Merit Medical: No Change To Hold Thesis, ROIC Still One To Watch (NASDAQ:MMSI)

Investment Summary

Following its latest set of numbers, the hold thesis on Merit Medical Systems, Inc (NASDAQ:MMSI) remains intact with little change to the valuation or investment case. I’ve previously covered MMSI extensively here and here and noted several points key to the investment debate:

1. Initially, that valuation and performance are heavily tied to return on invested capital and therefore, capital allocation.
2. Normalized margins are trending below peers, a key risk in the macroeconomic climate.
3. MMSI has strengths in free cash flow conversion and demonstrates a high return on investment.
4. MMSI warrants a hold recommendation.

With these points in mind, I’ve revisited the name and reiterated the hold thesis for MMSI on a $57 price target.

Catalysts to move the needle:

1. Clinical trial momentum.

Management noted progress in the company’s WRAPSODY endovascular stent graft [WRAPSODY AV Access Efficacy Study – “WAVE”] study. The device is being trialed for the treatment of arterial stenosis of occlusion along with dialysis outflow circuits. The study is made of three cohorts, 244 AVF peripheral subjects, 113 Anastomosis patients and ~120 central subjects. It is estimated for completion in 2026 with the primary completion date set for June FY24. Updates around this are central to the company’s outlook looking ahead.

MMSI also announced first enrollments in two additional studies. First is the “WRAP” study, commenced in June, set to evaluate clinical benefits with using WRAPSODY cell-impermeable endoprosthesis in patients that are undergoing haemodialysis with stenosis or occlusion in vessels that are required for access during dialysis. The trial will enroll up to 500 patients whom present with this criteria across a number of jurisdictions – namely South Africa, Australia and New Zealand. The completion is set for February 2025.

Next is the STREAMLoc study that is aiming to illustrate the effectiveness of the company’s SCOUT system in improving efficiency in Canadian breast cancer centres. According to MMSI, SCOUNT is “a wireless, radar-guided localization system used to assist breast surgeons in identifying biopsied tumors for removal during breast-conserving surgery”. The study’s secondary objective will assess the utility of the system’s reflector insertion at the time of biopsy.

2. SCOUT Mini Reflector launch

The company also launched its new SCOUT segment, the SCOUT Mini Reflector. This is designed for use in breast and lymph tissue and has been re-engineered at a smaller size [33% smaller at 8mm in length, see Exhibit 1]. The main advantage is the smaller units utilization in ‘harder to reach’ areas versus the bulkier unit, but more importantly, more enhanced directionality for accuracy. It can also be placed pre or post operatively and in conjunction with chemotherapy as well. However, MMSI said it also can be placed in other soft tissue malignancies as well [outside of breast and lymph tissue] potentially widening up the addressable market in the wider SCOUT segment.

Exhibit 1. The SCOUNT mini reflector size changes for scale reference. All of the size change is in the reflector itself.

The Mini has potential for placement in additional malignancies outside of breast and lymph tissue.

Earnings and investment analysis

I continue to firmly believe that two of the best measures of corporate value are earnings and a company’s return on investment (“ROIC”), whereas the value of a financial asset is of course, the present value of its future cash flows. We measure the latter in shorthand using multiples.

MMSI came in with a robust set of Q2 FY22 numbers, with revenue up 520bps YoY to ~$295 million (“mm”). Growth was underscored by a 750bps gain in turnover from cardiovascular products, whereas endoscopy products also lifted ~440bps over the 12 months. Within the peripheral interventional business, angiography sales were up 18% and contributed the most upside to the segment.

Meanwhile, revenue from sales of SCOUT radar localization products clipped a 9% YoY gain that was backed from additional 15% growth in OEM product sales. Whilst turnover spiked YoY OPEX on this narrowed by 350bps YoY to $111.8mm. With the jump in revenue, it bought this down to GAAP net income of $15.29mm or $0.27 per share from $4.9mm and $0.09 respectively.

On the FCF front, MMSI remains strong. It has converted persistently high levels of free cash below the bottom line since FY20, demonstrating that operating income is backed by a high degree of real cash, as seen in Exhibit 2. Whilst FCF conversion has been strong [$31mm for Q2 FY22], yields on this haven’t been as rosy, narrowing into c.300bps in the last quarter. Management forecast $75mm in FY22 FCF and this implies a forward FCF yield of 2.2% on these projections.

Exhibit 2. MMSI’s earnings pile in its corporate value is mixed, with reasonable FCF conversion and steady FCF yields.

Despite this, there are still potential doubts on the predictability of the company’s future free cash flow’s on my estimation.

Despite the lumpiness in the sequence above – in particular, the narrowing FCF yields – I’ve noted strength in its ROIC. As seen in Exhibit 3, the company has grown its asset value substantially over the period of FY16 to date.

In addition to this, the company’s asset book on the balance sheet has shifted off intangible assets to see the equity split more evenly to tangible assets. On this, the company has also realized an uptick in TTM ROIC, now back at FY16-FY17 levels. This is still below the WACC hurdle of ~8%, however. So there’s contention on whether this ROIC number is sufficient longer-term.

Exhibit 3. Despite a tightening FCF yield and lumpy operating metrics, the company is still able to compound return on its investments.

Valuation and conclusion

Shares are trading at a lofty 60x P/E and 17.6x EV/EBITDA, both premium’s to the GICS health care median. MMSI is also priced at 3.2x book value, again a premium to peers. The market consensus has MMSI priced on a forward P/E of 24.7x, and applying to our FY22 EPS estimates of $2.31, sets a price target of $57, marginally higher than my previous valuation here.

Based on the culmination of these points, I recommend that MMSI is a hold at the current point in time, on a $57 valuation.