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Fonar - A Micro-Cap With 40% Upside

|Includes: Fonar Corporation (FONR)

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Most people either know someone or have experienced for themselves an MRI scan.

MRI stands for "magnetic resonance imaging". MRI is a procedure used to obtain tissue and skeletal scans for diagnosis of a wide range of potential ailments, ranging from neurological to cardiological to gastrointestinal. The procedure utilizes magnetic fields and radio waves to perform scans, and is considered safer and preferable to CT (X-ray) scans when either can be used.

However, as anyone who has experienced one can attest, the procedure is not exactly enjoyable. Most MRI machines are built in a tunnel-like configuration, where the patient lies flat on his/her back and is fed back into the machine. The result is that the patient must lie in an uncomfortable, confining, immobile position, in a claustrophobic and noisy setting, for 30 minutes or more.

Today's Top Buy pick is looking to change that and improve upon the traditional negatives of the MRI scan.

An Old Name In MRI

Fonar Corporation (NASDAQ:FONR) is not a new name in MRI.

In fact, the company's founder (and still CEO), Raymond Damadian, invented the MRI machine back in 1972. Subsequently, he founded Fonar in 1978 and was the first company to ship a commercial MRI in 1980. Fonar held most of the original patents on the technology and successfully collected royalties for many years as large industrials like GE and Toshiba entered the market (it even won a $103 million settlement from GE in 1997).

In more recent times, Fonar invented the Upright MRI, which allows patients to sit, stand, bend, or lay during the scan - even watch television! The result is a much more comfortable, less claustrophobic experience for patients. Additionally, the Upright MRI allows for scanning patients in weight-bearing positions, which can be helpful in diagnosing issues where the pain is acute in certain bodily positions (such as spinal injuries). Even newer "open MRI" systems are not as comfortable or clinically useful.

Fonar originally pursued machine sales as its monetization strategy for the Upright MRI. New machines and service contracts still account for about 17% of the company's sales (and closer to 30% of profits), but new machine sales have been declining pretty dramatically since 2010. The larger part of Fonar's business is through its majority-owned management business, known as Health Management Corporation of America, or "HCMA".

HCMA provides full-blown management for 24 MRI centers - 23 of which are equipped with Upright MRI machines. Management services include pretty much all non-medical operations: staffing of non-medical personnel, accounting, billing and collection, leasing of office space, marketing, etc. In turn HCMA receives a flat monthly fee. The only exceptions are 4 facilities in Florida that are owned subsidiaries and are effectively operated directly by the company.

Growing By Acquisition

Fonar's growth has come, and will continue to come from, expanding their MRI centers under management. This has happened mostly through acquisition. In 2013, HCMA used debt and equity to acquire a 50.5% stake in Health Diagnostic Management (HDM), which operates 14 facilities, expanding revenue by almost 25% in fiscal (June) 2013 and 40% for 2014.

Another way Fonar can grow is to continue to consolidate HDM into the company, earning shareholders a larger piece of the profits of those 14 facilities. To this end, Fonar completed a $5 million deal in January to increase its stake to 60.4%. This will reduce the minority interest taken out of profits, balance sheet equity, and cash flows going forward.

Other Things To Like

Fonar has some other nice attributes, as well. For a tiny ($75 million) company, its competitive positioning is actually quite good. The firm holds numerous patents on the Upright MRI system, is not licensing them, has proven their effectiveness in the past, and has at least a decade of protection. The advantages of the Upright MRI vs. the traditional tunnel-style machine (and even newer open systems) are easily marketable, and indeed more aggressive marketing has driven a 9% increase in scans performed in the first 6 months of this fiscal year.

Also, Fonar is financially a strong company. