Merit Medical: No Change To Hold Thesis, ROIC Still One To Watch

Sep. 09, 2022 11:30 AM ETMerit Medical Systems, Inc. (MMSI)

Summary

  • Merit Medical came in with a fairly strong set of numbers last quarter that was backed by a high degree of free cash flow.
  • A number of catalysts weren't recognized by the market last quarter, suggesting further upside may be largely priced in.
  • The company continues to exhibit high degrees of return on invested capital, however, this doesn't cover its cost of capital.
  • The hold recommendation on MMSI is reiterated on a $57 price target.

Heart Health Concept

Eoneren

Investment Summary

Following its latest set of numbers, the hold thesis on Merit Medical Systems, Inc (NASDAQ:MMSI) remains intact with little change to the valuation or investment case. I've previously covered MMSI extensively here and here and noted several points key to the investment debate:

  1. Initially, that valuation and performance are heavily tied to return on invested capital and therefore, capital allocation.
  2. Normalized margins are trending below peers, a key risk in the macroeconomic climate.
  3. MMSI has strengths in free cash flow conversion and demonstrates a high return on investment.
  4. MMSI warrants a hold recommendation.

With these points in mind, I've revisited the name and reiterated the hold thesis for MMSI on a $57 price target.

Catalysts to move the needle:

1. Clinical trial momentum.

Management noted progress in the company's WRAPSODY endovascular stent graft [WRAPSODY AV Access Efficacy Study - "WAVE"] study. The device is being trialed for the treatment of arterial stenosis of occlusion along with dialysis outflow circuits. The study is made of three cohorts, 244 AVF peripheral subjects, 113 Anastomosis patients and ~120 central subjects. It is estimated for completion in 2026 with the primary completion date set for June FY24. Updates around this are central to the company's outlook looking ahead.

MMSI also announced first enrollments in two additional studies. First is the "WRAP" study, commenced in June, set to evaluate clinical benefits with using WRAPSODY cell-impermeable endoprosthesis in patients that are undergoing haemodialysis with stenosis or occlusion in vessels that are required for access during dialysis. The trial will enroll up to 500 patients whom present with this criteria across a number of jurisdictions - namely South Africa, Australia and New Zealand. The completion is set for February 2025.

Next is the STREAMLoc study that is aiming to illustrate the effectiveness of the company's SCOUT system in improving efficiency in Canadian breast cancer centres. According to MMSI, SCOUNT is "a wireless, radar-guided localization system used to assist breast surgeons in identifying biopsied tumors for removal during breast-conserving surgery". The study's secondary objective will assess the utility of the system's reflector insertion at the time of biopsy.

2. SCOUT Mini Reflector launch

The company also launched its new SCOUT segment, the SCOUT Mini Reflector. This is designed for use in breast and lymph tissue and has been re-engineered at a smaller size [33% smaller at 8mm in length, see Exhibit 1]. The main advantage is the smaller units utilization in 'harder to reach' areas versus the bulkier unit, but more importantly, more enhanced directionality for accuracy. It can also be placed pre or post operatively and in conjunction with chemotherapy as well. However, MMSI said it also can be placed in other soft tissue malignancies as well [outside of breast and lymph tissue] potentially widening up the addressable market in the wider SCOUT segment.

Exhibit 1. The SCOUNT mini reflector size changes for scale reference. All of the size change is in the reflector itself.

The Mini has potential for placement in additional malignancies outside of breast and lymph tissue.

ff

Data: Merit Medical

Earnings and investment analysis

I continue to firmly believe that two of the best measures of corporate value are earnings and a company's return on investment ("ROIC"), whereas the value of a financial asset is of course, the present value of its future cash flows. We measure the latter in shorthand using multiples.

MMSI came in with a robust set of Q2 FY22 numbers, with revenue up 520bps YoY to ~$295 million ("mm"). Growth was underscored by a 750bps gain in turnover from cardiovascular products, whereas endoscopy products also lifted ~440bps over the 12 months. Within the peripheral interventional business, angiography sales were up 18% and contributed the most upside to the segment.

