By Gino Verza:
Synergetics USA, Inc. (
) supplies surgical devices used in ophthalmology and neurosurgery,
including disposable and reusable devices, and surgical
On March 12, 2013, after market closing, the company
$1.4 million in net losses for 2Q 2013. Revenues for the quarter
declined 6.8% y-o-y. Gross profit margin was 36.8% due to a $2.0
million pre-tax inventory write-off vs. 59.5% in 2Q 2012.
Following the announcement, the stock dropped some 30%. Should
investors expect a quick rebound in the price of the stock?
This article reviews the performance of the firm in terms of
fundamental value metrics, such as ROIC, growth, and the cost of
capital. It provides a diagnosis and discusses a possible avenue to
unlock shareholder value.
Value Metrics Definition
- ROIC (Return on Invested Capital) = NOPAT / Operating
- NOPAT (Net Operating Profit after Taxes) = EBIT (1- Tax
- OC (Operating Capital) = NOWC (Net Operating Working Capital)
+ OLTA (Operating Long-Term Assets)
- WACC (Weighted Average Cost of Capital)
- EVA (Economic Value Added) = (ROIC - WACC) OC
- FCF (Free Cash Flow) = NOPAT - (Changes in OC)
- EV (Enterprise Value) = PV of prospective FCF, growing at g;
discounted by WACC
ROIC and Growth
ROIC for the last four fiscal years, ending on July 31, is as
follows: 4% (2009), 8% (2010), 10% (2011), 10% (2012). ROIC for 2Q
13 is minus 14% (annualized). Deferred Revenues are excluded from
the computation of Operating Capital under the rationale that the
cause behind Deferred Revenues is not inherent in the ordinary
operation of the business (even if Deferred Revenues are included
in the OC computation, the argument stands).
ROIC, a sticky financial attribute, results from two basic
conditions; industry structure, where rational pricing allows
reasonable economic returns to economically viable participants;
and the firm's unique competitive advantages among participants. In
the case of SURG, persistently weak ROIC indicates industry
conditions which are unfavorable to the firm and/or weakness in the
Investing in a business that produces returns below WACC
(estimated at 11% to 12%) is a questionable proposition for
investors, particularly when the path to improvement is
In the three-year period, from FYE 7/09 ($53.0 million) to FYE
7/12 ($60.0 million), revenues grew $7.0 million, or an annual
average of 4% . In 2Q 13 revenues declined 6.8% y-o-y.
Modest revenue growth is recorded even after recognition of
Deferred Revenues due to the Alcon settlement, which began in FYE
7/10. In 2Q 13 $0.32 million was recognized from Deferred Revenues;
equal to the amount recognized in 2Q 12.
Operating capital as percentage of revenues is high. In FYE
7/12, the firm required 71 cents in OC for each $1 of revenue. If
we exclude Deferred Revenues in the computation of OC, the OC
requirement increases; every Dollar of revenue requires one Dollar
Such heavy capital content requires a commensurate higher NOPAT
to reach an ROIC that exceeds WACC. This is not happening in the
firm. Further, high OC requirements make any goal of free cash flow
)) an almost insurmountable challenge.
High capital intensity is caused by a production-sales cycle
that is complex and/or expensive in relation to the resulting NOPAT
(in September, 2001, the firm transitioned inside plastic injection
molding to an outside vendor).
As part of the production-sales cycle, the firm has marketing
partner agreements with Codman, an affiliate of Johnson &
), and with Stryker (
). Dependency on external distribution channels represents
significant risk, notwithstanding multi-year agreements.
Furthermore, the firm is in a disadvantageous negotiating position
given the larger size and market clout of the marketing partners,
and in consideration of the magnitude of a loss that the firm could
suffer if distribution was discontinued. Revenue concentration is
major - 34% of revenues in 2Q 13; 21.1% Codman, and 12.9%
The point is that the firm's operations are excessively capital
intensive; and operationally entail significant risk. These
attributes engender low NOPAT and volatile revenues and increase
the difficulty in achieving ROIC that exceeds WACC. Concomitantly,
WACC raises with volatility as investors require greater expected
gains to compensate for risk.
We can stipulate the baseline that the problem facing the firm
refers to value drivers that extend beyond the short term, beyond
last period's financial results. The problem is not transactional -
a specific sale which closed a few days after the close of last
quarter, or an unhappy supplier, or a fluke, or a team which missed
a productivity mark.
The problem facing the firm is recurrent, having to do with
operating sustainability; competitive advantages, cost structure,
and general health of the commercial cycle. The problem concerns
strategic issues; the core business, operational risk, and
technology. Suggestions for quick fixes would not stand scrutiny
under the light of history - past results, initiatives undertaken,
changes made, and projects completed.
