Engaged Capital Urges HeartWare International to Terminate Proposed Acquisition of Valtech Cardio

  • Valtech acquisition significantly dilutes shareholders and adds unnecessary long-term business risks
  • Management can materially increase the value of HeartWare by exclusively focusing on the attractive LVAD market
  • Failure to terminate the proposed acquisition will leave shareholders with no choice but to campaign against the approval of the Valtech acquisition and seek board representation

NEWPORT BEACH, Calif.--()--Engaged Capital, an investment firm specializing in enhancing the value of small and mid-cap North American equities, today sent a letter to the Board of Directors (the “Board) of HeartWare International, Inc. (“HTWR” or the “Company”) (NASDAQ:HTWR).

The full text of the letter follows:

October 5, 2015

Board of Directors
HeartWare International, Inc.
500 Old Connecticut Path
Framingham, MA 01701

Ladies and Gentlemen:

Engaged Capital, LLC (together with its affiliates, “Engaged Capital”) has recently become a top 20 shareholder of HeartWare International, Inc. (“HTWR” or the “Company”). We established our investment in HTWR following the Company’s recent announcement of its intention to acquire Valtech Cardio, Ltd. (“Valtech”) – an announcement that drove an immediate 20% decline in HTWR shares. While we were able to establish our ownership position at prices that we believe significantly undervalue the Company, HTWR’s long-term investors have not been so fortunate.

    Total Return Performance
1 yr   2 yr   3 yr   5 yr
HTWR (30 %) (25 %) (44 %) (19 %)
Proxy Peer Group 36 % 41 % 68 % 173 %
S&P 1500 Health Care 8 % 35 % 74 % 144 %
S&P 1500 Health Care Equipment 12 % 35 % 56 % 104 %

HTWR Relative Returns vs:

Proxy Peer Group (67 %) (66 %) (112 %) (192 %)
S&P 1500 Health Care (39 %) (60 %) (118 %) (163 %)
S&P 1500 Health Care Equipment     (43 %)   (60 %)   (100 %)   (123 %)

Source: FactSet as of October 2, 2015. The Proxy Peer Group is from HTWR’s 2015 proxy statement.
Proxy Peer Group performance is based on an equal-weighted average calculation.

HTWR shareholders have suffered through years of disappointing returns. For numerous reasons, we believe the Valtech deal, if consummated, portends a continuation of HTWR’s underperformance. We urge the Board to walk away from this highly-dilutive, highly-risky acquisition and return the Company’s focus to the core left ventricular assist device (“LVAD”) business.

Further, the Board should be under no illusion that HTWR’s destiny is anything other than an eventual sale to a larger medical device company. There is no credible standalone plan that, on a risk-adjusted basis, will generate as much value as a sale to a strategic acquirer. The recent acquisition of the Company’s only competitor and the significant interest shown in the asset validate our assertion. However, the decision to approve the acquisition of Valtech leaves us concerned that the Board does not understand, or worse yet, is actively attempting to thwart, this inevitable outcome.

The LVAD Market Is Attractive

We established our ownership position in the Company because we agree with management’s thesis that the LVAD market is highly attractive. This fact is plainly evident as LVADs address a significant unmet need, receive strong reimbursement rates, and target a massively underpenetrated patient population. As next generation devices continue to improve clinical outcomes, reduce adverse events, and possess ever-shrinking form factors, the addressable market will expand tremendously; driving a sustained period of what we believe will be double-digit growth for all participants in the LVAD market.

Within the LVAD market, HTWR’s position is strong. HTWR’s flagship device, HVAD, has taken significant market share following its approval in the EU in 2009 and the U.S. in 2012. In fact, as of the most recent quarter, HTWR holds 33% market share in the U.S. and 60% market share in the international market. What makes these market share gains even more impressive is that in the U.S., HVAD has yet to be approved for use in heart failure patients eligible for destination therapy (“DT”) – an addressable patient population that is at least 15x the size of the bridge-to-transplant population. HTWR should gain additional market share over time as HVAD is approved for use in DT patients in the U.S. and HTWR’s next generation device, MVAD, progresses towards approval.

Finally, the LVAD market is, and will be, a duopoly market between HTWR and Thoratec for the foreseeable future. Unlike other medical device markets, the barriers to entry are numerous and significant. Between design challenges, clinical trial hurdles, and the significant cost associated with each, we believe it would take at least 10 years and hundreds of millions of dollars of investment for another company to even attempt to enter the LVAD market – with no guarantee of having an approvable device at the end of the process.

The Valtech Acquisition Distracts from the Core Business

Given the attractiveness of the core LVAD market and HTWR’s position therein, we are puzzled by the Board’s decision to pursue an acquisition of Valtech. Often when companies pursue transformational acquisitions it is a reflection of a lack of confidence in the acquirer’s core business. However, management has repeatedly asserted post-announcement that their confidence in both the core business and HTWR’s next generation device, the MVAD, has never been higher. Additionally, HTWR and Thoratec’s most recent quarterly results depicted a significant acceleration in the LVAD market both in the U.S. and abroad. This fact set makes the rationale for acquiring Valtech even more confounding.

