S&P Global Ratings rates seven medical technology (medtech) contract manufacturers that vary in size, specialty areas, and product and customer concentration (table 1). Over the past several months, we have noted lower-than-expected cash generation at many rated CMOs, resulting in negative rating actions or diminishing capacity for further underperformance across a broad section of the sector. While the rating actions we've taken in the sector reflect factors that are distinct to each company, they stem from the same set of industry trends.
In this article we will discuss the drivers behind our recent rating actions and some common CMO industry trends, as well as the differentiating characteristics that have resulted in a variation in our rating actions over the past few months.
|Rated Medical Technology Manufacturers|
|Company||Rating||Most recent rating action||Date of last publication||2019E adjusted leverage (x)|
Avalign Holdings Inc.
|B-/Stable/--||Rating assigned||December 2018||15.7|
Femur Buyer Inc.
|B/Stable/--||Rating assigned||February 2019||7|
Integer Holdings Corp.
|B+/Positive/--||Outlook revised to positive||March 2019||3.5|
TecoStar Holdings Inc.
|B/Stable/--||No action||May 2019||6.2|
Spectrum Holdings III Corp.
|B-/Stable/--||Rating lowered to 'B-'||June 2019||10|
Viant Medical Holdings Inc.
|B/Negative/--||Outlook revised to negative||June 2019||7.6|
LPC Holding Co./Q Holdco Ltd.
|B/Stable/--||No action/rating assigned||August 2019||7|
|E--Estimate. Source: S&P Global Ratings.|
The medical device segment is growing at a healthy low- to mid-single-digit rate as more and more large OEMs turn toward outsourcing. In addition, the sector is typically less cyclical than other industries where contract manufacturer organizations play a significant role, making it an attractive expansion opportunity. At the same time, a wave of consolidation among OEMs in recent years has created customers with increased scale. These customers can leverage their greater size and negotiating power to put pressure on their CMO suppliers to lower sales prices, extend the payment terms, or require CMOs to hold finished goods inventory for an extended period. In addition, OEMs are pursuing their own production efficiency, triggering the risk of insourcing. Those headwinds are hurting CMOs' operating margins and cash flow generation. In response, they are launching internal cost optimization initiatives and seeking to improve operating leverage through volume increase, typically by acquiring additional capabilities and consolidation to become a one-stop shop for their customers (table 2).
|Company||Rating||Managing a challenging acquisition integration or divestiture process||Revenue growth affected by insourcing||Pricing pressure or raw materials inflation||Increasing investment in SG&A and other items to support growth||Difficulties with working capital management leading to reduced cash flow generation||Leverage level increasing beyond the current rating range|
|Avalign Holdings Inc.||B-/Stable/--||✔*|
|Femur Buyer Inc.§§||B/Stable/--||✔|
|Integer Holdings Corp.||B+/Positive/--||✔||✔ §|
|LPC Holding Co./Q Holdco Ltd.||B/Stable/--||✔||✔||✔||✔|
|Spectrum Holdings III Corp.||B-/Stable/--||✔||✔||✔||✔||✔||✔|
|TecoStar Holdings Inc.||B/Stable/--||✔||✔|
|Viant Medical Holdings Inc.||B/Negative/--||✔||✔||✔||✔||✔|
|*Margin compression in the first quarter of 2019 was driven by SG&A increase, as well as other factors (i.e., unfavorable manufacturing variances and higher expedited shipments). §Expected to affect results in the second half of 2019. §§In the company’s first-quarter 2019 report it indicated that its gross margin was affected, inter alia, by an increase in material costs. Although the increase in material costs was passed through to customers, dollar for dollar it increases the material percentage of sales. E--Estimate. SG&A--Selling, general, and administrative. Source: S&P Global Ratings.|
Outsourcing Is Growing, But Insourcing Remains A Risk
As medical devices become more sophisticated, the vast majority of medical device companies are outsourcing at least some parts of the manufacturing process. We expect outsourcing growth to outpace the growth of the industry at large. The rationale is clear--contract manufacturers typically promise faster time to market, increased agility, economies of scale, and better return on investment. That allows OEMs to focus on what's most important for their growth, which is developing new innovative products.
The CMOs we rate mostly have a distinctive set of capabilities and specialties, and don't directly compete with one another. Their competition is generally their customers, who could theoretically produce the same product should they want to. Although a rare occurrence, outsourced manufacturing may be brought in-house. For example, Spectrum Holdings has recently reported that a few of its customers have decided to insource production, affecting the company's revenues and margins in the first quarter of 2019 and contributing to our downgrade of the company. In general, when evaluating companies' growth prospects, we typically assume about 1% revenue decline stemming from product lines reaching their end of life or from insourcing.
Companies Face Pricing Pressures, Integration Issues, And Working Capital Swings
In our view, greater scale and lower leverage are beneficial as they create larger cushion to absorb potential setbacks and enhance negotiating power vis-à-vis customers. However, it can be difficult to gain scale, especially when done through transformative acquisitions in response to the evolving landscape. This was evident in Viant's acquisition of the Advanced Surgical & Orthopedics (AS&O) business from Integer and Q Holdco's acquisition of Degania Silicone Ltd. In both cases, the companies faced significant integration issues and the actual costs associated with the transition were materially higher than the companies originally estimated.
