2023-08-29 02:38:56 ET
Summary
- Merit Medical Systems stock has been repriced to the downside following its last two acquisitions and flat Q2 numbers.
- Q2 FY'23 saw growth in sales and gross margin, driven by the cardiovascular and peripheral intervention segments.
- MMSI's acquisitions are strategic but need to generate satisfactory cash returns on the capital employed.
- Sentiment and valuation indicators are negative, supporting a revised outlook to neutral.
Investment updates
Since the last Merit Medical Systems ( MMSI ) publication there have been several updates to the investment thesis that must be discussed in greater detail. Critically, following two acquisitions and flat Q2 numbers, the market has repriced MMSI sharply to the downside to reflect its more pessimistic view. Shares have crimped from a high of ~$85 to sell at $67 at the time of writing, as shown in Figure 1. There are multiple inflection points supporting this revised view, and the market's reasoning-including softer FY'23 projections, potentially high-risk acquisitions, and flat economic earnings produced on ~$1.59Bn of capital invested into the business.
This had been quite a profitable position leading into FY'23, with shares running from the $75 mark to highs of $85 or so. Following the recent price action (from June-date) I've been forced to close the position to protect capital, clipping a $2/share loss in doing so. Net-net, on the combination of sentimental and valuation drivers, I revise my rating on MMSI down to a hold, in search of more selective opportunities elsewhere.
Figure 1.
Critical updates to investment thesis
1. Q2 FY'23 insights
MMSI booked Q2 top-line revenues of $320.1mm, up 9% YoY. Growth was underlined by a 9% rise in U.S. sales and an 8% increase in international turnover. Gross margin on this was 51.4%, nearly 300bps higher than Q2 last year. This was also the highest Q2 gross margin in the company's history.
The divisional highlights are as follows:
- Firstly, it observed a 9% growth in the cardiovascular segment and a 6% uptick in its Endoscopy business.
- Sales of peripheral intervention ("PI") products were up 14% YoY, and have clipped ~$240mm for the YTD. As shown in Figure 2, it's been the principal driver of the overall cardiovascular segment's growth for the year so far. Among the PI products, sales of access, radar localization, and embolic products rose by 19%. Additionally, sales of drainage and angiography products increased by 12%.
- Cardiac intervention and custom procedure solutions have gained $8mm and $1.7mm so far in FY'23 and clipped $179mm and $97.08mm in H1 respectively.
- Meanwhile, endoscopy device sales were up $47.2mm YoY to $617.6mm in the first half of the year.
Figure 2.
The firm generated $11.5mm in free cash flow during the quarter. Although, operating cash flows were down 55% YoY. This stemmed from quite intensive changes of working capital over the 12 months. Two primary factors underscore the increase in working capital density.
One is a decrease in accrued expenses linked to the final Cianna Medical milestone payment. Hence, this is a one-line item that will absolve itself from here. But the other aligns with its previously outlined strategy of increasing inventory balances. This came about during the supply shocks of '21/'22. Indeed, this ensures more consistent service levels and enough stock on hand. There's no denying this. But none of this has pulled through meaningfully below the bottom line as I write.
Figure 3 outlines the growth in inventories booked on the balance sheet vs. quarterly gross profit from Q4 2020-Q2 2023. Note, inventories on hand have increased 54% over this time, whereas gross profit has lagged at 37% incremental growth. This is a potential risk moving forward because conversions off the receivables account, and revenues booked haven't matched this pace of inventory growth. In fact, quarterly operating cash flows are down from $37mm to $17.3mm across this time, all seasonality effects considered.
Figure 3.
Furthermore, during the quarter, MMSI announced 2 acquisitions:
- The first involved acquiring the portfolio of dialysis catheter products from AngioDynamics ( ANGO ) on a cash consideration of $100mm [I am neutral on ANGO as well, see my latest publication here ]. The portfolio boasts product lines such as the BioFlo DuraMax dialysis catheter, which utilizes Endexo Technology- a proprietary material resistant to thrombus accumulation, reducing it by up to 83.5% versus competing products. Critically, this prevention of thrombus formation is a significant differentiator in these types of catheters. If a thrombus forms during a patient's dialysis treatment, it can obstruct blood flow through a catheter, hindering proper dialysis treatment-not to mention the risks to life.
- Alongside the dialysis portfolio, MMSI also acquired ANGO's BioSentry Biopsy Tract Sealant System. This move broadens MMSI's footprint in the biopsy market. The BioSentry is specifically designed to decrease the incidence of biopsy-related lung collapse, also known as pneumothorax . Management noted on the call that ~25% of patients undergoing lung biopsy are at risk of incurring a pneumothorax.
- The second acquisition involves an asset purchase agreement completed in May to acquire the Surfacer Inside-Out Access Catheter system from Bluegrass Vascular Technologies. The purchase was also made on a cash consideration, totalling $32.7mm. MMSI has a stake in Bluegrass Vascular, and was already the exclusive global distributor of the system from 2016-2022.
