Mesa Labs: Investor Capitulation In This High Return On Tangible Capital Business Has Created A Buying Opportunity

“…a strategy of focusing primarily on quality control products, which are sold into niche markets that are driven by regulatory requirements. We prefer markets that have limited competition where we can establish a commanding presence and achieve high gross margins. We are organized into three divisions across seven physical locations. Our Instruments Division designs, manufactures and markets quality control instruments and disposable products utilized in connection with the healthcare, pharmaceutical, food and beverage, medical device, industrial hygiene and semiconductor industries. Our Biological Indicators Division manufactures and markets biological indicators and distributes chemical indicators used to assess the effectiveness of sterilization processes, including steam, gas, hydrogen peroxide and radiation, in the hospital, dental, medical device and pharmaceutical industries. Our Continuous Monitoring Division designs, develops and markets systems which are used to monitor various environmental parameters such as temperature, humidity and differential pressure to ensure that critical storage and processing conditions are maintained in hospitals, pharmaceutical and medical device manufacturers, blood banks, pharmacies and a number of other laboratory and industrial environments.”

-Mesa Labs 2014 Annual Report

Mesa Labs Has a terrific track record of creating wealth for shareholders.  Over the past 15 years, Mesa Labs 18% compound annual return has crushed the relevant market indexes.

The Strategy

Throughout Mesa Lab's history, it has sought out and acquired niche quality-control related businesses in markets that are driven by complex regulatory requirements. These businesses have on average had a very high return on tangible capital (ROTC), which suggests that they have strong, durable moats within their niche markets. The same can be said for Mesa Labs as a whole.

The “catch” is that businesses like Mesa Labs tend to look more expensive relative to “asset heavy” lower return on capital businesses. However, this is not really a catch, because these businesses are indeed worth more over time. I documented this in my first article about Mesa Labs, which can be found here.

The company has recently put its acquisition strategy into high gear. Over the past 12 month, the company has utilized debt financing to acquire 5 new businesses. Two of these acquisitions were particularly noteworthy, as they moved the company into a new niche market – continuous monitoring systems.

In the last annual report, the CEO describes the logic for entering this market as follows:

“Why continuous monitoring? A major trend in many industries, and even in the consumer world, is to provide more and more information that can be acted upon to improve efficiency, enhance safety and increase security. Sensor networks are cropping up everywhere, including manufacturing, healthcare, retail, the home and even your automobile. Mesa now provides sensor networks to critical monitoring applications in regulated industries, primarily in healthcare and pharmaceutical manufacturing. As institutions realize the advantages of an integrated sensor network, we should see steady growth from this product line for many years to come. Additionally, the nature of this market lends itself to an ever expanding base of repeat business. Since regulators require frequent re-calibration of the sensors installed in these networks, the initial sale of a system is only the beginning of a long-term relationship with the customer. Most customers require the vendor to provide annual calibration and service of the installed sensors, providing an annuity that should grow continually, as the installed base expands.”

In other words, It appears that the industry follows the famous Gillette “razor blade” model made famous by Warren Buffett. This occurs when the sale of one  product generates an additional, continuing revenue stream over time. I suspect that growth in this segment will fuel growth at Mesa Labs for years to come.

Recent results:

In the most recent quarter, sales were up 46% (year over year) and GAAP accounting earnings were up just one percent. The 46% sales growth was largely driven by the recent acquisitions. However, there was also solid organic growth in the pre-existing businesses, with revenue up 9% year-over-year in those segments.

The earnings picture is where things turn interesting from a value perspective. With sales up 46%, why were earnings only up 1%? Much of the reason has to do with the amortization of certain intangible assets related to the recent acquisitions. This is a standard issue faced by companies that frequently acquire other businesses. In fact, the “rolling off” of these non-economic expenses was a major part of my FTD Companies (FTD) investment hypothesis, which can be found here.