Not only is Valtech an expensive and risky acquisition on a standalone basis, but the risk Valtech presents is further compounded by the numerous critical initiatives currently in process at the Company. Management’s efforts to execute on the MVAD clinical trials, improve regulatory compliance, and defend market share all require management’s undivided attention. If consummated, the Valtech acquisition will do nothing but compound these risks and add new risks of its own, including integration risk and enormous clinical development risk. We are dumbfounded that the Board would consider now to be the appropriate time for HTWR to pursue a “bet the company” acquisition.

The Valtech Acquisition Dilutes Shareholders and Drains Cash

Management stated that one of the reasons HTWR had to acquire Valtech now was that HTWR’s “exclusivity period” was on the verge of expiring in mid-September. This rationale is flawed for the simple fact that Valtech needed only to wait two weeks to formally consider any competing offers for the business. Like any option, the value of HTWR’s exclusive agreement with Valtech declines to zero as the expiration date approaches. With only two weeks remaining, the value of HTWR’s exclusive option to acquire Valtech was essentially zero at the time of the announcement. Additionally, if we take HTWR management at their word that Valtech was receiving significant inbound interest from other potential acquirers, it follows that HTWR may have had to overpay for the asset in order to convince Valtech to forego the option value of running a full auction process for the company.

Indeed, Valtech was able to extract a huge upfront sum from HTWR. The upfront equity dilution to HTWR shareholders from the Valtech acquisition is ~30% - equivalent to $425 million based on the closing price of HTWR prior to the announcement. Additional milestones and equity warrants have the potential to more than double the total cost of the transaction over time.

The cost of the Valtech transaction goes far beyond the purchase price. In order to bring Valtech’s products to market, HTWR must invest significant amounts of cash into added R&D expenses. By management’s own admission, Valtech will increase HTWR’s operating losses by $30 to $40 million annually over the next two years. This is on top of HTWR’s already significant R&D expense of $120 million over the last twelve months – a sum which represents a staggering 42% of revenue and is $10M greater than HTWR’s main competitor, Thoratec, spent in R&D over the same period, despite the fact that Thoratec generated 70% more revenue than HTWR.

This cash drain only compounds the risk Valtech presents to HTWR shareholders. Not only will Valtech take management’s focus away from the core LVAD business at a critical juncture, the added R&D burden will compete for HTWR’s limited cash resources. In a worst case scenario, Valtech-related spending siphons needed cash from the core LVAD business and increases the risk that HTWR must raise capital at unfavorable rates.

Valtech Adds Significant and Novel Long-term Risks

Despite the large purchase price, Valtech is a collection of unproven assets. While Valtech’s valve repair and replacement assets may have the potential to generate significant revenues, these assets will have to clear numerous clinical and regulatory hurdles before providing any meaningful revenue. In fact, a significant portion of the expected long-term revenue from Valtech is from products that have yet to be fully designed, let alone validated in the clinic. The enormous upfront dilution borne by HTWR shareholders is completely incongruous with the colossal risk associated with achieving management’s starry-eyed forecast for Valtech’s products. It is entirely possible that shareholders will bear dilution in excess of 30% for an acquisition that never generates any material revenue for the Company.

The seriousness of this risk can be seen in HTWR’s own limited M&A track record. HTWR’s only acquisition of any significance, Circulite’s SYNERGY pump, has experienced numerous delays and design changes despite management’s assurance at the time of the acquisition that it was a “straightforward logical fix” to make the design change necessary to bring the SYNERGY pump back into the clinic. Now, nearly two years post-acquisition, there is still no timeline for returning SYNERGY to the market. Management’s failure to execute upon the Circulite acquisition, a far smaller and less complex asset than Valtech, gives us no confidence that management’s assessment of the clinical and commercial timelines for Valtech will be achieved.

From a strategic standpoint, the Valtech acquisition represents a “poison pill” for many of the logical strategic acquirers of HTWR. Abbott Laboratories, Edwards Lifesciences and Medtronic have each recently acquired mitral valve replacement companies that will directly compete with Valtech’s valve replacement assets. These companies – all of which are logical acquirers of HTWR – would assign little to no value to these duplicative assets for which HTWR is paying hundreds of millions of dollars.

Additionally, these potential competitors all have significantly more resources and expertise than HTWR. Even if HTWR is successful in bringing Valtech’s valve replacement assets to market, HTWR would likely be the fourth or fifth market entrant competing with some of the largest medical device companies in the world; companies with sales and R&D budgets many times that of HTWR. This is in stark contrast to the core LVAD market, where HTWR has competed in a virtual duopoly with a similarly-sized peer.

