A Health-Care Stock to Avoid

I understand the current interest in health-care companies -- the coming wave of aging baby boomers is certainly compelling. Take that backdrop and add to it a health concern some are calling epidemic and endemic, and you may have the basis for a very favorable investment. But before you leap in, keep in mind that not all health-care businesses are potential gold mines.

Solving a big problem
Type 2 diabetes is a condition where the body doesn't produce sufficient amounts of insulin. The main function of insulin is to facilitate the transfer of glucose (sugar) from the blood into the body's cells, where it's burned as fuel. Insufficient insulin means glucose builds up in the blood. Over time, high blood glucose levels can damage your eyes, kidneys, nerves, and heart. It's a very serious disease.

Although diabetes is not currently curable, it is manageable. Big pharma companies Sanofi-Aventis (NYSE: SNY  ) and Eli Lilly (NYSE: LLY  ) manufacture synthetic injectable insulin. Earlier this year, Pfizer (NYSE: PFE  ) had its inhalable insulin drug Exubera approved by the Food and Drug Administration (FDA). And many Type 2 diabetes patients control their disease through diet, so Whole Foods Market (Nasdaq: WFMI  ) , United Natural Foods (Nasdaq: UNFI  ) , and Wild Oats (Nasdaq: OATS  ) should also be on the radar as potential investments.

Then there's the question of how to monitor one's diabetes on a daily basis. Enter PolyMedica (Nasdaq: PLMD  ) .

When a wide market opportunity ...
PolyMedica's main business is providing diabetes testing supplies -- namely test strips and lancets -- directly to the consumer. A smaller but rapidly growing pharmacy segment markets and sells prescription medications to diabetes patients. This segment is anticipating explosive growth from sales related to Part D of the Medicare Modernization Act, which gives Medicare beneficiaries access to prescription drug benefits.

Sounds great, right? But here's the trouble with PolyMedica. First, it's not exactly making a lot of money, although it would like you to believe that it is. One of its largest expenses is what is known as direct-response advertising (DRA). Accounting provisions allow specific expenses spent for the purposes of long-term customer attraction and retention to be capitalized and expensed over a longer time frame. For example, in the fiscal year ended this March, the company spent $59.5 million on DRA but only recognized an expense of $42.4 million, an amortized amount representing small chunks of DRA expenditures from years prior. The result? Pre-tax profit gets a $17.1 million boost. It's an acceptable, but aggressive, form of accounting.

Management has reinvented the company over the past two years, selling off non-core assets and focusing on the diabetes segment and growth of the Part D pharmacy. The diabetes patient list has grown, but a lot of that is attributable to timely purchases rather than organic growth. Management also repurchased approximately 19% of outstanding shares since in the last full fiscal year.

... isn't a resounding buy
But we've got a cash flow problem, folks. Let's start with the fact that both the diabetes segment and Part D pharmacy have no pricing power -- Medicare dictates pricing. The share repurchase was financed using variable-rate debt, which itself is now being partially exchanged for potentially dilutive convertible debt (but don't worry, management has set up a complicated hedge to keep dilution in check). Management continues to pay a dividend of $0.60 annually, which necessitates a further $14 million in annual free cash outflow. This is a company that has shown an inability to consistently generate free cash flow, and has arguably misled investors as to how much cash it has generated. Here's what PolyMedica presented as its fiscal year-end free cash flow:

FY04

FY05

FY06

Reported GAAP Operating Income

$44,979

$23,298

$62,283

Settlement Reserves

$2,690

$29,987

-

Depreciation and Amortization

$6,393

$9,259

$15,402

Stock-Based Compensation

$246

$42

$1,419

Non-GAAP EBITDA

$54,308

$62,586

$79,104

DRA Amortization

$25,591

$33,759

$42,409

DRA Expenditure

($40,954)

($50,430)

($55,945)

Capex

($15,546)

($8,093)

($12,747)

Free Cash Flow

$23,399

$37,822

$52,821

Source: Company investor presentation. 2005 results not adjusted for sale of discounted operations.
All figures in thousands.


Now, this would seem to be fine free cash generation. The problem is that it doesn't take taxes into account. And management also seems to be forgetting that a growing business needs to increase its working capital -- the equivalent of cash in the wallet for the day-to-day operations of a business. This was particularly damning in the most recent fiscal year, when working capital management faltered.

Bringing in the increases in working capital and taxes, real free cash generation looks like this:

FY 04

FY05

FY06

Reported GAAP Operating Income

$44,979

$23,298

$62,283

+ Settlement Reserves

$2,690

$29,987

-

Net Operating Profit Before Tax (NOPBT)

$47,669

$53,285

$62,283

Cash Operating Taxes

($17,161)

($19,183)

($22,422)

Net Operating Profit After Tax (NOPAT)

$30,508

$34,102

$39,861

Depreciation and Amortization

$6,393

$9,259

$15,402

DRA Amortization

$25,591

$33,759

$42,409

DRA Expenditure

($40,954)

($50,430)

($55,945)

Incremental Investment in Fixed Capital

($15,546)

($8,093)

($12,747)

Incremental Investment in Working Capital

($569)

($12,727)

($35,851)

Free Cash Flow

$5,423

$5,870

($6,871)

Assumed Cash Tax Rate

36%

36%

36%

Actual Cash Taxes Paid

$15,557

$3,916

$25,165

Source: Company filings. 2005 results not adjusted for sale of discontinued operations.
All figures in thousands.


I'm not a fan of management misleading investors, even if it's a result of its own misunderstanding of what free cash is (i.e., cash left over after all bills are paid, and all reinvestment in the business is complete).

Finally, after running a series of discounted cash flow valuations, even under the most optimistic scenario I'm willing to model, I don't get a fair value above the current trading price.

The Foolish bottom line
I can't predict any catalyst that will serve to implode the stock price. But I look at anemic cash generation, purchased (rather than organic) growth, price controls, aggressive accounting choices, and misleading management presentations, and conclude, "Look elsewhere, Fool."

And if you're indeed looking elsewhere, then I'd be remiss not to mention The Motley Fool's newest research report, The Big Boom: Explosive Opportunities in Biotech and Health Stocks. Like I said at the top of this article, changing demographics have put these industries at the forefront of growth. And while PolyMedica may not be a great way for investors to capitalize, we've used in-depth research and analysis to identify 10 investments (including a mutual fund and an ETF) that are. If you're interested in getting a copy of The Big Boom, simply click here for more information.

Fool contributor Jim Gilliesowns no shares of any companies mentioned. Eli Lilly is an Income Investor recommendation. Pfizer is an Inside Value recommendation. Whole Foods is a Stock Advisor recommendation. PolyMedica is a former Hidden Gems recommendation. The Motley Fool has a disclosure policy.


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