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Subject: Text Synovis SYNO Date: 1/23/2004 10:09 PM
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Synovis is the rare company that has actually decreased in price significantly in the last 3 months. Perhaps they deserve it and there is some reason other than a minor miss in revenue first quarter(discussed in more detail later). If there is some terrible fundamental flaw with Synovis, I have been unable to uncover it. Maybe the slash in price is Wall Street overreaction to missed earnings combined with a very rich valuation.

The fact that they seem somewhat undervalued for a growth stock is worrisome as I can find no identifiable reason for their demise. Has Wall Street made a mistake or am I missing something important? Any input is appreciated.

The Business

Synovis Life Technologies, Inc. is a diversified medical device company that develops designs, manufactures and markets products for the surgical and interventional treatment of disease. Its businesses are conducted in two reportable segments, the surgical device business and the interventional business, with segmentation based upon similarities of the underlying business operations, products and markets of each.

Acquisitions

In July 1998, they acquired Jer-Neen Manufacturing and changed Jer-Neen's name to Synovis Interventional Solutions, Inc.

In July 2001, Synovis acquired Micro Companies Alliancea which provides products to the niche market of microsurgery. MCA's surgical products include the Microvascular Anastomotic Coupler(putting blood vessels back together), a patented technology for connecting small arteries and/or veins faster, easier and as effectively as conventional suturing.

In March 2002, Synovis acquired Emtech a manufacturer of injection molding, computer numerical control machining and tool building for the medical device, pharmaceutical, biotechnology, and precision OEM markets.

Business Segments

Surgical Device Segment

The surgical device business develops and manufactures implantable biomaterial products for use by surgeons in various procedures where reinforcing, reconstructing and repairing tissue and preventing leaks of air, blood or other body fluids is necessary for the achievement of a favorable outcome. When something is cut and staple back together, internally, the microscopic holes must be sealed or infection and bleeding may occur.

Biomaterial products are produced from bovine pericardium (covering around the heart). Many of the product characteristics and competitive advantages are derived from the pericardium's collagen composition. Collagen, a fibrous protein found in animals, makes the pericardium durable and provides superior handling characteristics. The patient integrates the cow collagen by depositing their own collagen on the framework.

Any prohibition by certain countries of bovine pericardium products as a result of concerns related to BSE(mad cow) could have a material adverse effect on the Company's business, financial condition and results of operations.

Peri-Strips and Peri-Strips Dry soft tissue stapling buttresses are used to reinforce at the surgical staple line to prevent potentially fatal fluid leaks, most significantly in gastric bypass surgery, a treatment for morbid obesity. By 2004, the number of these gastric procedures performed in the United States is expected to reach 110,000, up from an estimated 63,000 procedures performed in 2002. This, along with the trend toward laparoscopic gastric bypass procedures, would expand the United States market potential to an estimated $100 million annually.

The surgical device business offers surgical tools to enhance productivity in a variety of cardiovascular and other surgical procedures. The primary microsurgical product is the Microvascular Anastomotic Coupler System (the Coupler), a patented mechanical anastomotic(puts blood vessels back together) product which is comprised of single-use rings in five sizes, the smallest is 1mm in diameter, to fit varying vessel diameters. Microsurgeons work across medical specialties, including plastic and reconstructive, head and neck, orthopedic and hand. The Coupler enables microsurgeons to perform highly effective anastomotic surgical procedures (the connecting of miniscule veins and arteries) faster, easier and as or more dependably than traditional suture or sleeve anastomosis.

Interventional Business Segment

The interventional business custom develops, engineers and manufactures complex micro-wire forms and polymers used in interventional devices for cardiac rhythm management, neurostimulation and vascular procedures. Through an acquisition, the interventional business has broadened its manufacturing capabilities to include polymer and computer numeric control machining. These products include micro precision coils, stylets and related wire products, and guidewire components and subassemblies. Each of these component categories comprises approximately one third of the interventional business' revenues.

The primary medical device companies involved in the interventional cardiac and neurological products include Medtronic, Inc., Guidant Corporation, St. Jude Medical (through its Pacesetter unit), Boston Scientific and Johnson and Johnson Cordis.

