Not Too Late to Follow Insiders at Isolyser

Investors are so skittish about this messy market we find ourselves in that they are not looking ahead at all before selling. Any blemish in quarterly numbers, either real or perceived, sends 'em running for the exits.

So shares of Isolyser sold off a good 20% in the two days after the company released earnings Feb. 20. The stock has strengthened again since hitting a low of $2.05 on Feb. 21, but only back to about where I recommended it to RealMoney subscribers on Dec. 31.

A consistent pattern of insider purchases throughout 2001 was what first brought Isolyser to my attention. Execs purchased 76,000 shares in total, averaging up as the stock started to reflect Isolyser's successful turnaround.

OREX was a good buy late last year, and it's still a good buy now. The stock remains a solid play that is likely to garner solid double-digit gains for investors over the next year.

Isolyser has at least a 60% market share in its core business of supplying protective drapes for medical equipment, and sells its 2,500-plus products through its own direct sales force, as well as through distributors such as Cardinal Health(CAH Quote) and Owens & Minor(OMI Quote).

Hospital equipment must be kept clean and sterile -- especially in operating rooms. This is much more difficult than sewing sheets of plastic together, and Isolyser's reputation for quality, dependability, and specialized films keeps repeat business coming. More important is the fact that noninvasive surgeries are growing at a healthy clip of 7% a year. The laparoscopy techniques now used require many more pieces of equipment in operating rooms, which means more for Isolyser to protect.

While the company's business is hardly going to generate a "wow" from your brother-in-law, its financial turnaround over the past year should. Revenue for 2001 increased 43.6% over 2000 results, margins improved all the way down the income statement, and Isolyser reported earnings of 11 cents a share instead of the 29-cent-a-share loss it had a year ago.

The perceived slight in Isolyser's fourth-quarter results was that, even though revenue was up 33.1% year over year, it was down slightly on a sequential basis. But this in no way marks the end of Isolyser's turnaround, as some investors obviously thought.

The fourth quarter is usually a tad slower because fewer people opt for elective surgeries before the holiday season. Also, Isolyser's previous two quarters had benefited from working off the backlog of orders that were inherited from its Deka acquisition in March 2001. Excluding Deka products, internal revenue growth in the fourth quarter was a solid 10% year over year.

After three quarters of increasing operating margins, the slight decline Isolyser posted in its fourth quarter seemed to spook investors. But a few hundred thousand in one-time expenses (and these really were one-time expenses) explains the decline and the subsequent slip in earnings per share from operations.

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The main story with Isolyser is cash flow. "Our EBITDA is now running at around $1 million per month," points out Dan Lee, Isolyser's president. This has allowed the company to pay off debt while still investing in the inventory necessary to meet growing demand. Even though the balance sheet for the fourth quarter shows long-term debt at $12.6 million, management says that figure is closer to $10 million today. By the end of the year, debt is expected to be only $3 million.

Adding to Isolyser's future cash flow is the fact that it will not be paying taxes for a good three years (the tax-loss carry-forwards it accumulated during its bad ol' unprofitable days resulted from the company's past focus on its sexy, but ultimately not-well-received OREX product line for the health care industry).

Sure, the EPS boost the company gets from its tax benefits is only the result of an accounting entry and should not be included when monitoring Isolyser's EPS growth. But the tax savings are a very real cash benefit. That cash can be used to invest in the business, pay off debt or for prospective acquisitions.

But even backing out tax benefits, Isolyser's bottom line is set for decent growth this year. Management is on record as expecting 10% top line growth in 2002 to result in operating earnings of between 11 cents and 13 cents a share. Not a bad increase from the apples to apples comparison of 8.7 cents.

(The actual guidance management gave was for earnings of 13 cents to 15 cents a share, but that includes a 2-cent benefit from adopting Statement of Financial Accounting Standards (SFAS) 142 this year. This accounting change, which all companies must adopt, makes companies write off intangibles that are deemed to be impaired. Isolyser's stated bottom line will benefit from the change, while no harmful write-off is expected).

In any case, management's bottom-line guidance is obviously conservative if its top-line prediction is met. In that case, my calculations bring EPS without tax or SFAS 142 benefits up to 15 cents a share. That would be apples to apples growth of 72%.

While there is little chance of Isolyser's boring business generating a forward price-to-earnings ratio for its stock close to its growth rate, I expect OREX to trade for at least 25 times my 15-cent operating EPS estimate at some point this year. That would price the stock at $3.75 -- solid double-digit appreciation from present levels. Given the company's healthy balance sheet and cash flow, plus the possibility for international sales, and the risk associated with OREX's potential gain, this stock is still a solid buy.