Last month, in A Quick Double? I wrote that there were three undervalued companies using biotechnology to improve the drug-making process. That column made the case for Canada-based photodynamic drug pioneer, QLT (NASDAQ:QLTI), leaving two others for later. Today brings the second.

To recap, I screened for the following criteria among 400 or so companies arguably in the biotechnology and drugs world:

  • Market capitalization over $100 million

  • Positive free cash flow (FCF) for the last 12 months and each of the last four quarters (FCF = net cash from operations minus capital expenditures)

  • Increased FCF for most recent fiscal year vs. prior, and for most recent two quarters vs. same quarters a year ago

  • A current valuation below its rate of FCF growth. (Check out Rex Moore's recent look at how to use growth in FCF to your advantage.)

The goal? To quickly find an undervalued company with at least two quarters of accelerating free cash flow growth and then look more closely at the business.

The company, the numbers
The No. 2 candidate, Meridian Bioscience (NASDAQ:VIVO), showed up with the right stats, which as of yesterday's close are:

  
           Change in FCF VersusPeriod    Year-Ago PeriodQ2 FY 03    63%  Q1 FY 03   127%FY 2002     16%---------------------------Market Cap      $137 mil.
Market Cap/FCF 12

The business
Meridian passed the first tests, so on to the business. Since 1976, it has sold medical diagnostics, both its own and those it licenses, with 30% of sales outside the U.S. It currently markets over 200 products that sell for $1 to $33 a test and diagnose gastrointestinal, viral, and parasitic diseases.

Diagnostics is a very competitive health-care business -- Abbott Laboratories (NYSE:ABT) and Becton Dickinson (NYSE:BDX) are two powerhouses in the market -- yet Meridian's been a conservative, steady performer, with (mostly) consistent earnings and free cash flow for the last seven years. Another good thing is that management is heavily invested: CEO and Chairman of the Board William Motto owns 28% of the shares (institutional investor Putnam Investments is second with 14%).

Stockwise, its chart since going public in 1986 shows roughly an anemic 5% compound annual growth rate (CAGR) (though frankly even after asking around Fool HQ I haven't been able to verify whether that includes the dividend -- currently 3.9% -- if the stock price is reduced on the ex-dividend date. I assume it would be, but if I'm missing the obvious, please e-mail me at tomj@fool.com). Certainly nothing to get excited about, and your mileage could easily have varied. Through the chart, you can see that purchasing in the late 1980s or at year 2001 lows would give you terrific returns of 350% and up, but buying at 1996 or 1998 highs would leave you down a third or so.

Two events suggest greater opportunity today. First, Meridian may be a kind of turnaround. The FDA in June 2001 issued the company a warning letter about compliance with its Quality Systems Regulations. Meridian spent about $2.3 million during the fiscal year to address FDA concerns and also discontinued about 30 products. These developments slammed the stock towards $2.00 a share (which turned out to be a great time to buy, by the way, given its close yesterday of $9.20).

The company became subject to three annual audits, and according to its latest 10-Q quarterly report, it completed the second one earlier this month without incident. While there are no guarantees, it appears that it rationalized its business and bought -- at a price -- some future FDA insurance for its stockholders. All good.

Proteins for the drug food chain
The second feature is a possible engine for new growth. The company began in 2000 to move into the biotechnology world when it purchased Memphis, Tenn.'s Viral Antigens for $8 million in cash. Viral made viruses for diagnostics, but under Meridian ownership it has constructed a facility to make recombinant proteins for biopharmaceutical companies. It reported its first contract in April.

The biopharma world suffers from a lack of manufacturing capacity for recombinant proteins, which make up an ever larger share of drugs in development and on the market. Given the failure rate for protein drug candidates that enter human trials -- 80%, according to the Tufts Center for the Study of Drug Development -- as well as constant technological advances that affect manufacturing, it should be more efficient for drug companies to contract out production. Good for Meridian.

It's not alone in pursuing this business opportunity -- Albany Molecular Research's (NASDAQ:AMRI) Organichem unit is just one competitor -- but it's the potential for this new life science business that makes Meridian exciting today. The company says it will start reporting this segment separately this year, and we will start seeing whether it fulfills hopes for a growth rate faster than its traditional diagnostics business.

Reasonable price
Now that we've got a good business, step two asks whether it is reasonably priced. I use two valuation methods to determine whether to buy and sell, but both are only guides: Valuation is an art, not a science.

The first is discounted cash flow analysis. For Meridian, I find an intrinsic value (IV) range between the current price and $15.00. But the IV yielding the current price assumes a rock-bottom 5% growth for five years and 0% forevermore thereafter. I don't see any basis for this pessimism, but it's a reality check to curb an investor's tendency to view a prospective buy or current holding with rose-colored glasses.

The higher range accepts management's estimates for 15% a year and lowers them to single digits over the next five years. I used a discount rate of 11% and 1% minimal shareholder dilution. A pure value investor prefers to buy below a low-range estimate and sell as the price moves to the high end, so might not buy here.

But in the second method, I estimate revenues and free cash flow for the five years ending 2008. This yields a projected return of 84% (less than a double) to over 300% (a quadruple) from today's $136 million market cap. The lower range assumes five years of anemic single-digit revenue growth and the higher range accepts management's 15% estimates for the next few years, a 13% free cash flow margin (the percentage of revenues the company converts to free cash flow), and a market cap-to-free cash flow multiple of 13.

The high range is not as much of a stretch as you might think. The company's free cash flow production is lumpy, but the last three quarters have been on a tear with year-over-year growth of 33%, 127%, and 63% increases -- and that's with capital expenditures for the new protein production facility and before the first contract even arrived.

Caveat
There are risks. The FDA regulates diagnostics as medical devices, and approval is never certain. And it could find more manufacturing problems. Meridian may find no more recombinant protein production contracts. The difference with Meridian is that unlike a new biotech drug maker with one hopeful in late-stage trials, Meridian appears to have a business able to withstand shocks without spontaneously combusting.

My one lingering concern about the company is that it doesn't hold quarterly conference calls for investors, so the individual investor can't get a sense of management from them. Though these events can be highly scripted, for small-cap companies like Meridian they are often highly revealing. I'd also like to see quarterly and annual calls archived on its website.

But, of course, the meat's in the 10-Qs and 10-Ks and they and the performance speak for themselves. I liked what I saw and invested 5% of my portfolio last month, and I plan to double to 10% if the life-science business prospers. Note that because the dividend is a substantial element of the return, I bought with funds in a tax-advantaged account, a rollover IRA from a former job's 401(k). That same dividend and steady performance over the years may make the company a nice investment for a Drip, or periodic investing, as well.

I hope you enjoyed the second of three undervalued companies that can claim the label "biotech." I'll share the third once I've had time for more research.

From my e-mailbox
After I wrote a short take on the biochip market recently, a friend of The Motley Fool reminded me that Agilent Technologies (NYSE:A) is still very much in the game. While I omitted them from the list of losers, the sin of omission was not to mention the company as one of the still playing! No one person can keep abreast of all the change in the biotech world, and I'm always grateful for help.

You can join our Foolish Community talking on our Biotechnology and Meridian Bioscience discussion boards (subscription or painless free trial required).

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Tom Jacobs (TMF Tom9) sings "D-N-A, R-N-A, M-O-N-E-Y!" He and the gang of Foolish analysts pick stocks each month in The Motley Fool Select -- get yourfree trialtoday! He owns shares of QLT, Meridian Bioscience, and other stocks you can find in hisprofile. Motley Fool writers are investorswriting for investors.