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 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, Medtronic (NYSE:MDT) -- a medical technology company reminiscent of the one I'll talk about today -- was equally underfollowed. Was I in on it decades 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 that Wall Street overlooks but also for ones you hear about almost exclusively in trade circles and SEC filings. Despite a cool name and wicked performance (the stock is up roughly five times in value since January 2001) only a few analysts follow 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 does it do it?
Since 1994, Medical Action has increased revenues at a compounded rate of 13.3%. Over the last six years, that's up to 15.5% -- over the last two, a blockbuster 24.8%. 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 does it do it?
In part, by means of a steady diet of acquisitions. Medical Action has acquired eight businesses in nine 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.
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 nine years, translating into consistent sales growth and seven years of earnings growth.
Of course, acquisitions aren't free. Shareholders of Time Warner (NYSE:TWX) reluctantly offer more than $20 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.
Let's take a closer look. To close out fiscal 2003, the company had more than $27 million in long-term debt on the books. It closed out its most recent quarter with about $9 million in total debt. At Hidden Gems, we love to see management paying down debt.
Now, let's talk value
Health-care investors are fascinated with dominant players such as Merck (NYSE:MRK) and Wyeth Labs (NYSE:WYE), but both these companies have demonstrated the regulatory risk of pharmaceuticals. Medical Action is free of those concerns. And frankly, many real bargains and the real potential for growth come 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 well below the average of the S&P Small-Cap Index. If estimates prove reliable -- and I think they will -- the P/E shrinks further. 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 $17 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).
Looking back...
When I first wrote about Medical Action last year, it had $24.9 million in debt, a significant reduction from the previous year. Today, a year later, it has reduced debt, increased revenues by 9% in Q2 2004, and increased net income by 13%. Although cash flow has not grown significantly, the company produced $6.7 million in cash flow for the first six months of fiscal 2004. These numbers may not generate a lot of excitement, but they will allow the business to become debt-free by my next update a year from now.
Medical Action has not made an acquisition in the last year. Next year, as debt is paid off and cash flow translates to cash accumulation, it is likely, once again, to go on the prowl for companies that fit management's long-term goals. It has a history of doing this well.
To many investors, Medical Action is growing too slowly to create much excitement. Investors transfixed on earnings and sales growth might miss other signs that the company is growing in value. It has reported record sales for the first six months of fiscal 2004, and kept dilution under 3% while paying off approximately 63% of outstanding debt. Next year, I believe investors will appreciate a debt-free Medical Action that produces an annual $13 million in cash flow.
Put that all together and 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 Industries. Like most endeavors, hunting for small caps is best done in groups. I can thank the Hidden Gems community at The Motley Fool for being a great place to share my ideas and get my fill of diligent fundamental analysis and lively conversation. If you'd like to take a look, you can take a 30-day free trial with no obligation to subscribe.
This article originally ran on Dec. 4, 2003. It has been updated.
Fool contributor Thomas Engle, TMF 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.
