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Utah Medical Products, Inc (NASDAQ: UTMD) makes a range of disposable medical devices used in hospitals. A reader suggested that I might be interested because the company’s relatively low P/E (less than 15) makes “little sense” given the company’s strong historical returns and outlook (it has recently made a sizable acquisition).

I am always on the hunt for companies such as UTMD, which sell disposable products that constitute a small but important element of the end user’s budget. In situations like this, there is often little reason for the end user to devote much time to assessing alternative products (the cost savings would be minimal) and so you sometimes stumble across situations where the company quietly sells products to a (slowly) growing list of customers, year in and year out, while earning outsized returns. These are often good acquisition targets for private equity firms and larger players in the industry, so I rarely pass on the opportunity to dig deeper.

Let’s start with the company’s historical returns (Note that I adjusted 2003 and 2005 financials for one-time gains).

Utah Medical Products, Inc - Historical Returns, 1994 - 2Q 2011

Utah Medical Products, Inc - Historical Returns, 1994 - 2Q 2011

Here we see that the company has enjoyed double digit returns over several measures. Moreover, the company has achieved these returns with very little leverage (though, as we will see in a moment, leverage has increased in the last two quarters).

Let’s look at revenues and margins.

Utah Medical Products, Inc. - Revenues and Margins, 1994 - 2Q 2011

Utah Medical Products, Inc. - Revenues and Margins, 1994 - 2Q 2011

I am somewhat concerned about the company’s gross margin which declined from a long-term average in the 56 – 57% range to the 52 – 53% range. Though the company has managed its operating expenses so as to soften the blow somewhat, this has been insufficient to fully neutralize the company’s declining gross margin.

Another thing to note about this chart is that the last quarter showed a dramatic increase in revenues and decrease in margins. Prior to this, the company’s quarterly revenues were largely flat (though down somewhat from mid-decade). We’ll discuss this increase in a moment (oh the suspense!), but first let’s look at free cash flow.Utah Medical Products, Inc. - Free Cash Flow, 1994 - 2Q 2011

Utah Medical Products, Inc. - Free Cash Flow, 1994 - 2Q 2011

Here we see that the company’s free cash flows and cash flows from operations track each other quite closely. The difference between the two figures is what the company spent on capital expenditures in the period, so the fact that the company has had relatively low capital demands. This is common for the type of company I described at the beginning of this article. These “Steady Eddie” companies operate largely under the radar, with stable revenues, margins and free cash flows. They quietly sock away money, growing book value per share or distributing it to investors, until they are bought out. UTMD has done both, as the following charts show.

First, dividends.

Utah Medical Products, Inc. - Dividends, 1995 - 2Q 2011

Utah Medical Products, Inc. - Dividends, 1995 - 2Q 2011

Next, share repurchases.

Utah Medical Products, Inc. - Shares Outstanding, 1994 - 2Q 2011

Utah Medical Products, Inc. - Shares Outstanding, 1994 - 2Q 2011

Over the period shown, the company has returned $24.65 million in dividends, and repurchased (net of issuances) $99.96 million worth of shares. The reflects essentially all of the company’s free cash flow over the period, indicating a shareholder friendly management.

Readers of Financial Shenanigans (Read my in-depth multi-part review here) will know to also look at the components of the company’s cash conversion cycle, which identifies a range of potential problems.

Utah Medical Products, Inc. - Cash Conversion Cycle, 1994 - 2Q 2011

Utah Medical Products, Inc. - Cash Conversion Cycle, 1994 - 2Q 2011

Here we see that, like the rest of the company’s operations, it has done an excellent job maintaining a steady cash conversion cycle for the last decade. There is nothing here that concerns me, though note the last two quarters are somewhat disrupted. Let’s discuss what’s been going on with this company recently.

In March, UTMD announced the purchase of UK-based Femcare Group Limited. Femcare, via its Femcare-Nikomed and Femcare Australia subsidiaries produces the “Filshie Clip System” which is used for female sterilization (tubal ligation, or “getting one’s tubes tied”). For those interested, check out the press release which provides far more detail about the Femcare’s products than do most acquisition-related press releases. The important takeaway is that Femcare’s products appear to have many of the same characteristics as UTMD’s, in that there is an ongoing need to purchase new inventory from the company and that this market appears to be quite stable due to the Filshie Clip’s safety advantages.

In justifying the purchase price, the company noted a range of revenue and cost synergies that it expects from the acquisition. While they sound fantastic, it is important to note that synergies often do not materialize to the degree used to sell the deal to shareholders. That said, in UTMD’s first full quarter since closing deal, things are looking good. UTMD’s domestic sales of OEM components were up 149% in 2Q 2011, with the company reporting that this gain was due to sales of Femcare’s Filshie Clip System components to Cooper Surgical Inc. This indicates that revenue synergies are beginning to take hold, as UTMD begins distributing Femcare’s products in the United States.

UTMD’s gross profit margin also increased significantly, to 60.3% from 52.1%, the result of Femcare’s higher margin products. However, operating profit margins were weaker as a result of increased amortization expense, accounting costs related to the merger and Femcare’s higher G&A expense ratio. UTMD expects that this will improve in the coming quarters, so we will have to wait and see.

Given the dramatic change in UTMD’s performance since the Femcare acquisition, valuing the company in the future relies on a significant number of assumptions. Using in part UTMD’s statements to guide my projections, I find UTMD to be undervalued by quite a bit. Unfortunately, these valuations are based on management’s public statements, which may not prove accurate. When valuing a company, I prefer to anchor my valuation in what the company has actually been able to achieve in the past. Unfortunately, when valuing UTMD using figures more closely resembling its past performance, the company appears fairly priced.

Some might say that you could do worse than to buy a company for a fair price based on its historical performance and then getting all of the potential upside from the acquisition for free. Unfortunately, the acquisition did not come without its costs. The company’s debt increased dramatically, from holding an average of $16 million in net cash over the last six years to having $19.8 million in net debt currently.

What do you think of Utah Medical Products?

Disclosure: No position

Source: Utah Medical Products: Stable Operator Rocks The Boat