This "dj" is Primed to Play Hits

Investors sent the stock of medical device company dj Orthopedics (NYSE: DJO) up as much as 15% after the company released preliminary fourth-quarter results, which showed a 25% increase in quarterly revenue over the same period last year.

At the end of November, the company confirmed it expected to have revenue of $65 million to $67 million for the fourth quarter. Analysts expected $65 million, and the company reported today it would be $68 million -- a mere $1 million above the company's upper November estimate.

The big 25% revenue increase deflates quickly to 8% when you compare the quarter-to-quarter results to the year-ago quarter -- fully factoring in the company's big Regentek acquisition on a pro-forma basis. The acquisition was in November 2003, meaning unadjusted numbers include only a portion of Regentek's sales in dj Orthopedics' results for the quarter ended Dec. 31, 2003. Ah, that apples-to-apples thing gets in the way again!

The company did not give an earnings target, but analyst expectations of $.27 a share for the quarter ($0.93 for the year) seem assured with the revenue target exceeded. But that yearly figure is 1/25 of today's stock price. Is this company worth it?

Analysts are expecting earnings to surge ahead 32% to $1.23 a share in 2005. That gain is based of a new manufacturing facility helping reduce costs and from cost savings from the integration of Regentek. But look closer. Analysts expect company sales to increase 6%. Are you ready to pay 19 times forward earnings for a company growing sales at 6%?

The jewel is that the last four quarters produced $37 million ($1.72 a share) of free cash flow. While debt-to-equity sits at a hefty 52%, the company has used $14.8 million to buy its own shares since September -- banking on its own projections that it can continue to build margins significantly as sales build slowly. That's promising.

Prior to today, the stock was down 22% from a year ago. The story here is free cash flow and margin improvement. But, as some might ask, why wait for that story to play out when you can buy faster-growing (in terms of analyst-expected, next-five-year earnings growth), higher-margin, debt-free competitor Biomet (Nasdaq: BMET) for 23 times forward 2005 earnings? Or consider a medical company such as 2003 Pig of the Dow Johnson & Johnson (NYSE: JNJ) at 20 times trailing earnings, with strong free cash flow, already-high operating margins, and solid revenue growth.

Valuation is subjective, but I'd say dj Orthopedics is likely fully priced considering today's exuberant rise, although it is making excellent progress in its operating metrics. And if the price declines, astute investors could find themselves with a buying opportunity.

The Motley Fool is investors writing for investors. Join in the discussion of dj Orthopedics  and Biomet on the Motley Fool discussion boards.

Fool contributor W.D. Crotty does not own stock in any of the companies mentioned.