MERIT MEDICAL SYSTEMS INC quarterly report, Q2 FY2017

Business context and reporting period

Merit Medical Systems, Inc. designs, manufactures and markets single-use medical products for interventional and diagnostic procedures. This unaudited Form 10-Q covers the quarter and six months ended June 30, 2017; comparisons are with the corresponding 2016 periods. Merit reports cardiovascular and endoscopy segments.

Financial performance and position

Q2 operating margin was 7.2%, versus 7.7% a year earlier; first-half operating margin was 5.3%, versus 6.7%. Management attributed improved gross margin to product mix and operational efficiencies. SG&A rose 31.5% in Q2 and 34.9% in the first half, driven by acquisition/integration costs, DOJ-subpoena response expenses, added personnel, amortization and international expansion. R&D increased 16.5% in Q2 and 17.4% in the first half.

First-half sales growth was 23.7%; cardiovascular sales increased 23.9% and endoscopy sales 18.2%. Stand-alone devices were a major growth contributor, including acquired product lines. Argon products generated about $11.7m of Q2 sales and $19.0m in the first half; Catheter Connections products generated about $2.5m and $4.3m, respectively.

For the six months, operating cash flow was $34.6m, compared with $25.4m in 2016. Investing cash outflow was $73.7m, including $54.8m net cash paid for acquisitions and $17.8m of property and equipment spending. Financing cash inflow was $57.6m, including public-offering proceeds; debt payments were $179.4m and new debt proceeds were $96.9m. Cash rose to $37.7m from $19.2m at year-end.

At June 30, total debt was $241.9m, down from $324.4m at December 31, 2016; long-term debt was $224.9m. The company reported $129.5m of available borrowing capacity under its main credit agreement, based on the applicable leverage ratio, and said it was in covenant compliance. Working capital was $180.6m and the current ratio was 2.57, compared with 2.76 at year-end. About $36.7m of cash was held by foreign subsidiaries, including $12.7m in China subject to restrictions on transfers abroad.

Material changes, outlook and risks

• First-half net income benefited materially from an $11.6m non-taxable bargain-purchase gain on Argon’s critical care division. The gain explains much of the increase in first-half net income despite slightly lower operating income. The gain remained provisional and subject to purchase-price-allocation adjustments.
• The company completed or announced several transactions, including acquisitions of Argon’s critical care division and Catheter Connections, and purchases of technology/customer-list assets and a minority interest in Fusion Medical. Integration and realization of acquired-product growth are important execution considerations.
• The DOJ is investigating certain marketing and promotional practices following an October 2016 subpoena. Merit incurred $8.5m of response expenses in the first half and expected expenses in a similar range, potentially higher, in subsequent periods. The investigation’s scope, duration and outcome were not predictable; adverse outcomes could include significant damages, injunctions, fines or civil or criminal claims.
• Management said existing cash, operating cash flows, equipment financing and credit-facility borrowings should fund current and planned operations for the next 12 months and foreseeable future; significant future acquisitions could require additional debt or equity funding. No specific revenue or earnings guidance was provided in the filing text.
• Key risks include debt and tightening leverage covenants, acquisition integration and provisional purchase accounting, product liability/recalls, regulatory and healthcare-reimbursement changes, currency and interest-rate movements, supplier and inventory risks, competition, and dependence on certain products and procedures. A 10% U.S. dollar strengthening against the euro was estimated to increase annual net income by about $2.6m, while a 10% strengthening against the Chinese yuan was estimated to reduce it by about $5.3m, before hedging effects.

Important facts for investors to verify

1. How much of sales growth is organic versus attributable to acquired products, and whether acquired businesses meet integration and growth expectations.
2. The final Argon purchase-price allocation and whether the provisional bargain-purchase gain changes.
3. The trajectory of SG&A, particularly DOJ investigation costs, acquisition integration costs and amortization, and any further effect on operating margins.
4. The status, duration, costs and potential consequences of the DOJ investigation; the filing says the outcome cannot yet be predicted.
5. Debt repayment, borrowing availability and compliance with progressively tighter leverage covenants, alongside cash availability given foreign cash and China transfer restrictions.
6. Working-capital and inventory trends, including the rise in receivables and inventory and the reported decline in trailing-twelve-month inventory turns to 3.04 from 3.09.