset sales to deal with the front-end maturity (granted they will get nowhere near the price they paid for S&IP if they sell that).

However, a few things to note are that: (i) leverage is high and likely getting worse, and (ii) refinancing the debt stack to 9% implies that this capital structure will no longer work, as its current FCF generation is ~$30-40MM (likely going lower), but it has debt that it pays a 4% interest rate on. At market rates, this company burns cash on a levered FCF basis, so even if it makes it past the frontend maturity, the longer-term capital structure needs to look different. 

My view is that bonds on the back-end (2024 maturity) probably make for OK shorts, but it is painful to eat the carry cost to shorting them, so the right trade may be to wait until the 2021 maturity is closer. Taking out the front end bonds in cash (assuming a fair value asset sale) results in increased downside for the back-end bonds. 

Valuation: 

I cut valuation a few different ways, but any way I look at it, it is hard to justify a 10x EBITDA valuation for a stock that will face significant secular issues and could see results rebase materially lower in the near-term from their disclosed contract losses. Here is my SOTP framework (using some fairly optimistic assumptions on the pace of decline in my mid / high cases): 

I use a range of 6-8x to value S&IP and a range of 5-7x to value the distribution business. I think you can get reasonably comfortable with these multiples given that this business is unquestionably of worse quality than Cardinal, which trades at 7.5x. This company does benefit materially from the fact that it has a significant amount of positive working capital that will be released as it declines, so I build the NPV of working capital release into my valuation. Of course, they could pull more working capital out quickly, but this business does require inventory on demand in a high-touch way, which implies that working capital is not as easy to pull.

Other ways to cut valuation are looking at normalized FCF yield (remarking the interest expense given how levered this structure is, and using my guess at 2019 EBITDA).

Any way you cut it, this should not be a 10x stock, so I see fairly asymmetric risk/reward shorting it here. 

Risks: 

Lack of NT Catalyst: I’m sure the community on VIC could tell based on my verbiage, but this thesis will not play out overnight, or over the next 6 months. While there are events that aren’t too far away in the form of the near-term bond maturities & contract losses, there won’t be one thing that catalyzes this stock to the downside that I can see in the near-term. 

M&A: Biggest risk that I can see to the short is the potential for someone to acquire OMI. During my diligence work, a few potential buyers were thrown around as potentially interested parties. I address a few of them below: 

1) Medline – They have been aggressively taking share in the industry and could look to acquire a competitor as to build share more rapidly. Nobody really knows much about Medline, they are fairly private / tight-lipped and run by a family that has been conservative over time. One mitigant is that they take pride in being fully internally funded on their website without taking on any debt, so it would be surprising if they made a leveraging acquisition of OMI given that.

2) Pharmaceuticals Distributors - The drug distributors (ABC, MCK) have been rumored acquirers of these assets given that there are likely logistical synergies on the distribution side. However, drug distributors have historically shown little interest in this space and have actively avoided it over time, with McKesson selling its MedSurg distribution business to OMI in 2006.

3) Amazon - Industry trade rags suggested interest from Amazon in acquiring OMI or an existing distribution platform a few years ago as they foray into healthcare distribution more broadly. While Amazon has yet to compete for GPO distribution contracts (and may not for a while given the low returns on capital), they could look to build their platform in the space by acquiring OMI or another competitor. This is purely speculative at this point but could represent a negative outcome for the short. I’m not really sure what the likelihood is of it happening, but it is a risk.

Volatile Margins / Results: As I mentioned above, the lack of a near-term catalyst may make investors need to absorb negative price action as it comes. A big driver of negative price action could be the volatility of margins & results, which occur due to pricing, raw material costs, and somewhat variable volumes. While the long-term secular trend is negative, short-sellers should be weary of temporary blips / positive data points, and not overly excited by temporary negative ones. 

Liquidity: This is a <$500MM market cap with not a ton of borrow out there, so I’d recommend this for small funds / PA as opposed to for larger institutions. IB has 2.6MM shares available at 0.3%, as you can see below. 

Catalyst

Deteriorating results as the 2021 maturity approaches and refinancing options are diminished