Value Play: Utah Medical Products (Nasdaq: UTMD)

The Roadrunner Value Portfolio has been underweight healthcare for a few months now, and I actually wanted to add a healthcare stock to the portfolio last month, but my preliminary selection – HealthNet (HNT) – received a takeover bid before I could publish the Roadrunner issue. So I’ve limited my search this month to the healthcare sector and believe that I have found a great idea – a company that truly represents a Roadrunner Stock.

On June 25th, the U.S Supreme Court ruled in favor of Obamacare for the second time in three years, with Chief Justice Roberts writing the opinions in both 2015 and 2012. Healthcare was the only industry sector in the S&P 500 to post gains on the day. In an article I wrote three years ago after the first Supreme Court save of Obamacare called Medicaid Nation, I argued that many healthcare stocks would perform well under Obamacare because of the huge increase in federal healthcare spending and the 32 million additional people insured (half Medicaid expansion and half individual private insurance). My prediction proved accurate, as the healthcare sector has outperformed all other industry sectors over the past five, three, and one-year periods.

The tailwind for healthcare stocks provided by bullet-proof Obamacare spending and the aging of America is so strong that there is no reason to believe this past outperformance cannot continue for the foreseeable future. As one article explains:

Slowly but surely, though, it became clear that the Affordable Care Act was going to boost company bottom lines, not hurt them. About 17 million have signed up for healthcare insurance since the exchanges opened in October 2013, and that’s resulted in billions of more dollars for hospitals, pharmaceutical companies, medical device operations and more.

According to Jeff Loo, a health-care analyst with S&P Capital IQ, valuations for the high-growth healthcare sector remain reasonable:

While the sector has certainty rebounded since 2010, valuations aren’t unreasonable for what’s considered a more growth-oriented sector, in Loo’s analysis. He pointed out that health-care stocks on the S&P 500 are trading at 18.5 times earnings, compared to 17.9 times for the overall index. “That’s a small premium,” Loo said.

The one healthcare subsector that has slightly lagged is the medical device area because of the 2.3% excise tax Obamacare levies on the manufacturers and importers of medical devices, but ironically this underperformance makes the medical-device subsector one of the most attractive today because of the potential for repeal of the tax. Both Democrats and Republicans in Congress hate the tax and, even though President Obama has threatened to veto legislation repealing the tax, there may be sufficient votes in Congress to override a presidential veto.

Feminine Health Care, Buffett Style

Utah Medical Products (UTMD) produces medical devices for women and their babies that are predominantly proprietary, disposable and for hospital use. UTMD has four business segments:  

Source: Company 10-K Filing

Women’s healthcare is an especially lucrative segment because women undergo more medical procedures than men do, most obviously because they are the ones who get pregnant and they live longer.

U.S. sales comprise slightly less than half of total revenues (47%), so UTMD is vulnerable to the negative effects of a strong U.S. dollar, but only two-thirds of international sales (35% of the 53%) are invoiced in foreign currencies (primarily British pounds, Euros, and Australian dollars), so 65% of total sales are U.S.-dollar denominated. Despite the negative foreign exchange impact, UTMD was able to achieve higher earnings per share (EPS) for both 2Q 2015 and 1H 2015 compared to the same periods in 2014.

CEO Kevin Cornwell has been at the helm of UTMD for 23 years and I really like him because he is an honest straight shooter, similar to John Greisch of Hill-Rom. As I wrote in What is a Roadrunner Stock? Part 2: Honest and Competent Management, the integrity of a corporate leader is one of the most important attributes of a successful business:

How important is honest management? In a 2009 meeting with business-school students, Buffett was asked what he considered the three most important attributes of corporate managers. Interestingly, Buffett put integrity at the top of the list — ahead of intelligence or energy:

“Passion is the number one thing that I look for in a manager. IQ is not really that important. They need to be able to work well with others and the ability to get people to do what you want them to do. I’d say intelligence, energy, integrity. If you don’t have the last one, the first two will kill you. All you have is a crook who works hard and finds lots of clever ways to make all your money theirs. If a person doesn’t have integrity, you want them dumb and lazy.”

An important part of integrity is respect for the average shareholder, both in terms of maximizing shareholder value, returning cash to shareholders, and communication clearly and often with shareholders. CEO Cornwell does well on these shareholder-friendly metrics. Just look at the investor home page on the UTMD website, where it clearly states that the mission of the company is to increase value:

UTMD is dedicated to a sustained substantial increase in shareholder value by focusing financially on earnings per share growth and a high return on shareholder equity; and by focusing functionally on developing, manufacturing and marketing specialty medical devices that provide a real improvement in quality, safety and overall cost of care.

