Who Will Control Osteotech?
Osteotech, one of the oldest suppliers and developers of allograft implants for surgery is about to become, apparently, Medtronic’s latest division. Spending a whopping 3% of its available cash (we think that qualifies as petty cash), the $39 billion Medtronic is buying $123 million Osteotech.
Just yesterday, owners of nearly 30% of the shares of New Jersey-based Osteotech, Inc. were preparing to challenge the company’s current management and board of directors charging that current management and board needed to be replaced.
Now, Osteotech’s upcoming August 23 shareholder meeting at the Sheraton Hotel in Eatontown, New Jersey, will likely be a bit anti-climactic. Perhaps, instead of fighting, dissident shareholders Heartland Advisors, Inc., Spencer Capital Opportunity Fund, LP, Spencer Capital Management, LLC, Spencer Capital Partners, LLC and Boston Avenue Capital LLC can congratulate management and board for, finally, obtaining a price for the stock that is—well, the same as the price when most of these guys bought in.
Still, why would Medtronic buy Osteotech?
Here are four reasons:
Exclusive access to DBM and other allograft bone and soft tissue products. Over the years Medtronic has purchased its allograft bone products from a variety of sources including Regeneration Technologies (now THAT was a tempestuous relationship) and even had its own allograft subsidiary. Some commentators have suggested that DBM is, in some way, a substitute for BMP. Right. The amount of BMP in a plug of DBM is roughly equivalent to a single drop of rain on the plain in Spain. Not much. Scott (Boden), back me up here.
Cheap revenues. Osteotech, at a market cap of about $80 million was one of the cheapest companies in all of orthopedics. But, as the dissident shareholders made very clear and as did Osteotech’s management in their annual reports, you basically get what you pay for. Namely, a company that has always struggled to be profitable.
Control of their own allograft destiny. Or, density. This deal is particularly notable for the fact that a hardware supplier is finally buying an allograft company. No longer can anyone say that a hardware company won’t buy an allograft company. Medtronic may have been in the body parts business, but it was fairly well under the radar. No more.
Exclusivity. Bye-bye to Osteotech’s other customers who compete with Medtronic. Where will they go? Hello MTF, Allosource, Lifenet, TissueLink, RTI, etc.
But, why would Medtronic NOT want to buy Osteotech? Two reasons:
Lack of operating profit. Medtronic boasts one of the highest rates of operating profit in all of medicine—32.5% of sales. Osteotech’s operating profit is (0.7)%.
Body parts. Approximately every seven years someone does something stupid and tries to circumvent established AATB or FDA rules. Like the funeral parlors in New Jersey that shipped parts around without consent or concern for rudimentary safety factors. Now Medtronic will be on reporter’s speed dial for the next flare up
Osteotech’s dissident shareholders had six major concerns as they girded their loins for a fight with management on August 23.
The Price of Osteotech’s stock is too low: Now it is 65% higher— roughly the same amount that dissident shareholders were claiming was lost due to management failures. The dissident group pointed out in their SEC filings that from April, 2007 to August 3, 2010, Osteotech’s stock price had declined by approximately 55%. The dissident shareholders even pulled a chart from Osteotech’s own annual report for 2009 to show that Osteotech’s cumulative total stock return during the five-year period ended December 31, 2009, was worse than the NASDAQ Stock Market Index and the Dow Jones Medical Supplies Index. Specifically, an investment in Osteotech common stock on January 1, 2005 would have resulted in a nearly 42% loss. The Dow Jones Medical Supplies Index, which Osteotech has selected as the nearest comparable sector index, rose over 42% in that same period.
Operating results and financial conditions have deteriorated: Sure, but that’s Medtronic’s problem now. The dissident shareholders were pointing out that Osteotech’s sales have stayed essentially flat between 2005, when the company generated $93.3 million, to 2009 when Osteotech reported $96.7 million in sales. They also stated that Osteotech lost a large customer in 2009 and, not entirely coincidentally, reported a $4.0 million loss that year versus a net income of $2.2 million in 2008. “Osteotech is also hemorrhaging cash, "wrote the dissident shareholders in their filing; "In the past two years, the company has burned over $12.0 million in cash, reducing its cash from $22.8 million as of December 31, 2007 to $10.7 million as of December 31, 2009.”
The core business is eroding: Hey, after this deal it may erode further, but it could pick up from Medtronic’s expanded business as well. Osteotech’s DBM product line, which represents most of the company’s sales, fell 6% in 2008 and fell another 8% in 2009. Sales from the client services segment fell a sobering 74% in 2009 which came after yet another large decline in 2008. Why the decline? Osteotech’s largest customer, Musculoskeletal Transplant Foundation, had decided NOT to renew their contracts with Osteotech. Ouch!