Backlog

At October 31, 2002, the surgical device business did not have any customer order backlogs representing firm customer orders not yet shipped due to insufficient inventory levels. Because the interventional business is "build-to-order", it has firm customer orders awaiting manufacture and release based on customer specified future - delivery dates over the next 12 months. This order backlog in the interventional business was $10,363,000 at October 31, 2002 as compared to $3,992,000 at October 31, 2001.

Ratios and Discussion for Income Statement

**Profit margins are good. Net margins are increasing.
**Double digit growth in revenue and net would indicate that acquisitions
are benefiting the bottom line and the company is competing successfully in
the market
**COGS rising: would not like to see this grow more quickly than revenue.
**Dilution not excessive.Company doesn't increase shares precipitously

**The surgical device business net revenue increased 24% to $19,546,000
in fiscal 2002 from $15,737,000 in fiscal 2001. Revenue increases occurred
across all surgical device product groups during fiscal 2002. Peri-Strips a
ccounted for 52% of the revenue growth in this segment, with a worldwide
growth rate of 37% in fiscal 2002.

**R&D increasing which is vital in the industry. Must bring new and better
things to market ahead of the competition

**The microsurgery product line of the surgical device business represented 22% of this segment's fiscal 2002 growth, with net revenue of $1,062,000 in fiscal 2002,
up from $232,000 in 2001. It appears to be a successful acquisition.

**The interventional business net revenue increased 60% to $20,416,000 in
fiscal 2002 from $12,798,000 in fiscal 2001, expanding upon its fiscal 2001
growth rate of 46%. The interventional business added polymer and computer
numeric control machining capabilities through an acquisition in March 2002.

These capabilities expanded the scope of offerings to our interventional customers,
resulting in net revenue of $1,123,000 in fiscal 2002.Also a good acquisition.

The fiscal 2002 growth rate of the base interventional business was 51%,
driven by market share gains coupled with growth in the markets served. It is important that Synovis carve out a business niche when competing against such giants as JNJ and Medtronic.

**Selling, general and administrative (SG&A) expense during fiscal 2002 increased 25% to $12,182,000 from $9,711,000 in fiscal 2001. SG&A expense, however, declined by
four points as a percentage of net revenue, from 34% in fiscal 2001 to 30% in
fiscal 2002. Effectively targeting SG&A spending increases in a period of significantly higher levels of revenue growth resulted in this decrease. Sales is important and
cannot be scimped on when trying to place your product with hospitals and physicians.

Its great to see it grow and yet decline as a percentage of revenue. This is efficient use of the sales force

Ratios and Discussion for Balance Sheet

**During the second quarter of fiscal 2003, they opened a manufacturing facility in Puerto Rico, expanding the capacity of the interventional business. The investment in the Puerto Rico facility is expected to be financed through a combination of Puerto Rican incentives
for job creation and facility improvements, with the remainder to be provided by the Company's cash and cash flow.

**Possibly, this facility accounts for the increase in inventory(TTM). Synovis says the inventory increase in fiscal 2003 generally reflects the growth of the businesses as well as interventional customer purchase order inventory requirements. This was partially offset by an increase in net income, accounts payable and accrued expenses.They were accurate in noting an increase in interventional business. The growth of the business perhaps refers to the new manufacturing facility?

**Current ratio shows assets in excess of liabilities and the quick ratio show fair liquidity.
**Inventory has grown by over 50%. The reasons are speculated on above
**Acounts receivable grew by 26% and revenue grew by 45%. This is quite reasonable
**DSO has decreased significantly from 2001 to 2002
** Low returns on equity and capital
**Low debt ratios. Company is funding expansion, R&D and acquisitions with very low debt and still have cash on hand.
**Working capital increased. They ae not burning assets to accommodate cash flow
**Cash conversion cycle is long, but Synovis has to receive the orders, manufacture the equipment, send the bill and receive the cash. For their business, this does not seem unreasonable.

Ratios and Discussion of Cash Flow Statement

**Making good acquisitions that have improved revenue and growth
**Able to pay off the acquisitions and remain free cash flow positive
**Spending in capex and growth appears positively impacted
(opened new plant in PR)
**Company makes provision for uncollectible accounts
**Increase in shares from private placement of 1.5M shares to raise money. The company does not dilute shares much over the years.

**Capex grows most years and the company has experienced double-digit growth in revenue and net income for several years.
**free cash flow has been positive except for the TTM figures. That may be a reflection of decreased sales of the interventional products division in the first quarter. It would be expected to be positive again if company does not lower guidance.

