Mesa Laboratories, Inc.

(NASDAQ:MLAB)

Mesa Laboratories, Inc. manufactures and distributes electronic measurement systems and disposable products for various niche applications, including renal treatment (pertaining to kidneys), food processing, medical sterilization, pharmaceutical processing and other industrial applications. Its worth noting one sentence within those lines above: Disposable products for niche applications.Thats a pleasant combination to hear in any business (especially when you own it or its publicly traded). However, not all of Mesa products are disposable. Basically Mesa lab manufactures and markets several brands used in many industries. Some of their products are Data loggers: used in critical manufacturing and quality control processes in the food, pharmaceutical and medical device industries. Torqo torque testing systems : used to measure bottle cap tightness in the beverage and pharmaceutical industries, Medical meters : which are used for quality control in dialysis clinics and dialysis machine manufacturing operations Nusonics concentration analyzers, Pipeline interface detectors and Flow meter products used in the chemical, food, pharmaceutical and plastics industries. Biological Indicators: used for validating sterilization processes. The product line includes self-contained Biological Indicators, spore strips, culture media, custom and industrial use chemical indicators. Mesa has grown steadily in the past 16 years. In 1995, it reported net sales of $ 6 million and EBIT of $1.8 million. Their latest 10 k (2011) reports sales of $33 million and EBIT of $ 10 million. Roughly that translates into compounded annual return of over 11 % of both sales and operating income. Mesas historical 10 year record below puts it into the growth company club.

2011 2010 2009 2008 2007 2006 2005 2004 2003 2002

Sales Growth $3,28,26,000.00 50% $2,19,29,000.00 2% $2,15,36,000.00 10% $1,95,58,000.00 13% $1,72,42,000.00 49% $1,15,83,000.00 15% $1,00,41,000.00 10% $91,26,000.00 0% $90,81,776.00 0% $90,43,844.00

EPS $1.88 $1.49 $1.50 $1.45 $1.25 $0.88 $0.76 $0.69 $0.69 $0.61

Growth EBIT Per share Growth 27% 3.01 31% -1% 2.30 -4% 3% 2.39 7% 16% 2.23 25% 41% 1.79 38% 16% 1.29 13% 10% 1.14 8% 0% 1.06 2% 13% 1.04 17% 0.89

CAGR

13.76%

11.92%

13.00%

One key thing that comes to mind is that growing at this rate in this brutal industrydominated by much larger players with much larger resources- is not that easy. And it gives us a hint that the company is delivering something unique .It is doing something special.

PROFITABILITY Margins Mesas profitability track record is extraordinary as its 10 year record of gross margins, operating margins and free cash flow margins show below

YEAR 2011 2010 2009 2008 2007 2006 2005 2004 2003 2002 AVERAGE CV

Gross Margin 59.61% 60.17% 64.16% 65.74% 63.19% 64.21% 62.94% 62.44% 62.59% 59.61% 62.47% 0.03

Operating Margin 30.05% 33.60% 35.33% 36.10% 32.82% 35.48% 34.61% 35.60% 35.09% 32.53% 34.12% 0.05

Free Cash flow Margin 18.97% 24.60% 20.43% 22.54% 13.06% 18.92% 24.21% 35.94% 31.20% 24.49% 23.44% 0.26

Mesa has enjoyed fat margins in its niche. Not only fat but consistent and reliable as well. A gross margin of 62.46% and low Coefficient of Variation(CV) of 0.03 tells us it could pass

on the rising costs to its customers .It commands a good pricing power. Operating margins of 34.12% with low CV of 0.05 shows that the management has done good job at managing its costs and expenses. And 23.44 % of free cash flow margin with 0.26 CV shows that its a good quality business that efficiently and reliably translate its sales into excess cash that could be benefit its shareholders over the long term.

ROIC Of course ROIC is an essential metric to gauge the profitability of the business core operations. And below is the mesas solid 10 year record of return on invested capital in which EBIT is used as numerator. Similarly in CROIC (cash return on invested capital) the numerator used is free cash flow. In both the calculations goodwill and intangibles have been deducted and so has been excess cash to provide better picture of what the business is truly earning on its invested assets.

