When most of us think of small-cap growth stocks, we envision relatively young companies with new products or services that are growing sales at a fast rate, typically 20% to 25% per year or higher. Growing revenues at a fast clip is usually the surest route to growing earnings, and earnings growth is what it's all about, right?

In today's column, I'd like to introduce you to a company that has taken a much different route to growing shareholder value. Utah Medical Products (Nasdaq: UTMD) makes high-quality, specialized medical devices and tools. It also makes a ton of money. Utah Medical has been growing earnings per share at an average of over 20% for the past five years. This growth has not gone unrewarded by the stock market, even during this particularly nasty bear market. Since the end of March 2000, Utah Medical stock has increased from $7.50 per share to $18.42 as of Friday's close, an increase of some 145%. In comparison, the Nasdaq index has declined from 4,572.83 to 1,411.14 in that time span, a loss of 69% in value.

What differentiates Utah Medical from most small-growth companies is that virtually all the company's earnings-per-share growth has been due to two factors: improving profitability and share buybacks. Its revenues haven't grown much at all, declining from an all-time high of over $42 million in 1995 to $24 million in 1997 before rebounding slightly to just under $27 million in 2001. Starting from 1997, revenues have grown by a cumulative 11%, while earnings per share have increased from $0.51 in 1997 to $1.14 in 2001, a 124% cumulative increase in the same span.

Its increasing profitability has played an important role in this impressive growth. Gross margins have increased from 51.9% in 1997 to 57.1% in 2001, and that additional 5% of gross profits has worked its way to the bottom line, improving the net profit margin from 17.9% to 22% in that time. These expanding profit margins resulted in Utah Medical achieving a 37% improvement in net income in 2001 versus 1997 on only 11% higher sales -- an outstanding performance.

But as impressive as that is, the vast majority of the 124% increase in earnings per share has come from the other factor -- smart share repurchases. In both 1999 and 2000, Utah Medical completed self-tender offers, in which it offered to repurchase shares from its stockholders at a premium to the then-quoted stock price. In each case, shares tendered exceeded the company's announced limit. Utah Medical bought back over 1 million shares in each case, at prices of $8 in 1999 and $8.20 in 2000. I guess the departing shareholders are wishing they'd kept their stock, what with the shares sitting at over $18 today.

A primer on share buybacks
Before we look at what Utah Medical has accomplished through intelligent share buybacks, let's quickly review how share buybacks add value.

First, a properly executed share buyback will increase earnings per share, assuming earnings stay constant, because there will be fewer shares outstanding after the repurchase. Using a simple example, Company X has 100 shares outstanding, each priced at $10. So, its market cap is $1,000. Last year, it earned $100 in profits, or $1 per share. Let's assume it decided to use that $100 to buy back shares and repurchases 10 shares at $10 each. The buyback reduces the shares outstanding to 90 shares. This year, it once again earns $100 in profits, but there are now only 90 shares outstanding. Earnings per share increase to $1.11, an 11% improvement from the year before. Thus, by judicious use of share buybacks, Company X is able to produce earnings-per-share growth of 11% without profit growth.

When buybacks make sense
Berkshire Hathaway Chairman Warren Buffett has written extensively on the proper use of share buybacks in his annual shareholder letters, demonstrating his fondness for companies that engage in share buybacks when shares are significantly undervalued. The following is taken from his 1984 letter (I have edited it slightly because of space considerations):

The companies in which we have our largest investments have all engaged in significant stock repurchases at times when wide discrepancies existed between price and value. As shareholders, we find this encouraging and rewarding for two important reasons. The obvious point involves basic arithmetic: major repurchases at prices well below per-share intrinsic business value immediately increase, in a highly significant way, that value. When companies purchase their own stock, they often find it easy to get $2 of present value for $1.

The other benefit of repurchases is less subject to precise measurement but can be fully as important over time. By making repurchases when a company's market value is well below its business value, management clearly demonstrates that it is given to actions that enhance the wealth of shareholders, rather than to actions that expand management's domain but that do nothing for (or even harm) shareholders. Seeing this, shareholders and potential shareholders increase their estimates of future returns from the business. This upward revision, in turn, produces market prices more in line with intrinsic business value.

Back to Utah Medical
Let's now turn from theory to practice. Utah Medical has treated its shareholders to a textbook example of how good capital allocation adds to per-share intrinsic value. This first table shows revenues, net income, and free cash flow for Utah Medical for the years 1997 through 2001 (all figures in thousands). Note that there has been virtually no growth in sales, but some growth in net income. Free cash flow has been slightly declining for the past four years.

            2001     2000    1999    1998    1997  

Sales       $26,954  27,193  29,444  27,677  24,272
Net income  $ 5,934   5,373   5,468   4,858   4,322
FCF         $ 7,336   7,464   8,415   8,677   3,339

Now look at this table, starting with shares outstanding. Utah Medical has reduced average shares outstanding from slightly below 8.5 million to 5.2 million in just five years. This has allowed the company to more than double earnings per share and more than triple free cash flow per share over the five years.

             2001    2000    1999    1998    1997 

Shares out.  5,210   5,978   7,197   8,273   8,495
EPS          $1.14   $0.90   $0.76   $0.59   $0.51
FCF/share    $1.41   $1.25   $1.17   $1.05   $0.39

Adding it all up
As best as I can figure it, Utah Medical has repurchased some 7.3 million shares since 1992 at a cost of about $65.3 million. That's an average of about $8.95 per share. Today, the price is $18 and change. I think it's fair to say that Utah Medical has gotten well over $1 in value for every $1 spent in share buybacks, value which has accrued to its shareholders.