Description
Utah Medical Products, Inc. (UTMD): long.
Utah Medical Products is an extremely steady business with an attractive valuation offered up by a market that mis-evaluated the risks of a recent regulatory lawsuit. UTMD trades at 10x ttm FCF/EV for a growing 10% FCF yield and has been managed in a mostly shareholder friendly manner (nice dividend with aggressive share buybacks that are well in excess of options issuance).
Last year (2004) was one of the most challenging in the history of UTMD and it still matched its 2003 record for cash flow and earnings generated.
The FD market cap is $93 million (approx. 4.3 mm FD shares) of which $17 million is net cash and equivalents (or about 18% of the market cap, leaving an enterprise value of approximately $76 million). Shares trade for $21.70 and have $3.95 of net cash per diluted share as of December (leaving $18 EV/share).
The Company:
[additional detail can be found in stat820’s 11/3/02 write-up of UTMD)
Based in Utah (stunner) the company designs and makes a variety of medical products used in obstetrics and gynecology (more than half of sales), neonatal intensive care and urology. These products include disposable pressure transducers to monitor blood pressure, intrauterine catheters used to monitor pressure in the womb during high-risk births, and a device that clamps and cuts the umbilical cord and collects a blood sample from the cord. The firm also makes electrosurgical systems. With plants in Oregon, Utah, and Ireland, Utah Medical sells its products around the world (77% of 2004 sales in U.S., 14% in Europe, and the remainder in “other”).
The vast majority of products are disposable and thus create a predictable, repeat-purchase revenue stream. The company expects slow top-line growth and competes against a handful of seemingly rational competitors.
On product development, in their own words: “Product development takes three interrelated forms: 1) improvements, enhancements and extensions of current product lines in response to clinical needs or clinician requests, 2) invention of devices that allow significantly different methods of performing medical procedures, representing a quantum improvement in safety, efficacy and/or cost of care, and 3) acquisitions of products or technology from others.
“UTMD's current product development projects are in three areas of focus: 1) obstetrics/ fetal monitoring, 2) neonatal intensive care, and 3) specialized procedures for the assessment and treatment of cervical/uterine disease. UTMD has had 7 patents issued in the last five years. Internal product development expenses are expected to be in the range of 1-2% of sales in 2005. In 2004, UTMD spent $292 (in thousands) on internal product development activities, or 1.1% of sales. In 2003 and 2002, internal new product development expenses were $288 (1.1% of sales) and $285 (1.0% of sales), respectively.”
Currently, UTMD owns or exclusively licenses 31 unexpired patents and licenses other technologies.
Tyco Award:
UTMD has successfully defended its intellectual property and in January 2004 received $31 million from Tyco (including interest) as the result of an IP lawsuit initiated by Utah Medical. The bulk of Utah Medical’s existing cash is a result of this award. Much of the balance has gone to repurchasing shares ($10.7 million in 2004) and dividends ($1.3 million in 2004). Another $1 million went toward a small acquisition.
FDA Issue:
Utah Medical’s products are subject to regulation by the FDA and other countries’ regulatory bodies. All of UTMD’s products are Class I or Class II devices and it believes they are in complained with all applicable material performance standards as well as CGMP standards (CGMP = Current Good Manufacturing Practice). However, issues have arisen. In August 2004 the FDA announced it will seek an injunction against the company until it corrected alleged “deviations” from the Quality System Regulation, 21 CFR Part 820. Utah Medical, of course, vigorously denies these charges and has been somewhat derisive toward the FDA in its several public responses since August (see the series of press releases since August in which UTMD virtually mocks the FDA, though I view the behavior as largely unnecessary, they do make a point). Utah Medical believes that the FDA actions have basically been the result of a vindictive employee who does not like UTMD management.
The bottom line is that this action has hurt UTMD in a couple of ways:
1) bad press that has allowed UTMD’s competitors to aggressively market against it;
2) UTMD responded by initiating a 10% across-the-board price cut that lasted for just over one quarter;
3) UTMD expensed $500k in Q4 04 for legal expenses. It estimates this will be sufficient to cover all litigation expenses required for the case through 6/30/05.