YEAR 2011 2010 2009 2008 2007 2006 2005 2004 2003 2002 AVERAGE CV

ROIC 69.26% 54.51% 61.98% 64.09% 86.65% 74.65% 66.14% 52.48% 47.09% 40.33% 61.72% 0.21

CROIC 43.73% 39.91% 35.84% 40.02% 34.48% 39.79% 46.27% 52.98% 41.88% 30.36% 40.53% 0.15

Mesa Labs pre -tax return on invested assets is unusually high and its high core business profitability without any distortions of its capital structure.

. .

Financial Health

In the the current balance sheet of MESATotal cash, securities and receivables stand at $12 million and current liabilities at $4.6 million gives a pretty solid quick ratio of 2.60 And it employs little leverage. Total liabilities stand at $8.5 million which it can easily pay off with its current free cash flow of $ 6 million. And there are no off balance sheet liabilities or any operating leases. Overall it sports a healthy, clean balance sheet. SAFETY The Altman Z score of the company is 16.29. Over 3 is considered safe.

Z score calculation A, B, C, D, E, Working Capital/Total Assets Retained Earnings/ Total Assets EBIT /Total Assets Market Cap / Total liabilities Net Sales/ Total Assets Z- score

Points 0.31 1.00 0.65 13.68 0.65 16.29

The major boost comes from points scored by the Market cap/ liabilities. Simply put the total liabilities of $8.5 million is extremely low for a company having a market cap at $194 million . And this tells us that its a safe stock. Similarly F score is as follows:

F-score 1 Net Income 2 Cash flow from Operations 3 Change in ROA 4 Quality of Earnings 5 Change in Debt leverage 6 Change in Current ratio 7 Change in Shares Outstanding 8 Change in Gross margin 9 Change in Asset turnover F score

1 1 0 1 0 0 0 0 1 4

F-score looks for trends in business and most of the changes are percentage points for example in gross margin the difference has been miniscule. But main quality measures Net income, Cash flow from operations and quality of earnings are all positive.

M-SCORE The M score was created by Professor Messed Beneish. In many ways it is similar to the Altman Z score, but optimized to detect earnings manipulation rather than bankruptcy.

Derived Variables Year 1 Year 2 Year 3 Other long term assets 2,64,14,000.00 89,26,000.00 71,42,000.00 Days sales in receivables index 1.063 1.00 Gross Margin Index 1.009 1.02 Asset Quality Index 1.952 0.81 Sales growth index 1.497 1.10 Depreciation index 0.776 1.04 SG&A expenses index 1.113 0.97 Leverage index 3.936 0.97 Total accruals to total assets 0.053 0.01

M-score

2.84

2.48

M score calculation that used data of previous four years gives us scores of -2.84 And -2.48 both above -2.22 indicate less chance of accounts being manipulated. Overall we see that MESA is in good financial health. We have looked at the track records NOT to do any projections of any sort (sorry no use of DCF!) but to prove that Mesas management team is stellar and their brilliant decisions have enabled Mesa to steadily grow in all those years at a good pace. Mesa management has been its key competitive advantage. Why? Because they focus on competitive advantage of their business. At the heart of these myriad product lines lies a super-efficient capital allocation strategy employed by Mesas management. The famous investing dictum Invest in business even a fool can run doesnt exactly apply to Mesa labs .We have an ace jockey who decides he wants to ride a good horse and so he acquires a good horse and runs it competently. And this has been the case in Mesa Labs. The companies they have acquired develop products that meet the needs of clearly defined niches. Products that not only serve niche markets but can establish dominant market positions. This strategy has paid off. And this shows in solid track record of return on capital and extremely attractive gross, operating and free cash flow margins. And proves that the management has done a great job in identifying these businesses .The result: Most of Mesas growth has been as a result these fruitful acquisitions over the last 20 years. Moreover these acquisitions that have been done through surplus cash provided by its operations rather than debt and equity injections.

