David Reilly

For a market to function properly, consumers must be able to properly judge the inherent value (risk vs. reward) of goods brought to the marketplace. This is true whether a product, service or financial instrument. Because the tradeoff between risk and reward was obscured by government subsidy and an implicit government guarantee—as exemplified by Fannie Mae and Freddie Mac—the
consequences have proven dire.

How This Happened

The current credit crisis is a direct result of political decisions starting in the late 1990s to loosen the rules of lending so that home loans would be more accessible. A lesson should be learned through this disaster: When there is a choice between facilitating mortgages for the unqualified and maintaining a sound credit system, choose the latter every time.

Simplistically, there used to be a direct relationship between lender and borrower, where lenders evaluated and verified a borrower’s ability to repay, where lenders typically funded loans with the deposits held by the institution, where lenders assessed and monitored the performance of the loan and of the underlying collateral, where loan officers were held accountable and banks took losses for writing bad loans, and where excessive lending was curbed by limits related to capital levels.

With Sarbanes-Oxley and other regulations dampening Wall Street’s traditional and lucrative businesses (IPOs and other underwritings), many financial institutions turned to enhancing liquidity and investment alternatives by creating and selling complex financial instruments. Such alternatives
included collateralized debt obligation (CDO), securities in which debt instruments (mortgages) are pooled and stripped into pieces (principal and interest) that have similar characteristics and are sold as a single security composed of these tranches. Many types of investors (mutual funds, hedge funds,
banks, etc.) that were financed by debt had a ravenous appetite for such securities and their derivate products, such as credit default swaps (CDS). Sellers of CDSs collect premiums in exchange for the risk of returning a payoff to the buyer if the underlying financial instrument (eg, CDO) defaults.

There is nothing inherently wrong with CDOs and CDSs; in fact, the markets for CDS and other derivatives not tied to the housing crisis are functioning normally. Though the sellers of and investors in CDOs and CDSs certainly made dreadful judgments in assessing the likelihood of defaults, the government fueled the boom in the market for these toxic securities by facilitating mortgages to unqualified people and, via an irresponsible monetary policy, helped drive the supply of such securities and their derivatives that were in turn branded as solid by government-anointed credit rating
agencies. Before the housing bubble, few investors knew what CDOs or CDSs were, but most knew what AAA meant (highly unlikely to default).

As default rates mushroomed, the value of the assets underlying these CDOs plummeted (even to irrational levels with accounting-imposed marked-to-market requirements), causing the holders of CDOs and CDSs to scramble for life-supporting capital.With the government-promoted imbalance of risk and return in portfolios of mortgagebacked securities and derivatives, trust and transparency evaporated, the effects of which paralyzed the credit markets. To regain balance and transparency, it will take time to unwind this damage and scrutinize mortgages down to zip code levels. The valuation process is a necessary step for the effective use of the controversial bailout and to avoid the consequences of what otherwise, long term, would be a stagnant or declining economy.

Direct Impact

Against this backdrop, the orthopedic industry, in aggregate, remains strong with relatively solid business fundamentals, high profitability and modest leverage. Despite likely delays in elective
orthopedic procedures, procedure volumes should maintain their constant growth rate. As long as there is insurance, Medicare and Medicaid, the demand for orthopedic devices and services will remain steady given attractive demographic characteristics. While the financial crisis should not directly impact revenue, unemployment and the ranks of the uninsured will rise if a severe economic
recession ensues. Nonetheless, from a revenue perspective, orthopedic companies are as strongly positioned as any so long as the Centers for Medicare & Medicaid Services continues to provide
coverage for seniors and the indigent. Likewise, with relatively high gross and operating margins, industry profitability should not be materially impaired.

Indirect Impact

Orthopedic companies will be affected by the impact that the financial crisis is having on hospitals and surgical centers. Already highly leveraged and struggling with collection challenges from patients with rising credit problems, hospitals and surgical centers (with a median net debt to EBITDA multiple of 5.3 for Viant’s publicly traded hospital/surgical center index) will continue to find it difficult to obtain credit, which in turn will affect purchasing decisions.

Just since the beginning of calendar 2008, the average days sales and inventory outstanding for Viant’s publicly traded orthopedics index has increased from 56 to 62 and from 247 to 276, respectively. With the usual sources of working capital availability constrained, customers will be trying to enhance liquidity through any means, including by stretching payables; over the same time frame,
the average days payable outstanding for the hospital/surgical center index has already increased from 30 to 38.

Similarly, the orthopedic supplier market, which is highly fragmented with smaller, privately owned and less profitable companies in comparison to their OEM customers may find more difficulty financing working capital needs with diminished revolving credit. A more diversified supply chain may help OEMs mitigate exposure with capital constrained suppliers, but diversifying a supply base takes time, is difficult when products require complex components and FDA qualification and validation processes, and otherwise disrupts the streamlined supply chain most OEMs have been working toward.

Areas of Focus

Orthopedic companies must be vigilant and proactive in working capital management and financing within the constraints of their capital base. Extending payment terms can be used to help and
significantly strengthen relationships with customers. Likewise, offering payment advances against purchases can relieve burdened suppliers as well as bolstering key relationships, but can be a
challenge when one’s own customers are stretching payments. While such options may be available for larger cash-rich companies, even they need to be careful when serving as a de facto bank to their
customers and more closely evaluate signs of financial distress. With less credit available for term loans, smaller, private players should consider raising private equity or asset-backed debt facilities
if working capital is insufficient. While terms are now more expensive, there are still lenders and private debt and equity firms providing financing.

Times of financial distress can yield great transaction opportunities, which we expect to see. Larger companies will capitalize on strategic acquisitions at attractive prices, adding more critical mass and depth to their existing product portfolios. Owners of smaller companies impacted by the credit crunch will either merge with a complementary industry partner to leverage scale and operating expenses and to be on a stronger footing with customers; sell their businesses to a strategic buyer; or sell a partial interest to a financial buyer in order to diversify (if not salvage) much of their net worth tied up in the business. 

David Reilly is a managing director of Viant Capital LLC, an investment banking firm that specializes in mergers and acquisitions; private placements; and financial advisory services. He runs the firm’s healthcare practice, which has a focus on the orthopedic market. David can be reached at (203) 682-1880 or [email protected]. Author’s Note: Nothing contained in this article is to be considered the rendering of financial, investment or professional advice for specific circumstances.
Readers are responsible for obtaining such advice from professional advisors and are encouraged to do so.