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OnPoint Medical (ONMD): Initiating Coverage at Outperform

|Includes:Vertical Health Com (VHSL)
We have initiated coverage of OnPoint Medical Diagnostics (ONMD) with an Outperform rating and $3.50 price target.  The company's MRI Quality Assurance software, which should commence commercial roll-out before the current year-end, fills an unmet need in the large and growing market for advanced imaging quality control.  Our 19-page report on the company includes our financial model and valuation methodology, a detailed explanation of OnPoint's novel software, and analysis of their target markets and competition.  
Logging almost 30 million scans per year in the U.S. alone, magnetic resonance imaging (MRI) remains the imaging modality of choice for the visualization of many of the body's soft tissues including the brain, muscles and connective tissue.  Complex and sensitive, MRI scanners need to be regularly evaluated, calibrated and maintained to ensure optimal performance and image quality.  Today, MRI quality control is largely a manual process which is not only time and resource-intensive, it can also be highly subjective, inconsistent, inefficient and unreliable.  
OnPoint Medical Diagnostics' (ONMD) MRI Quality Assurance software, which was developed by the world-renowned Mayo Clinic of Rochester, MN automates many of the ACR weekly quality control requirements that imaging facilities are required to perform in order to continue to receive Medicare reimbursement (beginning January 1, 2012).  Validated on over 200k images by highly-acclaimed imaging experts, OnPoint's MRI Quality Assurance software directly addresses the deficiencies of the antiquated manual methods, affording significantly faster and more reliable streamlined quality control which in-turn reduces expense, scanner down-time and risk of image degradation.  The software has been in limited use since 2006 and is currently being refined through ongoing field-testing on over 50 MRI scanners in major imaging centers.  Management expects final product revisions and enhancements to be completed over the next several weeks and is in the midst of preparing for the commercial roll-out, slated for Q4. 
Essentially a cloud-based software company (with revenue generated on a per-scanner basis) with only modest sales infrastructure, OnPoint's business model should be highly scalable.  The company is led by highly-experienced management and advisory teams.  Expected early adopters, including the company's network of industry contacts as well as other multi-scanner imaging facilities bogged down with performing manual QC, represent a large portion of the overall market.  This affords the potential for rapid market penetration and, coupled with a low-cost business model and little direct competition, means revenue, profitability and cash flow could accelerate in short-order. 
We estimate OnPoint's direct U.S. market opportunity for MRI QA at approximately $250 million annually with the international market worth another ~ $300 million.  While substantial for a company of OnPoint's size, perhaps not significant enough for imaging heavyweights such as GE, Siemens, Philips or Toshiba to enter organically - if, however, they do decide to enter the space, OnPoint could be an acquisition target.  While we believe OnPoint can reach profitability and generate positive cash flow with only a modest penetration of the domestic MRI market, the company is already looking to diversify into other imaging modalities including CT, mammography and nuclear which would substantially increase the size of their target market, as well as their visibility.
OnPoint Medical Diagnostics was the surviving entity of an April 2011 reverse merger with Vertical Health Solutions.  The company is headquartered in Minneapolis, MN.   
As OnPoint has yet to launch its software and is still a development-stage company, there remains a significant amount of unknowns which makes predicting its future challenging.  And although OnPoint's software appears to be a major improvement over manual QC with the potential for significant added-value (including streamlined processes and less scanner downtime), novel technologies often suffer from slow acceptance.  This may especially prove to the case with smaller imaging facilities which may have only one scanner and have less of an opportunity to reap the benefits of OnPoint's software.  Our "Outlook" considers these challenges and risks (such as assuming the early-adopter market are facilities with more than one scanner) and reflects our "best guess" of how OnPoint's future will develop  based on our due diligence of the company, industry, market and competition.
Beta-testing and validation is wrapping up and the software is currently going through final enhancements.  Based on our discussions with management, we look for commercial sales to begin in Q4 of this year (i.e. - within the next 2 months).  Management has proven to be fairly frugal and cash-conscious and we expect the initial roll-out will be reflective of this cautious approach.  The selling function will at first be handled by a skeleton crew of industry veterans including OnPoint's CEO who will be calling on high-potential business contacts.  The initial launch will likely be somewhat anti-climactic from a revenue standpoint but is expected to be as much about making sales as it is about generating publicity and interest in the software as well as receiving customer feedback.  With virtually no direct competition, OnPoint has a rare first-mover advantage and we expect the company will exploit this opportunity by offering attractive front-end pricing in an attempt to grab early market share.  Assuming feedback is positive and customer retention high (both of which we expect will be the case), there will hopefully be opportunity to significantly raise prices over the longer-term.    
