In a Tough IPO Market, a Marriage of Convenience

With the IPO market still in a deep freeze, we thought it would be interesting to revisit a rather unique deal that closed last week involving  Cardiovascular Systems  and Replidyne. When the two companies announced back in November 2008 they were merging, we found it to be somewhat of an oddity because these two firms have little in common. Replidyne focused its efforts on anti-infective drugs, while Cardiovascular Systems, which had filed to go public in early 2008, had developed a novel system to fight peripheral arterial disease, which is the buildup of plaque in vessel walls that can severally restrict blood circulation. With no obvious up-front synergies apparent to us, we deemed it to be a desperation move; a firm with a potentially viable product but no cash merges with another company with ample liquidity but lacking a product as a result of multiple failures. At the same time, this deal was a creative alternative, a work-around to the suddenly dormant public markets. So the question remains: Does a deal of this kind make sense?

When we established coverage on Cardiovascular Systems back in August 2008 as part of our IPO service, we deemed it an exciting growth story with a chance for success, albeit one facing several hurdles. The company's Diamondback 360 system is designed to attack the buildup of plaque and other fatty deposits by sanding it down into smaller particles that would then be removed by the bloodstream. We believe the system to be quite innovative and that it could become a viable alternative to current treatment methods such as stents and balloons.

Although Cardiovascular Systems was long on innovation, it was short on liquidity. The company disclosed after the first quarter of 2008 that it had only $16 million in cash against $11 million in debt. By the end of the third quarter, its cash on hand was approaching zero, and it had an additional problem: Deal activity had ground to a halt because of the prevailing dysfunction in the capital markets.

Enter Replidyne, a firm with a number of challenges of its own. The company was suffering after its lead drug, Orapem, experienced a significant setback during Phase III clinical trials; the Food and Drug Administration demanded more rigorous efficacy data. This failure coupled with the loss of commercialization partner Forest Laboratories effectively sent Replidyne back to the drawing board with a clinical pipeline we considered rather weak. Although Replidyne had no future prospects (at this point we were valuing the company at net cash of $1.50 per share), it did have the much-needed liquidity that could rescue a cash-starved firm such as Cardiovascular Systems.

And just like that, a marriage of convenience was born when the two firms announced their intention to merge in November 2008. We're still a little unsure of how these two firms managed to find each other, but we understand the short-term drivers that would support a deal of this type. The real question remains: Do we think it makes sense over the long haul? Morningstar equity analyst Meera Venu weighs in:

"Replidyne's merger with CSI comes as a surprise, as the medical device firm offers little synergy with Replidyne's anti-infective research. CSI holds little cash and has a short sales history. This deal looks to combine two fledgling firms instead of seeking out an established partner for Replidyne. From a cash standpoint, we think management is taking a big risk by investing in a firm that may never generate profits. A better and less risky alternative would have been to return cash to investors, letting shareholders choose how to invest their money."

Forgetting for the moment our overall lukewarm reaction to the merger from the standpoint of a Replidyne shareholder, we certainly think a deal of this type is fairly positive for CSI given the market conditions. The company was certainly desperate at this stage of the game and would've likely partnered with any number of willing firms in an unrelated industry to gain access to liquidity. However, though the deal solved a short-term problem for both, the combined entity faces a number of additional hurdles beyond the apparent lack of synergies. Venu further expounds on the main risk that could hamper the transformed company going forward: Cardiovascular Systems will face a competitive landscape cluttered with more-established systems:

"CSI is not alone in the marketplace. Several medical device companies have established positions in this field. EV3's SilverHawk, Boston Scientific's Rotablator, and Spectranetics' laser technology all specialize in removing hardened plaque. These firms have more sales and distribution experience, giving them an advantage in managing physician relationships. CSI also faces competition from alternative procedures, such as stents that are often used to treat peripheral arterial disease. Firms such as Cook Medical offer cutting-edge stents for these procedures. CSI will need to convince physicians to switch from these popular procedure options by demonstrating the advantages of its device."

Regardless of whether this deal will hold up over the long term, we are keeping our eye on this type of activity going forward. Although it's possible that the merger could turn out to be an anomaly, it's also the kind of arrangement that other firms might look to replicate until the public markets begin to function normally.