Both bulls and bears can find information in Mindray's (NYSE:MR) second quarter report to uphold their preexisting biases about the stock. Convinced that that growth is slowing and the company is seeing less margin leverage? There are data to support that. Convinced that Mindray can continue to exploit a huge market for quality value-priced medical equipment while generating good free cash flow? We've got you covered there too.
At a minimum, I'd say Mindray is in that awkward phase where the company is alienating pure med-tech growth investors, but not yet attracting the margin/cash flow-driven value/GARP crowd. Although I think recent ventures into immunoassay and ultrasound could pay off down the road, I'm not as willing to stick my neck out right now for a stock like Mindray.
Some Good, Some Bad In Q2
Mindray reported nearly 15% revenue growth for the second quarter, which would normally look pretty good against most of the numbers we've seen from companies in the monitoring, imaging and diagnostics space like Covidien (COV), Abbott (NYSE:ABT), GE (NYSE:GE), Philips (PHG) and Roche (OTCQX:RHHBY). We all know that's not how the Wall Street game works, though, and the company did in fact come in a bit shy (about 2%) of expectations - not exactly refuting the bearish argument that Mindray's growth trajectory has slowed significantly.
On the other hand, the margin performance was pretty good - certainly better than the Street expected. Gross margin improved about a half-point and came in around 70bp higher than expected. Likewise, adjusted operating income rose 15% and Mindray saw slight margin improvement. It's worth noting that the sell-side is not consistent with forecasting GAAP/non-GAAP operating income - in a worst-case scenario Mindray beat by about 5% at the operating line.
Good Diagnostics, But Weak Monitoring And US Sales Will Rankle
Mindray reported that sales within China (just under half of the total) rose 28%, comparing pretty favorably to other Chinese med-techs like Shandong Weigao and MicroPort. On the other hand, ex-China sales were up less than 5%, with sales in the U.S. down double-digits. With export data showing 12% growth in the second quarter, I would be concerned about the risk of channel-stuffing if ex-China sales don't re-accelerate presently.
By category, Mindray saw nearly 20% growth in diagnostics, with 27% growth in reagents sales and equipment sales of almost 16%. That is far and away better than what most multinational rivals like Roche, Abbot and Danaher (NYSE: DHR) are seeing, and it looks like product introductions like the hematology analyzer, chemistry analyzer and immunassay platform are getting good acceptance in the high-growth Chinese diagnostics market.
Imaging was up 19%, which is likewise quite a bit better than what multinationals like GE and Philips are seeing in the global imaging market. On the other hand, the 2% growth in monitoring and life support is disappointing as this has long been a core business for Mindray.
Can Mindray Leverage Zonare?
A large part of the Q&A session in Mindray's conference call was devoted to talking about the company's relatively recent acquisition of Zonare. Previously a privately-held U.S. ultrasound company, Zonare is seen as a player in high-end ultrasound with its unique software-based imaging approach. While Mindray paid $105 million for the company and actually paid less (in terms of multiples) than Fujifilm paid for SonoSite, Zonare is not profitable yet and will be dilutive to Mindray at first.
Still, I think it's short-sighted to look at this deal in terms of what it offers to Mindray's 2013/2014 profits. For starters, the company is going to be relocating manufacturing to Shenzhen, China, over the next six to 12 months and that should improve the gross margins of the business.
Even allowing for the probable hyperbole, Zonare has claimed that its technology is two generations ahead of traditional ultrasound technology. With that, Mindray has a significant opportunity to improve the quality of its ultrasound product offerings - while Mindray's current ultrasound products sell for about $10K to $30K per unit, Zonare's go for around $30K to $100K.
With over 50% of the ultrasound market in the U.S., Western Europe and China in the high-end/premium segment, this significantly expands Mindray's addressable market. Zonare is currently active in most of the major ultrasound markets (radiology, cardio, emergency/ICU) and is the #1 player in peripheral vascular. At a minimum, incorporating Zonare's tech will close the gap with comps like GE.
The Growth Dilemma
Some Mindray bulls make a lot of the company's decelerating growth in recent quarters, but I wouldn't say that Mindray's growth days are over. If the integration of Zonare goes well, imaging revenue growth could significantly re-accelerate, and I likewise wouldn't ignore the significant growth in the Chinese diagnostics market. While Mindray may need to consider additional acquisitions to shore up its high-end pedigree in diagnostics, the company has the cash to do it.
I still believe that Mindray can generate low teens revenue growth and couple that with improved margins and cash conversion sufficient for mid-teens free cash flow growth. That leads to a valuation range of around $40 to $45 today, though the company's EV/EBITDA and ROE/PBV don't immediately argue for a significantly higher stock price. Should the company manage the transition from being just a value-priced player to a legitimate option in higher-end markets, there would likely be upside to those numbers.
The Bottom Line
If Mindray can resuscitate growth in its monitoring/life support business and get the U.S. business growing again, opinions could turn around fairly quickly on Mindray. Of course, the way this story goes, it wouldn't surprise me if that was accompanied by some shortfall elsewhere in the business that allowed the bull-bear tug-of-war to continue.
The shares have done alright since I last wrote on them in late February, but others in the med-tech space have done better. While bargains are fewer and further between in med-tech today (and I do believe that Mindray is undervalued), I'm not as excited about Mindray's short-term performance potential, though I think the long-term potential is still worthwhile.
Disclosure: I am long OTCQX:RHHBY. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.