Even today the management rather than being self-complacent is on constant look out for acquiring favourable businesses. As they say about their acquisition criteria in their latest annual report: As always, we will continue to be extremely prudent about the businesses we acquire. Any business added to Mesas portfolio must be synergistic with our markets and technology and must meet our high standards of profitability. The goal is, and has always been, to utilize our shareholders cash to enhance their investment in Mesa. This is not empty talk. They have walked their talk in the past. Back in 2003 unable to find suitable businesses for acquisitions the management bought back the companys stock. As we observe in their 2003 10 k:

Lacking what we consider good acquisition candidates during the past fiscal year, we focused on increasing shareholder value by repurchasing shares, driving further improvements in earnings per share. And their extremely high return on invested capital over the years show their high standards of profitability.
ROIC was calculated before using tangible invested assets before. The return on Tangible assets -which ignores capital structure- should be backed up with high ROIC including goodwill to signal a business successfully using its intangibles to create true shareholder value. This is important for companies like Mesa labs who have grown primarily through acquisitions. It is not uncommon for companies to earn high returns on capital on operating basis while failing to earn high returns when acquisition premiums are considered. ROIC including goodwill measures how well the company has used its investors' funds. The following table of ROIC and CROIC calculated including intangibles and goodwill proves what management says that - The goal is, and has always been, to utilize our shareholders cash to enhance their investment in Mesa.

YEAR 2011 2010 2009 2008 2007 2006 2005 2004 2003 2002 Average

WITH INTANGIBLES ROIC CROIC 42.58% 26.88% 35.94% 26.31% 38.50% 22.26% 37.15% 23.20% 52.70% 20.97% 42.31% 22.56% 36.73% 25.69% 31.24% 31.54% 29.03% 25.82% 25.58% 19.26% 37.17% 24.45%

Mesa tapped the stock market in 1984 and at that time had a business plan that was going to address the home kidney dialysis market. But after some time the government regulations on how they were going to incentivize home dialysis had an adverse impact on Mesa. So their business plan crumbled, But a product for kidney dialysis they made became a life saver. The product generated good cash flow to develop the home dialysis system. In the words of Mr Luke Schmieder, the founder and then CEO The product was successful and kept us from going out of business. But from 1986 to 1989, we were basically in a regrouping effort and trying to develop a plan for going forward. We acquired a product line from Ball Corporation in 1989 called DATATRACE. That has fuelled a lot of our growth over the years since then. In kidney dialysis they came out with a new calibration instrument for the kidney dialysis machines. That product also provided them growth over many years. Then in 1993 they acquired a business in Tulsa called NUSONICS that manufactures ultrasonic flow meters and ultrasonic concentration analyzers. This business also grew nicely but then then went into accommodating phase. Then they acquired Automata Instrumentation. Automata was a company that made measurement instruments and calibration solutions for the kidney dialysis market. This was very synergistic with their medical products group In 2006, Mesa completed the acquisition of Raven Biological Laboratories, Inc. of Omaha, Nebraska- a leader in the biological indicator industry for approximately $6.75 million. Founded in 1949, Raven produced annual revenues in excess of $4.3 million from the design, manufacture and sale of biological indicators used to provide quality control testing in sterilization processes. The Raven acquisition has also proved very fruitful. And we can see its results in the companys 2009 annual report: Our Raven product line posted 15% revenue growth during fiscal 2009, driven by strong international sales. Since acquiring this product line early in fiscal 2007, Raven revenues have increased an average of 17% per year. This is a direct reflection of a focus on quality products and customer service by the Raven organization, along with healthy worldwide demand for sterility assurance products. We expect that the Raven product sales will hold up well during the current economic downturn, as use of these products is mandated in most situations. Also, being a consumable, the Raven products are little affected by capital equipment spending cycles. Emphasis added . Commentary would be redundant. In 2010 they acquired another company called Torqo. Management is very optimistic that .this line of bottle cap torque testing products, which was purchased from Vibrac, LLC in New Hampshire, would represent a major growth opportunity for Mesa. Here is straight from Horses mouth -their 2010 10 k states: While the Torqo lines revenues are currently not as large as our other three major product lines, we expect to see considerable growth in the years ahead. Vibrac is continuing to assemble the Torqo products for Mesa until December, 2010, when we will move production to our facility in Lakewood, Colorado. With the move of production, our gross margins will improve and Torqo should contribute to improved profitability in the years ahead. Another favourable event in 2010 was the purchase of SGM Biotech, Inc. for $11 million cash. SGM , a major producer of biological indicators , with a product line very similar to Raven division. SGM acquisition has doubled their biological indicators revenue and this acquisition has positioned Mesa as a market leader in the industry.

