When I last wrote on Medical Action Industries (NASDAQ:MDCI) in April, I thought the shares looked like an interesting idea given management's intention to pare away less profitable products and really focus on improving margins. Since then the shares are up more than 40% and the company has followed through on their stated plan of self-improvement. Between ongoing margin improvement and a debt refinancing that created valuable breathing room, I believe these shares are worth more now and still have around 20% upside.
Margins Are Coming Along
There was never much disagreement or dispute that Medical Action needed to do something about its margin structure. Procedure trays, medical textiles, and other assorted disposables have never been high-margin products, and Medical Action lacks the same sort of operating scale as larger OEMs like Becton Dickinson (NYSE:BDX), Cardinal Health (NYSE:CAH), and Medline Industries. Add in higher labor costs in China and higher resin costs, not to mention a collection of sub-scale products, and you can see the source of Medical Action's margin issues.
Management has attacked this problem on multiple fronts. The company has tried to get a little more proactive about dealing with resin prices, but has also looked to deprioritize and phase out products that didn't meet the company's margin and market share goals. It may sound simple, but not all that many companies have the discipline to willingly turn away revenue.
So far, so good. Quarter-to-quarter performance has been a little wobbly, but gross margins are now in the high teens and management seems to believe there is room to go further. As I said in April, I don't think gross margins in the mid-20%s are feasible again (or not without acquiring some significantly higher-margin lines of business/products). I am incrementally more optimistic that 20% is attainable, though, and there should be good flow-through to the bottom line.
A Refinancing Gives Breathing Room
The biggest near-term risk I saw for Medical Action in April was the imminent maturity of over $50 million in debt, as the company had nowhere close to the cash on hand or free cash flow potential to repay that loan. Medical Action responded by essentially refinancing this debt, reaching a new credit agreement with Wells Fargo that gave them access to up to $65 million and a lower interest rate.
With this new agreement, Medical Action should save a few pennies per year in interest expenses. While management apparently intends to dedicate its free cash flow for the next couple of years to repaying debt, this financing arrangement does give them the flexibility to do small tuck-in deals if or when the right opportunity arises.
Growth Still A Challenge, And It's Not Getting Easier
One significant issue remains for Medical Action - the question of its top line growth potential. Reported revenue has declined on a year-over-year basis for several quarters running now, with a few misses relative to sell-side estimates along the way.
True, the underlying growth performance is not so bad on an adjusted basis, as revenue has been flat or up in the low single digits after adjusting out the discontinued businesses and products. That's not so terrible when you look at other companies like Cardinal Health, ICU Medical (NASDAQ:ICUI), or Owens & Minor (NYSE:OMI) that manufacture and/or distribute lower-ASP medical disposables. On the other hand, "not so terrible" is not exactly a great stock thesis, and investors cannot be thrilled with the recent share losses in procedure trays.
I do believe that Medical Action needs to keep its eyes peeled for value-adding acquisitions. The company does not spend a meaningful amount on R&D, so internal product development is not really going to change things. As time goes on, I see no reason to believe that the procedure tray/kit market won't continue to get more and more competitive. Bundling is a fact of life in the healthcare world, and if a company like Medline can supply all of a hospital or clinics needs (and at a competitive price), it is going to be hard for Medical Action to hold its place.
The good news is that there are always clever products being developed in the med-tech world by individuals or companies that need distribution. The acquisition of Femcare and its Filshie Clip made a major difference for Utah Medical (NASDAQ:UTMD) and ICU Medical has likewise seen significant revenue contributions from niche products designed for the oncology space. Now, the ICU Medical example is apples-to-bananas as their oncology products were developed internally, but my point is that there are many products out there with annual revenue potential of $20 million to $60 million that Medical Action could consider adding, and there are always new products in search of a home.
Growth Largely A Margin Question Today
I'm looking for Medical Action to grow its revenue at a long-term rate of less than 3%, as I believe the company will find it difficult to offset ongoing price erosion. I do believe that the company's margin improvement efforts can lead free cash flow margins back in the mid-single digits, and that results in a long-term free cash flow growth estimate of 5%. Even with an elevated discount rate and the net debt on hand, that suggests a fair value of more than $9.
The Bottom Line
Medical Action's shares have already recovered nicely and are no longer the easy value pick they may once have been. Likewise, I feel that investors should not underestimate the risk that this company's low organic growth prospects leave it on the sidelines for most institutional med-tech investors. Value is value, though, and I believe management still has more to deliver in terms of margin improvement, and that margin improvement can lead to double-digit appreciation from here.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.