Globus Medical Inc (GMED)’s Inside Job by Roddy Boyd, SIRF

Last February spinal orthopedic device maker Globus Medical purchased Branch Medical Group, a key supplier and contract manufacturing operation based just three miles away from its Audubon, Pa. headquarters.

The BMG deal was announced on the same day Globus Medical released fourth quarter and 2014 earnings and little attention was paid to what looked like another instance of a high-profile, larger company merging with a small, privately-held one.

But with a $52.9 million all cash price tag, the purchase of BMG was not so small for Globus, which had just reported $474 million in sales for the prior year. Moreover, it was no ordinary deal: in the bloodless language of business law the BMG purchase was known as a related party transaction. On paper, as referenced in several annual reports, the families of Globus Medical’s top three executives owned 49% of BMG and management enthusiastically proclaimed a good opportunity to take control of the production process. In reality, however, a stroke of the pen allowed those same Globus executives to legally transfer $25.9 million in shareholder cash to themselves.

(It should be noted that while the majority of related party dealings–where the company conducts business with insiders like board members and senior executives–are often as benign as employing an executive’s son or daughter, they have also been at the center of numerous instances of self-dealing and abuse.)

[drizzle]As far as the Securities and Exchange Commission is concerned, the BMG purchase was legal and met the requisite disclosure standards. Since the 2012 initial public offering filing, Globus had acknowledged that the families of its chief executive officer David Paul and senior vice president of operations David Davidar, as well as former president and chief financial officer David Demski, owned the 49% stake in the then-unnamed “third-party” supplier.

It’s how very little the disclosure rules really mandate that should trouble Globus Medical investors.

A Southern Investigative Reporting Foundation investigation found that the purchase price–it increased in under eight weeks to $68 million–is very difficult to explain when compared to what a Globus competitor paid for a key vendor under two years prior.

BMG has a host of other issues that merit investor concern, including the undisclosed financial relationship between David Paul and BMG’s ex-CEO and the inability of the supplier’s supposedly remarkable margins to meaningfully contribute to Globus Medical’s earnings.

While the concept of purchasing a key supplier has merits in a time when insurance plans are forcing a movement to capitation, or flat fee payments per patient–thus setting off concentric rounds of price-cutting throughout the healthcare system–Globus Medical’s BMG deal has a big head-scratcher: the price.

Unusually, the $52.9 million price in the February press release became $68 million when the Proxy was filed in late April, a 22% increase. The reason given: working capital adjustments from $9 million additional cash in a BMG bank account and $5 million in accounts receivable. To be sure the deal’s legal provisions did note that the price was “subject to adjustment to certain working capital items.” Most every acquisition has a provision for it — examples include tardy customers finally paying up or some inventory getting written down as a project is cancelled.

A 22% working capital adjustment upwards, however, would appear to be exceptionally rare.

How so? One of the first things the suitor verifies in the due diligence process is cash balances. Obviously any company would want to know what’s in the bank; less obviously, cash accounts have often been the proverbial canary in the coal mine with respect to operational or governance problems. Inexplicable swings up or down in cash balances, or large payments to or from unknown entities, can suggest a host of looming problems. So this part of the vetting process often gets granular quickly as one team of finance executives grills the other about the minutiae of their payment cycles and receivables portfolio payments.

For a company that did $21.9 million in revenues in 2014, $9 million cash is a great deal of money to surface over an eight-week period. The Southern Investigative Reporting Foundation sought clarification from Globus on the specifics of the working capital adjustment.

Globus president Anthony Williams, in answering a question about the working capital adjustments, took exception to the Southern Investigative Reporting Foundation’s characterization of the BMG deal’s price as having increased. He said the net expense to Globus Medical remained $52.9 million given that the $9 million in cash, $5 million of accounts receivable and another minor adjustment effectively canceled the roughly $15 million price spike. (See his full answer here.)

In any event, by several yardsticks the BMG deal is remarkably expensive.

At the time of purchase BMG had $24.3 million of net assets–$14.9 million of which was plant, property and equipment–and over 60% of the allocated purchase price was goodwill. Despite interviews with former BMG officials who point to the supplier’s equipment being both modern and well-maintained, at the end of a day, paying over 2.5 times net assets for a contract manufacturer is considered remarkably expensive.

Looking at the purchase another way, during the Globus conference call discussing 2014 annual results, the interim chief financial officer David Demski said Globus planned on pumping “approximately $15 million to $17 million” into BMG to double its “sourcing.” If taken as an approximation of replacement value, this implies that between $15-$17 million would allow someone to replicate the supplier’s existing production capacity. So a $68 million price means that Globus paid 4.3 times replacement value. Investment bankers who work in the medical manufacturing sector told the Southern Investigative Reporting Foundation that twice replacement value is standard.

Then there are transactions within Globus Medical’s marketplace.

NuVasive, a Globus competitor in the spinal orthopedic market, beat it to the punch when it purchased one of its own key contract manufacturers, ANC, in 2013 for $4.5 million. ANC is about two-thirds BMGs size, with 65 employees and 35,000 square feet of production space to BMG’s 110 staff and 50,000 square feet. Their economics were broadly similar, according to their last available financial filings — ANC did $19.5 million in revenue in 2013 and BMG reported $21.9 million in 2014.

Globus Medical’s Williams said that an independent committee of Globus’ board of directors had hired Houlihan Lokey to do a fairness opinion. The investment bank concluded that comparable transactions were done between 5.5 times and 7 times 2014 EBITDA, making the BMG deal, he said, at 5.7 times its EBITDA a bargain for Globus shareholders.

The Southern Investigative Reporting Foundation asked Williams for a copy of Houlihan Lokey’s fairness opinion and received no reply; he was also asked why Globus Medical, unlike many other companies, didn’t include a copy of the opinion when the merger documents were filed. In reply he said, “In my experience we took all of the steps that would be appropriate for an acquisition of this nature.”

A call to Houlihan, which does not list the BMG deal on its website’s list of advisory clients, was not returned as of publication time. (Williams’ full response is here.)

Buying BMG created an interesting dynamic rarely seen in the world of mergers and acquisitions: a husband and wife on the opposite sides of the

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