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.
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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.)
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 negotiating table. While this sounds more dramatic than it likely was, David Paul’s wife, Sonali Paul, was the designated shareholder representative for BMG’s investors, according to the merger agreement; she was also BMG’s designated representative.
There is some evidence to suggest the deal had been long planned for. Spine Therapy Technologies LLC, the North Carolina holding company she used during the BMG sales process, was created in January 2014. Don Reynolds, the lawyer from Raleigh, N.C’s Wyrick, Robbins, Yates & Ponton law firm who set it up, is a longtime Globus adviser who was listed on their IPO prospectus. (and Anthony Williams’ former law partner.)
In response, Williams said that the use of entities like Spine Therapy Technologies is standard in mergers and that Don Reynolds’ law firm had represented BMG since its inception. (See here for his full response.)
One oddity of the merger has been BMG’s minimal contribution to Globus Medical’s bottom line, despite having disclosed $9.1 million in adjusted EBITDA in 2014. IBMG’s 39% adjusted EBITDA margin was almost three full percentage points better than Globus’ so it should have been an immediately visible contributor to profits.
Using pro-forma numbers, released in Globus Medical’s quarterly filings which include BMGs results, the supplier would have added only $816,000 in income in 2014. That’s a difficult number to understand — assuming a standard 35% corporate tax rate, and eliminating interest (BMG had no debt) this leaves only depreciation as a culprit, but a three- or four-year depreciation schedule on modern equipment is very unusual.
Asked about this, Williams said, “The profit and loss benefits take time to realize based on accounting principles. As we’ve publicly stated on several occasions, BMG’s profit becomes part of Globus Medical’s inventory and is recognized on our income statement as that inventory is sold.” (See his full statement here.)
BMG began life as BCD Manufacturing Group LLC in March 2004, started operations the following year with a $2 million loan from Globus and was located in Globus’ headquarters building for five years; in February 2008 its name was changed to Branch Medical Group. (Anthony Williams, then a lawyer for the Wyrick, Robbins firm above, handled the paperwork.)
Through March of 2009, David Paul was BMG’s president and CEO. Within a year after Paul stepped down, his wife Sonali, as well as David Davidar’s wife Janet, became board members. David Demski, who would become Globus president and chief operating officer, was also a BMG board member and its treasurer.
Globus Medical’s classified BMG as a variable interest entity, meaning that the supplier’s revenues were kept on its books–but presented separately. That changed in late December 2009 when an investor–the company refuses to disclose who–made a $2 million investment and the company became independent.
After Paul gave up BMG’s helm in March 2009, Mahboob Khan, a childhood friend of his, moved to America and was appointed the supplier’s choice. Despite the pair’s personal bonds, he was not an intuitive choice to run a a complex orthopedic device business, having run a shoe business in India. In reply to a question about Khan’s qualifications to run BMG, Williams said, “Mr. Khan did much more than just run a leather shoe factory in Chennai. Mr. Khan’s expertise was in a large-scale manufacturing operations supplying a global market. He ran factories with thousands of employees.” (See Williams’ full reply here.)
Khan and Paul must be truly close friends because when Khan and his wife bought a very attractive 7,900 square foot house in Phoenixville, Pa. on 2.5 acres, Paul co-signed two mortgages worth $836,000 (one for $804,000 and another for $32,000.) In May 2011, when Khan refinanced the property, Paul assigned his one-third interest in the property to Khan and his wife for $1.
A personal guarantee of the magnitude Paul extended Khan could have conceivably raised questions about Khan’s ability to aggressively stand up for BMG’s interests.
The reason relationship wasn’t disclosed, according to Williams, is because Paul did not pay any amounts under the initial mortgages and he had only co-signed in the first place because his friend didn’t have the requisite credit history to obtain a loan.
Khan had an ownership stake in BMG, Williams said, but he declined to specify how much. Pressed on why its owner group remained hidden, Williams said the supplier had goals of doing business with other large medical device manufacturers and its owners argued to Globus that publicly disclosing their relationship in the IPO prospectus might alienate prospective customers.
As it emerged, BMG had few customers, prospective or otherwise, apart from Globus which regularly accounted for between 90%-95% of its revenues, according to Securities and Exchange Commission filings. (See Williams’ full response here.)
The Southern Investigative Reporting Foundation spent a week seeking answers to our questions via phone and email from a series of different Globus Medical executives that were named in this story, including Brian Kearns, its new investor relations chief (if the name seems familiar, it’s likely because of the SEC complaint brought against him in 2009 over his stint as a CFO of MedQuist, a failed medical billing operation. As part of a settlement, he paid $50,000.) Neither Sonali Paul or Mahboob Khan replied to a series of detailed voice messages left on their mobile phones.
Only Anthony Williams replied. Here are the answers he gave to questions posed to him.
Globus Medical Inc (GMED)