Applying Short Sale Framework to Medstone International Inc (1988-1990)

Company Description: Medstone International was a lithotripsy company that makes machines for noninvasive disintegration of kidney stones. In layman's term, this company's product crushes kidney stones.

Key Document: IPO Prospectus.



I. Short Sale Categories:
 Medstone has a tremendously inflated stock price that suggests a speculative bubble in a company's valuation.
Medstone will be affected in a significant way by changing external events.

Supporting Facts from prospectus:

1. The product was not patented.
2. The competition was large and international with a significant installed base.
3. Limited operating history, deficit net worth, working capital deficit.
4. Dependence on two key executives.
5. Only one product.
6. Some of the offering money went to senior officers to pay for prior services.

II. Signs of Potential Short Candidates:
1. The stock was trading at $40 between Q2 and Q3 of 1988 because the doctors are promoting the stock extensively. Doctors are reputed to be the marginal suckers on new drugs or medical-products companies for aggressive retail brokers. The doctors promote the stocks to peers and friends and enthusiastically inflate the market value, especially if the product is remotely associated with their area of expertise.
2. Founder and president Richard Penfill sold 100,000 shares of stock in September 1988 before the deadline elapsed.
3. Chairman of the board resigned in December.


III Research the Short Candidates:

What's driving the hype?

1. Q3 1988 was strong, EPS $0.52 per share vs $0.18 estimates. Sales doubled.
2. One analyst estimated earnings of $4.40 in 1989, up from $0.33 in 1987. $4.40 implies only 6 times P/E for a company that's growing fast with the group trading at 15 to 20 times earnings.
3. Signed an agreement with GE and GE will sell Medstone's machine in Europe and Middle east, providing parts, installation, and maintenance.

Reality Check from 10K 1988 and 10Q 1989.

1. Sales to a single shareholder and his affiliated companies made up 13% of the 1988 and 1987 revenues. The shareholder loaned Medstone $75,000 back in 1984.  In connection with his first machine purchase in 1987, he had the right to buy another machine at 80% of the price and received $86,500 in consulting fees from Medstone in 1985 and an additional $123,000 from the offering.
2. 2Q 10Q showed inventory soared from $385,000 in June 1988 to $5.5 million in June 1989.
3. 2Q 1989 sales were donw.
4. Founder and president resigned in August 1989 and the company reported noncompliance issues.
5. Competitor check: Dornier Company, whose product is patented and have the most installed base of 250 machines. Medstone has only placed 9 machines selling $1 million each.