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InfuSystem Holdings ($INFU) is a company that I ran across when I was reading about Ryan Morris in Businessweek.  Ryan Morris is a young activist investor, and Businessweek wrote up a story about him and a couple of his activist forays.  One of those companies was InfuSystem Holdings, so I decided to do some more research about the company to see if it was a good opportunity. Ryan Morris is the managing partner at Meson Capital Partners.  Meson had an outstanding year in 2009, which you should read the annual partnership letter, as the partnership gained 753% for the year!  However,  the past couple of years of returns were lagging the S&P 500.  The total 3 year return is still incredible.

Introduction

$INFU is in a transitional period, which started earlier in 2012.  Prior to 2012, the company produced high gross margins and solid free cash flow but management was poor.  The stock price had declined 70% over the past several years but management decided to grant themselves 18% of the stock as compensation.  This is a good business, but being mismanaged with unacceptable stock compensation and high salaries.  A handful of the largest stockholders that held a considerable amount of stock were all value firms, but the size of their positions relative to their firms size was small which meant the stockholders weren’t as motivated to band together and make a change at the top.  Because $INFU is a microcap company with a market cap around $30-$40 million, the largest stockholders were limited in selling their shares on the open market.

The situation changed in December of 2011, when Ryan Morris heard about the company and discovered the businesses current situation.  2% of the company was purchased through Meson Capital, and Ryan Morris brought in some of the largest stockholders to form a 13D group to make management and board changes.  I won’t go into all the details of what ensued, but the end result was the removal of the CEO and a change out of the board.  A new CEO was found (Dilip Singh) and put into place to help begin the turnaround of the company.

The Business

From the 10-K

Our core service is to supply electronic ambulatory infusion pumps and associated disposable supply kits to oncology clinics, infusion clinics and hospital outpatient chemotherapy clinics to be utilized in the treatment of a variety of cancers including colorectal cancer. Colorectal cancer (CRC) is the second most prevalent form of cancer in the United States, according to the American Cancer Society, and the standard of care for the treatment of CRC relies upon continuous chemotherapy infusions delivered via electronic ambulatory infusion pumps.

We provide these pumps and related supplies to oncology clinics, obtain an assignment of insurance benefits from the patient, and bill the patient’s insurance company or patient as appropriate, for the use of the pump and supplies, and collect payment. We also provide pump management services for the pumps and associated disposable supply kits to approximately 1,400 oncology clinics in the United States, while retaining title to the pumps during this process.

In addition, we sell, rent and lease new and pre-owned pole mounted and ambulatory infusion pumps to oncology practices and provide biomedical certification, maintenance and repair services for, these same oncology practices as well as to other alternate site settings including home care and home infusion providers, skilled nursing facilities, pain centers and others in the United States and Canada. We also provide these products and services to customers in the hospital market.

As you can see, the business is pretty straightforward, InfuSystems purchases a fleet of infusion pumps, and then works with oncology clinics to rent these pumps to patients and directly bills the insurance companies to receive payment for the services rendered.  Gross margins are consistently in the low 70% range and free cash flow has average over 15% for the past 4 years.  Renting infusion pumps to cancer patients isn’t economically sensitive, and has grown ~10% per year.  However, management was inept, and has put the company in a situation where the debt and financing of the company was resulting in poor earnings.

In addition to renting ambulatory infusion pumps, pole mounted infusion pumps are rented  and infusion pumps are sold.  Pole mounted infusion pump rentals and pump sales are smaller revenue generating businesses.  The majority of revenue, and the focus of the company is renting ambulatory infusion pumps to colorectal cancer patients.

The Industry

The healthcare industry is ever-changing, and with Obamacare moving forward, there are many changes coming in the near future.  Since InfuSystem deals with patients and insurance companies, it is necessary to try to understand the upcoming changes and the impact that they may have on the underlying business.

Here is an excerpt from a recent study which can be read here:

According to Millennium Research Group (MRG), the global authority on medical technology market intelligence, growth in the US market for infusion pumps through 2017 will be largely driven by government initiatives. An uptake in sales of infusion pumps with smart capabilities that can be integrated with electronic medical record (EMR) systemswill be fueled by incentive funding from the Health Information Technology for Economic and Clinical Health (HITECH) act, while purchases of infusion pumps designed specifically for pain management will be encouraged by Centers for Medicare and Medicaid Service (CMS) incentive bonuses

Facilities and physicians can qualify for incentive funding by demonstrating meaningful use of healthcare information technology (HCIT), which includes infusion pumps that offer interoperability with EMR systems. As of 2012, only CareFusion and Hospira had hospital sites that integrated infusion pumps with EMRs, positioning both companies to take advantage of the trend toward hospitals integrating healthcare devices with information technology through 2017.