Shareholders Have Effectively Already Voted “No”

We cannot recall any acquisition announcement in the healthcare industry that drove a more negative stock reaction than the Valtech announcement. On Sept 2nd (the day following the Valtech announcement) HTWR’s market capitalization declined by 20%, or nearly $300 million on an absolute basis. Since then, HTWR shares have continued to decline and the total loss in market capitalization since the announcement now stands at 34%, or a staggering $479 million. The market has already shown the Board that acquiring Valtech makes HTWR a significantly less attractive asset for investors. We are confident that there is hardly a shareholder who owns HTWR for any reason other than their conviction in the long-term growth potential of the LVAD market. By acquiring Valtech, the Company is diluting HTWR shareholders’ exposure to the very market they likely desired to invest in when they purchased HTWR shares. Rather than waste management time and shareholder capital attempting to defend an indefensible acquisition, the Board should move immediately to terminate the proposed transaction.

HTWR is a Desirable Asset

Our conviction in the attractiveness in the LVAD market is validated by St. Jude’s recent announcement of its intention to acquire Thoratec, HTWR’s only real competitor. Additionally, Thoratec’s recent SEC filings describing the sale process indicate there were multiple parties who evaluated a competing bid for Thoratec during the go-shop period. Our research and discussions with industry participants (bankers, executives, analysts, and shareholders) leads us to the conclusion that these same parties would aggressively compete for HTWR should the Board decide to pursue a sale – especially considering HTWR’s superior growth rate and the duopolistic structure of the LVAD industry. If any potential acquirer wants a place in the LVAD market, HTWR is truly the last seat at the table.

  EV / Sales Multiples
THOR   2014   2015E   2016E   2017E   2018E   '15-'18 CAGR 2015E   2016E   2017E
Revenue $478 $504 $546 $602 $606 6.3% 6.8x   6.2x   5.7x
Growth (5%) 5% 8% 10% 1%
HTWR   2014   2015E   2016E   2017E   2018E '15-'18 CAGR 2015E   2016E   2017E
Revenue $278 $282 $317 $377 $456 17.4% 3.2x 2.9x 2.4x
Growth 34% 1% 12% 19% 21%          

Source: FactSet consensus estimates as of October 2, 2015.

If HTWR were to receive THOR’s valuation of 6.2x estimated 2016 revenues in a transaction, HTWR shareholders would receive $105 per share, a premium of 94% to HTWR’s current trading value. Further, HTWR’s superior projected growth rate would support a premium multiple to Thoratec in a transaction.

While we are wholeheartedly opposed to the Valtech acquisition, we agree with management’s vision that an integrated heart failure company can create significant value for patients and shareholders alike. However, the correct way – the value-creating way – to create such an organization would be through selling HTWR to an acquirer who already owns a portfolio of heart failure assets and the infrastructure to leverage them, not by building such a company independently through a high-risk, prohibitively expensive acquisition strategy.

The Board Must Heed Shareholders

Management recently stated that we love building this business and fully intend to continue building this business well into the future… we now have the capabilities to carry this company forward independently, really indefinitely.” We are compelled to remind the Board and management that a company’s independence is not a right; independence must be earned through sustained, consistent value creation. Despite HTWR’s strong position in a duopoly market, HTWR’s lack of value creation calls into question the Company’s ability to generate returns for shareholders as an independent entity. Further, the decision to pursue an acquisition of Valtech – when the promise of the Company’s core LVAD assets has yet to be realized – spawns credible doubt in the Board’s commitment to upholding its fiduciary responsibilities.

We therefore call upon the Board to immediately terminate the ill-conceived acquisition of Valtech. If the Board fails to do so, shareholders will have no choice but to campaign vociferously against the approval of the Valtech acquisition and seek board representation to ensure the commitment in the boardroom to maximizing shareholder value is paramount.

Sincerely yours,
Glenn W. Welling
Managing Member

About Engaged Capital:

Engaged Capital, LLC (“Engaged Capital”) was established in 2012 by a group of professionals with significant experience in activist investing in North America and was seeded by Grosvenor Capital Management, L.P., one of the oldest and largest global alternative investment managers. Engaged Capital is a limited liability company owned by its principals and formed to create long-term shareholder value by bringing an owner’s perspective to the managements and boards of undervalued public companies. Engaged Capital manages both a long-only and long/short North American equity fund. Engaged Capital’s efforts and resources are dedicated to a single investment style, “Constructive Activism” with a focus on delivering superior, long-term, risk-adjusted returns for investors. Engaged Capital is based in Newport Beach, California.


Engaged Capital, LLC
Glenn W. Welling, 949-734-7900
Bayfield Strategy, Inc.
Riyaz Lalani, 416-907-9365

Release Summary

Engaged Capital urges HeartWare International to terminate proposed acquisition of Valtech Cardio, which significantly dilutes shareholders and adds unnecessary long-term business risks.


Engaged Capital, LLC
Glenn W. Welling, 949-734-7900
Bayfield Strategy, Inc.
Riyaz Lalani, 416-907-9365