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Arrhythmia Research Technology, Inc. (NYSEMKT:HRT) develops medical software for analyzing the heart’s electrical impulses. Through its wholly owned subsidiary, Micron Products, Inc, the company manufactures and distributes conductive resin sensors used in the manufacture of disposable electrodes used in cardiograph equipment. It currently trades for a market capitalization of $16.6m (<$6/share), less than twice its net current asset value (NCAV) and below tangible book value, despite having a track record of zero losses over the last decade, shareholder friendly management (both dividends and share repurchases) and a product that has won numerous awards and inclusion in several prestigious studies, indicating the potential for an economic moat.

Trading at nearly twice NCAV is too high to be justified on Benjamin Graham’s asset-based philosophy alone (where one would look for a discount to NCAV of approximately 1/3), so we have to look deeper and consider the Earnings Power (EPV) of the company. Using a three year average revenue rounded down to the nearest million (not a major adjustment in this case) and 10-year averages for operating expenses, we find a normalized earnings before interest and taxes (EBIT) of approximately $2.4million, ultimately leading to an EPV calculation from derived free cash flows of approximately $7.1, or nearly 20% above today’s price.

This alone is not enough to justify a purchase, since there are several things working against this analysis and the company more generally. We notice immediately that $2.4million EBIT has not been achieved in four years, as the company has suffered a severe erosion in operating margins, predominately due to an increase in COGS from 61% in 2004 to 83% in 2009 (and similar figures for the three quarters of 2010). From this, we investigate whether the costs before goods sold (COGS) will decline to 10-year normalized levels, or whether we are seeing a secular change in the company’s operations. The company reports the following:

The increased cost of silver negatively affects margins as the higher cost increases both the revenues and cost of sales. The cost of sales excluding silver continues to improve as a result of the ongoing lean manufacturing projects and capital investment in new automated equipment.

From the graph below, we see that over the previous five years, silver has nearly tripled. Although management’s efforts to transition to a leaner manufacturing process, it has been unable to counteract the increases in one of its component costs.
ag1825nys Arrhythmia Research Technology, Inc. (<a href='http://seekingalpha.com/symbol/hrt' title='Arrhythmia Research Technology, Inc'>HRT</a>)
Although there is no end in sight to the metals bull run, it is important to keep companies like HRT in mind in the future. As the price of silver returns to normal levels, this will combine with management’s efforts to improve manufacturing to achieve operating margins that should exceed historical levels, when the pressure to decrease manufacturing costs was less.

Disclosure: No position

Source: Arrhythmia Research Technology's Fortune Tied to Silver Fluctuations