January 28, 1996
Medicis Pharmaceutical Corporation (NASDAQ: MDRX)
Type: Small-Cap Growth
HQ: Phoenix, AZ
Closing prices: $25 3/4 ask, $25 1/2 bid
Trailing 12-month sales: $21.7 million
Trailing 12-month earnings per share: $0.86
Last quarter reported: 2Q Fiscal '96 (December)
Next quarter reported: 3Q '96 (March), around April 24
Consensus EPS for quarter: No analysts---Foolish guess, $0.31
Fool Ratio: .56
Trade: BUY 250 shares
The Motley Fool Portfolio has been a teensy bit less fun ever since we tossed out Ride Inc. last November 30th at $21 1/8. That highflyer, which more than doubled for us during 1995, proceeded to zoom up over $30 in the ensuing weeks, casting a pall of disappointment over the roof at Fool HQ. (Soon after, Ride came crashing down below our exit price following scaled back earnings estimates.) As anyone who's read our just-out 'Motley Fool Investment Guide' knows, we harbor a deep and abiding affection for small-cap growth stocks. Smaller stocks are generally ignored by institutions, whose billions of dollars would drive up the price of a small-cap stock far beyond attractive levels, just in the act of trying to establish a position. Thus, small caps remain the province of small investors like us, who can get in well before the Wall Street blokes pile in. By then, if we've run the bases right, our stock's already rounded second, the ball is bouncing off the wall, and we're staring hard at home.
It is with great satisfaction, therefore, that we present Medicis Pharmaceutical Corp. (NASDAQ:MDRX) as our next Foolish small-cap pick. To our knowledge, no mainstream Wall Street analyst is yet following MDRX.
Medicis Pharmaceutical, based in Phoenix, AZ, markets dermatological products, both prescription and over-the-counter, nationally. The company's motto (and service mark) reads, simply, 'The Dermatology Company.' That's quite apt, because Medicis's products are aimed solely at this $5 billion sector of the pharmaceutical industry. Its two primary products, DYNACIN (an oral prescription therapy for acne) and ESOTERICA (an over-the-counter fade cream for age spots and skin discoloration) own leading market positions, and its supporting products are ALL, as well, dermatological. Competing mostly against huge, and hugely diversified, multinationals, Medicis is proving to be the nimble little guy with the tight focus who can outmaneuver his heavier competitors due to their inefficiencies, lack of commitment, and frequent management changes. And it may even come down to something so intangible as the 'will to win'; Medicis just seems to want it all a bit more. Describing his company as 'passionate' and 'almost monomaniacal,' CEO Jonah Shacknai strikes us as a savvy marketer and a sensible corporate manager.
While still quite small, the company has grown substantially since doing just $100,000 in sales during 1990. By comparison, 1995 sales and earnings came in at $19.1 million and $1.6 million, respectively. (The company operates off a June fiscal year.) Medicis's sales grew a lukewarm 12% over 1994, but the company's margins improved substantially, putting net income 146% ahead of the previous campaign. The first half of fiscal 1996 (the September and just-reported December quarters) have seen far better growth. Sales have really begun to kick in (up 31%) and net income has exploded (up 516%). Earnings per share (EPS), which were 51 cents for all of fiscal '95 (ignoring a one-time relocation charge), are exploding as well. In just the first two quarters this year, EPS already sits at 43 cents fully diluted, putting the current trailing earnings per share at $0.86. Further, Medicis's business is somewhat seasonal in nature, its second half typically well exceeding its first (and we always see a dropoff from fourth quarter---June---to first quarter---September). Thus, now that we've reached sight of the company's better half, we're expecting earnings in excess of $1.00 per share.
Medicis concentrates its sales efforts on the nation's 6000 biggest dermatologists, whose buying habits and recommendations fuel the industry. MDRX currently does about 70% of its sales through prescription (or 'ethical') drugs, and this segment will be the primary source of Medicis's growth going forward. DYNACIN has definitely been the recent kicker here, as the nation's second best-selling acne prescription drug continues to gain increased acceptance from dermatologists. For fiscal 1996, Medicis's aggressive, highly incentivized sales force is so far responsible for 42% sales gains in DYNACIN. The company even offers full refunds on the product to dissatisfied customers, and claims to have only done so in about a dozen cases out of hundreds of thousands of customers. The Scottsdale Progress Tribune quotes CEO Shacknai as saying, 'I'm not sure it didn't work even for those,' but that the refunds were 'cheerfully provided---just as Nordstrom will take back any item of clothing with a smile and the hope that the customer will come back.'
