Infusystem Holdings: Bright Future For This Microcap

| About: InfuSystem Holdings, (INFU)

Summary

In late February I went down to the city to visit Infusystem. On the visit I was able to tour the facility and speak with multiple members of management.

The company visit was very enlightening and helped enable me to understand the business model in a more clarified way.

Now that I understand the business model more clearly, I believe that my original upside scenarios were understated.

I believe there is high upside with little downside at the current share price.

It is interesting how much you can learn from visiting a company versus just reading financial filings from your desk. On Tuesday, February 17, I had the pleasure of visiting Infusystem Holdings (NYSEMKT:INFU) headquarters in Madison Heights, Michigan. More importantly than the visit, I was able to pick Eric Steen's brain, talk to the COO and CITO and chat with other employees.

Leaving the interview and tour with Eric, I came away impressed, more clarified on the actual business model, and with feelings that the potential upside is greater than presented in my original thesis.

This article will be used as an outlet for my thoughts after visiting the company and to update my original upside case.

The Importance of the IT Department

In my original report on INFU I briefly touched up on the benefits of investing in an IT Department. From reading the financials and listening to the conference calls, I understood why an IT Department was important, yet not in exact context or depth. Yes, I understood that it would increase the operating efficiency, cut back on paper work and maybe, just maybe provide a more 'sticker' business model. How it would do those three key items, in reality, I had no idea.

Talking to Eric about the IT Department was enlightening and very clarifying. Eric told me that before he took over as INFU's CEO, old management did not have a Chief Information Technology Officer and still ran the business on old school fax machines. Think about it for a minute, in today's digital age, how can a multi-million dollar company run efficiently still using old school fax machines?

From working his way up from a salesman and eventually becoming the CEO of INFU, Eric knew the importance of investing into an IT Department. Yes, the investment into the IT Department would make the company FCF negative for a few years, yet the benefits more than outweigh the costs. Moreover, the benefits of an investment into an IT Department are much higher operating efficiencies, accretive top and bottom line improvements, and a sticker business model.

Before INFU had an IT Department, employees had to enter patient data by hand via computer. Besides being inefficient, cumbersome and time-consuming, entering data by hand was prone for mistakes. For an example, if one word was misspelled, the patient data would not go through, and INFU would not get paid for that patient report (until the mistake was found and redone). Think about how many times you can mess up a financial model when entering data and compare and contrast with medical information.

With the investment into the IT Department, employees do not have to manually enter data anymore. This is a huge deal in terms of operational efficiency. Furthermore, the bottom line will be increased on a few different fronts (decrease in labor and increase in operation efficiency).

INFU also now has a very sticky business model due to the investment into the IT Department. What I mean by sticky is that INFU can now take their IT Department to hospitals and offer to take care of their patient data. This is a win win situation. First, once a hospital signs up, typically, they will not switch to another provider (huge opportunity cost to do so). Secondly, the hospital will save on operational costs, for now INFU can take care of the data themselves. Finally, it provides INFU with a sticky business model with recurring revenues, which is very important to most analysts and the overall value of the business.

Today, INFU is practically done investing into the IT Department. There are still a few nicks and kinks that will need to get worked out, however the large initial investment is done. All in all, the IT Department can now fire on all cylinders, which will be beneficial to the company's top and bottom line. Furthermore, the company has reduced their capex spending by $4.5-5mm going forward, which will pump up the FCF.

The Value of Infusion Pumps

In one of the recent conference calls, Eric stated if an opportunity to buy more infusion pumps presents itself, he would jump on it. As an outside investor, with little knowledge of the infusion industry, one of my main questions was; what is the value of your typical infusion pump?

A brand new infusion pump costs around $1,500. Interestingly, these infusion pumps can be reused over and over again. In fact, the model of infusion pumps has not changed at all in the past 20 years. Thus, a brand new infusion pump looks exactly the same as one that has been used for 20 years. Furthermore, an investment into a new infusion pump, will pay itself off in a short nine months (in profits).