Management hasn’t met new product launch expectations: Medtronic is now in charge of that. And there apparently is a lot to fix. According to the dissident shareholders’s again, Osteotech’s initial launch date for its Plexur M product was mid-2007. On March 8, 2007, in the company’s quarterly earnings call, Osteotech’s CEO Sam Owusu-Akyaw announced that the product would not be released before 2008. On July 30, 2009, Osteotech said that there would be more delays and that the full product launch was pushed to the fourth quarter of 2009. Come November 6, 2009, Robert M. Wynalek, Osteotech’s President Domestic, indicated that Plexur M’s full release should happen in the second quarter of 2010, three years later than originally planned. Then for MagniFuse, Osteotech initially estimated that it would be released by 2008. Instead, Osteotech’s management announced, in a May 10, 2010 press release that the national launch of MagniFuse products was more likely to occur in the second quarter of 2010. Finally, Osteotech’s new Human Collagen Technology product, DuraTech BioRegeneration Matrix, was expected by management to roll into the market by mid-2010. We are still waiting. In fact in Osteotech’s annual report to shareholders for the year ended December 31, 2007, filed with the SEC in March 2008, management said that DuraTech would be released in early 2009. On May 1, 2009, Osteotech’s management then said that they expected to file a 510(k) submission to the FDA in the early third quarter of 2009, with a commercial product release expected late in the fourth quarter of that year. On December 17, 2009, the company announced the filing of its 510(k) application for FDA clearance of DuraTech.
There is poor accountability to shareholders: Ok. But there’s about to be just one shareholder soo....Its academic now.
Poor Corporate Governance: Actually, this should be fascinating. According to SEC filings, senior management stands to walk away with several million dollars in change-of-control compensation. The dissident shareholders had drawn attention to these “poison pill” and “anti-takeover” provisions and now they will, we’d guess, likely be put into effect.
Osteotech Management’s Response
Hey, we just sold the company for a 65% premium.
And, by the way, we think:
Our Stock Price Performance was fine: According to management the stock has performed well. Osteotech's total stockholder return increased, on a year-over-year basis, in 2006, 2007 and 2009. Osteotech's total cumulative stockholder return since 2005 has exceeded the returns of its primary competitors, RTI Biologics, Inc. and Orthovita, Inc.
Our Operating Results Have Improved: Osteotech returned to profitability in the second quarter of 2010 and increased its cash position in comparison to the first quarter. Osteotech's results of operations and financial condition have been improving since the current management team was put in place in 2006. In 2005, the company realized a net loss of $21.1 million. Mr. Owusu-Akyaw began leading the new management team as Chief Executive Officer in 2006, and Osteotech was profitable in 2006, 2007 and 2008.
Our Core Business is Improving: Management doesn’t argue with the point that sales declined in 2009 due to decisions by Smith & Nephew and MTF to end relationships with Osteotech, but it didn’t significantly erode the business. With the launch of several new products, management has put Osteotech in the position to grow its sales. The three new products which have management excited are MagniFuse, Plexur and HCT (human collagen technology). In the first quarter of 2010, new products generated $1.8 million in sales, up 88% from 4Q09. In the second quarter, new product sales were $2.5 million, up 39% from the immediately preceding quarter.
And we DID Launch a Review of Strategic Alternatives: Osteotech's board of directors engaged Deutsche Bank Securities Inc. in 2009 to help it find and review strategic alternatives to raise stockholder value. Furthermore, Osteotech’s board chairman spent a considerable amount of time in 2009 and 2010 on the ongoing evaluation and exploration of strategic alternatives for Osteotech that are focused on maximizing stockholder value.
Finally, our Corporate Governance Practices Are Sound: "The Dissident Stockholders claim that Osteotech ignores the concerns and interests of its stockholders. This claim is completely untrue, reflects the Dissident Stockholders' lack of information regarding communications the Company has had with other Osteotech stockholders, and completely discounts the numerous communications the Company has had with stockholders over the years. The Board has been actively working with an investment bank for months to evaluate strategic alternatives, bases a substantial portion of management's compensation on performance-based incentives and is involved with, and provides feedback and guidance on, the Company's strategies."
What Happens Next
Unless this deal falls apart, Osteotech is now part of Medtronic and, it would appear, all’s well that ends well.