But sales are also being helped by a key new product introduction. In its December quarter, MDRX just debuted a topical anti-acne prescription product ('topical' means it's applied directly to the afflicted area), TRIAZ, developed by Medicis scientists. The 'TRI-' part of TRIAZ is intended to suggest the product's three main ingredients. TRIAZ combines the efficacy of benzoyl peroxide with the exfoliating power of glycolic acid, throwing in a bit of zinc to reduce the redness. Shacknai: 'As we attempt to gain a significant share of the $442 million topical anti-acne market, we expect a steep growth curve for the product.' Indeed, Fool HQ expects TRIAZ to contribute substantially to sales this year and in the future, further bolstering the company's position as an industry leader. We know we'll now be knocking on OUR doctor's door for this stuff, should fate determine the need. . . .
Based on these products, and more development of new products, and further market penetration, management has stated its intention of growing MDRX's sales to $100 million by 2000, making for 40% annualized sales growth. With the ongoing improvement in profit margins that generally follows a fine small-cap company's growth, we see earnings growing even more substantially. As we sit here on our perch in late January 1996, we're lookin' at lotsa profits ahead.
THE RIGHT MOVES
We're impressed by management's savvy. In fiscal 1995, Medicis departed its expensive New York City office to relocate to Phoenix, Arizona. Phoenix is a cheaper, sunnier, more agreeable place to work than New Yawk, and CEO Shacknai wangled some decent incentives from Governor Fife Symington's economic development staff. We consider this a Foolish move.
Another pretty darn Foolish move was that Medicis used a substantial portion of its 1995 profits to help pay down $2 million of debt. As a result, the company is almost debt-free. That's the beauty of running a cash-flow positive operation, which habitual Fool readers know is one of our essential requirements for a small-cap pick. Medicis generated $1.75 million from operations in 1995, and halfway through '96 it's already generated another $1.6 million. (You can read a good deal more of our Foolish stuff about cash flow in chapters 15-16 of 'The Motley Fool Investment Guide.')
What we're seeing, then, is a company that is doing a fine job of reducing its costs. It's cheaper to operate in Arizona than New York, and it's cheaper to operate with little to no interest expense. In fact, operating costs grew less than 4% last year, and so far in 1996 they're up only 10.6%, in the midst of sales growth exceeding 30%.
Combine these numbers with a company that is in no danger of making the dumb move of 'diworsifying' its business into other drug sectors, and you have a tightly-focused operation producing strong sales, reducing expenses, and building up big profits. We likes.
Medicis stock has been quite simply phenomenal over the past 12 months. Rising from a low of $2 5/8, these shares closed at $25 9/16 on Friday, having traded 389,000 shares. Last week was particularly stellar, as the stock rose 6 points---about 30%---following an outstanding earnings report on Wednesday. With 4.7 million (fully diluted) shares outstanding, Medicis sports a present market capitalization of $120 million, well within the range of $50-$200 million that denotes 'small cap' by our Foolish definition.
The relative strength, needless to say, is 99. (Newcomers can read more about relative strength in our 'Motley Fool Investment Guide,' or 'The Motley Fool Investment Primer.')
The stock is 15% owned by insiders, with a float of 3.5 million shares.
Average daily volume is now up to 190,000, meaning that MDRX's daily dollar volume (the amount of money that trades through the stock on an average day) is $4.9 million. A month and a half ago, when we first found this stock at $12 1/2 (we've watched it more than double since), Medicis's daily dollar volume was less than $1 million. What we're seeing, then, is a surge of interest in these shares, more liquidity, and more chance that institutions will pile in. (To a limited extent, they may already be.) That's part of our strategy with small caps, to get in ahead of the institutions, so we like to see daily dollar volume on a steady increase. What is happening is that Medicis is in the midst of getting discovered. We think, however, that we're still at the outset of this.
One of the things that's probably kept analysts away is the skepticism typically associated with reverse splits. With a reverse split, a company raises the price per share of its stock by lowering the number of shares outstanding---the exact opposite of a regular stock split. In Medicis's case, the company executed a 1-for-14 reverse split in mid-1995 that brought shares outstanding down from 60 million to the current 4.7 million. The company's aim was to raise its share price (below $1, at that point) to a level well over $5 a share in order to attract more attention from Wall Street. That appears to have been achieved. Though we generally sneer at reverse splits, in Medicis's case it's the exception that proves the rule.
