An unusual earnings report that revealed its usually predictable and profitable Biological Indicators division had underperformed, resulted in Mesa Laboratories (MLAB) taking a big hit over a three-day period, dropping from $67.33 on August 6, 2013 to $58.79 on the close of trading on August 9, 2013.
As the anomaly was understood by investors, the share price started to rebound, already soaring almost 5% on Monday, August 12, 2013, to close at $61.63 per share. Having dropped just under 14%, there is still a lot of upside in the near term, and over the long term will continue on its upward run.
With the incident leading to the miss in the latest quarter having already been taken care of, that combined with the expectations that growth will continue on, could provide a psychological slingshot effect, pushing the share price up even higher. In other words, the fact the company quickly and effectively dealt with the challenge may provide added confidence that it can deal with other challenges equally as successfully.
The acquisition of SureTorque line from ST Acquisitions is the second short-term catalyst I'm looking at, which will add cash flow immediately to the company, and reinforce the expertise of Mesa Laboratories in acquiring and assimilating companies it buys.
Over the long term the catalysts will continue to be the business model of the company and its expertise in acquiring companies and successfully integrating them into the firm.
(click to enlarge) source: StockCharts.com
(click to enlarge) source: Yahoo
Latest Earnings Report
Revenue for the first quarter ended June 30, 2013, increased from $10,559,000 for the same quarter in 2012, to $11,218,000 in the first fiscal quarter 2013, a gain of 6%.
Net income in the first quarter dropped from $2,099,000 or $0.59 per diluted share of common stock in the first quarter of 2012 to $1,860,000 or $0.52 per diluted share of common stock year-over-year, a drop of 11 percent.
Of primary importance in the earnings report is the anomaly in the Biological Indicators ("BI") Division mentioned earlier, which pushed down revenue and margin in the quarter. Sales fell 5% while gross margin as a percentage of revenue dropped from 57% in the same period last year, to 53% in the first fiscal quarter of 2013.
Here's how John J. Sullivan, President and Chief Executive Officer, described the results:
"The declines were due to an initiative to replace three batches of non-conforming product that had been shipped to customers in previous months. The product in question had longer than expected incubation times, which is used to determine a positive or negative BI test result. We chose to dedicate a significant portion of our production capacity to replacement product rather than new orders, which lowered revenues for the quarter and increased our cost of goods sold."
Sullivan went on to say that very little business, if any, will be lost throughout the process. The shipments that were delayed are expected to be recovered in the second quarter. Gross margin will go back to regular levels in the second or third quarters. I see no reason to doubt this will be the case, as the company has put in place "new spore crop screening procedures to now identify such issues prior to manufacture or shipment." For that reason I consider this a catalyst, and not just an unusual challenge that was remedied.
What I mean by that, as mentioned earlier, is it shows the company quickly responding and plugging a weakness in the division, which normally performs extremely well and predictably. Even more important though is the fact the company, from at least 1996, has never had a plunge in share price like this over a three-day period. There have been a couple of times over several months where it dropped severely, but never in such short of a period of time.
On the psychological side it points towards the company quickly being ready to resume its upward trajectory. I think the quick drop in price and rebound could give it momentum in the near term it may not have otherwise had, as it gets a big bounce from the drop in share price, with shareholders and investors breathing a sigh of relief and getting back in the company.
The net income is going to rebound nicely in the next quarter, with the product replacement initiative accounting for the drop in net income for the first quarter.
Income Statement
(click to enlarge) source: Ycharts
Cash Flow Statement
(click to enlarge) source: Ycharts
Performances of Biological Indicators and Instrument Segments
Mesa Laboratories operates in two segments: the Instrument Division and a Biological Indicator Division. What it does is provide quality control products in the medical device, healthcare, pharmaceutical, food and beverage, petrochemical, industrial hygiene and semiconductor industries.
Its Biological Indicator segment is the horse of the company, as it provides steady and predictable earnings year after year, which allows it to make the acquisitions and be able to fund R&D and other projects, which make it an industry leader in the markets it serves.
The reason this segment is so steady is it offers products to companies that serve in highly regulated markets, so they must be sure quality meets legal requirements by validation processes. Mesa provides that ability to validate products, and so even at times the economy may be down, this segment continues to generate significant cash flow. This is why the underperformance in the quarter was so unusual, and I consider it a short-term catalyst to rebound nicely from its current price.
This division sells Chemical Indicators to measure how effective various sterilization processes used in the overall health, pharmaceutical and dental industries are.
In the Instrument segment it offers products, which aren't regulated as tightly as the sterilization market is, so can be prone to the usual market forces, which makes it less predictable as to outcomes than the Biological Indicator segment is.
