Analyzing business models are a very important part of investing, especially with micro-cap companies where poor business models are abundant. Auxilio (OTCQB:AUXO) is one of the rare micro-caps that has barriers to entry, a quality recurring revenue model, aligned management/directors, yet trades at a significant discount to intrinsic value. Recent light earnings from poor weather and a conversion of debt into shares have been driving down the stock price. We expect that stronger earnings from the Delphiis acquisition and large deals in the company's sales pipeline should catalyze up to 100% upside in the near to midterm with minimum downside. For those that are patient, there could be a potential takeover many multiples higher than today's price.
It is likely you have never heard of Auxilio, but ask any person that works at a hospital using their managed print services and they will instantly know of the company.
Auxilio is the leader in managed print services with hospitals. Essentially, they provide and implement a customized detailed strategy to help the hospital run a more efficient printing operations. Some might think that as hospitals transition to electronic medical records -EMR- there will be less paper printed. In actuality, EMR has created a need to print more, at least in the beginning phases, and large print volume is expected to persist at hospitals for a variety of reasons: patients like to get hard copies, paper billing, documented internal communication, health compliance, etc,. Managing print volume of millions of papers a month efficiently then becomes a low hanging fruit for hospitals to cut costs.
Auxilio happens to be the only vendor-independent - they do not try to push a specific brand of printing equipment - managed print service provider focused on the healthcare industry. The company has gained significant, specific knowledge on how to manage printing at hospitals that competitors often lack. Auxilio also recently expanded their offering to providing HIPAA compliance and security and risk strategy implementation with their acquisition of Delphiis, which is likely to increase the valuation proposition to hospitals.
Auxilio creates 3-5 year contracts with hospitals where hospitals pay Auxilio on a page by page basis for the whole service instead of purchasing equipment, supplies and paying salaries to employees themselves. Since hospitals generally are oversold on printing equipment and there is little strategy and efficiency in printing, hospitals generally pay much more per page then they could. Auxilio's knowledge of managing paper at hospitals allows them to drive significant operational efficiencies driving down costs significantly enough where they save hospitals a guaranteed 10-30% while maintaining a profit.
We like the recurring revenue streams, especially at hospitals, since the industry is recession-proof and the long-dated contracts and relationships provide plenty of downside protection. Since Auxilio staff are on the client hospital's premises, there is a relationship that is formed creating stickiness with revenues as contracts have high rates of renewal. To observe sustainability of demand, there has only been one contract that has not been renewed in the past few years and that was due to the hospital deciding to do the managed print service in-house.
Generally, it is difficult for a hospital to achieve similar cost savings to Auxilio since Auxilio has scale in both purchasing products for the customer and the specialized knowledge necessary to drive the greatest efficiency. By providing more value through their Delphiis security platform, it is likely that the stickiness of revenues increases.
Delphiis acquisition & Larger Order Pipeline
There are significant opportunities to expand with managed print services alone, but Auxilio should benefit greatly from the addition of Delphiis' security offering. HIPAA compliance is a significant challenge for hospitals and it just so happens that each printed paper could be considered a HIPAA compliance issue. That means that current customers of Auxilio could benefit from the extra security services that Delphiis would provide. Additionally, Delphiis customers, who are likely not current customers of Auxilio, could benefit from the managed print services as well. The cross selling is hard to gauge at the current time but does provide a catalyst to minimize the valuation gap.
The combination of a managed print service provider with HIPAA security compliance capabilities combines to make a high value proposition for hospitals. CEO of Auxilio Joe Flynn mentioned on the recent earnings call that they have some very large hospital systems in the pipeline, which has grown the lead time in giving service, but with Delphiis' security solutions we think there is a greater likelihood that Auxilio will be able to convert these hospital systems into clients.
Keep in mind that Delphiis' security offerings have considerably higher margins from their security platform, so the more that Auxilio is able to cross-sell these services to current clients, the higher the margin will go. This will then negate the current problem of the new contracts masking the true margins of mature contracts.
Auxilio earns significant returns on net-tangible assets, indicating that the company is of high quality. Net-tangible assets are less than $1 million, yet the company produced $1.34 million in 2013, which is not taking into consideration the masked earnings of new contracts. As contracts mature and margins improve, it is likely that after-tax profits will continue to grow, while the company needs very little in the way of capital to grow.
One of the nice things about owning micro-cap companies is that often times you will find insiders owning a large portion of shares, so management and the board are all incentivized to create long-term wealth for themselves and other shareholders. Auxilio management and board members hold 30.4% of Auxilio's outstanding shares as of the last proxy; in addition, William Leonard - board member as ex-CEO of Aramark Corporation - and director Edward Case have been purchasing shares on the open market (these purchases have been small however).
