FOOL ON THE HILL
Meridian: A Short Mistake

Meridian Medical Technology has attracted short sellers in droves, even though its fundamentals are rock-solid. The company has a laundry list of favorable qualities: 90% market share in its core market, no debt, well-managed receivables and inventory, solid free cash flow, significant expanding opportunities, and an undervalued stock. The shorts of this stock don't have a limb to stand on.

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By Matt Richey (TMF Matt)
September 20, 2002

I have a rule of thumb in investing that I won't buy or hold a stock if its short percentage is above 20% of float. Normally, companies with large short positions have glaring fundamental weaknesses, such as massive debt or accounting concerns. With more than 9,000 publicly traded companies out there, why bother with controversial situations that face the attack of short sellers? That's typically my logic. But currently, I'm facing a situation in my own portfolio where I may soon have to consider breaking this rule of thumb.

One of my favorite holdings is Meridian Medical Technology (Nasdaq: MTEC), a specialty pharmaceutical company with a 90% market share in self-administered drug auto-injectors. The stock has a publicly traded float of 2.9 million shares, of which about 17.3% were sold short as of Aug. 8 (the latest available date). The stock's short interest has been rising all year, and doubled between July and August. Since Aug. 8, the stock has been under heavy selling pressure, falling from a perch in the low $30s to as low as $23 recently (where, incidentally, I bought more). In all likelihood, the stock's short interest has already risen above 20%.

I've racked my brain to find any plausible reason why short sellers would target Meridian. In my investment playbook, a good short candidate has some combination of the following qualities:

  • Deteriorating earnings power
  • Massive debt
  • Bloated working capital
  • Little or no free cash flow
  • Limited growth opportunities
  • Promotional management
  • Overvalued stock

I've scrutinized the financials; I've listened to the conference calls; I've read the 10-K; I've read the message boards; and after all that, I'm here to tell you that Meridian doesn't qualify on any of the above points. In fact, Meridian offers the opposite of each of those negative qualities. Let's take it point by point.

Expanding earnings power
Meridian's auto-injector business is a cash cow. With 90% market share, Meridian has production efficiencies that no competitor can match, even if one dared to try. In addition, the company benefits from guaranteed revenues as the sole supplier of nerve agent antidote auto injectors to the U.S. Department of Defense (DoD). Earlier this week, the DoD renewed its contract with Meridian for three years, guaranteeing minimum annual revenue of $11 million, a 10% increase over the previous contract.

This is a high moat franchise business, and you can see it in the company's margins and returns on capital. For the just completed fiscal year (ended in July), Meridian generated a pre-tax operating margin of 23.3%, up from 17.1% last year. Return on invested capital for the year was an incredible 33.4%, up from 16.3% in fiscal 2001. That's the very definition of expanding earnings power.

Cash aplenty
As of July 31, Meridian had cash of $13 million, with not a penny of debt. Late last year, it raised $11 million in a well-timed private placement of equity, which allowed it to pay off its previous debt balance of $17 million.

Lean working capital
Meridian has been making excellent progress in tightening up its working capital management. The Foolish Flow Ratio has declined each of the past four quarters, thanks to compressed accounts receivable collection times and stretched accounts payable terms. The Flow Ratio as of July was 1.67, which isn't as low as we like to see it, but not bad for a company that needs to hold about a quarter's worth of inventory in case of emergency orders.

Solid free cash flow
I don't yet have a cash flow statement for fiscal 2002, but for the four quarters through April, Meridian generated free cash flow of $9.9 million on revenue of $78.3 million. That's a free cash flow margin of 12.6%, which is superb. Its free cash flow actually runs higher than its reported net income, which was $8.3 million over the same period of time, or a 10.6% net margin.

Expanding opportunities
The interesting twist to the Meridian story is that not only does it have a solid base in its existing auto-injector business, but there are also several exciting areas of expansion that should begin yielding results in the coming years.

Most significant among the new opportunities is Prime ECG, a new electrocardiac mapping system that dramatically improves the diagnosis of heart attacks. This product was approved by the FDA in March, at which time Meridian began building a sales force to market the product. Management expects Prime sales of $3 million or so to start trickling in during the first half of calendar 2003. As with any new medical device, the Prime rollout is expected to be a lengthy one, but there's the potential that one day the proprietary 80-lead Prime ECG could replace the current 12-lead ECG as a new medical standard.

A second opportunity on the near-term horizon is DiaJect, an emergency treatment for epileptic seizures, delivered by auto-injector. The only currently available alternative treatment is a rectally administered gel -- and that product has $25 million in annual revenue. Not to be crude, but if your friend or loved one is having a seizure, would you rather administer an injection or a rectal gel? (Uh huh, that's what I thought.) Clearly, DiaJect has the opportunity to capture most of this market. FDA approval is expected by year end, and sales should materialize perhaps by the second half of calendar 2003. DiaJect, by the way, is Meridian's first internally developed commercial pharmaceutical product.

Third, Meridian is working on its second internally developed drug product, currently called DHE45. This is an auto-injector treatment for migraines. The only other injection-based treatment on the market has annual sales of $200 million, so this is a significant market opportunity. It hopes to file for FDA approval by late next year.

Finally, Meridian has a small telemedicine business whereby its devices allow diagnostic information to be transmitted by telephone, which can allow for much more economical home-based care. It's currently a small revenue stream, but with growth potential.

Conservative management
When Meridian reported earnings on Wednesday, management didn't say a word about the fact that earnings of $0.42 per share handily beat the consensus estimate of $0.38. Nor did it trumpet that it was "upping guidance," even though it did in fact project next quarter's earnings to come in around $0.38 to $0.42, which would be well ahead of the consensus of $0.28. Finally, it steered clear of any derogatory comments about short sellers, even though they're obviously impacting the stock price. I appreciate a management team that lets its business performance speak for itself.

Undervalued
Meridian's upcoming fiscal year isn't expected to see the marvelous growth that marked fiscal 2002, but the stock is still cheap, no matter how you slice it. If it can generate a 12% free cash flow margin on the consensus fiscal 2003 revenue estimate of $86 million, that would be a free cash flow of $10.3 million. Sprinkle in about 5% share dilution from options, and free cash flow per share should be around $1.90. At a current price of around $27, that's a forward price-to-free cash flow multiple of 14. For a company with a monopoly core business and expanding possibilities, that seems like a steal to me. It's certainly nowhere close to being overvalued.

So there you have it. The shorts so far have had their way with Meridian, but I think this is largely due to the stock's small and easily manipulated float, along with the tailwind of a prevailing bear market. But in the end, the merits of its business are going to speak for themselves and be reflected in the share price. The catalysts of new products, a potential war with Iraq, and sheer value are all in place to give this stock a lift. To be a short seller of Meridian in light of these facts is sheer folly.

And yet even if the shorts pile into 30% of Meridian's shares, I'm not letting go of mine. The fundamentals are too strong and the future is too bright for me to be scared out of this one.

Matt Richey is a senior investment analyst for The Motley Fool. At the time of publication, he owned shares of Meridian Medical Technology. Matt's personal portfolio is available for view in his profile. The Motley Fool is investors writing for investors.