Are you beginning to understand the importance of continuing to buy infusion pumps? I mean think of another investment in which it can pay for itself in nine months and continue to produce profit for the next 20 years. Furthermore, infusion pump revenues are very recurring. For an example, after one patient is done being treated, INFU will reuse that same pump (after a little cleaning and fixing) and recognize profits on a totally different patient.

What is even more interesting is that INFU's infusion pumps are almost 100% wholly depreciated, which is a suggestion that their balance sheet value is understated and undervalued.

Another valuable aspect of infusion pumps that I missed and did not touch up on in my original thesis was the company's ability to buy used infusion pumps and then resell them with a warranty. For an example, INFU will approach hospitals that just bought new infusion pumps and offer to buy them. INFU can scoop these pumps off the hospitals for a very low cost (hospitals just want to get rid of them), for $100-200/pump.

INFU will then recondition these pumps and then resell them with a warranty. In my original case, I did not take into consideration the reconditioning and reselling of infusion pumps. Taking into consideration the former, FCF looks a lot better than originally presented. I will talk more about this later in the valuation section.

What makes infusion pumps valuable besides the fact that they have a high ROI and a continual ability to be reused for many years to come? Well, first, INFU's infusion pumps and the industry as a whole are going through a long-term secular demand period, from an increase in colorectal cancer. Shifting demographics from a younger to older population and an increase in obesity have shot the rate of colorectal cancer through the roof.

Thus no matter what day of the year it is, what governmental regulations go through, or what the economy looks like, INFU will continue to experience demand for their products. Recurring and predictability are very important and provide a significant amount of value to the business model.

Infusion pumps are also starting to be used for other treatments of cancer such as soft tissue sarcoma. Currently INFU drives the majority of its revenues from colorectal cancer treatment. However, if infusion pumps continue to take over the industry for cancer treatment (and other treatments), it could provide the company with a significant amount of value in the future.

Finally, infusion pumps are important for making sure the patient gets his or her medicine on time, every day. Remember the last time you had to take a medication and continued to forget to take it? Infusion pumps provide continuous therapy and treatment, coupled with the fact that the patient will not have to remember to take their medicine. Moreover, the small size of infusion pumps (size of a cassette tape) allows for the patient to carry on their daily life activities while getting treatment (ground breaking to me).

Personal Opinions/Takeaways on Eric

Eric has spent his whole 30 plus career working in the health industry. Starting from a salesman level to the CEO of a public company today. He knows the business like the back of his hand, knows the competitors and knows how to run an efficient productive company.

Walking around the facility, Eric says hi to everyone, no matter the individual's position. To me, this is a sign of great management and people skills. I had an employer once where the CEO did not say hi to anyone as he walked by. Needless to say, no one respected him. Eric's goal for the fiscal year was to decrease the turnover rate at INFU to 3%. He exceeded this goal with <2.00%, which is another suggestion that he is a great manager with excellent people skills.

A further goal that Eric has is to promote individuals at the company to make them feel like working for INFU is a great career. Why hire outsiders when you can promote within your own four walls? This is a great way to retain important assets such as employees.

Finally, Eric uses the Harvard Balanced Scorecard in order to measure and beat performance metrics. A brief synopsis of this performance standard is highlighted below

"The first process-translating the vision-helps managers build a consensus concerning a company's strategy and express it in terms that can guide action at the local level. The second-communicating and linking-calls for communicating a strategy at all levels of the organization and linking it with unit and individual goals. The third-business planning-enables companies to integrate their business plans with their financial plans. The fourth-feedback and learning-gives companies the capacity for strategic learning, which consists of gathering feedback, testing the hypotheses on which a strategy is based, and making necessary adjustments".

Goals and performance standards are great to have. They will help to ensure operational efficiency and also show where a company is lacking. This is yet another suggestion that Eric is an outstanding executive.

