MERIT MEDICAL SYSTEMS INC quarterly report, Q2 FY2019

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, 2019; comparisons are with the corresponding 2018 periods. Operations are reported in cardiovascular and endoscopy segments.

Financial performance and position

Metric	Q2 2019	Q2 2018	Six months 2019	Six months 2018
Net sales	$255.5m	$224.8m	$493.9m	$427.8m
Gross profit	$112.0m	$100.0m	$216.6m	$188.1m
Gross margin	43.8%	44.5%	43.9%	44.0%
Operating income	$12.2m	$15.1m	$21.7m	$23.9m
Net income	$6.9m	$10.9m	$13.1m	$16.2m
Diluted EPS	$0.12	$0.21	$0.23	$0.31

For the six months, operating cash flow was $35.7m versus $35.0m a year earlier. Investing used $74.8m, including $36.0m of property and equipment expenditures and $37.3m net cash paid for acquisitions. Financing provided $7.8m. Cash declined $32.2m to $35.2m.

At June 30, cash was $35.2m and current assets were $426.9m against current liabilities of $176.6m; working capital was $250.4m and the current ratio was 2.42. Total debt principal was approximately $400.5m, with $38.7m of additional borrowing capacity under the then-existing facility. Operating lease liabilities totaled $83.0m following adoption of lease accounting.

Material changes versus prior comparable periods

• Sales rose 13.7% in Q2 and 15.4% for the first half. Cardiovascular sales increased 14.0% and 15.7%, respectively; endoscopy sales increased 5.3% and 7.3%.
• Growth included acquired product revenue: Q2 sales included $11.2m from Cianna Medical; first-half sales included $24.1m from Cianna. First-half sales also included $23.4m from BD products and $3.2m from Vascular Insights products. The filing does not provide a comparable organic-growth rate.
• Despite higher sales, operating income and net income declined. Q2 operating margin was 4.8%, compared with 6.7%; first-half operating margin was 4.4%, compared with 5.6%. Management cited acquisition-related amortization, higher contingent consideration expense, lower gross margins, higher SG&A as a share of sales, and higher effective tax rates.
• Gross margin decreased, primarily from higher amortization associated with acquisitions. SG&A rose 15.7% in Q2 and 18.1% for the first half, primarily due to increased headcount and acquisition-related amortization. R&D increased 6.6% and 9.2%, respectively, reflecting added development personnel.
• First-half effective tax rate increased to 17.6% from 9.6%; Q2 rate was 23.8% versus 5.4%. Management attributed the increases mainly to a smaller discrete share-based payment tax benefit and a discrete expense related to the Cianna contingent liability valuation.

Outlook, commentary, risks and unusual items

• No numerical revenue or earnings guidance is provided. Management said cash balances, expected operating cash flows and borrowings were expected to fund operations and currently planned needs for the next 12 months and foreseeable future; significant future acquisitions could require additional financing.
• Management cited a new group purchasing organization agreement and other opportunities as potential sales drivers, while noting that much of the expected legacy fluid-management sales carry lower margins. It also reported 10% Q2 growth in embolic products and identified potential opportunity from competitor divestiture, EmboCube and recently FDA-cleared Torpedo products.
• The BD product manufacturing transition to Merit’s Tijuana facility was reported on schedule for completion by year-end 2019. Brightwater Medical was acquired in June for $35m plus working-capital adjustment, with potential earn-outs of up to $15m. Merit also agreed in August to acquire a UK sclerotherapy-products business for approximately £11.2m.
• On July 31, 2019, Merit replaced its credit agreement with a facility providing a $150m term loan and up to $600m revolving commitments, with maturity in 2024. The filing later describes potential borrowings under the amended agreement of up to $750m. The debt is secured by substantially all assets and subject to financial and other covenants.
• Contingent consideration liabilities were $93.2m at June 30, up from $82.2m at year-end; fair-value adjustments added $3.2m to first-half operating expense. These estimates rely on projected sales, milestone probabilities and discount rates and may change.
• The company recorded a $0.5m intangible-asset impairment in Q2 after discontinuing a product. A U.S. Department of Justice subpoena investigation concerning marketing and promotional practices remains ongoing; legal expense was $2.7m for the first half. Merit said it could not predict the investigation’s scope, duration or outcome, and noted possible significant penalties or other adverse outcomes.
• Other disclosed risks include acquisition integration, regulatory and product-liability exposure, foreign-exchange and interest-rate changes, debt covenants, and healthcare-market and reimbursement pressures. Management reported effective disclosure controls and no material change in internal control over financial reporting during the quarter.

Important facts for investors to verify

1. How much of reported sales growth reflects acquisitions versus underlying product and geographic growth, and whether acquired businesses are improving operating profitability.
2. Whether gross-margin pressure, acquisition amortization, SG&A growth and contingent-consideration revaluations persist or ease.
3. Cash conversion and funding needs: operating cash flow was below property-and-equipment spending in the first half, while cash fell and debt remained approximately $400.5m.
4. Terms, covenant headroom and actual borrowing availability under the July 2019 credit agreement, including the distinction between its $600m revolving commitment and the filing’s stated potential borrowing limit.
5. Developments and potential financial consequences of the DOJ investigation, acquisition earn-outs, and the newly announced Fibrovein transaction.