Description

Merit Medical has used a string of acquisitions to avoid missing guidance and to mask declines in its core business. It has diverted investor attention by promoting adjusted numbers that bear little resemblance to the GAAP results. This game will ultimately prove unsustainable and I suspect the stock eventually trades to $14, down ~50%.

MMSI is a low-tech medical device company. It generates the majority of its revenue from commoditized, single use products (such as catheters, tubing and inflation devices). These products face ongoing pricing pressure and this is reflected in Merit’s financials with gross margins well below peers and returns on tangible capital of ~10%.

You wouldn’t know this though by glancing at Merit’s stock chart. After languishing between $10 and $15 for the better part of the last 15 years, MMSI has just about doubled since the beginning of 2016, hitting an all-time high of $31.70 in late March. The stock today is at $28, trading at 25x earnings – the higher-end of where it has ever changed hands.

Over the past several years, MMSI – led by its charismatic and promotional CEO, Fred Lampropoulos – has embarked on a number of high multiple acquisitions. Fueled by these deals, non-GAAP numbers have been on the rise in each of the past 3 years. As to be expected, the Street loves the story. Reported sales growth is solidly double digit and non-GAAP EPS jumped 16% this past year. Analysts project this growth to continue, no doubt aided by further M&A (and more deal fees). Merit, in fact, just completed a secondary with a majority of its analysts on the cover.

A closer look, however, suggests that there might be another story to tell. In March 2015, Merit hosted its first ever Investor Day. It used the occasion to issue its first ever guidance and a new 3-year plan (as shown in the chart below). Not only was this Merit’s first stab at guidance, but it was also a very bullish one. Indeed, the new plan called for 12-15% EPS growth over the next 3 years.  

Fast forward to today and it seems like Merit is successfully on its way. Now entering the third year of its plan, earnings are projected to be similar to what it initially foresaw. Over this time though, Merit has acquired ~$100m in revenue at significantly higher margins than its corporate average. In addition, it has seen a meaningful benefit from the unexpected repeal of the medical device tax and a temporary recall at a competitor. None of this was contemplated in its initial outlook.

As one would expect, Merit’s sales guidance has been revised upward to reflect these benefits. Curiously though – and this is the key – Merit’s EPS outlook hasn’t changed. Despite $100m in much higher margin revenue, the earnings guidance hasn’t budged. In fact, Non-GAAP EPS is now slated to be 2% lower than originally forecast and GAAP EPS is projected to be a whopping 50% below the Investor Day target.

While betting against roll-ups can be tricky business, I think Merit is an attractive short and there’s reason to believe that the timing may be opportune. The idea is as follows:

1. Merit has used a string of high margin acquisitions to avoid missing its guidance.

2. These acquisitions have masked declines in Merit’s legacy business, which still accounts for ~80% of sales.

3. Moreover, these have not been good deals; they’ve come at high multiples and subsequent results have been poor.

4. Given increasing leverage and little FCF, Merit’s roll-up strategy is reaching the late innings.

5. Despite these risks, the Street is bullish and focused on Non-GAAP results that bear little resemblance to economic reality.

6. Potentially most interesting, the timing is ripe. Expectations are high following a strong FY16; yet, a host of 1-time benefits are set to roll-off over the next 6 months.

7. Last but not least, there are some worrisome red flags. These include an ongoing DOJ investigation and key management departures.

Background
UT-based MMSI was founded in 1987 by Fred Lampropoulos and Kent Stanger (the former CFO) – both of whom came from neighboring Utah Medical. Fred is quite the character and very much a politician. In fact, he’s run for public office twice while serving as CEO! As a former salesman, Fred is enamored with top-line growth and he makes this quite clear: “Now I dislike immensely, by the way, I dislike immensely slow to grow. I think it's crap, just so you know. Crap.”

Merit’s products are the equivalent of “everyday stuff” for cardiology, radiology and endoscopy (used in interventional and diagnostic procedures). Merit also has a low margin OEM business that accounts for ~20% of sales. While MMSI competes with larger players (BSX, ABT, JNJ, BCR and Cook), the big guys pay less attention to these lower margin areas. This allowed Merit to create a niche, which was good for its early growth.

The story of MMSI though is really a tale of two periods: before and after 2009:

• Before FY09. MMSI came public in 1990 and grew quickly through the early 2000s. It was able to grow because it paid more attention to its niche categories, innovated in areas where the large competitors were less interested and spent aggressively on SG&A to grow sales. Growth, however, started to slow in FY07, falling below 10% for the first time. Merit’s products were becoming increasingly commoditized and the company was finding it tough to grow off a larger base. With hospitals becoming more cost conscious, Merit’s basket of product came under pricing pressure. As Fred himself noted in late 2014, “Look, we built tubing connectors and stopcocks and manifolds and kits and trays, and that sort of thing and that's been Merit's legacy business. 5 years ago we looked at the business and said, ‘Look, we're not going to be able to compete in the long-term with that kind of product mix.” In the latter part of this period (FY04-FY08), compounded EBITA growth slowed dramatically to just 4.5%.

