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Kinetic Concepts develops and manufactures medical devices and equipment and operates an extensive distribution and service network worldwide. The firm derives most of its sales from V.A.C. systems for the treatment of deep, complex wounds. It also sells therapeutic beds and surfaces to prevent complications in a variety of patients, including the critically ill and obese.

I added KCI to my list of investment ideas following a screen on the Medical Instrument and Equipments industry.

Over the last month, the company has been trading between $38.0 and $40.3

Please visit this Google Doc Spreadsheet to see all the underlying data and calculations for this analysis; you can also refer to the stock review explained post if you have questions on what I look for in this stock review

1- Business Performance (+/=)

Metric

Status

FCF / Sales

LTM: 12.3%, lower than the 3 and 5 year averages. Other than 2000-02, FCF/Sales has generally been over 10%

ROE

No data before 2004. ROE is currently 19.9%, down from higher levels in previous years, probably inflated due to a succession of leverage buyouts

ROA

LTM: 8.3% which is ok but not great; ROIC is at 10% still acceptable but lower than my goal of ~12%

Revenue Growth

Revenue growth has been strong over time, with a 3 and 5 year growth averages at 13 and 15% respectively. However this growth has slowed in 2009 and over the last quarter, with an expected growth rate of ~6% in the future

Cash distribution to shareholders

Dividend: KIC does not pay a dividend

Stock repurchases: Over the last 5 years KIC only bought back about 3% of shares, using FCF instead to repay debt.

KIC’s business overall seems strong with good cash flow generation, and strong revenue growth over time albeit lower in recent quarters. The company’s returns while solid may be distorted by a series of leverage buyout/recaps making the measure less meaningful.

2- Intrinsic stock returns (+)

Using the assumption of 6% growth and 20% ROE, intrinsic stock returns could break down as follows:

This is a fairly high return, however I don’t believe that the company will be accumulating cash given its debt position.

3- Balance Sheet (-)

Metric

Status

Current Ratio

2.1x which is acceptable

Debt / Equity

Total debt / equity is currently at 0.8x, below my threshold of 1.0x…

Debt / FCF

…however Total Debt / FCF is at 4.6x which is too high a level for me. This represents over a billion in debt for a company with a FCF of $250M

KCI is highly leveraged, making it vulnerable to volatility in earnings/FCF in the future

4- Valuation (+)

Metric

Status

Price to earnings ratio (NYSE:TTM)

11.4x, lower than the S&P and the company’s average of 14.8x over the last 5 years

Price to earnings ratio (3-yr average EPS)

13.0x, which is low – leading to an earnings yield on that basis of 7.7% which is higher than my yardstick of 2x AAA-bond rate

Cash Return

7.7% which is attractive

Overall KCI’s valuation appears to be quite attractive, both on a relative basis (vs. past 5 years and vs. S&P500) as well as on an absolute basis (earnings yield in excess of 2x AAA-bond rate

Conclusion

While KIC appears to be a good business, its current balance sheet is too leveraged for me making it an unlikely investment candidate, despite attractive potential intrinsic returns and good valuation. I will not keep KIC in my watch-list and will not proceed to a more detailed stock analysis.

Have you looked at KIC recently? What was your conclusion?

You can find some investment ideas, more one-page “stock reviews” as well as more in-depth “stock analysis”, including valuation and copies of my financial model on my investment research blog: Margin of Safety Investing.

Many happy returns!

Ben

http://marginofsafetyinvesting.com

Source: Kinetic Concepts Stock Review: Wounded Balance Sheet