As I discussed in my May recommendation of MSC Industrial Direct, to have a competitive advantage, a company must have a management team with the right focus. According to Michael Raynor, director at Deloitte Consulting and coauthor of The Three Rules: How Exceptional Companies Think, the managers of companies consistently delivering above-average returns on capital focus on three things:

1. Better before cheaper
   
   
2. Revenue growth before cost cutting
   
   
3. There are no other rules

Simply put, Cornwell gets it. He is a three-time graduate (bachelors, masters, MBA) of prestigious Stanford University (my father’s alma mater) so you know he is smart. Financial performance has been stellar before and during his tenure as CEO, which began in 1992 — UTMD’s annual return on equity (ROE) has averaged an astoundingly-high 29% in the 28 years since the company turned profitable in 1986, only four years after it went public in 1982. Even over the more recent past, UTMD has exhibited tremendously consistent profitability:

Utah Medical Products Exhibits Consistent Profitability

The dip in cash balance during 2011 was caused by the acquisition of England-based Femcare Holdings Ltd., which cost $41 million. Since then, the cash balance has steadily increased thanks to the company’s positive annual cash flow. At the time of the acquisition, CEO Cornwell described why the deal made sense:

This is the kind of acquisition that makes sense for UTMD: a stable, profitable business with well-accepted products, in a specialized market niche with some growth potential, with proven management resources and where distribution to customers can be leveraged. If we can effectively integrate the two businesses, the result should be immediately accretive to UTMD’s earnings per share performance looking forward.

I just like the way this Cornwell guy thinks! He didn’t dilute existing shareholders by issuing stock, but utilized existing cash and low-cost debt. As he explained earlier this year in the company’s annual report for 2014:

In February 2015, UTMD retired the remaining principal balances of its debt incurred to help finance the $41 million acquisition of Femcare in 2011. Four years after the acquisition, UTMD is debt free with about the same cash balances as it had immediately prior to the acquisition. I would like to take this opportunity to thank JPMorgan Chase for its confidence in UTMD management, allowing the Company to acquire Femcare without diluting shareholders. With the renewed strength of its balance sheet, management was vigilant for additional acquisition opportunities in 2014.

While the opportunities were available, and one was nearly concluded which met UTMD’s investment criteria but for which the owners decided not to sell at the last moment, the valuations and market risk in general were not conducive to achieving UTMD’s targeted investment returns for its shareholders. As concluding another accretive acquisition that fits within UTMD’s focus is a key to UTMD’s continued growth in shareholder value, I am actually looking forward to a stock market correction in 2015 and a continued challenging medical device industry environment, including burdensome regulatory requirements, that encourage people to sell their businesses.

Cornwell is thinking like a value investor, which shareholders should like, and he sounds a lot like Warren Buffett, who has said similar things about his investment in IBM, hoping the stock price declines in the short term so that the company can buy back stock at a bargain. Not only did Cornwell not issue company stock to purchase Femcare, but more generally the company has never diluted existing shareholders by issuing company stock since the 1992 IPO. Not once. That’s impressive and exhibits a skepticism to share issuance similar to what Buffett argued in Berkshire Hathaway’s 1982 letter to shareholders.

Cornwell also sounds like Buffett in terms of his recognition of the small-investor advantage (including small company advantage) in generating high investment returns:

A benefit of UTMD’s small size is that even a small acquisition can move the Company’s performance needle significantly on the margin. Because the effort required of senior management in completing and integrating an acquisition is not particularly proportionate to its size, larger companies do not have the same level of interest at the smaller end of the scale, which allows UTMD a competitive advantage.

On November 4, 2014, UTMD increased its quarterly dividend for the 11^th consecutive year. Cornwell notes in UTMD’s most recent annual report that the best way to increase the company’s profitability is through an earnings-accretive acquisition, but only if the purchase price is a bargain and until such time, share repurchases and dividend increases are the next best thing. Very shareholder friendly!

One reason Cornwell is so shareholder friendly is that he is a significant shareholder himself in the company. As of the end of last year, Cornwell owned a 6.9% ownership stake and insiders in total owned 9.7% of the company (page 4). It’s always reassuring to have the financial interests of management aligned with the average shareholder.

