Dj Orthopedics (DJO)

TOP CONTRIBUTORS

Greg Aurand

www.zacks.com

DJO Incorporated, formerly dj Orthopedics, Inc., is a global medical device company specializing in rehabilitation and regeneration products for the non-operative orthopedic, spine and vascular markets. The company's broad range of over 700 rehabilitation products, including rigid knee braces, soft goods, and pain management products are used to prevent injury, to treat chronic conditions, and to aid in recovery after surgery or injury. The company s regeneration products, acquired through the November 2003 acquisition of the Regentek division of OrthoLogic, consist of bone growth stimulation devices that are used to treat nonunion fractures and as an adjunct therapy after spinal fusion surgery. DJO Incorporated sells its products in the United States and in more than 60 other countries through its sales channels: DonJoy, ProCare/Aircast, OfficeCare, Regeneration and International. DonJoy is the company s largest sales channel, which comprises the sale of rigid braces, pain management products, and certain soft goods. Approximately 60 independent sales agents who employ approximately 420 independent commissioned sales representatives and a few of the company s direct sales representatives sell DonJoy products to orthopedic surgeons, podiatrists, orthopedic and prosthetic centers, hospitals, athletic trainers, and other healthcare professionals. The representatives are technical specialists responsible for educating patients on device usage. The company s Regeneration products consist of bone growth stimulation products in the U.S. The OL1000 long bone products are sold through a combination of DonJoy sales representatives, with an additional 138 direct sales representatives and certain independent regional sales agents, of which 66 are employed directly by DJO with the rest employed by DonJoy agents. SpinaLogic (for spine stimulation) is sold through Johnson & Johnson's DePuy Spine under a non-exclusive sales agreement, as well as other leading orthopedic companies. In the ProCare channel, approximately 100 direct and independent representatives sell products. The representatives manage over 380 dealers focused on primary and acute facilities. Products are sold primarily to national third-party distributors, other regional medical supply dealers, and medical product buying groups, generally at a discount from list prices. These distributors resell these products to large hospital chains, hospital buying groups, primary care networks, and orthopedic physicians for use by patients. The majority of these products are soft goods products requiring little or no patient education. Through the OfficeCare program, products (mostly soft goods) are disbursed to patients directly from inventory that is maintained on hand at about 1,100 physicians' practices. In the International channel, products are sold in more than 70 foreign countries, including the U.K. and Canada, through wholly-owned subsidiaries or independent distributors. In the fourth quarter 2006, soft goods were 50% of total revenues, rigid knee braces 22% of revenues, regeneration (bone growth stimulation) 15% of revenues, pain management 8% and vascular systems 4%. For the full year 2006, the Domestic Rehabilitation segment contributed 65% to revenues, Regeneration contributed 16% to revenues, and International accounted for 19% of the total revenues. Geographically, in the fourth quarter 2006, international revenues were $23.6 million, or 21% of revenues, while U.S. revenues were $87.1 million, or 79% of revenues. For the full year 2006, International revenues were $81.5 million, or 20% of revenues, while U.S. revenues were $331.6 million, or 80% of revenues.

The Regentek acquisition for electrical bone stimulation is expected to be a major driver of sales growth for DJO Incorporated. Regentek was acquired from OrthoLogic in November 2003 and became a division of DJO Incorporated. In 2006, regeneration products grew 16.9% on an average daily sales basis, well above the market growth rate of 8%-9%. SpinaLogic increased 23% in 2006 and grew 17% and 27% in Q107 and Q207, respectively. The entire regeneration franchise grew 10% in Q107 and grew 18% in Q207. Non-invasive electrical bone stimulation enables more rapid healing of non-union fractures and spine fusion. SpinaLogic for spine - cervical (upper back) and lumbar (lower back) - was earlier sold through DePuy, the orthopedics division of Johnson & Johnson. The company modified the selling agreement with DePuy early in 2005, converting several underperforming territories, formerly exclusive to DePuy, to non-exclusive status. In 2006, the company made its selling agreement non-exclusive in the majority of the U.S., excluding 10 territories. The renegotiated agreement will enable the company to deploy its own selling strategies in the underperforming territories. The company has signed Zimmer and Stryker, among others, to spine distribution agreements. As well, some Medtronic Sofamor Danek distributors have signed on since the Orthofix acquisition of Blackstone Medical. Blackstone Medical offers a line of spine implants and biologics and former Orthofix distributors did not want to offer a competing line of spine products beyond stimulation. DJO is the only supplier of spine stimulation products that does not offer a competing line of spinal implant products. Long-bone fracture products like the OL1000 are sold through DJO's own sales organization. The company's stimulation products are technologically advanced and reduce patient therapy time. Their technology is a strong competitive advantage to offerings from competitors Biomet and Orthofix. In August 2007, the company received FDA approval for new product features on its Combined Magnetic Field (CMF) OL1000 and SpinaLogic bone growth stimulation product lines. The new stimulation devices, replacing the existing setups, are being launched in both domestic and international markets in September 2007.