• After FY09. Not surprisingly, once growth started to slow, MMSI discovered M&A. Fred made his first sizable acquisition in FY09 and since then has completed a plethora of deals. Reported sales growth has remained strong during this second period. While this has been aided by acquisitions, organic growth is still solid. MMSI posted 9% organic sales growth in FY15 and 7% in FY16 – lower than the past but still nothing to sneeze at. What is strange though is that earnings haven’t kept pace and profitability has significantly lagged. This is baffling given that Merit has been acquiring meaningfully more profitable businesses. Nevertheless, GAAP EBITA has been flat for the past 3 years and, during this post-FY09 period, EBITA has grown at a rate well below that of sales (see chart above). In addition, FCF has been paltry and debt has ballooned. While it's unclear what exactly is going on, the likely explanation is Merit’s “legacy business” continues to face challenges and, at the same time, management has done a poor job integrating its stable of new acquisitions.
  
  

Thesis
As noted, MMSI embarked on an acquisition spree starting in 2009 and since that time has completed a number of deals, shelling out ~$600m in total. The largest of these acquisitions were: BioSphere ($96m paid in FY10), Thomas Medical ($166m in FY12), DFINE and HeRO Graft ($116m in FY16), and Argon Medical and Catheter Connections ($48m in FY17). With the exception of the most recent Argon transaction, all of these deals have been 70-80% gross margin businesses. This is almost double Merit’s GM of ~47%. Yet, oddly enough, Merit’s consolidated gross margins haven’t improved:

Absent these acquisitions, it’s quite clear that Merit would have missed its guidance. One way to think about this is that since the Investor Day in early FY15, EBITDA has increased from $76m in FY14 to ~$100m for FY17E. Over this same period, MMSI has acquired ~$100m in revenue. Assuming these acquisitions have flowed through at 25% EBITDA margins (seemingly reasonable given 70-80% GMs), this would imply that organic EBITDA has been flat over the past 3 years – still at the same level from FY14 and 26% below the target MMSI laid out at its Investor Day.

This further implies that the profitability of the legacy business is under real pressure. While organic EBITDA appears to be flat, organic sales have been growing. By my math, this suggests that the gross margin of the legacy business has contracted by ~300bps from 47% to 44%. In short, Merit’s high margin acquisitions have been masking underlying margin pressure. This is problematic since these legacy segments still account for 77% of sales.

Given these challenges, it makes sense that MMSI is trying to diversify away from its legacy business and find less commoditized products. Unfortunately, management’s track record of integrating and growing these acquired businesses has been horrific:

• BioSphere: purchased in FY10 for $96m (3x sales). Per 10-K disclosure, sales declined 33% post-purchase.

• Thomas Medical, MediGroup, Ostail: purchased in FY12 for $193m (5x sales). Per management, sales decline 32% post-purchase as Thomas’ largest OEM customer (23% of sales) walked away the day after the deal closed.

• Datascope & Radial Assist: purchased in FY13 for $32m (4x sales). Per 10-K, sales declined 26% post-purchase.

• DFINE: purchased in FY16 for $98m (3x sales). 2H’16 sales came in 18% lower than guidance and FY17 sales are already expected to be lower than stand-alone FY15 results.

Plainly, MMSI has overpaid and under-delivered. While this is a backward looking observation, it’s a worrisome sign going forward since a key tenant of the bull thesis is the promise of Merit’s recent acquisitions and management’s ability to extract cost savings.

Meanwhile, as a result of these acquisitions (which have all been funded from Merit’s credit facility), the debt load has increased significantly. MMSI has gone from a net cash position in FY08 to $305m in net debt as of FYE16 (3.1x LTM net leverage). Moreover, given its lack of FCF generation, Merit has made little headway in retiring this debt. As such, it wasn’t surprising that the company announced a 5.2m share secondary just last month on 3/22. After all, Merit did the same thing back in FY11. Pro forma for the secondary, LTM leverage should come down to ~2.4x (on GAAP numbers this would be closer to 3x). So this buys Merit some time but it’s not out of the woods. With covenants at 3.5x, MMSI could likely borrow another $100-$150m, which might buy $30-$50m in sales and prolong the roll-up strategy a bit longer. Ultimately though, future acquisitions are going to have much less of an impact with sales at $700m relative to the $227m we started with back in FY09. With increasing leverage, underwhelming profit growth and limited FCF, the roll-up strategy appears to be entering its final innings.          

