(The company discussed has sub $50 million capitalization and trades by appointment.  Suitable for PA and small funds only)

MGC Diagnostics

MGC Diagnostics designs, develops, and markets noninvasive diagnostic products that have a wide range of applications within cardio-respiratory healthcare.  The company’s products determine the cause and extent of severity for shortness of breath and lung diseases such as asthma, emphysema and bronchitis (different forms of Chronic Obstructive Pulmonary Disease or “COPD”), and to handle related treatment. The company’s products help physicians measure the degree of disability and functional capacity in the diagnosis and treatment of heart diseases such as heart failure and coronary disease.  MGC addresses a $500 million market globally with an annual growth rate in the mid single digits.  Half the company’s market is within the US, divided among the following three players: CareFusion (58%), MGC (25%), and nSpire (10%).   Internationally, CareFusion holds a significant 65% share while MGC equipment is at 8%.  Even though MGC plays a second fiddle in the unit sales, the company holds the technology frontier with leadership in data-interoperability and equipment service.  MD Buyline has consistently rated the company #1 in its Quarterly User Satisfaction Report in following categories:  System Performance, System Reliability, Installation/Implementation, Applications Training, Service Response Time, and Service Repair Quality.

Background

MGC Diagnostics, formerly known as Angeion, has been around since 1984.  For the entire decade starting 2000, the company experienced poor execution as evidenced by revenues and EBIT in the table below:   

The company in 2010 had all the ingredients for a distressed situation:  threatened by a proxy fight, board room turmoil, rampant executive changes with three CEOs in the short-span of five months, and the operating losses with no end in sight.  The following URLs describe the story in great detail for anyone interested:

http://www.startribune.com/business/110850919.html

http://www.startribune.com/business/129981973.html

At the outset, the company looked like an easy candidate for quick turnaround:  Company had loyal customers for decades, one main competitor, ultra low capitalization under $20 million, and large cash balance at $9 million.  The turnaround however has taken longer than anyone’s expectations as the company was entangled with unproductive business practices at various levels of operation.  The news article below discusses Gregg’s plan-of-action one year after the initial cleansing of the operations.

http://www.bizjournals.com/twincities/print-edition/2012/09/28/new-ceo-sets-rx-for-diagnostics-firm.html?s=print

The company had a complete makeover in the past couple of years as evidenced by the following.  Changes in regulations and advances in diagnostics equipment space will provide additional tailwind, placing the company firmly on the path of growth:

• Divestiture of the New Leaf Business to Life Time Fitness.
• Gregg re-energized the company by replacing the entire executive management.  The company hired senior CareFusion executives Mark Margoles and Todd Austin to rejigger the operations and put the company back into growth track.  The hiring of Wes Winnikens as CFO (Gregg’s CFO at HealthFitness) may have completed the management stabilization at the top and we believe the company is now positioned take the next step in enhancing the shareholder value. 
• MGC sales strategy is to focus on its positives.  Even though CareFusion leads in market penetration, MGC is way ahead in offering the state-of-the-art software, data-interoperability with customers IT systems, and is well recognized in providing the best product experience and service among its competitors (recently recognized by MD Buyline).  Playing to its strengths, the new sales team at MGC has already taken over 71 CareFusion accounts so far this year.  The company has never experienced success to this magnitude ever before.  Management is continuing to execute on this strategy and believes it can grab over 20% of CareFusion’s accounts.
• The standard practice in the industry is to provide one month of free supplies, along with equipment purchase.  In the past, MGC had shipped twelve month of supplies and was therefore foregoing a lot of revenue.  This practice has been recently fixed and the revenue ramp will start flowing in the coming quarters. 
• The company sells new equipment with one year warranties.  Beyond that period, the company sells an extended service contract called Attachment Rate, lasting one to five years from the time of sale.  The typical Attachment Rates in the industry is 70% (i.e., 70% of new equipment is sold with an extended service contract).  MGC has historically maintained low attachment rates in the low single digits.  Under the direction of a new sales leader, this metric has increased meaningfully into the high 20s.  The company is determined to improve attachment rate to match up to the industry standards.
• MGC operates a razor-razorblade model.  It derives 60% of sales from equipment (razor) and 37% from service contracts and supplies (razorblades) with an average margin of 50% and 70%, respectively.  The company’s strategy is to alter the revenue mix to 50-50, thereby increasing the overall margin higher and providing revenue stability with lesser dependence on the macro economy.   
• Unlike its competition, MGC automatically populates the electronic medical records with minimal key entry.  Additionally, the company’s data interoperability with customers’ IT systems is the envy of the industry.  This differentiation is especially significant today considering the new regulation viz. Affordable Care Act.  As mentioned, the sales team has been effective in driving home this message as witnessed by the recent competitive takeaways.  The company is further widening the moat by extending support to mobile devices and advancing to latest cloud computing technologies.   
• MGC of the past lacked product lifecycle planning, like dropping support for old equipment and refreshing with new ones, and was forced to service 20 year old equipment and carry inventory of rarely utilized parts.  The typical replacement cycle for the cardio-respiratory equipment is between five to seven years.  New executive management has corrected this problem, the fruits of which will be visible in the future. 
• Historically, MGC’s sold its equipment for large hospital settings, CROs, and University-based medical centers.  With the enactment of the Affordable Care Act, an additional 30 million people will have access to medical diagnostics.  Physician practices and private hospitals will require new medical devices offered by the likes of MGC to satisfy the demand. 