DJO management expects low-mid double digit growth from Regeneration, with long bone stimulation expected to grow faster than spine, but does admit that spine market growth is around 8% and long bone market growth is 5%-6%. Market share dynamics between Orthofix, DJO and Biomet (EBI division) have been clearly affected since Orthofix launched a competitive cervical spine stimulator in early 2005 while Biomet suffered management disruptions in calendar 2005-2006. Orthofix spine group grew about 9% in Q406, 7% in Q107 and Q207 (on 11% volume growth), while BMET's spine stimulation group continues to experience weakness.

In 2006, International sales accounted for about 20% of the company's total revenue, up from 11% at the end of 2005. One of the growth objectives for the company is to continue to increase this share to 25% to 30% and it intends to achieve this goal through acquisitions. The company acquired Axmed (Newmed SAS), a French orthopedic bracing company in a deal that closed January 2, 2006. The acquisition expands the company s base of business in Europe. The manufacturing and distribution synergies from these acquisitions should increase soft goods margins. On the heels of the Newmed acquisition, DJO closed the acquisition of Aircast Incorporated for $290 million in cash in April 2006. Aircast is the leading manufacturer of ankle bracing products and vascular systems. Now that the integration of Aircast is complete, as of Q406, DJO expects the acquisition to be accretive to earnings. The deal was slightly dilutive in the initial quarters as DJO recorded one-time charges to write-off unamortized deferred debt issue costs, as well as inventory step-up and other integration costs. The transaction is expected to add annual cost saving synergies in the $18-$20 million range, up from the initial expectation in the $15-$20 million range, largely due to transferring manufacturing to DJO s new Tijuana Mexico facility from the U.S. The Tijuana facility was completed in September 2006. The Aircast deal has several positives. First, the acquisition complements and strengthens the Domestic Rehabilitation business as Aircast s ankle bracing products target the clinical market while DJO s ankle products have targeted the sports market. Further, the distribution synergies should create cross-selling opportunities for all the product lines. Some of Aircast s products, like the DVT (deep vein thrombosis) products, currently utilize DJO s distributors. Importantly, the acquisition will nearly double the size of the international segment as more than one-third of Aircast s revenues are generated outside the U.S. The manufacturing consolidation to Tijuana, and possibly to Newmed s Tunisia plant, will ultimately improve gross profit margin and, as Aircast's U.S. general and administrative functions are integrated into the company's existing operations, there should be additional operating expense savings.

The company consolidated manufacturing in its new Tijuana, Mexico facility that is expected to generate $1 million in annual savings. In particular, Regeneration segment gross margin was quite strong at 92.5% in the fourth quarter 2006, up from 91.7% in the third quarter 2006, and up from 89.6% in Q405. For the full year 2006, the regeneration segment gross margin was 92.3%. In Q107, Regeneration segment gross margin reached 92.7% while in 2Q07 it hit 92.2%.

In the first quarter 2007, DJO missed earnings estimates given production and distribution issues at its facilities. The company underestimated the ongoing operational costs to maintain high levels of customer service and meet inventory and shipping demands after the Aircast acquisition. The company believes it will be able to correct the higher cost structure that primarily impacted gross margin. Overall company gross margin was only 60.5% in the first quarter, compared to previous guidance of 62.5%-63.5% and 65% for the entire year. Adjusted gross margin reached 60.8% in the second quarter, a slower improvement than expected. The company now believes it can reach the 64% gross margin level by Q407.

The increased debt from the Aircast acquisition will increase interest expense by an estimated $14-$15 million annually, assuming an interest rate of about 6%. The company's total borrowings of $350 million under a new term loan agreement are at an interest rate of LIBOR plus 1.5%. Of the $350 million, $250 million of the outstanding borrowings were entered into a fixed rate interest rate swap with a rate of 6.79%. Post-closing, debt-to-equity stood at about 1.5x, a significant leverage level. In the fourth quarter 2006 net interest and other expense was $6.0 million. The company did pay down nearly $7 million ($15 million in Q306) of debt in the quarter, a little ahead of schedule but did not pay down any debt in Q107, given production and distribution issues. However, during second quarter 2007, the company repaid $16.3 million of debt, reducing long-term indebtedness to $311 million, with interest expense declining in the second quarter to $5 million. As of Q207, debt-to-equity now stands at about 1.1x. Cash flow should cover the additional interest expense, but the company's operations could be constrained if expected operational synergies do not develop. Given the high debt level, the company will find it difficult to make additional debt-driven acquisitions in the near-term.

In July 2007, the company agreed to merge with ReAble Therapeutics (formerly Encore Medical), a privately-held orthopedic and rehab company controlled by The Blackstone Group, for $50.25 per share. DJO had 50 calendar days to shop for a higher price from another buyer, with a breakup fee of $18.7 million. DJO and ReAble provide complementary products in orthopedic rehabilitation and pain management. The deal is expected to close in the fourth quarter 2007 and the 50-day window has closed without a competing offer. The U.S. Federal Trade Commission granted an early termination of the waiting period and has cleared the proposed acquisition of DJO by an affiliate of ReAble. The deal still requires shareholder approval, among other conditions. Of note, in an August 31 8-K filing, the company noted a shareholder lawsuit was filed in California challenging the merger. In a September 13th filing, it was announced the new combined company name will be DJO Incorporated, with corporate headquarters in Vista California.

Comparison to Competitors

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