EARNINGS ESTIMATES/FOOL RATIO
After we've located a stock and approved its balance sheet (looking for 'cashcentricity') and cash-flow statement (demanding positive cash flow from operations), our next step is to value the stock. The Fool Ratio, as you should well know by now, is based on comparing a company's price-to-earnings ratio to its company growth rate. To attain these figures, we need the earnings per share and an estimate for growth rate. We've already identified trailing 12-month earnings per share: 86 cents, fully diluted. But with no analysts following Medicis, we lack earnings estimates, and thus need to figure out for ourselves what our estimated growth rate should be.
We at Fool HQ have worked up our own numbers as best we can, but it's difficult for such an emerging company like this one. We completely disclaim the numbers we present below, because they are in no way 'endorsed' by company management (in the way that so many analyst estimates are), nor have we ever run these figures by management at all. We're simply trying to put up some guideposts on our way toward a growth rate and have developed a simple internal model looking at existing profit margins and sales gains. We're sharing them with you our readers so you can see our rationale for our estimates, NOT so that you'll take them seriously.
In working up our numbers, we were primarily struck by two figures that we just pulled from Wednesday's second-quarter earnings report. The first is the net profit margin the company achieved: 21.8%. That is extremely high. Now for one thing, Medicis is paying virtually no income taxes. Based on an unprofitable 1990-93, the company had $12.3 million of net operating loss carryforwards going into this fiscal year. We do not currently expect the company to have to pay regular income taxes until 1998, so we're not currently factoring taxes into our equation. Anyway, the net profit margin of 21.8% is extremely significant because it's well above any level the company had posted heretofore. (In the June quarter ending fiscal '95, Medicis had achieved margins of 17%, its highest ever until this quarter.) Anyway, the achievement of margins comfortably over 20% must be duly noted and accounted for.
The second striking number revealed in last week's earnings report was the big sales growth, quarter over quarter. Historically, the company has seen second-quarter sales gains average 29% over the first quarter; this year, however, Medicis just posted quarter-over-quarter gains of 41%. Why? You'd have to partly credit the company's new product introduction mentioned above, TRIAZ. Going forward, we've included a boost from this new product through this year and beyond.
OK, all of that said, here are our numbers:
SALES 1997e 1996e 1995 1994 1Q 6.40 4.57 3.69 3.58 2Q 9.03 6.45 4.73 4.67 3Q 9.83 7.02e 5.03 4.17 4Q 10.98 7.84e 5.68 4.59 36.24e 25.88e 19.13 17.01
NET INCOME 1997e 1996e 1995 1994 1Q 1.408 0.646 0.026 0.006 2Q 1.987 1.404 0.308 0.039 3Q 2.163 1.470e 0.312 0.120 4Q 2.415 1.710e 0.967 0.491 7.972 5.330e 1.613* 0.655
*includes extraordinary charge of .610, due to headquarters relocation
EARNINGS PER SHARE 1997e 1996e 1995 1994 1Q 0.29 0.13 0.01 0.00 2Q 0.41 0.30 0.07 0.01 3Q 0.45 0.31e 0.07 0.03 4Q 0.50 0.36e 0.22 0.11 1.65 1.10e 0.37* 0.14
*excluding extraordinary item, company EPS was $0.51
As you can see, we expect Medicis to earn $1.10 this fiscal year (ended June), and $1.65 the year after based on targeted sales gains of 40% and a net profit margin of 22%. We will simply emphasize again that we are investors, not analysts. These may be some of the worst earnings estimates ever developed. . . they are simply our own internal projections based on sales and earnings momentum. We encourage our readers to do their own work and publish it in the Medicis folder, as we'd appreciate further discussion and analysis, Iomega-style.
From this model, we can now come up with an estimated annual growth rate. We know that trailing earnings are 86 cents, and we see above that our 1997 earnings estimate is $1.65. That represents total growth of 92%. Annualizing that growth by taking the 1.5 root of 1.919, we get a growth rate of 54%. (If you're new to this, please read the Fool Ratio chapter in our brand new 'Motley Fool Investment Guide,' or read 'The Fool Ratio' article in our Fool's School.)