The boldface was added by me, to highlight a few key statements.  The infusion pump market is anticipated to grow strongly to $3+ billion by 2017.  Since InfuSystem’s primary line of business is to rent infusion pumps to patients through oncology clinics, we can’t use the total market size in a meaningful way except to show that infusion pumps are deemed valuable to patients and to patient satisfaction.  The government  will be tying incentive bonuses to patient satisfaction scores around effective pain management.  The government, through Medicare, makes up ~31% of the revenue that $INFU receives.  It is very likely that more physicians will be prescribing the use of infusion pumps because they are less intrusive when administering medication to colorectal cancer patients and increases the comfort of the patient.  In addition, as infusion pumps are integrated into the newly installed Electronic Medical Record (EMR) systems, more incentives are provided by the HCIT thus increasing the usage of infusion pumps for pain management.  One of the larger vendors that InfuSystems procures infusion pumps from is Hospira.  Market research is pointing to a growth in the use of infusion pumps because of the patient satisfaction of being medicated from outside of the hospital in small doses over a longer period.  Infusion pumps give a steady, small, dose of medication to the patient as they go along with their day which increases the patient satisfaction.  Why is patient satisfaction so desirable?

Infusion pumps designed specifically for pain management, such as disposable postoperative pain management pumps, hospital electronic ambulatory pumps and high-end pain management syringe pumps will see growth driven by the desire of healthcare facilities to boost their Hospital Consumer Assessment of Healthcare Providers and Systems (HCAHPS) scores. One area the HCAHPS survey scores is patient responses to pain management. HCAHPS scores determine CMS incentive bonuses under Medicare’s Hospital Value-Based Purchasing program. In addition, pain is a frequent cause of hospital readmission, and CMS can now penalize hospitals with a substantial number of readmissions by reducing payments.

If you are not familiar with HCAHPS, it is an important new score based upon patient satisfaction, and will be used heavily to decide incentive bonuses and payouts from Medicare.  If re-admissions are high because of patient pain and dissatisfaction, hospitals can be penalized and lose funding.  Ambulatory infusion pumps are found to be very effective in pain management and patient satisfaction, which is the primary pump that InfuSystem rents to oncology clinic’s patients.  Based upon these changes in healthcare,  growing demand for infusion pumps will be expected for the foreseeable future.

One last benefit of the increased use of infusion pumps is that a patient can be discharged from the hospital quicker than if they need to receive medication from within.  This leads to shorter stays  and lowers costs for the healthcare facility.  Shorter stays lead to more patients being able to be treated increasing the healthcare facilities revenues at the same time as lowering costs.

Competitors

I can’t find any direct competitors of InfuSystem Holdings that provide public financials.  However, every company has competition so below are some of the competitors.

Regional Durable Medical Equipment (DME) providers

These are companies that cover several states, and do not offer the same services and keep the same number of customer contacts as InfuSystems.  Due to their regional focus, these providers do not have the depth of payor contracts thus may not be able to bill to a patient’s insurance company to receive payment.  InfuSystems also staffs a support group of qualified nurses to answer questions about the use of infusion pumps and make sure that the patients are satisfied.

Hospital Owned DME providers

Hospital owned DME providers do not have a large choice of infusion pumps and do not offer the same services as InfuSystems.  Because the DME provider is owned by the hospital, it restricts the growth of the provider due to the limited patient population of the hospital.

Physician Providers

Certain physicians will stock their own supply of infusion pumps, but this can add to costs of the physician’s practice due to preventative maintenance, repairs and supplies to support the stock of infusion pumps.  The Physicians office will need to hire more staff to support the operation due to support of the pumps and added claims processes to the insurance companies.

Management

As I previously discussed, up until early 2012, the management team of $INFU was poor, and given themselves high salaries and very generous stock options.  Thankfully, a group of activist investors formed, and were able to remove the management team and replace the board of directors.  It’s only been 9 or so months with the new management team, so it is hard to understand their affect on the business as more time is needed.  But I see some good signs to date, and like that a shareholder friendly chairman is in place.