Given these concerns, you might think that the Street would start asking some tough questions. You would be mistaken! Part of the reason for this is that management directs analysts to Non-GAAP numbers, which look strong and growing. These numbers exclude deal expenses and other 1-timers that have surged in significance. In FY16, for example, MMSI added back $20m in expenses (not counting amortization of intangibles) to arrive at Non-GAAP earnings. These add backs represented an enormous 37% of reported GAAP EBITA! Not to be outdone, guidance for FY17 implies a similar level of adjustments. As a result, the wedge between GAAP and Non-GAAP earnings continues to widen (it’s averaged 75% over the last 5 years but reached its pinnacle this past year at 124%). The majority of these add-backs fall under common headings: severance, acquisition-related costs, inventory mark-ups, etc. While the line items are familiar, what is unusual is the size of these adjustments relative to the reported M&A. For instance, the $20m that was added back in FY16 was largely attributable to DFINE and HeRO, acquisitions that should contribute ~$45m in annualized revenue and ~$30m in gross profit. As such, acquisition-related add backs totaled almost 70% of the acquired gross profit! This seems a bit fishy and I’m left to wonder if some of these costs are ordinary course expenses.

Clearly, the GAAP numbers paint a very different picture. Cash from operations is little changed since FY12 and FCF is non-existent. Amazingly, cumulative FCF over the past 5 years totals a measly $33m and that’s relative to a market cap of $1.4b. Note that MMSI has never paid a dividend or repurchased any stock.
    

Why now?
This may all sound interesting, but why now? I’m the first to admit that shorting roll-ups can be a tough game to play and I fully acknowledge that Fred (who owns $33m of stock) has a strong incentive to keep this going. That being said, I think the timing might be ripe. Street expectations are particularly lofty following what was perceived as a strong FY16: sales grew 11% and Non-GAAP EPS jumped 16%. Analysts are particularly encouraged that Non-GAAP gross margins expanded 133bps in FY16 and that management has now delivered 5 consecutive quarters of gross margin expansion. Street numbers have come up and growth is expected to continue.

However, less discussed is that Merit benefited from a host of 1-time items in FY16 – some of which inflated gross margin and all of which become headwinds into FY17:

• Cook recall. In April 2016, Cook Medical unexpectedly initiated a voluntary recall of its Beacon Tip catheters. This was a tailwind for MMSI. It benefited FY16 sales by ~$10m, adding ~2% to reported growth. Cook is expected to eventually return to the market and regain it leading share (timing TBD). In the meantime, this 1-time benefit for MMSI becomes a tough comp starting in Q2’17.

• Medical device tax repeal. As a part of the ACA, a 2.3% excise tax was imposed on sales of certain medical devices. This was unexpectedly suspended at the start of FY16 and added ~70-80bps to gross margin. This was a 1-time benefit and becomes a tough comp starting in Q1’17.

• DFINE acquisition. Merit acquired DFINE, a spinal business, in Q3’16 for $98m. This acquisition provided a big boost to gross margin (~$35m in annual sales at 75% GMs). It added ~100bps to gross margin in Q3 and Q4 and ~50bps for FY16. DFINE becomes a tough comp starting in Q3’17.

Interestingly, if you go back to Merit’s initial guide for FY16, Non-GAAP EPS was projected to be $0.98. The ultimate number came in at $1.01. A (slim) beat! However, this initial guidance did not envision the Cook recall, the device tax repeal or the DFINE acquisition. Yet again, MMSI would have missed its own numbers by a wide margin if it wasn’t for these acquisitions and unexpected benefits – all of which become tough comps over the next 6 months.

In addition, the impressive gross margin expansion, which the Street is most jazzed up about (and views as organic), can be entirely explained by the medical device tax repeal and the mix benefit from DFINE. Excluding these items, organic gross margins were surely down. As MMSI moves into FY17, DFINE remains a benefit in 1H’17 and should add ~50bps to FY17 gross margins. But that’s the only real GM driver. Nevertheless, the Street is expecting an additional 110-160bps of GM improvement. Absent any more unexpected gains, gross margin is an area that will likely serve as an unwelcomed disappointment.

Valuation
I estimate that MMSI will earn $0.80-$0.85 in cash earnings this year. This is reflective of GAAP earnings plus amort of intangibles and ignores the Non-GAAP add-backs that I increasingly view as bogus. By comparison, Street has Non-GAAP earnings of $1.12 and that compares to guidance of $1.15-$1.20 (issued prior to the dilutive secondary, which wipes out ~$0.06 of EPS). At its annual lows, MMSI has traded at or below 16-18x EPS every year back to FY08. Applying this same 16-18x to my estimate of cash EPS yields $13-$15, down 45 to 55%. This still represents 24-25x my estimate of FCF and ~9x GAAP EBITDA.

Below is a snapshot of the last 5 years and guidance/consensus estimate for FY17E. In reality, I envision results for this year to coming in lower than what I’ve shown and expect the short idea to work as MMSI misses guidance and Street numbers come down.

Catalyst

Gross margin below plan leading to an EPS miss/guide down 

Slowing M&A revealing weak underlying growth 

Continued FCF weakness leading to liquidity issues