Their 2010 10 k states that : SGM will continue to operate out of their facility in Bozeman, Montana. Having two BI facilities provides a competitive advantage for Mesa,in that many of our Pharmaceutical and Medical Device customers prefer vendors with redundant manufacturing capability. A major initiative for fiscal 2011 is to realize the synergies that will be possible with the SGM acquisition and improve the profitability of our whole biological indicators business. Of course this envious past record does not profit investors who must invest for tomorrow . But here are few reasons to be optimistic. Mesa now has two major divisions. An Instruments division and a Biological Indicators division and that according the management enable us to more effectively manage the two somewhat different businesses. To cope with the unprecedented growth, we are improving our infrastructure, instituting new company-wide policies, and creating an organizational structure that will be capable of supporting a much larger company. At the same time we are mindful of the need to make sure that these enhancements continue to allow us to be responsive to our customers and not encumber us with unneeded bureaucracy. And both divisions have contributed evenly to revenues of $33 million in the fiscal 2011, an increase of 50% over the previous year. The Instruments segment grew 11% during fiscal 2011 bolstered from the acquisition of the Torqo products we discussed earlier as their traditional instrument businesses were essentially flat for the year. But the management has provided some guidance: Continued weakness in the global economy, particularly in Europe, suppressed our datalogger product sales in the early part of the year. Fortunately, we had strong orders for these products later in the year, and it appears that this momentum is continuing into fiscal 2012. Our Medical product sales were also flat for the year, likely as a result of the uncertainty in the dialysis market in the U.S., resulting from the Centre for Medicare & Medicaid Services (CMS), on January 1, 2011, instituting the first significant change in dialysis reimbursement in 30 years. Fortunately, this is now behind us; clinics in the U.S. are expecting little or no change in reimbursement revenue, and we have recently seen an increase in activity in this product line. But the company has lodged an impressive growth in Biological indicators segment during fiscal 2011, with a 130% increase over last fiscal year. Certainly we cannot expect this rate that could be sustained over next year let alone over the long haul. The future driver of earnings-as envisioned by the management- would be in Biological indicators and they started identifying favourable acquisitions from 2009 when they acquired Raven and then SGM but with $6.5 million cash acquisition of Apex Biological indicators business(BI) Mesa has strengthened its foothold in this niche manifold. John J. Sullivan, President and Chief Executive Officer says in his letter to shareholders: Apex Labs was the worldwide leader in sales of BIs for hydrogen peroxide vapor systems that operate at ambient pressures. These processes are commonly used for decontamination of glove

boxes, aseptic processing lines, and entire rooms in the pharmaceutical, medical device, healthcare, and food industries. Apex pioneered this market in the mid-1990s with the introduction of a BI using a small stainless steel disk as the bacterial spore carrier. As the market grew, the Apex disk became the standard in the industry for quality control applications. BIs for hydrogen peroxide systems is a growing market and we expect this product line to perform well in the years ahead. The key line to focus on is: As the market grew, the Apex disk became the standard in the industry for quality control applications. This is an important source of Mesas competitive advantage. Of course companies delivering high returns on capital invite attacks in brutal capitalism. So the key question is: How sustainable is MESAS competitive advantage? As Warren Buffett says: What were trying to find is a business that for one reason or another because its the low cost provider in some area, because it has a natural franchise due to its service capabilities, because of its position in the consumers mind, because of a technological advantage or any kind of reason at all has this moat around it. One key advantage enjoyed by Mesa is their diversified range of products. Its like a good investment portfolio which a good investor build by never putting all eggs in one basket to avoid catastrophic loss or judgement error .No matter how great a product is sustainable competitive advantage almost never comes through products which could be short lived . Blackberry was a great product. One competitive advantage it has enjoyed and likely to enjoy probably would come through its Customer lock in. Customer switching costs need not be just monetary but time and energy consuming. There is plenty of evidence if we go through annual reports of Mesa that its moat comes from customer lock- in. Here are few pearls from the annual reports: Quality control is essential in haemodialysis, where a mistake can literally cost a life. Mesa Laboratories meter products are used by manufacturers of haemodialysis equipment and in treatment clinics to assure safe therapy parameters. And In heavily regulated industries, such as the medical industry, theres a continual need for certification and recalibration of equipment to assure critical care standards are met. The durability of Mesas hemodialysis meters has resulted in a large installed base of equipment, which in turn drives servicing and parts revenues. To convince a customer that Mesa has an optimal solution for their application can be a relatively lengthy sales process, requiring product demonstration, training and validation of the DATATRACE monitors accuracy and ease of use. By transitioning to a direct sales force dedicated exclusively to selling DATATRACE products, we can be assured that the sales representative knows and understands our products and is dedicated to taking the time to help our customers get the most out of their investment.