Until 2012 the company had been struggling with organic growth in this segment, but it boosted its number of distributors and successfully integrated the Torqo product line it acquired in 2009 into its manufacturing facilities in Lakewood, Colorado, which reduced costs and increased gross margin.
Consequently, this segment is growing, and one of the reasons, when coupled with the Biological Indicator segment, Mesa Laboratories is transforming into such a compelling growth story.
Company Strategy
The strategy of Mesa Laboratories in the markets it serves is a simple but extremely effective one. What it does is stay away from the general, highly competitive products, and targets niche areas with very few competitors. Its much larger competitors rarely enter these markets, so Mesa is becoming the top dog in these narrow niches.
This in itself is a strong catalyst and a moat. While it's possible larger competitors could enter into these markets, it's highly unlikely because even if they were to come in and dominate them, it would do very little to boost the bottom line of companies, and wouldn't make sense.
While this strategy isn't anything new, Mesa has successfully implemented it, which is different than attempting it. It appears Mesa has the goal of being the king of these quality control niches, and these growing markets will continue to make it a significant growth company for many years into the future.
Many investors know this, so it becomes a question of how much of that future has already been baked into the share price, and how much further it can run in the near term. In other words, where is a good entry point? The recent correction from the surprising weak quarter makes it a good time to get in.
SureTorque Acquisition
Mesa Labs announced in July 2013, it had acquired SureTorque from ST Acquisitions. SureTorque has a product line of bottle cap testing instruments. The line will add to the cash flow of the company and be "mildly accretive to earnings per share for the current year, ending March 31, 2014."
As it has some prior acquisitions, it is moving production of SureTorque products to its Lakewood, Colorado facility.
This adds to its bottle cap torque testing market, which it entered in 2009 with the acquisition of the Torqo product line. That expanded nicely in the beverage industry, but wasn't as accepted in the pharmaceutical industry.
What the SureTorque acquisition does is provide a significant and immediate entry into the pharmaceutical and biotechnology industries, expanding the range of products and potential customers it serves.
This is a great example of how the company successfully adds value through acquisitions, while improving on the cost structure of the companies it buys. That will not only generate revenue, but increase margin by cutting costs.
Added to the other growth sectors in the company, SureTorque will be a catalyst in the short- and long-term performance of the firm.
Acquisition Strategy
This leads me to the overall acquisition strategy of Mesa Laboratories, which has also become a moat for it.
Companies I follow that have an effective acquisition strategy, successfully incorporate several elements to create a moat that is usually undervalued by investors. They include the disciplined acquisition of companies that will have immediate synergies with the existing product lines; the ability to cut costs and boost margin; and the potential to increase the customer base beyond that inherent in the company acquired.
That allows Mesa to expand the acquisition beyond its current performance level and grow it out organically. So when the existing revenue and earnings is improved by cutting costs and increasing margin, while expanding its customer base to boost revenue, you can see why a company with this talent can outperform its peers on a consistent basis to become a market leader.
It's a major reason why I see Mesa continuing to be a growth company for many years, and why the share price will continue to rise. The additional cash flow won't hurt either.
To give an example of how this drives the performance of the company, in 2012 Mesa acquired the Bios flow calibrator business. That helped the Instruments segment of the company increase revenues by 17%. It also raised gross margin as a percentage of revenues from 65% to 67% from the same quarter in 2012. Virtually all of that came from the acquisition, confirming the strength in identifying quality companies, which drive the bottom line of Mesa.
Conclusion
Mesa Laboratories is primed for short term and long-term growth. It is quickly gaining back what it lost after the latest earnings report, capturing over half of the approximate 14% it lost. It's going to gain much if not all of that back, and has the possibility of pushing above that on momentum.
In the long term the company has taken steps in its Instruments segment by increasing the number of distributors, which has had an immediate and positive effect on the company. That will continue on into the future.
The Biological Indicators will remain the core of the company, as it'll generate revenue and earnings year after year on a very predictable basis, giving the company flexibility to make deals and generate cash for its R&D department, among other uses. That means it'll continue to make solid acquisitions, add to its existing product line, and grow organically.
My only concern at this time is whether or not the company may be overvalued, as it has grown from $4.00 per share in October 1999, to over $60.00 per share today. Since May 2009, when it stood at $20.00 per share, it has over tripled in share price.
Since I consider this a growth story, I have no problems with the entry point, although obviously the lower it is the more profitable for investors. But its organic growth prospects, acquisition expertise, addition of distributors, lower costs, rising margin, and business model of competing in niche markets below the radar of larger potential competitors, make this a company that should provide good returns for many years into the future.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article. (More...)
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