In this cruddy market, investors understandably aren't giving any benefit of the doubt to companies whose growth stalls. Investors dump the stock, even if the slowdown is likely to be short term. But this can lead to a solid buying opportunity for long-term investors.
That scenario neatly sums up the situation for
, a leading vendor of arthroscopic surgery equipment. Prior to this year, the company had boosted sales at a 69% annual clip over the last five years.
But in the March 2002 quarter, sales grew just 11% and profits slumped as the company redirected its sales force and ramped up a new manufacturing facility. That has taken its stock from $33 last August to a recent price of $13. But by next year, the stars are aligned for ArthroCare to post strong growth, portending a rebound in the slumping shares.
ArthroCare has a strong patent-protected portfolio of intellectual property in an area know as "coblation." When a doctor needs to ablate, or remove some tissue from around a joint, he typically does so with a hot device. ArthroCare's gear uses electrodes that operate at lower temperatures, making for cool ablation, otherwise known as coblation. Coblation helps surgeons remove tissue without affecting surrounding healthy tissue that's often damaged by hotter devices.
The coblation gear has helped vault the company into the No. 1 spot for radio frequency (RF) electrosurgery. It's an admittedly small part of the larger arthroscopy market, but it is still growing.
Over the last few years, management has realized that the coblation technique has applications for other surgical areas such as the spine, and the ear, nose, and throat (ENT). So the company has developed a wide range of new products, which compelled management to wean sales away from an indirect sales channel and to a direct sales force. Trouble is, that sort of transition rarely goes smoothly. This is why sales growth has temporarily stalled.
Management believes the new sales force will start to get better traction later this year. The spine and ENT products are already seeing strong initial demand, and both have a potentially large market opportunity.
A New Plant
ArthroCare's stock also took a hit after management conceded that a shift in manufacturing in a new plant in Costa Rica has not gone smoothly. Instead of ramping up in early summer this year, late summer or early autumn is a more likely goal. As the new facility ramps up, management is keeping the U.S. plant running at full speed.
But running a pair of redundant manufacturing sites is obviously crimping margins. When the transition is finally complete, ArthroCare's margins should be higher than ever due to the low-cost nature of Costa Rican manufacturing.
ArthroCare's outlook should also brighten later this year due to competitive reasons. U.K.-based
Smith & Nephew
, which controls 22% of the RF arthroscopy market, vs. ArthroCare's 51% market share. Wall Street is looking for ArthroCare to take advantage of the temporary merger-related confusion, with First Albany's Bill Plovanic thinking ArthroCare can pick up 20% of Oratec's sales for the rest of the year.
Investors also have another reason to take notice: ArthroCare recently hired Fernando Sanchez as its new CFO. Mr. Sanchez brings a wealth of industry experience, including a long stint as a senior vice president at
. Also, he has a great deal of experience with the development of offshore manufacturing plants, which should help to untangle the Costa Rican plant's operational problems.
Those problems caused management to bring down full-year guidance in late May. That took the stock down from $16 to below $10 before its recent rebound to $13.45. After the selloff, three execs -- new CFO Sanchez, CEO Michael Baker and Director Ann Campbell-White -- bought a total of 82,600 shares in the $11-$13 price range, for a total investment of just under $1 million. Although this was Sanchez' first position, both Baker and Campbell-White have bought and sold smartly in the past.
We do note that Director Hira Thapliyal sold earlier this year at prices below $14, but do not feel it negates the significance of the recent buying. For one, Thapliyal appears to be a chronic seller, which makes the trades seem more like background noise. More important, this director also sold in past years when insiders were purchasing. In those instances the purchases were definitely better indications of ArthroCare's next moves than Thapliyal's sales were.
Valuing ArthroCare is a challenge as 2002 earnings will likely be weak year-over-year. Going forward, the factors appear to be in place to boost sales at a 30% annual clip. Those factors include new products that target new markets and a more effective direct sales force. And when the manufacturing problems are resolved, expanding margins should help profits to rise at an even faster clip.
After the recent downdraft, shares sell for less than 20 times projected 2003 earnings -- a level that has induced the company's board to restart a share buyback program. We agree with that move, as the shares do look genuinely undervalued in relation to the long-term outlook.
Jonathan Moreland is director of research and publisher of the weekly publication InsiderInsights and founder of the Web site InsiderInsights.com. At the time of publication, Moreland had no position in any of the securities mentioned in this column, although holdings can change at any time. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. While he cannot provide investment advice or recommendations, Moreland invites you to send comments on his column to