OnPoint expects to continue to further develop the software (handled by outside consultants) following launch so as to include additional functionality.  Management will also be gauging demand and collecting feedback throughout the remainder of the current year which will help determine staffing requirements (sales and support staff will be added in increments) and assist in directing marketing initiatives.  While OnPoint will need to raise additional capital to fund these initiatives, as noted above, we feel comfortable that there will be sufficient investor interest to continue to finance operations for the foreseeable future.  Our model incorporates an assumption that OnPoint raises additional capital through secondary stock issuance in the late-2011/early-2012 timeframe.   
Assuming the MRI launch is successful, OnPoint will begin a greater focus on follow-on imaging modalities, including CT which we think could come to market in 2012.  We note, however, that while our model incorporates revenue contribution from CT, that we assume that this added functionality is more of an up-sell opportunity offered at a significant discount to existing MRI customers - meaning margins on the CT product will be a fraction of that for MRI (and with little in the way of fixed costs, OnPoint has flexibility in trimming expenses based on the level revenue).  Based on our current model, we believe OnPoint can reach profitability and generate positive cash flow on their MRI product alone.  There may also be an opportunity to begin selling overseas, although we do not currently incorporate any international sales into our model.  We believe longer-term success will be largely determined by the rate of penetration of the domestic MRI (and to a lesser extent the CT) market.   
Our revenue model is based on certain assumptions including the rate of growth of OnPoint's share of the domestic MRI and CT imaging markets, overall growth in each of these markets, and OnPoint's initial pricing (for both MRI and CT) and future pricing power (which will largely be driven by demand/market share). 
We look for OnPoint to limp into the market later this year.  While we model only inconsequential revenue in Q4, management's focus will be to get their foot in the door and generate a buzz about their software.  Initial contracts will be relatively low-dollar and possibly shorter-term but there may be potential to score some easy shots on goal through business generated from management's industry contacts.
For the first half of 2012 we model more of the same - a slow ramp in sales with little in the way of price increases as OnPoint focuses on building the installed base and completes development for CT.  By the back half of 2012 OnPoint may begin to see a bigger return on their scaled-up sales and marketing efforts and have the opportunity to start ratcheting up pricing.  We model OnPoint's software to claim roughly 3% of the total MRI QC market (or about 6% of the early-adopter market - as defined earlier) by year-end 2012.  We also assume their CT quality assurance software is released towards the middle of 2012 which expands the company's total target market opportunity by approximately 50% (in $ terms).  As noted previously, while there are roughly the same number of CT scanners in use in the U.S. as there are MRI systems, the additional CT functionality to the software will not double OnPoint's target market as many imaging facilities offerboth CT and MRI - as such, we view CT functionality mostly as an up-sell opportunity (i.e. - volume price discounts) to existing MRI customers.  We model total revenue of $1.8 million in revenue in 2012 which includes $1.6 million from MRI QA (representing ~ 195 customer contracts) and $60k (representing ~ 30 customer contracts) from CT QA (with the remainder from installation and training revenue).
From 2013 and beyond we model the overall domestic MRI and CT markets to grow at about 3% and 5%, respectively.  We look for OnPoint to capture about 7% and 2% (15% and 5% of early-adopters) of these markets in 2013, growing to 20% and 11% by 2015.  We also assume OnPoint has ample pricing power and is able to increase average pricing by about 300% in 2013 (compared to 2011 pricing - when we assume OnPoint's pricing barely covers variable costs) and 550% in 2015 (compared to 2011 pricing).  We do not believe our 2015 assumed pricing, at about $1,500 per month per MRI scanner and $650 per month per CT scanner, is aggressive especially when comparing this to the cost of annual scanner service contracts (~ $100k per year) or the cost of unplanned scanner downtime ($1,000 per hour).  We model MRI and CT related revenue of $9.2 million and $1.3 million in 2013, respectively, growing to $47 million and $12.9 million in 2015.  
Despite a highly scalable and low-cost business model, we do not expect OnPoint to generate positive net income in 2011 or 2012 as meager revenue from incentivized front-end pricing and a relatively negligible number of customer contracts is insufficient to offset the scale-up in R&D (related to follow-on modalities and software enhancements) and SG&A ( related to increased marketing and additional sales and support personnel).  We model EPS of ($0.25) and ($0.14) in 2011 and 2012, respectively.
We expect revenue to begin to significantly ramp in 2013 as a result of firmer pricing, a full-year's worth of CT sales and realization of the benefits of ramped up sales and marketing efforts.  Revenue growth should outstrip that of operating expenses and, combined with significantly wider gross margins as a result of price increases, should result in 2013 being OnPoint's first full year with positive net income.  We model EPS of $0.02 in 2013 and $0.19 in 2014. 
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