Stock Options

The weighted average fair value per option granted during 2002, 2001 and 2000 was $2.17, $1.55 and $0.86, respectively, for the ESPP and $4.09, $3.40 and $3.33, respectively, for all other options. The fair value of all other options was estimated using the Black-Scholes option-pricing model.

Outstanding at end of year 1,272,826
Value of options is $5.3M
Value per share is $0.47
Dilution of common shares is 11.4%
The dilution is high, but not abusive.The value of the options per share is relatively low.

Selected Recent Financial Data

Trailing P/E (ttm): 36.17 High
Forward P/E (fye 31-Oct-04): 18.64 Buying opportunity?
PEG Ratio (5 yr expected): 0.80 Low
Price/Sales (ttm): 2.86 High
Price/Book (mrq): 4.72 High

Profit Margin (ttm): 8.58% Acceptable
Operating Margin (ttm): 12.12%

Return on Assets (ttm): 12.60% Fairly good--improved
Return on Equity (ttm): 15.32% Improved

Total Debt (mrq): 329.00K Low

From Operations (ttm): 3.36M
Free Cashflow (ttm): -900.00K recent development--usually positive

52-Week High (15-Sep-03): 32.50 Now trading at about half of this
Shares Outstanding: 9.88M Small number of shares
% Held by Insiders: 10.91% reasonable but not high
% Held by Institutions: 42.71% Discovered?


Recent Developments

On January 13,2004 Synovis warned that first quarterprofits would be well below analyst's estimates. They cited sluggishness in the interventional business as the cause. This segment was expected to earn more than the $5.5M it earned which was below the year-ago level of $6.4M. The surgical business
increased $7.0M from $6.1M a year ago.Synovis does not make quarterly earnings estimates, as they believe the varaibility of demand for products does not allow accurate short-term forecasting. Shares dropped 24% to $15.74.

In December 2003, the company confirmed 2004 estimates of $75M to $79M which is a 29% to 36% yearly increase.The guidance for 2003 was unchanged at $58M to $59M in consolidated revenue.This earnings of $0.43 to $0.46 per share.

The Street seems to have reacted irrationally to this decline, if the 2003 and 2004 earnings remain acheivable. We won't know that for sue until February 18 and the conference call. It is likely that the stock will recover if 2003 stays on track.

DCF

The assumptions are as follows:

The company has said they expect a 29%-36% increase in 2004. I have lowered this and given them 25% for 5 years. I think this may prove to be more in line than over 30% growth rate. They are a small company and do have room to grow, given continued good management and a growth strategy that includes more profitable acquisitions.

Stable growth is 4.5% which reflects a GDP of 3%+1.5% inflation
Capex is growing at the same rate as revenue
Capex exceeds depreciation by 100% long term
Working capital stays at the same percentage of revenue
Beta of 1
Cost of equity is 9.7%

The value of the stock is $15.50
Value of stock with options subtracted is $15.03

Since they are selling around $17, you could argue that they are overpriced. However, the recent high of $32.00 would indicate that this company is worth more than $15.03 to investors, when it is firing on all cylinders. It has shown it is capable of sustained growth and for that reason, it might be reasonable not to require a discount on this growth stock.



Discussion

Synovis appears to be a well-run company, competing successfully in the medical devices niche. Their best-performing product, PeriStrips, seem to have established themselves as a fixture in a variety of medical procedures and are in continual demand. The interventional segment has been a disappointment in the first quarter. That is of some concern. They have had a very poor showing in the first quarter of 2002 and went on to make a nice recovery. I believe the company can do that here. They have already stated that the volume of orders has increased and the next quarter should be better. They do not have a history of deceit, so I would tend to believe them. Add to that the fact that their 10K and most recent 10Q are straightforward and transparent, and I think you have a company with moral management(until proven otherwise).

I like the fact that Wall Street overreacted to the lowered guidance. It has placed Synovis back to a more reasonable valuation. At $32, they were very much overvalued--at $17 they are slightly undervalued to fairly valued. I would expect shares to climb again if the company reaffirms guidance in 2004 and meets expectations in 2003. The conference call is February 18 and if you are a potential investor or a shareholder, this is a date to remember.

>^..^<




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