In a scenario of ROIC below WACC, any growth actually lowers
value, as a negative EVA worsens from larger OC [EVA = OC (ROIC -
WACC)]. Further, coupling rapid revenue growth with high OC
requirements not only preempts FCF, but rapidly increases the need
for bank debt.
How can the firm's business model be reconfigured into a
sustainable combination of attractive risk-adjusted returns to
shareholders, products that add value to clients, and effective
management? What should be the response to low ROIC, high capital
intensity, and slow growth?
These are loaded questions involving a complex problem that
presumptively can be resolved by means of unbiased analysis,
thoughtful consideration, deliberate decision-making, and
Enhancing shareholder value is a guiding principle in the search
of a strategic solution.
A possible solution considers potential owners (potential
buyers) who have relevant attributes of knowledge, resources,
scale, and linkages in the industry (and with the firm's
stakeholders) which represent potential avenues for adding
The attributes of potential owners are critical as a foundation
to the core activities of the firm in discovering synergy. The
firm's activities can be piggybacked into the potential owners'
process, costs, and products.
An obvious avenue of value is distribution. A potential owner
with an established distribution network can use it for the
products of the firm. The firm's marketing partners come to mind as
potential owners. An analysis of logistics, volumes, costs, would
give a sense of the savings involved.
Studying manufacturing, outsourcing, R&D, and other
activities, from the perspective of the potential owner, can also
point to potential savings.
Potential owners (with expansive market coverage) who have
industry insight can foresee growth opportunities; new products,
expanding products to a new class of users, expanded users, etc.
They can also add value in the relationships with the firm's
stakeholders, including governments, regulators; and by means of
Ultimately, a potential owner is motivated to make the
acquisition when ((
)) the acquisition price paid (sum of the price of the stock plus
any premium to shareholders to motivate them to sell) is no greater
than ((B)) the value of the firm to the potential owner (sum of
intrinsic value of the firm, as it is, plus the present value of
the improvements made after the acquisition).
Inherent in the intrinsic value of the firm is its unique core
competence (not easily duplicated elsewhere). Influencing the
acquisition price are the priority avenues of value and related
magnitudes of potential savings and potential gains.
Nothing in this discussion detracts from the improvement sought
by the firm's current
, including improvement in production and distribution, expense
control, and new product introductions. No doubt these are
well-meaning and well-intentioned actions that connote improvement.
However, they do not zero in, front and center, on the causes
behind unfavorable value metrics - capital intensity, low ROIC,
Any reasonable man would anticipate an unchanged operating mode
to yield the same performance in the future as it has in the
The solution to firm's problem resides in the domain of core
competency, entails strategy, involves the foundation in
operations, and is rooted in value. It can entail as many
combinations and mode of cooperation with different potential
partners as there are avenues of value. The potential owner
perspective discussed earlier is just one alternative.
Solutions are not single announcements, or single decisions or
actions. Solutions take the form of a process that attacks the
cause(s) behind unfavorable metrics. It starts with analysis,
decisions and actions that drive (improved) outcomes, which turn
into (improved) value metrics and revised (higher) expectations
that drive (higher) enterprise value and eventually move the price
of the stock. The process takes time and outcomes are
How the problem is defined, the diagnosis and the medication
prescribed and taken, and the follow-up, all determine outcomes. In
multi-period horizons, outcomes are studied and suitable
modifications and adjustments are incorporated into the next
business period, and so on.
What is the motivation to tackle such a tough problem?
The motivation is shareholder value; to take the shareholders
into a sustainable value-creation state of attractive risk-adjusted
ROIC and rapid revenue growth. The challenge of transformation
falls within the jurisdiction of the board of directors; to be
addressed in collaboration with the management of the firm.
Should investors expect a quick rebound in the price of the
There is no way of knowing what the market will do. However, in
my opinion, the current operating mode supports an intrinsic value
estimate no higher than the current price of the stock.
I have no positions in any stocks mentioned, and no plans to
initiate any positions within the next 72 hours. I wrote this
article myself, and it expresses my own opinions. I am not
receiving compensation for it. I have no business relationship with
any company whose stock is mentioned in this article. The material
presented here is for informational purposes only. Nothing in this
article should be taken as a solicitation to purchase or sell
securities. Before buying or selling any stock you should do your
own research and reach your own conclusion. Views and opinions in
this article may be wrong. The analysis, including financial
computations, presentation, and views, do not necessarily conform
to any sanctioned or accepted standards. Presentation and
computations entail a probability of error, which is entirely
possible. I am not an investment management professional. Please do
not rely on this material, do your own due diligence.
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