From a valuation perspective, UTMD is quite inexpensive with my favorite metric of enterprise value-to-EBITDA at only nine times. Anything under 10 is considered cheap. One reason that the company is so cheap given its high profitability is that it is not covered by Wall Street and is, in my opinion, an undiscovered gem. As one fellow investor described the UTMD investment case last year:

Utah Medical has grown through acquisitions as well as new products. The company has been well managed, with superior profitability (profit margins and return on investment) relative to its industry peers and to the overall stock market. It has generated more cash than is needed in its normal business operations, which allows for acquisitions of other products or entire companies. Its balance sheet is strong. Despite these attributes, the stock is almost completely overlooked by Wall Street—only one analyst follows the company. We like that, as it leaves room for a wider audience and potentially greater demand for the stock.

The company’s balance sheet is even stronger now than it was then. Debt is now zero. Nada. Zilch. All of the $26.9 million in debt incurred for the 2011 Femcare acquisition has now been paid back in full.

The only wrinkle in my investment thesis is the company’s lack of recent growth, which a few bargain acquisitions would easily fix. In the company’s early years (1987-1997), it had a lucrative partnership with Baxter International which enabled UTMD to access international markets through Baxter’s rolodex of blue-chip contacts. But the Baxter partnership ended in 1997 and small-cap UTMD has been on its own ever since. The company’s revenues dropped precipitously after the Baxter partnership ended, but in 2012 finally reached the same level of revenues it had enjoyed at the peak of its Baxter partnership in 1995. I think Baxter has matured sufficiently and developed enough international contacts to grow on its own through acquisitions, thank you very much. The 2011 Femcare acquisition with operations in England and Australia demonstrates UTMD’s ability to grow globally. It’s just a matter of time and the right price.

Utah Medical Products is a buy up to $62.50; I’m also adding the stock to my Value Portfolio.

Value Sell Alert

To make room for Utah Medical Products, Roadrunner is selling:

• Brocade Communications (BRCD)

This small-cap computer networking stock has been a big 80%-plus winner for the Roadrunner Value Portfolio, and the stock remains cheap based on several valuation metrics, but I’ve always been a little concerned that the cheap valuation is justified given the company is competing against much larger and better financed competitors like Cisco Systems and EMC. Now, with evidence that  enterprise storage demand is slowing down thanks to the explosion of public cloud storage systems offered by Amazon, Microsoft, and Google, I want to ring the cash register. Warnings from storage competitors like QLogic (QLGC) and Quantum (QTM) do not bode well for Brocade. There appears to be a buyers’ strike starting in mid-2015 as they wait for the industry to transition to the Gen 6 Fibre Channel standard of 32Gbps and 128 Gbps speeds in 2016. Both RBC Capital Markets and UBS recently downgraded Brocade to a sell rating based on these industry-wide concerns and we don’t need to go along for Brocade’s likely ride down.

Brocade Communications is being sold from the Value Portfolio.

Momentum Buy:

Ambarella (Nasdaq: AMBA)

Ambarella  is a leading developer of low-power, high-definition (HD) and Ultra HD video compression and image processing solutions. The company’s products are used in a variety of professional and consumer applications including security IP-cameras, sports cameras, wearable cameras, flying drone cameras and automotive video processing solutions. Ambarella compression chips are also used in broadcasting TV programs worldwide. The company provides the video chips for the digital cameras manufactured by GoPro, used by sports enthusiasts to take snowboarding, car-dashboard and other point-of-view videos. Drone camera manufacturer DTI is another customer of Ambarella. One risk factor is a negative investment opinion from short-seller research firm Citron, but Citron has been wrong in the past.

• Price gain between 12 months ago and two months ago = 266.68% (100th percentile)
• Price gain over the past two months = 9.63%
• Price gain over the past month = 11.16%
• Roadrunner Momentum Rating: 266.68 – (9.63) – (3*11.16) = 223.58

Ambarella is a buy up to $130; I’m also adding the stock to my Momentum Portfolio.

Momentum Sell Alert

To make room for the new momentum stock, Roadrunner will be selling the following price laggard: 

• NuStar GP Holdings (NSH)

Energy stocks have gotten crushed thanks to the Chinese slowdown, the Iran nuclear deal, and the strengthening U.S. dollar. Energy master limited partnerships (MLPs) like NSH have not b immune to the carnage.  I still like NSH as a long-term value play, partly because insiders continue to buy the stock like crazy, but price momentum is totally gone and the company’s second-quarter financial report missed analyst estimates, so there is no evidence of a near-term turnaround. The other sell candidate was EQT Midstream Partners (EQM), but it is performing slightly better than NSH so it hangs on by a fingernail for another month.

Let me stress that this sell call is based on momentum criteria only and that value investors may wish to hold on. Credit Suisse recently upgraded the entire MLP sector based on valuation and projects 40% total return potential.

NSH GP Holdings is being sold from the Momentum Portfolio.