OK, time to do the Fool Ratio. We simply divide the P/E by the growth rate. At a current asking price of $25 3/4, and with earnings per share of 86 cents, the P/E on this stock is 30. The growth rate we found above: 54%. Divide 30 by 54 and you get .56. Our traditional Foolish buy range is .65 or less.
WHAT COULD GO WRONG
Medicis is an extremely volatile stock, with little if any institutional following. Anytime we locate a company with no analysts following it, we're of two minds. On the one hand, we're excited to have found something before Wall Street. On the other, there's always the chance that Wall Street already has taken a look and for one good reason or another, passed. So particularly in situations where there's no analyst coverage, we're looking at that much more uncertainty. We're quite well aware that in adding Medicis to our portfolio, we're taking on high risk.
MDRX has run up from below $3 to its current price, having doubled in the past month, and having risen six points just last week. Our timing may be good. . . it may also be quite poor. As our regular readers know, the Fool spends very little time trying to 'time' its entries. Applied Materials and KLA Instruments were both great companies when we bought them back in August, and they're still great companies today, but meantime both stocks are down in excess of 30%. So as always, we think we're making the right move buying Medicis now, but we're doing so after a huge run, and substantial profit-taking could occur.
Finally, our numbers are built on our own estimates, and should these estimates prove unrealistic, or should the market disagree with our valuation, Medicis could wind up sleeping outside in the Fool Doghouse without supper.
If the past is any prologue to the future, with the publishing of this recommendation Medicis Pharmaceutical may well rise on the Monday open. We can't ever predict for sure what will occur, of course, but we've seen jumps in our last couple of purchases, both of which were bigger companies with more liquid stocks.
Why is this? Because a fair number of readers seem to buy along with the Fool Portfolio. That behooves us to state up front: please remember that your decision to buy or not is your own, should (as always) be made after thorough thought and research on your part, and should only be undertaken with the understanding that this is a high-risk investment not suitable for new investors or those who can't afford to keep the money in the market for a few years. Further, some people may be under the mistaken impression that we have some Foolish equivalent of the Midas touch, due to our strong historic returns. However, please go back and review our Foolish trading archive and you'll note that our last two purchases have so far turned out to be Fool's Gold. Both are down more than 30%. That could always happen again, and if it does, none of us should fret about it. . . As stock market investors, we're prepared to trade higher risk for higher reward.
The Friday close for MDRX was a bid of $25 1/2 and an ask of $25 3/4.
As usual, we at Fool HQ commit to making the purchase at some point during the day Monday, though not necessarily at market open. Investors not wanting to 'pay up' for the stock could put in 'limit orders,' specifying a purchase only at or below a certain price. That's one way of assuring yourself you get your price, should market makers jack it around a bit. Only problem is, limit orders are given lower priority for execution than 'market orders,' and if this stock continues its roll, some would-be passengers may miss the boat.
Company CEO Jonah Shacknai has two decades' experience in the pharmaceutical industry, including stints in Washington D.C. as chief aide to the House of Representatives with responsibility for the Food and Drug Administration, as a member of the Commission on the Federal Drug Approval Process, and as a lobbyist and consultant serving 34 medical multinationals (including Pfizer, Sandoz, and Upjohn).
Besides looking very much like a GQ model (there's a faint resemblance to Richard Gere in there somewhere), Shacknai strikes us as highly Foolish. Combing through our information packet on the guy, we've come across some fine quotations which we'd like to share in this brief section:
On the dermatology industry: 'We can realistically expect to dominate this market. . . . It is inevitable in my view that we will become the number one dermatology concern in the United States. I do not believe there to be a company out there as highly motivated as we are and as aggressive as we are.'
On the company's move from New York to Arizona: 'We're saving a great deal of money by operating here; our employees are enjoying a higher quality of life, and the business atmosphere is relaxed. I've retired my 40 suits to canvas bags.'
On Medicis's 1-for-14 reverse split: 'Well-informed shareholders will view this as a very positive development because it marks an important moment in the progression of the company from its early start-up phase of 1990 to a fast-growing, profitable, stable company in 1995.'
On not misusing technology: 'Because a technology is new and interesting does not necessarily mean that it is going to be financially successful. . . . By understanding [customers'] needs and their perceptions of existing technology, we are able to then go into the academic and research community to match needs and expectations against cutting-edge technologies that may exist.'
Explaining why he dressed up as a pig, a bear, and a musketeer during a recent sales conference: 'When the sales organization observes the CEO making a Fool of himself to help business they may be more ready to think out of the box in their own dealings.'