- Merit Medical is trading within sight of an all-time high as the company looks to procedure volume recovery, new product launches, and a significant margin improvement initiative.
- Sample collection kit sales for COVID-19 testing were an invaluable offset to procedure volume declines in 2020, but will likely decline in '21, as procedures recover and new products launch.
- Management is aiming for a near-doubling of non-GAAP operating margin in 2023 from pre-pandemic levels, driven by a richer product mix, shifting production to a lower-cost plant, and SG&A efficiency.
- Even if Merit's margin goals are a little too ambitious, 6% to 7% revenue growth (annualized) over the next three years can support a 4x forward revenue multiple and a $67 fair value.
Merit Medical Systems (NASDAQ:MMSI) (“Merit” or “Merit Medical”) shares trade near their 52-week high and within sight of an all-time high, and not without good reason. Business held up pretty well in 2020 considering the sharp declines in elective procedures across the world, and the company is leveraged not only to recovering procedure counts in 2021 but new product introductions that were delayed by the pandemic.
Beyond that, the company is also in the early stages of a meaningful margin improvement initiative that includes deprioritizing low-margin products and relocating more production to lower-cost factories. Add in a significant new product (in trials) and the possibility of more R&D allocated to more sophisticated new products, and the growth-plus-margin-enhancement story looks pretty appealing.
Investors need to keep some sense of perspective here – this isn’t Intuitive Surgical (ISRG) or Stryker (SYK) and it never will be – but valued for what it is, I think it’s still a solid med-tech with a self-improvement story. If management can stay on target with its 5% to 7% annual top-line growth, a fair value in the mid-to-high $60s is reasonable today.
Can Management Hit Its “Foundation For Growth” Targets?
I’ve followed Merit off and on for over 20 years now, and the company’s track record of hitting its targets is mixed – revenue growth targets have been reliable more often than not, but margin targets have proven more challenging. The company’s track record on GAAP operating margins is what it is – a decline from the double-digits a decade ago to the mid-single-digits recently (though in the low double-digits on a non-GAAP basis) and low GAAP-based returns on assets and invested capital. Investors can quibble with the GAAP/non-GAAP differences if they like, but the reality is that margin leverage hasn’t been a particularly meaningful positive driver.
Now management is on a different path, likely helped by the involvement of an activist investor (Starboard) that led to three new outside directors and a new committee focused on margin improvement opportunities. I do want to credit management here, too, though – the CEO of Merit has been at the helm for over 30 years and I think the willingness to listen to, and work with, outsiders is commendable.
Anyway, Merit is looking for a major improvement in its margin structure, targeting a near-doubling of non-GAAP operating margin from pre-pandemic levels in 2023.
On the gross margin side, management has exited some lower-margin business and may continue with that process, including targeting areas like custom trays where gross margins are less than half of the company average (this business has already shrunk noticeably over the past 10 years). Management has also closed several higher-cost manufacturing facilities and transferred more products to its lower-cost facility in Mexico – something that other med-techs similar to Merit (like ICU Medical (ICUI)) have done in the past.
While gross margin improvement will be an important driver, it won’t be the only one. Management is also looking to tighten up SG&A spending – I wouldn’t say that SG&A spending is problematically high, but there should be “do more with less” opportunities here that can help drive the targeted improvements in margin.
Growth From Multiple Drivers
I do believe that Merit is leveraged to improving procedure accounts as the impact of the pandemic fades. With recent infection rate surges in many areas, that may well be more of a second half phenomenon, but the ongoing vaccination program in developed markets should drive improving counts as early as the second quarter.
Several companies in the peripheral vascular space, including Penumbra (PEN), have talked about increased case backlogs during the pandemic, and so I do expect to see improved volumes for Merit.
I’m also expecting to see a boost from new product launches in 2021, as these launches were postponed by the pandemic. Management has said that they have at least 10 significant new products ready to launch in areas like electrophysiology, biopsy, endoscopy, and peripheral and coronary intervention.
A New PMA Opportunity
Beyond the next couple of years, I’m also intrigued by the potential of the company’s Wrapsody endovascular stent graft. This device is meant to increase long-term patency in the dialysis outflow circuit (part of an arteriovenous fistula) for patients undergoing hemodialysis. For hemodialysis patients, occlusions of the fistula are a “when, not if” phenomenon, and dealing with them costs time, money, and aggravation – this is definitely an area where a “better mousetrap” would be welcome.
Merit has sized the addressable market opportunity at $100M – a major opportunity for a company with $1B in revenue that generally serves a large collection of small markets. It’s also an unusual opportunity for Merit in that it requires a pivotal clinical trial (the WAVE study) and will be handled through the FDA’s PMA pathway (as opposed to the 501k that Merit uses for most devices).
Management has been a little cagey about whether this is going to be the start of a new trend in device development at the company. As management has noted, the PMA process is expensive and time-consuming, and it’s not likely to be a “new normal”, but the company does seem to be more willing to consider R&D projects in the future that will require the PMA pathway.
To a large extent, I believe Merit Medical is an “is what it is” sort of med-tech company. It’s not going to be a double-digit revenue grower on a reliable basis, and apart from a few exceptions, it’s not going to be focusing its R&D dollars on high-profile growth projects.
Instead, Merit is more of a facilitator with a focus on serial innovation in areas like hemodialysis, interventional procedures (guidewires, catheters), biopsy, and electrophysiology (including devices that help attach pacing leads). Done right, that can be enough to allow the company to be a “procedure count-plus” type of grower, and I think management’s revenue growth target of 5% to 7% is consistent with that characterization, particularly as peripheral vascular procedures continue to grow.
I’m looking for long-term revenue growth in the 5% to 6% range, with revenue growth over the next three years likely to exceed that rate on an annualized basis. Merit has been a serial acquirer over the years, and I don’t expect that to change, so the opportunity to boost growth with deals is certainly still valid. I’d also note that the company logged almost $20M in sales in 2020 from sample collection kits for COVID-19 testing and that revenue is likely to decline significantly in 2021 (and that is factored into my expectations).
I’d also describe myself as “cautiously bullish” on the margin expansion story – I think management has set an ambitious bar, but even if the company falls short, a 20% non-GAAP operating margin in 2023 would still be a big improvement over the recent pre-pandemic results in the low teens.
The Bottom Line
I expect revenue growth of between 6% and 7% over the next three years, and I believe that should support a forward revenue multiple (EV/revenue) of 4x. That, in turn, supports a fair value of around $67 today. That’s not huge undervaluation, and there is execution risk on the margin improvement plan, but with a tailwind of revenue re-acceleration and margin expansion, there are opportunities for Merit to outperform and re-rate higher.
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