One area of concern with the company was the debt load. When $INFU was purchased from I-Flow, the blank check company (HAPS Inc) which became InfuSystem Holdings, received a loan from I-Flow.  This was eventually replaced with a term loan from Bank of America at a pretty high interest rate.  The old management team did not aggressively use the free cash flow to pay down the debt.  The debt structure has been a focus of the new management team, and just recently a new term loan was signed with a more appropriate interest rate.  When the 13D group wrestled control from the previous management, it triggered a change of control clause in the term loan.  The new team negotiated with Bank of America to not call the full loan due, but had to agree to a 1% ticking fee per month.  The high interest rate, and monthly ticking fee were expensive, and thus created a sense of urgency to refinance the debt with a lower rate.  This was accomplished in December of 2012, and now InfuSystem Holdings is in a better state in terms of it’s financing.

Overall, the new management team is a big positive for the stock as they are changing the capital structure of the company, paying down debt with cash flow, and following sound management principles.  With Ryan Morris, and his value philosophy, as chairman is another positive for the company and leads me to believe that management will be aligned with shareholders.

Valuation

Trying to value a turnaround is quite difficult because the underlying business is changing quite dramatically and using historical data can introduce a large margin of error when studying the value of the business.  Using a DCF calculation is not a good process because it is impossible predict future earnings with any accuracy.  I’m not a big fan of using DCF to value a company because so much of the calculated value is attributed to the terminal value, which is the least precise.

I’m going to follow Greenwald’s process here, and find a value for the assets which is the easiest to perform.  Then I’ll use  normalized current earnings to find a value based upon current earnings without factoring in future growth.  Along the way, I’m going to use a few ratio’s that I believe are the best ratio’s to use during the valuation process.

Valuing Asset Value –Net Reproduction Cost of Business

InfuSystem’s book value has changed drastically over the past 1+ years.  $67m of goodwill was written off completely, drastically reducing the assets on the balance sheet.  The balance sheet on the latest 10Q (Q3 2012) is pretty straightforward.   Being conservative, I’m going to use stated book value as the reproduction cost of assets.  In reality, I could have added back in the depreciation of assets because if another company wanted to invest money to build a similar business to $INFU, they would have to pay the market price for the depreciated assets.  I’m not going to do this to be conservative in my valuation.  After subtracting Total Liabilities of $1.69 per share, I have Total Equity of $1.71 per share.  Because I’m trying to determine the reproduction cost of the business, I need to add value for the SG&A, and Marketing that has been spent.  Again, I’m conservative and just building back in 25% of the average Marketing spend over the past 5 years.

The result equates to $2.31 per share as a Total Net Reproduction Cost of the business.   At today’s price of $1.65, this tells me that if a company wanted to build a similar business, it makes more sense to buy $INFU because of the significant discount that the shares provide when compared to investing $2.31 per share to build the business from scratch.

Earnings Power Value

Using Greenwald’s EPV process, I calculated what the earnings power of the business and equity of $INFU to value the business using just current earnings (no growth).

I calculate a EPV of $2.51 a share for $INFU, and a Total Net Reproduction Value of $2.31 a share.  Since EPV is greater than the reproduction value, there is a small amount attributed to a competitive advantage.  I believe this makes sense since InfuSystem’s has a large network of payor’s under contract and a relationships built with over 1500 oncology clinics.  It will be very tough for new entrants to build these types of relationships and agreements.

I believe a fairly conservative value for $INFU is $2.50 a share, which is a 70% increase from today’s price of $1.65 per share.  I also believe that the value of the company can increase dramatically with the new management in place because the debt will be paid down with free cash flow, increasing the equity.  Management has been managing the company more efficiently since March, as the Cash Conversion Cycle is declining.  This was even mentioned in the latest conference call proving that management has identified areas that need to be improved.

The company does not own any land or buildings.  PP&E consists primarily of infusion pumps, which are depreciated over 5 years.  The life of an infusion pump used to be about 5 years, however the newer pumps are of higher quality and can have a useful life of 10 years.  This results in a large over depreciated asset line item on the balance sheet.  Management is working with their auditors to understand if the useful life can be updated to reflect the longer life.  This will have an effect on the balance sheet to increase the assets, and will lower the expense item increasing earnings.   All things equal, the depreciation expense will be cut in half if the life can be extended by another 5 years using the straight line depreciation method.

