Readers familiar with The Motley Fool have picked up on co-founder Tom Gardner's nagging obsession with undiscovered small-cap stocks, what he calls hidden gems. And in the spirit of full disclosure (we're all about disclosure here at the Fool), I myself subscribe to Tom's service. But there are many fish in the sea, and no one fisherman catches them all.
Like Tom, I'm driven by a desire to find companies that are undervalued at least in part because nobody -- especially the big boys on Wall Street -- is looking. Back in the day, Southwest Airlines (NYSE:LUV) was just such an underfollowed operation. Was I in on that one 30 years ago? No. But I think I have one now.
Taking Medical Action
Hidden Gems investing is all about digging out small, well-run businesses whose stocks are cheap. I go one step further by searching not only for companies Wall Street overlooks, but ones you hear about almost exclusively in trade circles and SEC filings. Despite a cool name, and wicked performance (the stock is up roughly 5 times in value since January 2001) only one analyst follows little Medical Action Industries (NASDAQ:MDCI).
The company's main business is disposable medical products, including kits and trays, sterilization products, surgical sponges, and collection systems for medical waste. Sounds a bit like the early days at Johnson & Johnson (NYSE:JNJ), with a touch of Baxter International (NYSE:BAX). But the word of the day is disposable, which means repeat business.
Legendary investor Bernard Baruch once advised investors to look for companies whose products are used up, tossed out, and repurchased on a regular basis (read: disposable). That process assures captive markets, repeat business, and sustainable sales and profits. And that's good news for investors, in booming economic times and bust.
How do they do it?
Since 1994, Medical Action has increased revenues at a compounded rate of 12.3%. Over the last six years, that's up to 14.6% -- over the last two, a blockbuster 17.9%. Notice a trend here? Sales are growing and they're growing at a faster and faster rate (another tip of the hat to Hidden Gems). How do they do it?
In part, by means of a steady diet of acquisitions. Medical Action has acquired eight businesses in eight years. Going forward, the strategy includes entering new markets, including veterinary and dental. Round that out with the inexorable aging of the U.S. and global populations -- as the world's baby boomers age, they'll need more medical care -- and you get some idea of where the demand for disposable medical products is headed.
Partly because of this, competition is fierce in this industry. Sales of Medical Action's sterilized towel product line grew 25% last year, but at the cost of a 14% price cut. In the laparotomy sponge business, both volumes and prices took a hit. A good deal of pressure comes from various divisions within gorilla Tyco (NYSE:TYC), which, mismanagement aside, runs a number of very profitable and very competitive divisions.
Can Medical Action compete?
Yes, through sound strategic vision and excellent management. Two recent acquisitions -- one being the Biosafety Division of Maxxim Medical -- bolstered the company's position in infectious waste containment. And both were integrated quickly and are accretive to earnings. This pattern has been repeated over eight years, translating into consistent sales growth and six years of earnings growth.
Of course, acquisitions aren't free. Shareholders of Time Warner (NYSE:TWX) reluctantly offer more than $25 billion in unpaid debt as evidence. Medical Action Industries hasn't escaped entirely unscathed; however, management has consistently paid down such obligations over the years, drawing primarily on the generous free cash flow generated by the business.
In the fourth quarter last year, for example, Medical Action had $32.7 million of total debt on the books. Within six months, it had paid that debt down to $24.9 million. Last year, the business generated more than $8 million in cash flow; roughly $14 million is expected this year. Nice.
Now, let's talk value
Health-care investors are fascinated with dominant players like Pfizer (NYSE:PFE) and Medtronic (NYSE:MDT). Many real bargains, however, and the real potential for growth, are in smaller operations, especially those expanding their sales and earnings. Medical Action's accelerating growth in free cash flow makes it a clear standout.
Currently, the stock trades at an earnings multiple a full 10% below the average of the S&P Small-Cap Index. If estimates prove reliable -- and I think they will -- the P/E shrinks to under 15 times. Once investors see this company generating cash, paying down debt, and consistently accelerating its growth in earnings and sales, this should prove a real bargain here at around $16 per share.
I'm not alone in this. Executives and other company insiders -- traditionally known for a keen sense of value -- own 20% of the stock. That also means leadership with a real stake in the long-term success of the business, and helps explain the reasonable rate of share dilution (less than 3% per year).
Put that all together, mix in a long history of growth and the prospects of the business, and I say I've found a true hidden gem in Medical Action Technologies.
Like most endeavors, hunting for small caps is best done in groups. The Hidden Gems community at The Motley Fool is a great place to share your ideas and get your fill of diligent fundamental analysis and lively conversation. Take a 30-day free trial .
Thomas Engle, 1000 on the Fool discussion boards, does not own shares of Medical Action Technologies. You can reach him at [email protected]. The Motley Fool is investors writingfor investors.
