How This Stock Turned Into an 8-Bagger

Since Motley Fool Stock Advisor opened its pages in 2002, David and Tom Gardner's stock picks have returned an average of 80% each. That compares to 25% for equal positions of the S&P 500.

We're celebrating the newsletter's 10-year anniversary by releasing -- for free -- the recommendation articles for several of the newsletter's biggest winners. Today we look at Tom's top-performing pick: Quality Systems (Nasdaq: QSII  ) . He recommended the company in both February and March of 2003, and the two positions have returned 620% and 719%, respectively.

Below you'll find the original recommendation as it appeared in the February 2003 issue of Stock Advisor:

Tom's Top Pick: Quality Systems
Of the many great questions you asked in response to our Charter Member Survey, perhaps the most frequent was, "Where do you find the stocks you pick?"

I take it this question was aimed at me. Dave has made it a point to focus on companies whose products he uses. ... These provide a stunning consumer profile of my big bro. (To which I'll add, it's a wonder he found a wife!)

My companies and I make for stranger bedfellows. Turns out, I use virtually none of their products or services. I am a Costco member, but rarely go. I'd love to make Whole Foods my market, but without one nearby, I get my natural foods elsewhere. ...

Yet, as I write to you today, all nine of my companies and all eleven of my buy recommendations are beating the market. Buy what you know doesn't mean buy what you use. So where do I find them?

For one, I scan Investor's Business Daily religiously, looking for companies with either: 1) poor stock performance, 2) (temporarily) weak earnings or 3) both. I use free screening software online at wallstreetcity.com. And I read our message boards at Fool.com.

As I've said, I research 50-200 companies a month just to narrow my search to five. I then turn these loose on the track with my existing holdings and the market. The horse that looks most capable of beating the market by the widest margin wins. (As an aside, when it came to Costco (Nasdaq: COST  ) , I slackened some of my price criteria. And look where that got me. Costco has marginally beaten the market but is down 20%).

So, that's where I find them. Except for this month. This month I turned for ideas to our editorial group at Fool Global Headquarters. Matt Richey, an outstanding investment writer and thinker here, asked if I'd run across a company called Quality Systems. Accelerating sales growth, he said. Strong free cash flow. No debt. A very attractive valuation. I took his suggestion home with me, signed onto Edgar Online, and began working through the company's 10Qs and Ks.

Very impressive, indeed.

Headquartered in Irvine, California, and more than a quarter-century old, Quality Systems is small by public-market standards. It's capitalized at just $132 million (by comparison, my selection last month, BorgWarner (NYSE: BWA  ) , has a market cap of $1.4 billion). The business? Doctors and dentists use proprietary Quality Systems software and services to upgrade and manage their record-keeping, essentially moving from paper scribblings into the 21st century.

You'd think this would be a fairly mature niche. After all, larger facilities went digital years ago with the help of systems from companies like Cerner. Turns out, these systems were not successfully scaled or marketed to smaller practices. To this day, electronic medical records and back-office billing are a rarity among doctors and dentists with private practices.

Quality Systems released its Q3 earnings on January 23. Let's take a look at the financials. First, the balance sheet. Quality Systems has $33.1 million in cash. Accounts receivable (unpaid bills from its customers) grew 20%, while inventory declined. I like that the business has no debt.

Over on the income statement, sales to the company's more-than-700 clients grew 30% (nicely outpacing accounts receivable and inventories). Net income grew an impressive 40%. The company paid taxes at a 33% rate. And the board diluted existing shareholders by a relatively modest 2.9% last year.

As is customary, Quality Systems has not yet released a Q3 cash-flow statement. Working from the income statement, I come up with structural free cash flow just below $6 million through the first nine months of this fiscal year. (As you run your numbers, remember to build free cash flow out of the following equation: net income + depreciation + amortization + deferred taxes - capital expenditures.)

While I was surfing the reams of financial statements filed over 25 years of operation, one curiosity jumped out. Sales have really picked up of late. What had been 10% annual growth for the past four years has ballooned to in excess of 30%.

Why? In 1996 and 1997, Quality Systems paid more than $20 million in cash and stock to acquire complementary businesses. The first, Clinitec, sells clinical software for doctors' use during patient examinations.

The second, MicroMed, develops back-office, administrative applications. Both are Windows-based. The two were merged to form the Quality Systems NextGen division, which offers an integrated electronic medical records system for both clinical and administrative information. This has become the growth engine of the company.

Put it all together, and what we have in Quality Systems is a financially strong company that is containing costs, while at the same time enjoying rising demand.

So let's try a back-of-the-envelope valuation, a process I like to keep intentionally loose. I'd rather work in general ranges than try to conjure target prices like some big Wall Street firm (one that might have banking opportunities with the companies it rates!).

Quality Systems has been growing revenues in excess of 30% annually. I'd prefer to work off a more conservative assumption of 20% free cash-flow growth. In Year Three, this has the business spinning out in excess of $13 million in free cash flow. A reasonable multiple of 22X (off a 20% growth rate) prices the venture right around $290 million. Backing out the 3% yearly stock dilution gets you just north of $40 per share.

At less than $22 today, Quality Systems could generate in excess of 20% annual returns over the next three years. Time will tell.

Until it does, thanks to Matt Richey. I love stock tips, though strictly as an invitation to do some original research. My research says Quality Systems is a quality tip
-- Tom Gardner, February 2003

Investing lessons
Tom delivered great lessons here in both finding great stock ideas and how to evaluate them. Nearly 10 years later, it should be even easier for you to copy his methods -- for instance, no need to leaf through newspapers nowadays, and screening software has become more prevalent.

The most amazing thing to me is how behind the times, still, the medical offices are in this country. I still find myself filling out papers on a clipboard every visit, writing the same phone numbers and checking the same medical history boxes.

 This type of ancient and error-ridden record-keeping won't last forever. Quality Systems, Merge Healthcare (Nasdaq: MRGE  ) , Allscripts Healthcare Solutions (Nasdaq: MDRX  ) , and others will continue to benefit as it slowly gets better. Quality Systems has had some problems of late, including the tough competition just mentioned, but the opportunity remains.

Speaking of record keeping, there's been a massive increase in the amount of data being collected by companies worldwide. That trend has created a massive opportunity for companies that can help make sense of it, which is why we've written a special report on the topic. We've called it: "The Only Stock You Need to Profit from the NEW Technology Revolution," and inside we detail one company taking advantage of the trend in a big way. Click here for instant access to this limited time free report.

Fool analyst Rex Moore tweets but is not a twerp. He owns no companies mentioned here. The Motley Fool owns shares of Costco Wholesale. Motley Fool newsletter services have recommended buying shares of Costco Wholesale, BorgWarner, and Quality Systems. The Motley Fool has a disclosure policy. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. Try any of our Foolish newsletter services free for 30 days.


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