Mood change at Meldex

This article is for information and discussion purposes only and does not form a recommendation to invest or otherwise. The value of an investment may fall. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment adviser.

Last week, I noted how AIM-listed GCM Resources is pertinent to watch currently (Coal boom boosts GCM). Likewise, and another share I cited among Five special situations for 2008, is AIM-listed Meldex (MDX), the emerging pharmaceuticals and healthcare products group. I own a holding in this potential growth share due to its novel means of delivery for drugs and health supplements that address a variety of major public health issues: obesity, diabetes, anti-smoking, colds and flu, menopause, and much more. It is also a useful example of the risks with popular, speculative

shares, as mood swings accentuate the volatility.

In the New Year, Meldex shares stood at 60p then tested an 80p range after several potential bid approaches; but after five months there was no firm offer the board could recommend and the price has slumped to about 40p. It is not unusual, however, for speculative positions to take a while to unwind after bid talks peter out, and possibly traders have accentuated the fall. The price is now below the 48p level where Meldex's three main executive directors bought a total £121,500 worth of shares last September.

You can visit meldexinternational.com to learn more about its technologies and also the blog of its chief executive, to follow development issues. The 2007 annual report is downloadable from the investor area of the website and is a thorough exposition of the business, well worth digesting. In this piece I seek to clarify key issues for evaluating the shares.

The 2007 results showed revenue from existing operations up 83% to £17.4 million and on a 'pro forma' basis (that is to say, as if the contribution from acquisitions had been recognised from purchase date) of £37.6 million. With the shares in a low 40p range, the 'price/sales' (or market value to revenue) ratio is about 2.5 times, with Meldex capitalised near £90 million, however this could fall to 1.5 if management's 2008 projection is realistic. Take a look at the May 2008 Prelim Presentation. Page three shows management as confident enough to publish its target of making an adjusted operating profit of operating profit of £13 million on £60 million turnover this year. The prospect of, say £8 million to £10 million after-tax profit means a forward PE ratio possibly in single figures. If management can deliver reasonably in line with its forecast, then Meldex shares have scope to at least double - as the shares merit a growth rating; and if the track record continues well, then you can appreciate why the board recently rejected a takeover approach said to be in the region of 100p per share.

Cause for concern

The end-2007 balance sheet gives some cause for concern although the three key issues arising are not unusual for this kind of company and at this stage: actively investing for growth in 'intellectual property' businesses. 

First, net assets of £70.1 million involved goodwill of £34 million and 'other intangible assets' of £40.8 million. Certainly, technologies and patents have intangible value, although a banker might find this a bit ephemeral when considering the strength of balance sheet to lend against; at least until those 'assets' have proved what they can earn. 

Second, current assets involved £14.9 million trade debtors, which look high in relation to turnover. 

Third, year-end cash was only £1.9 million and it is hard to guess what the current balance might be between cash generation and investing activities. 

The 2007 cash-flow statement shows a £5.7 million outflow from operations, which needs to improve given the balance sheet context.  £10 million spent on investment was nearly covered by £6.3 million raised by issuing shares and £3.3 million by new borrowings.

Hence publication of the financial statements has not surprisingly led to speculation whether a further equity might be necessary, especially with management being guarded about current trading as "broadly in line with expectations". Investors need a better sense for the cash dynamics currently. Management's projections imply a transformation in 2008, yet growth can also bring strains and actually destroy value.    

All this helps to explain why the share price chart is a rollercoaster with speculative trading both ways, as trends get established.  This is a concern when, for example, shares being issued as (part) consideration for acquisitions may end up priced lower hence more dilution for owners.  Short-term trading in Meldex can affect intrinsic value besides being frustrating for holders watching market price.

A short-term approach was however the example set last year by Meldex's chief executive  in exercising 1.9 million share options at 70p, for a £777,100 profit. (See page 19 of the annual report.) His options were already a source of controversy since it was felt they had been granted at an artificially low price when the market was not fully aware of underlying progress. It perturbs me as a shareholder that big profits have already been taken by a chief executive when rewards from options should be linked to delivering sustainable long-term value. 

Secondly, in 2007 the Meldex chief executive received £664,357 total salary, bonus and benefits, which is more than many FTSE 250-listed companies making over a £100 million profit. The ex-chairman received a pay-off over £80,000 relative to nearly £51,000 salary when the explanation given for his departing last November was "for personal family reasons". This may also have undermined investors' confidence in Meldex recently.

On 5 June, a new non-executive chairman was appointed who has been a non-executive director since October 2006 and has a strong industry background as a co-founder of Shire Pharmaceuticals (SHP); a highly successful firm now in the FTSE 100 index. As chairman of Meldex's remuneration committee, he may however find himself facing a few questions at the 26 June AGM.

It will be interesting to watch for any updates and the outcome of the AGM, as the board currently has a challenge to ease investor frustrations given the low share price.  Yet the blend of a vigorous company proving growth credentials, with investor exasperation, ought to be bullish for its shares.

For a slightly different look at Meldex, why not watch our iBall episode featuring the firm?