Overall, I came away very impressed with the turnaround Eric has done thus far, coupled with his personal management skills. Furthermore, I believe that if someone took INFU private, they would keep Eric as the CEO due to his skills and knowledge of running infusion companies. Thus, it could be comparable to Warren Buffett's relationship with Rose Blumpkin and the Nebraska Furniture Mart.

Valuation

In my original report on INFU I was estimating that FCF would be from $5-7mm in the FY. In my model, I did not take into consideration cash flow from the reconditioning of used infusion pumps and reselling. Furthermore, the acquisition of Cisura, the 1,800 infusion pumps, and the relationships acquired via Cisura acquisition, will continue to create synergies and drive for higher topline growth. Finally, the IT Department will also be firing on all cylinders, which will create accretive top and bottom line growth, in the near, mid and long-term.

My conviction, for the mid-term, is that INFU can drive for $12-13mm in OCF in the FY, with only $5mm in capex.

Base FY Estimates

Bull FY Estimates

OCF

12

13

Capex

5

5

FCF

7

8

Shares Outstanding

22.51

22.51

FCF Per Share

0.31

0.36

Current Price Per Share

3.17

3.17

FCF Yield

9.78%

11.35%

Click to enlarge

In millions

This FCF can be used for early payments on debt and continual organic growth via acquiring more infusion pumps. Thus, instead of spending ~$5mm/year on an investment in an IT Department, INFU can now spend (if they want) ~$5mm/year on more infusion pumps. Given the high ROI that infusion pumps have, this can give the company huge top and bottom line potential.

Finally, my model in my previous report was based upon near-term estimates. I believe that INFU is a great buy and hold, due to secular demand, a great management team and potential for high ROI (remember the company's gross margins are >70%). Furthermore, I believe that in the mid-term, INFU will not have a problem hitting $100mm in revenue. With their potential for high future margins, I have a strong conviction that EBITDA margins between 25-30% are very feasible and conservative (EBITDA margins in 2013-2014 were ~22%).

Mid-Term Base

Mid-Term Bull

Revenues

100

100

EBITDA Margins

25%

30%

EBITDA

25

30

Multiple

6.50

7.00

+Cash

1.00

1.00

-Debt

35.24

35.24

Total Equity

128.26

175.76

Shares Outstanding

22.51

22.51

Estimated Equity Per Share

5.70

7.81

Click to enlarge

In millions

Finally, my base and bull cases are assuming the same multiple as in my original thesis. Investors should note that the high debt position is currently acting as an overhang on the future estimated share price. However, if management continues to stay ahead of the debt schedule and continues to generate decent FCF, debt should decrease and the overhang will be lifted.

Risks

The same risks to investing in INFU exist as when I first wrote about the company.

A cure for colorectal cancer. Shareholder dilution. Paying too high for an acquisition or growing too fast in terms of organic growth. Future regulations such as the CMS regulation and the affordable care act.

I did get to speak with Eric about his thoughts on the affordable care and future regulations. He told me that regulations will always change and always be around. What matters is that INFU's products are needed by patients no matter what kind of regulations get tossed out. I thought that was a very important statement and should give investors some peace of mind in regards to regulations surrounding the healthcare industry.

Overall, I feel like INFU is presenting itself with an asymmetrical risk/reward profile with a skew towards the upside and minimal downside.

Conclusion

Microcaps can be exciting and can create a substantial amount of alpha for the investor willing to do his or her own research. In my opinion, finding a business model that is outstanding, with future growth that looks very bright, is not hard. However, finding an excellent business model with a great future, coupled with a quality management team, is very hard to find.

INFU has always had an excellent business model (gross margins >70% suggest this). Also, due to secular demand and shifting demographics, the future looks bright. With Eric's knowledge of running infusion companies and his overall industry experience, I believe that INFU has a bright future. Microcap investors can take advantage of INFU while the rest of the street continues to focus on large caps.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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