Free Cash Flow has been outstanding and averaged 14.8% over the past 5 years.  The company’s only real CapEx expense is the purchase of new infusion pumps (which are realizing longer lives than depreciation states).  This results into a very healthy FCF yield.

The last column (2012 Adj) reflects assumptions that I’ve made to normalize the 2012 earnings.  Management has stated that $4.5M has been used in the past year to deal with the changeover in control, which I treat as a one-time expense.  I’ve also made some other adjustments, but the column labeled 2012 – 9mo states financials from the latest 10-Q and only provides  9 months of results.

2011 numbers look very bad, and that’s because the company wrote off over $67M from goodwill.  Due to the large write-off, the company shows large negative numbers below the EBITDA line item.  However, asset impairment charges are not cash charges, so we can remove the impairment charge from our analysis of the company (which I’ve done in the column 2012 Adj).  I’ve also taken into account the debt refinance which just happened in December.  The 2012 10-Q statements were showing the full debt repayment amount in current liabilities since the loan was due in the next 12 months.  Thankfully, the company was prudent and solved the full debt repayment in July 2013, so I backed out the current liability and replaced the debt in long term.  After I have fully adjusted the financials, I calculate an EBITDA of $9M.

EBITDA Multiples

Using a range of EBITDA multiples, I calculated the valuation of the business to show a range of per share valuation figures.  Using an EBITDA range of 5x to 15x, the value of INFU ranges from $2.07 to $6.22 per share.  I’m going to use the range between 7x and 10x EBITDA as a fair value which results in ~ $3.50 per share.

Valuation’s are more art than science, and can never be calculated with precision.  I prefer to value a business using a few different techniques, and create a range of value per share.  For $INFU, The net Reproduction cost is $2.31 per share, and the EPV of Equity is $2.51 per share, and finally using an EBITDA multiple of 8.5 results in a value of $3.50 per share.   All of these valuation techniques produce a value greater than the current stock price of $1.65.

Risks

• As technology changes, a new, preferred, method of delivery medication to patients will evolve.  Until that time, I think that the infusion pump will be the choice among most of the oncology physicians.  It is proven to work, is perceived as valuable by the patient.  If a new piece of technology is developed, it will take awhile for the physicians to become familiar with it and recommend it to their patients, and the goverment and insurance companies would have to approve the use of product under their coverage.
• Debt Repayment – I think this is a low risk as new management has taken over and will be focused on creating long term value.  However, the risk of the debt burden on the business is greater than 0%.
• Medicare is responsible for 31% of the payments to INFU and Blue Shield/Blue Cross another 22%.  It is difficult to be in healthcare, and not have these two large companies make up a pretty large percentage of the revenue, however, it is a risk because if anything changes with the reimbursement policies, it can have a dramatic effect on INFU.

Catalysts

• Expand outside of the colorectal cancer market.  Infusion Pumps are used for many applications, and INFU can use their existing processes and relationships to build a business around other uses of infusion pumps.
• The 13D group consists of a large percentage of the outstanding shares, and they were able to align over 51% of the outstanding shares in their attempt to wrestle control from the old board of directors.  The group may be interested in selling the company after the new management team can work on stabilizing the business and optimizing the capital structure.  I firmly believe a sale could happen in the next 12-24 months.  I would never invest in a company solely to be cashed out due to a sale of the business though.

Conclusion

InfuSystems is a very small company, but with a very interesting business.  In the past 9 months, a new management team and board of directors were put in place led by Ryan Morris who is a known value investor looking to buy undervalued companies and realize full value.  That’s exactly what is taking place with INFU.  Since the new team was put in place, the debt has been restructured with a better term and rate, costs are being brought under control, operating performance is being enhanced and overall the company is on the right path.  Due to the company’s small market cap, not many analysts follow the company, and the stock is not followed by many.  It now trades on the AMEX at a price of $1.65 per share for a market cap of ~$40M.    INFU has an advantage in that it is a national company with relationships built for the majority of the oncology clinics (1500+).  In addition to working directly with the cancer physicians, they support over 150+ different payors so that it is very easy and efficient for the physician and patient to rent an infusion pump, and for INFU to collect the money from the government or insurance company.  I believe the intrinsic value of the business is between $2.50 and $3.50 per share which is significantly above the current stock price of $1.65.

Disclosure: I own shares of $INFU

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