NightHawk Radiology IPO: An Overview (NHWK)

| About: NightHawk Radiology (NHWK)
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The Story: NightHawk Radiology (NHWK) is a teleradiology company, meaning that they have a staff of radiologists that evaluate scans transmitted electronically to them from around the world. Teleradiology was in development in the mid 1990's, and became truly functional in the late 1990's. Today the infrastructure necessary is standard (it's easy to transmit large graphics files securely around the word), so the technological risks to this field are no longer a concern. NightHawk operates 2 foreign radiological evaluation centers, one in Sydney, Australia, and one in Zurich, Switzerland. This is ostensibly so that the staff at those centers are operating during local normal business hours, which correspond to nighttime across the US. All radiologists are US educated and US Board Certified. I personally do not have a good handle on the supply/demand situation for radiologists (they discuss it in their SEC prospectus), but there are a number of casual points worth mentioning:

* their doctors are NOT low cost alternatives (e.g. from India)
* there may be certain tax or liability advantages to their foreign services, although they are incorporated in Idaho. Just a thought, I don't really know one way or the other.
* their foreign locations are NOT low cost cities
* there may be other corporate competitors, of which I am unaware
* their market is dominated by local on-call or on-staff radiologists and radiology groups
* their primary customers are those local radiology groups - using NightHawk obviates their need for nighttime on-call duties.

They seem to provide a desirable service to the main players in their market space. Hitting it at the right price, etc. is another matter. Rather than trying to evaluate the competitive landscape and the market and their market share, of which I don't have much advantage, we'll just look to see how they've been doing. Radiology is an old (and very very profitable) field, and technology costs are cheaper today than they have ever been, so these guys should be making a ton of money.

The Company: Quick stats for Q3 2005 (30 Sep): 383 customers, 746 hospitals (13% of all US hospitals), with most using fewer hours than available - i.e. good growth possible through market share gains. Approximately 60 radiologists going into 2006. Financial data are for FY 2002-2004 and 9 month 2005:

* Revenue growth Y/Y of 247%, 165%, and 76% [$16.22M/$4.67M, $42.97M/$16.22M, and $48.79M/$27.67M]. So, as they scale up their growth percentages naturally decrease, but are still very good. In absolute terms, their revenue increased Y/Y by $11.5M, $26.8M, and $21.1M
* Operating expenses Y/Y have increased by 219%, 168%, and 95% [$11.5M/$3.6M, $30.9M/$11.5M, and $36.4M/$18.7M], or in absolute terms by $7.9M, $19.4M, and $17.7M. Comparing both the percentages and the absolute values show that their end-run expenses are increasing at about the same rate as their revenue, with only a $3-$5M marginal difference. There is also some irregularity to the trend. They are little better than linear, but not much, which is exactly what we would expect for a service business. We would have hoped for a wider gap, though.
* Operating earnings Y/Y have increased by 272%, 152%, and 37% [$4.76M/$1.04M, $12.0M/$4.76M, and $12.36M/$9.02M]. In absolute terms that gives $3.7M, $7.2M, and $3.3M. Given the small initial numbers the end-run rate is more representative of forward expectations.
* Operating margins for the 4 periods were 22%, 29%, 28% and 25% [$1.04M/$4.67M, $4.7M/$16.2M, $12.0M/$42.97M, and $12.36M/$48.79M].
* They have had a number of non-operating charges related to share holdings. Ignoring those, they have always shown operating profits.
* Operating EPS for 2002-2004 and annualized for 2005 were $0.02, $0.10, $0.38, and $0.68 [$1.041M/49.732M, $4.76M/49.732M, $12.038M/31.443M and $12.360M/24.259Mx4/3]. Much of the EPS change is due to the changing share basis.

We thought these guys would be hitting it gangbusters, but given their ca. 25% margin on ca. $20M annual revenue growth, they're only likely to increase operating earnings by about $5M/year. Small potatoes, and linear. I'm surprised, but these guys are Blah.

The Stock: NHWK came public on Feb. 9 for $16/share, up from their original range of $12-14, and they also increased the number of shares from 5.8M to 6.3M (21% of the company) for a final deal size of $100M. They opened at around $20. Projecting for 2006 that they will add about $5M in operating earnings, and keeping the share base fixed (this will likely overestimate the EPS number) gives a projected 2006 operating EPS of $0.72 [($12.36M+$5M)/24M] and a projected 2006 operating P/E of 28 [$20/$0.72]. That's not crazy, so they are not worth shorting. They seem reasonably valued going forward, but given their likely slow growth we don't expect much share price increase.

Generally, successful IPO's come with a good deal of hype, leading to overpricing for good growth. Their IPO price was raised during the initial listing, indicating greater investor enthusiasm than anticipated. After looking at their numbers, it seems that that enthusiasm was probably based on Story, not Company. After they post their first numbers as a public venture there may be a deflation in that hype and a sell-off. We're not going to short them, but if they hit the low teens without any other significant corporate deterioration we may do some buying.

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