Currently there is little market attention given to Auxilio due to its $28 million market cap, which is likely a large reason for the company's undervaluation. The lack of analyst coverage and institutional ownership is a result of both the company's size as well as the illiquidity. That should not deter investors however, since Auxilio is a high quality company with recurring revenues and plenty of runway for growth. In cases with quality companies, illiquidity should be looked at as a benefit because the liquidity discount provides an attractive price for those investors who are willing to be patient.
Auxilio also has been impacted by two events that are likely to have no impact on the company's long-term intrinsic value. First, the company's billing is on a quarter lag. That means that the recent results that were announced for Q2 are actually the results from January to March of 2014 and not April to June. For those who live on the east coast, they know that this year's winter has impacted many businesses and is likely one contributor to Auxilio's modest revenue gains in the recent quarter. It is likely that Auxilio's Q3 results, which will represent April to June, could be significantly better than Q2 results.
Also, Auxilio announced in late July that they converted their debt into 1.5 million shares, which could be another likely reason for the downtrending share price. Both of these factors have no impact on Auxilio's long-term business nor intrinsic value, so the lower share price is not warranted.
Another reason why Mr. Market continues to ascribe a low value to Auxilio is due to the lack of profitability masked by the low initial margins of new contracts. Most investors will overlook the fact that as Auxilio's contracts mature, margins improve to 25% and high cash is generated relative to EBITDA. So the recent addition of new contracts is masking the nearly 25% margins the company receives from more mature contracts in the 3-5 year range.
Since contracts take nearly a year (6-9 months) to become cash flow positive and Delphiis is expected to boost margins, we think it is better to use the upper part of CEO Joe Flynn's target operating margins of 25% as a normalized EBITDA figure going forward - even with growth from new contracts. Auxilio has recurring revenues, and are growing, so it is likely that trailing numbers would not be a great guide for future earnings. We estimate that the company should be able to generate $45 million - potentially more with Delphiis - making normalized operating earnings of ~$11 million. With $6.5 million in operating costs, EBITDA would likely be $4.5 million. Back out cash and the EV currently is $21.7 million. Essentially, we can buy a high quality company with recurring revenues, high cash flow and virtually no similar competitor for 4.8x EV/EBITDA. Just for the company to revert to a respectable multiple of 8x could indicate at least 65% upside and up to 100% upside with a 10x multiple.
Looking at the valuation from a different perspective, the company has generated $3.1 million in FCF the last twelve months, so the current FCF/EV yield is 14.8%. We have to remember that FCF is impacted by new contracts and the Delphiis platform will likely add significantly to FCF, so the trailing FCF is likely lower than the future FCF.
Since the company generates high cash flows and has zero debt, it could become a target to private equity firms or a larger company in the future. A possible buyout in the next 5 years does not seem out of the realm of possibility. Along with the company's growth, Auxilio could be sold at a price much higher than today.
On the flip side, we see almost no downside with the recurring revenues lasting up to 5 years and beyond with high renewal rates. Add in the extra value proposition that Delphiis brings to hospitals and there is an even greater likelihood that hospitals will renew their contracts with Auxilio.
Regardless of which way we look at valuation, we are paying a low price for a high quality company, run by incentivized individuals, that continues to grow at a healthy rate.
As we stated earlier, Auxilio has very limited liquidity with volume of less than $20,000 a day. Even for small investors it could take a significant amount of time to accumulate and sell a decent sized position. Strict attention to limit orders and buying over long periods of time is necessary. We feel that this risk is mitigated by the very low current valuation as well as the high quality of the business model. With patience this company could become much more liquid as it grows making selling easier.
The top five customers make up more than 50% of revenues which is not ideal, however, the 3-5 year contracts and sticky relationships mitigates this risk significantly. We do not know how large the Delphiis clients are, however, they are likely different than the current roster of Auxilio clients, which will also slightly diversify clients.
The integration of Delphiis could run into problems, but we think that the small size of the acquisition - only a few people - is likely to be much easier than acquiring and integrating a billion dollar company with thousands of employees.
Success in micro-cap investing is more probable when weeding out the poor businesses from the quality businesses. Auxilio's business quality is high: sticky recurring revenues, increasing value proposition for customers, and high returns on little capital invested, yet the share price has been impacted by short-term headwinds. Auxilio is sporting a FCF yield of nearly 15%, has plenty of runway ahead of it and has minimal downside. We expect stronger Q3 earnings and future growth to catalyze up to 100% in the mid-term and much more in the long-term.
Disclosure: The author is long AUXO.
The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: This article is meant for instructional purposes and not meant as a recommendation to buy or sell. The only kind of intelligent investing is through your own due diligence
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