Via SeekingAlpha.com

OrthoPediatrics Corp. (NASDAQ:KIDS) is now wildly overvalued relative to small-cap peers. I expect shares to trade down following the 1Q earnings call as the company discloses the magnitude of the revenue decline it is experiencing due to disruption to elective procedures. While this unfortunate disruption is temporary, it is likely to have lingering effects. Most small-cap, spine-related public companies have seen their stock prices decline substantially while KIDS is barely off its recent high. KIDS is not profitable and still trades on over 10x 2019 revenues as compared to a group average now around 3x TTM revenue. A more reasonable price for the stock would be in the 6-7x revenue range (still a large premium to peers) which would lead to a $24-$28 share price.

Revenue Growth

KIDS had been rapidly growing sales of its pediatric orthopedic products mostly related to spine surgeries; total sales grew around 25% in both 2018 and 2019 (10-K). Consensus for 2020, as of April 20, still calls for 18% sales growth although the company withdrew its guidance on March 30 saying that business would be “materially” impacted from deferrals of elective procedures. However, the company like many others did not give clarification on expectations for 2Q and beyond.

In order to arrive at a reasonable revenue estimate for KIDS, we can look at NuVasive’s (NASDAQ:NUVA) pre-announcement on April 14. NuVasive also develops, manufactures, and sells spinal orthopedic products. The company announced preliminary 1Q results would be down around 5% vs. previous expectations for growth of around 4% due to the impact of a decline in elective procedures beginning in mid-March. So, if NUVA’s revenues were tracking 4% growth until mid-March, that means revenues for the last two weeks of March would likely have been down around 40%. This 40% hit to revenues is in line with other anecdotal evidence for elective orthopedic surgical procedure volumes.

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This decline is likely to persist for several months and then to only rebound slowly later in the year. While some may expect a quick rebound from “deferred” procedures, this seems unlikely. While some types of products can truly be “deferred” such as tech or industrial products, surgical procedures once they are missed cannot be made up in the same fashion. Under normal conditions, surgeons and operating rooms typically have a reasonably full schedule, so it seems unlikely that there will be a bolus of spine surgeries that will occur when elective procedures begin to return to normalcy. It also appears that a true return to normalcy for this type of procedure could be several quarters away.

Forecasting is extremely difficult for these companies given the disruption, but I view the most likely scenario to be a small revenue decline in 2020, with 2Q down substantially followed by a decelerating decline in 3Q and perhaps a return to some growth in 4Q. I would estimate a best-case revenue scenario for KIDS in 2020 of flat revenues versus 2019, and a worst-case scenario is probably down around 20% (assumes elective procedures are 60% of revenue). Consensus for growth of 18% appears far too aggressive in my view and will likely be reset following the first quarter earnings call.

Valuation

Even for a high-quality company growing revenues 25% per year, 10x sales is a steep multiple. However, for a company that faces an extremely uncertain environment and has a peer group trading around 3x, in my view 10x sales appears unreasonable.

mkt cap

Return 1/31/20 – 4/20/20

Sales 2019 (A)

Sales 2020 consensus

P / 2019 Sales

ATEC

222

-49%

113.4

112.0

2.0

GMED

4480

-10%

785.0

795.9

5.7

KIDS

754

-4%

72.5

85.9

10.4

NUVA

2852

-26%

1168.0

1099.0

2.4

SPNE

265

-36%

159.0

149.2

1.7

Source: Bloomberg as of 4/21/2020

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GMED is the only small-cap spine comp trading above 3x revenues with a multiple of 5.7x but has huge margins (EBITDA margin around 30%) while KIDS is unprofitable and will burn cash this year. Smaller cash burning spine companies such as SPNE and ATEC trade at 1.5x and 2.1x sales respectively. While KIDS ended 2019 with around $70m of cash and $39m of debt, the company will burn cash this year. The current consensus calls for $17m of cash burn in 2020 (cash burn in 2019 was around $29M), but due to the disruption it could be substantially higher which could warrant caution.

KIDS has also substantially outperformed its peer group since the COVID-19 related sell-off began (see table above). Most spine related device stocks are down significantly, with unprofitable smaller cap companies such as ATEC and SPNE down 49% and 36% respectively (from Jan. 31 to April 20). Note that KIDS’ 2019 absolute revenue is below peers ATEC and SPNE, but KIDS has a significantly larger market capitalization. KIDS has received a premium due to its niche product offering with fewer competitors and perhaps a general halo effect. However, at this point the premium appears too large and a more fair price for the stock should be around 6-7x sales. While this still represents a large premium to other small cap spine players, I think it is warranted due to its niche product offering and higher growth rate.

Recent Acquisition Is Dilutive

On April 1, the company announced the acquisition of ApiFix Ltd. This is an Israel- and Boston-based private company that is focused on pediatric orthopedics. KIDS is buying this company for 934k shares, plus $2M of cash, plus substantial earn-outs. Thus, it appears it paid approximately $39M upfront (assumes a stock price of $40) plus earn-outs of at least another $30m (can be paid in cash or stock) over the next four years. While the company could have a significant growth opportunity, ApiFix appears to currently have 9 employees and 2019 sales of $500k, which appears to be a price tag of almost 140x 2019 revenues. This is quite a high price tag and causes further dilution to shareholders. It indicated on the April 2 M&A call that the cash drag would be about $3M over the next 12 months.

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Conclusion

While OrthoPediatrics is a high-quality company, the current valuation appears out of line with comparable companies. Now with the company facing a difficult environment and potential decline in revenues that will likely have a larger impact than expected by investors, the stock could have a substantial correction. The company may burn more cash this year than expected due to the downturn and recently made a dilutive acquisition. A more reasonable valuation level for the share price should be around $24-$28, about 6-7x my 2020 sales estimate which is flat versus 2019.

Disclosure: I am/we are short KIDS. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.