The company’s adjusted figure for net income (adding back in non-economic amortization) shows earnings up 17% year-over-year. Yet even here, earnings seem to be lagging the massive 46% sales growth. CEO John Sullivan had the following to say with regards to this issue in the press release for the quarterly report:

“While this level of profit growth was good, profits still were not at the desired level, compared to Mesa’s historical results. Unusual expenses and integration costs associated with the acquisitions of the two continuous monitoring businesses in fiscal year 2014 continued to negatively impact our profitability this quarter. Additionally, we acquired two new businesses during the first quarter of fiscal year 2015; the BGI business near Boston, Massachusetts and the Amilabo business near Lyon, France. Acquisition and integration costs of these two businesses also had a negative impact on profits for the quarter. Going forward, we expect to get these unusual costs behind us, resulting in improved performance for adjusted net income. Net income was also negatively impacted by these unusual expenses, in addition to increased non-cash expenses for amortization of intangibles acquired as part of the five recent acquisitions.”

My conclusion is that the temporary lag between sales growth and profit growth has added to the investment opportunity. Sullivan is clearly motivated to get profits back up to historical levels, as stated above. Given that the unusual acquisition expenses should be behind the company next year, I think we can expect profit growth to be much closer to sales growth, particularly after adding back in non-economic amortization expense.

Valuation:

Due to its strong track record and very high return on tangible capital (See here); Mesa Labs is not the type of company that typically trades at a low valuation relative to its assets or earnings. This the is the nature of asset-light businesses with strong economic moats. Yet precisely when the future looks very bright for the company (significant future sales and earnings growth on the horizon due to recent acquisitions, financed at an extraordinary low cost of capital) the market has been kind enough to offer entry into Mesa Labs stock at a reasonable price.

I estimate that over the next 12 months, Mesa Labs will generate around $70 million in annual sales. If the company is able to get adjusted net income back up to historical profitability levels (around 21% of sales) the company will earn around $15 million in economic profits. Putting a 20 multiple on this figure gives a market cap of $300 million, or about 50% above the current market cap. Let’s say the company is only able to move adjusted net income up to 18% of sales (relative to the last quarter’s historically sub-par 16% of sales). In this case, economic profit would be $12.6 million and the market cap would move to $252 million given our 20 multiple – still 26% above what is implied by the current market price.

Indeed, the recent selling (20% decline month-to-date) looks like capitulation – investors who bought in at higher prices are “throwing in the towel” and giving up. Such circumstances often make great buying opportunities on a short-term basis. Some readers know that I am a specialist in quantitative, price based trading strategies. One of the most persistent effects that I have ever found is that in common stocks, large dips are (on average) followed by above average short-to-intermediate term returns. The capitulation rebound effect is very real and is measurable. While this is not the basis for our investment case, it does provide an immediate catalyst beyond the fundamental growth and valuation story.

My current hypothesis is that over the short-term, Mesa Lab’s price will retrace the drop that occurred month-to-date and move back to a trading range north of $70 per share. My estimate of longer-term fair value is currently $80 per share.

In conclusion, Mesa Labs is a great business with a great track record – which until very recently was trading at a price that made a purchase non-ideal from a valuation perspective. Thanks to the mood swings of Mr. Market, we now have the opportunity to buy shares at a very fair price.

What I will be watching for going forward

• Focus on ROIC and growing economic income per share vs. gross margin and sales growth absent per-share metrics
• Keep a tight lid on general and administrative costs – It is too easy for overhead to absorb economic returns over time, particularly as a company grows larger through acquisitions
• Shareholders want to see recent sales growth move to the bottom-line at the company’s “historic” profitability level
• Once the recent acquisitions have been “digested”, consider Sierra Monitor SRMC as a potential acquisition target – With 58% gross margins and what appears to be the excess administrative costs (perhaps do to being a very small stand-alone public company), it might fit in well as part of the new continuous monitoring division.

Stay tuned: I intend to report back in 2015 to evaluate the company’s progress.

Disclosure:  I own shares of Mesa Labs.