Hence, the acquisitions are arguably strategic for MMSI in my view, the question is, will they pull their economic weight? Management's projections indicated the acquisitions could collectively yield ~$30mm in annualized revenues, and positively impact EPS within year 1 post-closure.
Whether or not that's the case is less relevant as to the incremental profits earned as a percentage of the investments in my view. It allocated ~$133mm ($2.30/share) to both transactions; hence, I'd need to see it doing at least ~$16mm on this ($0.27/share) annually to show they have generated satisfactory cash returns on the capital employed. That's calling for a 12% return on the investments, roughly in-line with long-term market returns to breakeven ($15.96/0.12 = $133mm).
Management revised up guidance marginally on the call and sees less contribution from its endoscopy business to top-line growth in FY'23, revising forecasts from 15-16% growth to 12-13%. It calls for $1.23-$1.24Bn in revenues, with a reduction in endoscopy of ~$1mm, and a revision to cardiovascular revenues. Figure 4 summarizes the marginal changes to FY'23 projections, which, at the numbers listed above, call for 700-800bps growth in overall turnover.
Figure 4. Figures are represented in ("Bn") and ("MM").
Sources: BIG Insights, Company Filings
Sentiment taken a hit
We see the negative sentiment in MMSI's stock in two primary ways. As a reminder, sentiment is one of the three or so catalysts required to see a stock catch a bid, or re-rate in market value.
One, there's been 6 revisions down to earnings from Wall Street analysts in the last 3 months. This is telling, as it suggests The Street sees a challenging period for MMSI's bottom-line fundamentals going forward. Consensus now calls for 6.7% growth in earnings this year, and 11% in FY'24. Given these targets are used by so many within the investment community, you have the representation of a large substrata of the market populous in these downward revisions. To me this supports a neutral stance.
Two, market-generated data is equally as flat on inspection. This is shown via the cloud charts in Figures 5 and 6. Figure 5 shows the daily chart, and looks to the coming weeks. It has clearly busted below the cloud base, following the company's earnings in July. Both price and lagging lines (in blue) along with the two turning lines (pink and orange) have shifted lower, indicating a reversal in both short and long-term trends.
Figure 5.
Figure 7 is the weekly chart, looking to the coming months. It too is at a critical juncture, with the price line testing the cloud top as we speak. A break into the cloud would further support the neutral stance I'm taking. A break higher could be an upside risk to the hold thesis. It would need to push past the $79.00/share mark by January/February next year in order to corroborate a reversal by these standards. Based on the points discussed here today, I have reservations on the distribution of probabilities being biased to the upside.
Figure 6.
Three, options-generated data implies that investors are positioned to sell the stock at $75/share with the distribution of puts centered heavily around this strike price. There are also plenty of contracts at $75 on the calls side too, which may or may not be strategy-based, or some form of hedging activity. Still, the demand for puts at this strike level to me is not a bullish sign, and further supports the hold thesis in my opinion.
Valuation and conclusion
The stock still sells at 23x forward earnings and 18x forward EBITDA, both 17% and 38% premiums to the sector, respectively. It's a difficult task advocating to pay $23 for every $1 in future earnings, with a PEG ratio rated at ~1.5x, indicating the growth isn't well-supported in this valuation.
Analyzing in more economic terms, as a percentage of the capital MMSI has now employed into the business (including goodwill), $1.588Bn ($27.03/share) in capital at risk produces $146mm ($2.53/share) in trailing earnings after-tax [defined here as the net operating profit after tax], just 9.2% return on capital. MMSI's enterprise value is $4.2Bn as I write, meaning the EV to invested capital of 2.65x.
Taking a 12% hurdle rate, the firm's ROIC/Cost of capital ratio is 0.76x (0.092/0.12 = 0.76x). This gap (0.76x-2.65x) implies the firm hasn't created value for shareholders, as you'd be looking for the ROIC/cost of capital ratio to be higher than the EV/invested capital number, which it isn't in this instance. Hence, it would appear that 1) MMSI is not undervalued, and 2) it has plenty to do to drive capital returns higher for the benefit of shareholders. At 23x management's FY'23 earnings estimates of $2.92/share, this gets you to $67/share in implied value, in line with the current market value as I write. Collectively, all the calculus presented here supports a neutral stance in my opinion. The quant system also supports these findings objectively, reiterating its hold rating on MMSI.
Figure 7.
In short, whilst MMSI continues to advance its financial performance, economic indicators of the company's growth aren't as appealing. A lack of identifiable catalysts also supports this view, and this is also seen in the poor sentiment in the company's stock at the time of writing. The two acquisitions formed in Q2 are potentially accretive but we'll have to wait for subsequent quarters to see what pace it has integrated these into its operating lines. Further, valuations are unsupported, with the market selling MMSI to you are 23x forward earnings, well above sector averages. With multiple selective opportunities available elsewhere right now, I revise my rating on MMSI to a hold at $67/share.
For further details see:
Merit Medical: Soft Expectations, Capital Productivity Into FY2023 (Rating Downgrade)