Here is the language from the 10-K on the regulatory issue. Feel free to skip and come back to it.
“In 2003 the FDA began withholding export certificates from UTMD, which action was part of an unresolved disagreement regarding the issuance of a Warning Letter by FDA to UTMD in September 2001. Export certificates are nonbinding letters assuring other countries that a company is in compliance with FDA regulations. The export certificates have now been withheld for many months while UTMD distributes its products in the U.S. without any FDA restriction, or any FDA claim that UTMD's products are unsafe or ineffective. The Company strongly believes that there is no reasonable basis for this denial.
“On August 10, 2004, the FDA issued a press release announcing it would seek an injunction against UTMD until it had corrected alleged ‘deviations’ from the Quality System Regulation, 21 CFR Part 820 (QSR). UTMD responded with several press releases shortly following the FDA's announcement, and with periodic public updates since then. The FDA press release and filing of the action in the U.S. District Court for the District of Utah caused significant disruption to UTMD's business, in part because of inappropriate activities of UTMD competitors incorrectly telling customers that the Company has been, or was about to be, shut down. As a matter of fact, through the date of this report: 1) UTMD continues to manufacture and distribute all of its products worldwide without any regulatory restriction, 2) there has been no mandated recall or any other regulatory enforcement action that restricts customers from using UTMD's products, 3) There has not been, and is not now, any allegation by the FDA that UTMD's products are not safe or effective, 4) there is no FDA claim of defective products or products not conforming to specifications, and 5) the proven extremely low product liability risk using UTMD's products has not changed. On November 16, 2004 UTMD announced that an FDA enforcement official, officially designated as the knowledgable FDA representative, testified under oath that the FDA is not claiming in the lawsuit that UTMD's devices are either unsafe or ineffective. Discovery in the lawsuit is ongoing at the date of this report, with a pre-trial conference scheduled for June 20, 2005. As part of its expert witness testimony in the lawsuit, the Company has provided independent QSR expert certification that UTMD is in substantial compliance with the QSR. (See Item 3. - Legal Proceedings.)
“In 1994, UTMD received certification of its quality system under the ISO 9001/EN 46001 standards ("ISO" stands for "International Organization of Standardization") which it maintained until December 2003. In October 2003, UTMD's Utah facility was initially certified under the more stringent ISO 13485 standard for medical devices, which it currently maintains. UTMD's Ireland facility is certified under the concomitant ISO 13488 standard. The U.S. FDA QSR was developed in harmony with the ISO standards. UTMD remains on a continuous periodic audit schedule by its independent notified body in order to stay current with international regulatory standards, and retain its certification. The most recent audit was conducted in November 2004. UTMD has received formal product certifications allowing the use of the CE Mark (demonstrates proof of compliance with the European Community's ISO standards) for essentially all of its products.”
My understanding is that UTMD’s Chairman & CEO, Kevin Cornwell, is a stubborn and bullheaded man. One of his primary competitors is run by former UTMD execs (they left quite a while ago) that see Mr. Cornwell is a formidable competitor. He is reputadly not the sort of person that will settle with the FDA. They believe he could settle this issue now for less than $1 million, but that it is his nature to fight and he will fight this case. They admit to aggressively marketing Utah Medical’s troubles to potential customers, though judging by the results, the damage has been limited (but it certainly exists).
On the day the FDA made its initial announcement public (mid-August), UTMD’s share price fell from $27 to $17 or so. This reduced the market cap from $124 million to $78 million. When the $6-7/share of cash UTMD had taken into account, the size of the hit is magnified. While the price has recovered somewhat to $22, the enterprise value decline of about $20-$25 million seems excessive considering the stock was already cheap and the limited liability even UTMD’s staunchest competitors assume.
Financials:
Utah Medical’s business has been very stable over a long period of time with slow top line growth and modest bottom line growth fueled by a combination of operating leverage and attractive share repurchases. For the foreseeable future, capex (excluding M&A) will run at half of D&A.