Meanwhile, revenue from sales of SCOUT radar localization products clipped a 9% YoY gain that was backed from additional 15% growth in OEM product sales. Whilst turnover spiked YoY OPEX on this narrowed by 350bps YoY to $111.8mm. With the jump in revenue, it bought this down to GAAP net income of $15.29mm or $0.27 per share from $4.9mm and $0.09 respectively.

On the FCF front, MMSI remains strong. It has converted persistently high levels of free cash below the bottom line since FY20, demonstrating that operating income is backed by a high degree of real cash, as seen in Exhibit 2. Whilst FCF conversion has been strong [$31mm for Q2 FY22], yields on this haven't been as rosy, narrowing into c.300bps in the last quarter. Management forecast $75mm in FY22 FCF and this implies a forward FCF yield of 2.2% on these projections.

Exhibit 2. MMSI's earnings pile in its corporate value is mixed, with reasonable FCF conversion and steady FCF yields.

Despite this, there are still potential doubts on the predictability of the company's future free cash flow's on my estimation.

rrr

Note: FCF yield calculated on TTM FCF to enterprise value. Free cash flow calculated on quarterly basis. Operating income to FCF ratio demonstrates what percentage of GAAP operating income is backed by 'real' cash. It is calculated by taking quarterly or TTM GAAP operating income and dividing by free cash flow for the period. (Data: HB Insights, MMSI SEC Filings)

Despite the lumpiness in the sequence above - in particular, the narrowing FCF yields - I've noted strength in its ROIC. As seen in Exhibit 3, the company has grown its asset value substantially over the period of FY16 to date.

In addition to this, the company's asset book on the balance sheet has shifted off intangible assets to see the equity split more evenly to tangible assets. On this, the company has also realized an uptick in TTM ROIC, now back at FY16-FY17 levels. This is still below the WACC hurdle of ~8%, however. So there's contention on whether this ROIC number is sufficient longer-term.

Exhibit 3. Despite a tightening FCF yield and lumpy operating metrics, the company is still able to compound return on its investments.

rrr

Note: All figures in $mm or %. Return on invested capital calculated on GAAP earnings with no reconciliations. Intangible assets inclusive of goodwill. (Image: HB Insights. Data: MMSI SEC Filings)

Valuation and conclusion

Shares are trading at a lofty 60x P/E and 17.6x EV/EBITDA, both premium's to the GICS health care median. MMSI is also priced at 3.2x book value, again a premium to peers. The market consensus has MMSI priced on a forward P/E of 24.7x, and applying to our FY22 EPS estimates of $2.31, sets a price target of $57, marginally higher than my previous valuation here.

Based on the culmination of these points, I recommend that MMSI is a hold at the current point in time, on a $57 valuation.

This article was written by

Buy side equity portfolio strategists serving mandates throughout EU/US/APAC. Helping you position your portfolios for the future is our top priority. We offer unique insights via our holding strategies that rest at the long end of the equity curve with minimal drag/drawdown. Shoot us a message to discuss trade ides or talk portfolio construction. Disclaimer:The opinions expressed in all articles do not constitute as investment advice. Please remember to conduct your own due diligence. Hummingbird Investment Group Ltd ("The Company") does not provide investment counsel to non-cliental. Additionally, all investing comes with inherent risks, and there are a plethora risks investors must consider before any investment decision. Past returns are not indicative of future performance, and should not be relied upon as an indicator for investment outcomes. Therefore, the opinions expressed in any and all analyses conducted on Seeking Alpha from The Company, does not constitute as advice, guidance, recommendation or counsel, and therefore should not be received as so. The Company's opinions and commentary are subject to unforeseen market forces which may result in outcomes different from postulates within quantitative modelling. In any case or situation, neither The Company, or its acquired interests, accepts any liability for loss of capital or liquidity erosion, based on an individual's own investment reasoning.

Disclosure: I/we have no stock, option or similar derivative position in any of the companies mentioned, and no plans to initiate any such 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.

Recommended For You

Comments

To ensure this doesn’t happen in the future, please enable Javascript and cookies in your browser.
Is this happening to you frequently? Please report it on our feedback forum.
If you have an ad-blocker enabled you may be blocked from proceeding. Please disable your ad-blocker and refresh.