Beyond transformative acquisitions, we have seen companies expanding their offerings with adjacent components and capabilities through tuck-in acquisitions. We generally view these moves as positive to longer-term growth prospects. Yet the cumulative impact could be negative given the high price typically paid for strategic acquisitions, even if relatively small in size. The immediate EBITDA contribution from tuck-in acquisitions can be very limited, resulting in an increase in leverage and lower cash generation. For example, we view Spectrum's 2018 medical sector acquisitions as an example of capabilities expansion. Although the company still has a substantial cash balance that it plans to spend on tuck-in acquisitions, we believe they may not be immediately EBITDA accretive, and will not necessarily result in deleveraging.
In some cases, the investments in building capabilities have resulted in elevated capital expenditure. While we recognize that capital expenditure is necessary for long-term growth, higher spending can lead to negative free cash generation and a diminished cushion for unforeseen setbacks (such as unanticipated input prices increases). For example, in 2018 Q-Holdco experienced a difficult pricing environment due to a shortage in the silicone market, which is a major input for the company. Coupled with integration challenges and elevated capex, the company's free cash flow in 2018 was meaningfully negative.
Working capital swings
To win new contracts and address input and wage inflation, CMOs are optimizing their cost structure. In general, such initiatives should be beneficial but they may entail significant costs in the short term. For example, moving manufacturing to lower-cost geographies to remain competitive typically requires the company to hold duplicative inventories to minimize supplier disruption. Raising input prices also can push CMOs to higher inventory levels. This creates significant inventory build-up and results in material working capital outflows. For example, over 2018 Q HoldCo materially increased its inventory due to both abovementioned factors, as well as some excess finished goods inventory because of a temporary slowdown in the customer purchases.
Working capital swings can also occur when customers extend payment terms or require the CMOs to hold finished goods inventory for a prolonged period, which further highlights the relative power of OEM customers. Although all CMOs face those pressures, working capital outflows typically have a greater impact on smaller players (such as Spectrum). Participants with a larger EBITDA base (such as TecoStar) may be better able to absorb those swings.
Pricing pressures and margin erosion
Although CMOs are key partners of the OEMs in an increasingly complex and sophisticated market, OEMs sometimes exercise their pricing power over CMOs by negotiating lower prices, especially for mature product lines. For example, Integer reported that price concessions given to the large OEM customers in return for long-term volume commitments lowered its first-quarter 2019 sales by approximately $3 million (about 1% of the quarterly sales) over first-quarter 2018. Thus even the largest players are not immune to this trend.
As we noted earlier, CMOs are implementing ongoing cost optimizations to preserve margins and remain attractive to their customers when trying to win new business.
Some Companies Have A Better Chance Of Meeting Cash Flow Targets
Out of four CMOs that underperformed our base-case projections over the past 12 to 18 months (Spectrum, Viant, Q Holdco and Tecostar), we downgraded one (Spectrum) and revised the outlook on another to negative (Viant). The key differentiating factors were the variability in leverage, the cushions to sustain unexpected setbacks, and the ability to improve cash flow generation over 2019-2020.
Ratings within the subsector remain closely correlated with the leverage levels of the rated companies (see chart). The two companies with the highest leverage--Avalign (adjusted debt to EBITDA of 16x, funded leverage of 8x expected in 2019) and Spectrum (adjusted debt to EBITDA of 10x expected in 2019)--are rated 'B-', at the low end of the rating scale. Other peers we rate at 'B' are typically within the 5x-7x leverage range: TecoStar (6.2x expected in 2019), Q Holdco (approximately 7x expected in 2019, including a convertible note that we treat as debt), Femur Buyer (7x expected in 2019) and Viant (7.6x expected in 2019).
Cushion to withstand challenges
We view smaller players, such as Spectrum, Avalign, and Q Holdco to be unfavorably positioned to withstand industry pressures. For example, Q Holdco's low EBITDA base and constrained liquidity position (with its revolving facility maturing December 2019) limit the company's ability to absorb sudden working capital swings or unexpected raw material increases. In 2018 the company's integration expenses, working capital outflows, and capex absorbed about 80% of the EBITDA base and in combination with interest payments, led to negative free cash flow. At the same time, Q Holdco's funded leverage level is on the lower end of the range compared to peers in the CMO group (reported debt to EBITDA at about 5x), which is an offsetting factor in our rating considerations.
Lower rated peers have on average a reduced cushion to withstand unexpected fluctuations. For 'B-' rated peers on average EBITDA cushion is below 10%, for peers rated 'B' it is about 15%, and for Integer (rated 'B+') it is about 40%.
Prospects to improve cash generation
We incorporate a forward-looking view on the companies' potential for improved cash generation. We base this on new-order bookings and growth prospects in markets they are focusing on, identified synergies with respect to prior acquisitions, and our assessment of a company's ability to reduce its working capital outflows.
We believe TecoStar and Q Holdco are better positioned to improve their cash flow generation. For both companies the second-quarter 2019 results indicate that steps taken to offset the headwinds faced in 2018 made a positive change. Their cash flow generation is now positive. Our base case for both companies indicates our expectations for improved cash flow generation. Those were the grounds for rating affirmations, despite both companies' negative free operation cash flow (FOCF) in 2018.
Viant is making progress in its integration of the Advanced Surgical & Orthopedics (AS&O) business from Integer Holdings Corp. and has outlined a plan to extract substantial synergies over the next two years and address working capital swings. However, we believe that the risk to the company's plan remains elevated given that it is working on multiple initiatives with minimal room for error. Our negative outlook reflects those risks.
This report does not constitute a rating action.
|Primary Credit Analyst:||Alice Kedem, Boston (1) 617-530-8315;|
|Secondary Contact:||Maryna Kandrukhin, New York + 1 (212) 438 2411;|
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