Last week I said I would do some more digging on the companies that presented at the Brean Murray Carret Small Cap conference. Upon further review, at least one, Encore Medical Corp.( ENMC), warrants your attention.
Encore is an orthopedics and medical device manufacturer. Its bread-and-butter used to be artificial knees, shoulders and hips. Through prudent acquisitions, the company has diversified its product offerings to include electrotherapy and noninvasive rehabilitation devices. Encore has terrific growth prospects and is trading at a bargain valuation. The company serves a demographic that is the envy of almost any marketer -- active yet aging baby boomers. At the conference last week, Encore CEO Kenneth Davidson quipped that when boomers take care of their hearts, they hurt their joints, and that's good for Encore.
The company is growing, not only through acquisitions but also internally. Encore's orthopedic implant business should grow 19% in 2006 vs. low teens for the overall orthopedic market, according to Bank of America analyst Steven Lichtman.
The company has a few unique products including the "Reverse Shoulder," a prosthesis that works for people with a particular type of rotator cuff injury. Until the introduction of the product, certain patients were not able to use a prosthetic shoulder. Additionally, acquisitions broaden its product portfolio, give Encore a wider distribution network and will likely help to de-lever the balance sheet, one area where Encore need not take a bow.
The company has a lot of long-term debt -- $309 million worth vs. $164 million in stockholder equity and $554 million in assets. Bank of America's Lichtman points out that Encore only has approximately $10 million in debt coming due in 2006 and $9 million next year. He expects the company to generate $17 million in free cash flow in 2005 (Encore reports fourth-quarter and full-year results Feb. 27). The company's cash position will be enough to fund operations and pay down debt, according to the analyst. Bank of America has an investment banking relationship with Encore.
Sean McLeod, portfolio manager of
First American Small Cap Growth Opportunities fund, said companies with a lot of debt "tend not to get an overly great multiple." So why does his fund own about 1.5 million shares of Encore as of Dec. 31? "We like the valuation and the recent acquisitions," he said. "On a forward PE basis it's cheap."
The stock trades at a price-to-earnings multiple of 18, based on the consensus 2006 EPS estimate of 32 cents. That's a 25% discount to its peers, including
. According to Thomson Financial, Encore's five-year growth rate is 22.5%, giving the stock a forward PE-to-growth ratio of just 0.8, more than a 35% discount to its peer group.
Successful integration of acquired companies may help light a fire under the stock. Encore has been buying higher margin businesses, such as the soon-to-be-completed purchase of
, an electrotherapy device maker, which just reported a 17% jump in revenue and earnings of 10 cents per share in the quarter ended Dec. 31. Electrotherapy is the stimulation of muscles to alleviate pain. Electrotherapy equipment manufacturers should benefit as physicians switch to alternative therapies from Cox-2 inhibitors such as Vioxx and Celebrex, which have been linked to heart disease.
The acquisition of Compex should significantly expand Encore's sales force. While Encore won't discuss specific territories, some analysts and fund managers are especially interested by the potential for filling in some holes (including Chicago) in Encore's distribution network.
Dr. Daniel Chai, portfolio manager with Merlin BioMed Group, a hedge fund with roughly $500 million in assets, believes there will soon be consolidation in the orthopedic space. He said other orthopedic players trade at much higher multiples, especially on a price-to-sales basis. Chai is confident that in a takeover, Encore could sell for two to three times sales vs. the current multiple of just under one, implying a price of over $10.
The $10 target makes sense to me too. Despite having the second-highest growth rate in the group, I assigned the stock a 25% discount to its peers (across a variety of valuation metrics) for having such a highly-levered balance sheet. I arrived at a price target of $10.30.
The Technicals Agree
wrote last month, I love finding a chart that is aligned with my take on the fundamentals. This is the case with Encore.
Standing Up to Cheer
After more than quadrupling in 2003, Encore went on a well-needed break. The stock now appears to be emerging from a symmetrical triangle. Confirming the break is the spike in volume. The height of the pattern suggests a price target a little north of $10.
There is some noteworthy resistance at around $7. Interestingly, First American's McLeod said that $7 is the price at which he would sell at least half (if not all) of his 1.5 million share stash. "Unless the fundamentals change, we are very disciplined about our price targets," he told me. McLeod's fund owns over 4% of the float, so if he does sell at $7, that level could once again prove to be tough resistance. Of course, there is no guarantee that he will sell at that or any other price.
Please do keep in mind, this isn't a stock for the faint of heart. It can be volatile and a stumble in earnings and/or cash flow could make the debt situation more serious. That being said, I believe Encore is a solid small-cap value play that has potential to nearly double. While I tend to shy away from companies with heavy debt burdens, management appears to be making the right decisions to grow the business and be able to pay down the debt. And it's that debt load that created the opportunity to get in at a low valuation -- a valuation I don't believe will last too much longer.
Please note that due to factors including low market capitalization and/or insufficient public float, we consider Encore Medical Corp. to be a small-cap stock. You should be aware that such stocks are subject to more risk than stocks of larger companies, including greater volatility, lower liquidity and less publicly available information, and that postings such as this one can have an effect on their stock prices.
In keeping with TSC's editorial policy, Lichtenfeld doesn't own or short individual stocks. He also doesn't invest in hedge funds or other private investment partnerships.
Marc Lichtenfeld was previously an analyst at Avalon Research Group and The Weiss Group and a trader at Carlin Equities. He holds NASD 86,87, 7 and 63 licenses. His prior journalism experience includes being a reporter/anchor for On24 in San Francisco and a managing editor of InvestorsObserver, a personal finance Web site. He is a graduate of the State University of New York at Albany. He appreciates your feedback;
to send him an email.