As Mesas installed base of dialysis meters has grown over the years, so too has the demand for annual certification, servicing and recalibration of the meters and the sale of accessories. This has become a stable and important part of revenues for the medical products division.

And most important: Working closely with customers and better understanding their processes and monitoring requirements has the additional benefit of opening up new markets and applications for our products. Mesas willingness to adapt our products to meet the needs of a specific application is an advantage that helps us compete successfully in the marketplace. As Mesa former president Luke Schmieder explains poignantly: By continually improving and offering new generations of your own products, you make it very difficult for other players to enter your markets And another way creating a customer lock in so through having industry standard products . And Mesa gets this in Biological indicators through acquisition of Apex unot. The business prospects look bright for Mesa Labs. Mr Luke Schmieder has served as Chief Executive Officer and a Director of the Company since its inception in March 1982. At March 10, 2009, Mr. Schmieder retired from his positions as Chief Executive Officer and Treasurer, and now devotes such time as is necessary to the affairs of the Company. He owns about 6 % of the company stock. Effective May 2006, John J. Sullivan, Ph.D. was promoted to the new position of President and Chief Operating Officer of Mesa Labs Luke Schmieder, Mesas President and CEO since the Companys founding in 1982, retains his position of CEO and has assumed the newly created position of Chairman of the Board of Directors. Dr. Sullivan joined Mesa in 2004 as Vice President of Sales and Marketing and has played a key role in the Companys expanded sales and marketing efforts. Dr. Sullivan came to Mesa with 16 years of experience in analytical instrument manufacturing, where he served in various capacities in research and development, sales and marketing management and in business development. Prior to his work in private industry, Dr. Sullivan was with the Food and Drug Administration, where he was involved in the development of laboratory procedures. He owns about 2.2% of the company stocks. Overall insiders own about 24 % of the companys stock. Always a good sign. Of course there are some risk factors Technological changes in these kind industries could render many products obsolete. Profits could be affected through regulatory approvals of new products. This can even halt sales of existing or new products. But its history shows that the odds are in favor of the company. VALUATION: Mesas current market cap is around $185 million with stock trading at P/E ( trailing) of 24.

And ev/ebit of 20 . Thats hardly cheap. A reasonable p/e would be around 15 for this . The best time to scoop up shares which are very thinly traded -is when Mr Market becomes depressed. Peter Lynch warns in his brilliant work one up on wall street- that 20 % sustainable growth is extremely difficult over the long run. So investors should well pay heed to his advice by not getting carried away no matter what returns historically Mesa has achieved. He warns that a good company may not necessarily be good investment if you pay too much for its stock. By avoiding projections and buying it a reasonable price you could be assure that you have adequate margin of safety in this stock . And if you dont like Peter Lynchs advice pay heed to the words below that comes from the towering figure of Value investing Ben Graham , the mentor of Warren Buffett who is regarded as the worlds greatest investor: Todays investor is so concerned with anticipating the future that he is already paying handsomely for it in advance. Thus what he has projected with so much study and care may actually happen and still not bring him any profit. If it should fail to materialize to the degree expected he may in fact be faced with a serious temporary and perhaps even permanent loss.

Gurpreet Narang narang.gp@gmail.com