Evidence of a Turnaround

Prior to Gregg’s arrival in 2011, the company marketed its products primarily under two brand names: MedGraphics branded products to healthcare industry and New Leaf to the gymnasiums and health fitness clubs.  Previous managements continued to plough resources and large investments into the New Leaf business, even though it was never profitable.  By placing the New Leaf business up for sale as soon as practicable and successfully disposing of it in August 2012, Gregg plugged a giant cash drain almost instantly.  The next critical step was to rebrand the company as MGC Diagnostics and to communicate better with its customers and clearly articulate to the market where it competes.  Below, we provide the pro-forma financials of the MGC Diagnostics with MedGraphics as the only operations.      

• The new management team elected to perform the majority of its sales through group purchasing organization (GPO), a deviation from the company’s strategy prior to 2011.  Since the large GPOs cover 90% of hospitals, the company chose to pursue selling in higher volume as the products are available to a wider market.  The GPO sales increased more than fourfold since implementing this strategy.   The increased volume sales and decreased sales cycle compensated some margin compression adequately. 
• The company recorded a double digit revenue growth over the past five quarters since the turnaround plan started to take hold.
• Unearned revenue has seen a nice ramp up and should continue into future quarters as the attachment rate increases.  Management will record this revenue on the income statement after completion of the one year warranty period on the sold equipment. 
• Operating margins have shown steady improvement in the recent quarters.  Considering that there are no one-time effects on margin in the latest quarter, we believe an 8.4% operating margin is sustainable and will improve further going forward.  It should be noted that 8.4% is the second highest margin that the company has had in the past decade.  
• Historically, MGC struggled to introduce new products in its industry.  New management’s initiatives have facilitated the conversion of external consultants to accept full-time employment with the company.  This was the main reason: R&D allocation has lately shown a downward trend in dollar terms.  Improved utilization of R&D dollars has produced a better pipeline, as witnessed by the introduction of Real Time Diffusion and Forced Oscillation Technique products in 2012 and 2013, respectively.   The company has beefed up its software offering as well, with the latest version of the BreezeSuite diagnostic software.  This HIPAA compliant software populates EMR records and provides data interoperability with Hospitals native IT systems.
• Management has reigned in high SG&A expenses of the past as seen by the marked improvement in the recent quarters. 

We believe the operating metrics have some more room to improve in the coming years due to following operating factors:  a) the service revenue hits the income statement, b) supplies reordered at higher volume, and c) equipment sales improve moderately.  We provide the projected financials in the table below:

Following catalysts, not discussed in the projection, can provide further upside:

• The present forecast is for the cardio-pulmonary equipment space to grow in the mid single digit range.  Management’s strategy for competitive takeovers can provide a further boost to the company’s top line performance.
• Company plans to achieve a 60% gross margin in three to five years, primarily by increasing the contribution from sale of supplies and service to the overall mix.  If the company reaches the goal earlier than our estimates, we believe MGC’s stock will be valued higher.
• MGC, under the guidance of its CFO, has recently initiated the Continuous Process Improvement (CPI) program to improve the company’s gross margin.  If the CPI effort takes hold, the margin targets may arrive earlier than originally planned.
• The prolonged growth in countries like China has caused severe air pollution in the tier-1 and tier-2 cities.  Air pollution is the main cause of the COPD and asthma related diseases.  Management is looking forward to participating in these markets as mentioned in  recent communications with investors.  

Valuation

MGC Diagnostics has a unique niche in the specialized COPD diagnostics space, sharing the market with just one dominant competitor.   The loyal customer base, the best software and data interoperability with the customer IT systems, and superior service focus have positioned the company as the top choice among new customers.  Probably due to its checkered history and low market capitalization, the company has lost following on the Wall Street.  Table below shows a peer comparison with companies operating the medical diagnostics space.

The turnaround of MGC Diagnostics is taking hold as evidenced by the following metrics:

• Double digit increase in the Q-o-Q revenues in the recent quarters.
• Stabilized gross margin and decrease in SG&A% spend
• Improvement in unearned revenues suggesting that the margin improvement strategies introduced by new management is taking hold.  We believe the recurring revenues from supplies will improve once the renewed strategy discussed above flows through the system.

The management has transformed the company by systematically de-risking operations since the takeover.  MGC has been revitalized and the fruits of the heavy-lifting will be visible in the future.  After years of losses and one-time charges, EBIT has turned around in the recent quarters and is showing a steady ramp-up.  The company has trounced the CIQ estimate for fiscal 3Q by a huge margin.  Also, management’s latest comments on the earnings call points to the company on track to deliver the best quarter probably in the past few years. 

We believe the PPS could drift higher once the financial statements reflect the improvements in the future reporting periods.  The run-rate EPS is at 64 cents and should exceed $1 in the not-so-distant future.  When that happens, company can be easily valued at 15x which we believe is likely in the next 12 to 24 months providing support at $15 per share.  MGC’s large NOLs could be fully utilized as we believe the profits will be sustainable.   Loyal customers, long operating history in various market cycles, strong balance sheet, and able management will provide an adequate margin-of-safety to weather unforeseen macro environment.

Risks:

• Aside from acquisitions, the management has indicated an interest to grow by acquisitions.  Clearly, an imprudent acquisition can derail the company’s ascent.
• The executive management has undergone a complete makeover in the past few years.  Company has incurred several one-time cash expenses mainly due to severance charges.  Even though we believe new management seems motivated, we worry about any future turnover and its impact on the company especially considering its limited resources.
• Volatile macroeconomic winds can dampen the momentum and can delay the turnaround.