Snapshot:
Share price: $21.70
Net Cash per share: $3.95
EV per share: $17.75
EPS (ttm): $1.53/share
FCF (ttm): $1.74/share
Diluted Shares Out: 4.3 million
Ignoring for a moment the regulatory issues, this company has had bond like stability with nice bottom line growth. Sales have been spot on $27 million per year for each of the past five years (with a slight dip to $26.5 million this year resulting from the 10% discount). At the same time, FD EPS has grown nicely since 2000: $0.90/share, $1.14/share, $1.36/share, $1.50/share, and 2004: $1.53/share (these ignore non-recurring profits like the Tyco award and non-recurring expenses).
For just over three months immediately following the FDA’s announcement in the summer of 2004, Utah Medical initiated a 10% across the board cut in its prices as an enticement to customers to not leave it for competitors. This cut was effective as sales volume was stable. The price cut obviously did impact overall margins as the resultant negative operating leverage slowed bottom-line growth.
In a perverse sense, the negative business impact was cushioned by the fact that Utah Medical was able to deploy a great deal of cash buying back $10 million of its own shares at prices that otherwise would not have been available. Oddly enough, if operations revert back to normal, this FDA episode could turn out to be an excellent event for those of us lucky enough to participate in UTMD equity going forward. Assuming a return to normalcy, that cash deployment will have been a productive per share use of book value.
Cash Uses:
UTMD generated over $7.5 million in FCF last year (inclusive of the 10% price cut but excluding the extra legal fees) and it has $17 million in cash on its books. In the past, cash has been deployed to the benefit of shareholders.
Utah Medical has been an aggressive buyer of its own shares at attractive prices. In Q4 2004, the company purchased 255k shares at an average price of $17.88. In total, UTMD has repurchased over 8.7 million of its shares at an average price of $10.40 per share since 1992 via a combo of open market purchases and tender offers (roughly 75%/25% split). To complete the picture relating to current shares outstanding, since 1992 the company's employees and directors have exercised and purchased 1.4 million option shares at an average price of $6.24 per share. All options were awarded at the market value of the stock on the date of the award.
In 2004, Utah Medical also established its first ever dividend which is currently at $0.60 per year (paid quarterly).
* Stock buybacks by year: 2004 - $10.7 mm, 2003 - $2.2 mm, 2002 - $11.8 mm;
* Debt paydown: Over the past three years, $2.5 mm of debt was paid off leaving the company debt free;
* Acquisition: In 2004, a small $1 mm cash acquisition occurred. I would not be surprised to see others, selectively, going forward;
* Dividends: In 2004, two quarterly dividends totaling $1.3 mm were paid. Annualized, it is $2.6 million per year.
Overall, UTMD has used cash in a shareholder friendly manner while generally avoiding options abuse. Assuming $7 million per year of share repurchases and $2.6 million per year of dividends, the $9.6 million per year creates a very attractive compounding return to investors without impairing the company's balance sheet.
Management Incentives:
Chariman, President, and CEO Kevin Cornwell owns 12% of the FD outstanding shares. Over the last three years, he has made between $500k and $750k (the $750 in 2004 included a one time $280k “Tyco” bonus for the $31 million award UTMD received). 2004 is the only year since 1998 in which he received an option grant (50k shares priced somewhere between $18 and $26). If the company is sold, he also would be paid 1% of any excess over $14/share the company receives.
Risks:
The primary risk is obviously related to the FDA. If this pissing match gets out of hand, it will continue to be expensive to shareholders via ongoing litigation costs, high settlement costs, and/or further business disruption (including the long-shot possibility of the FDA forcing a production halt).
A secondary risk is that with 17% of the market cap in cash, poor capital allocation could impair long term value.
A third risk is that in 2004, more options were issued that in the prior several years combined. A continuation of this (unlikely) would destroy per share value.
Catalyst
1) Settlement of the FDA dispute;
2) Continued predictable business performance;
3) Continued share buybacks and dividends;
4) Sale of the company.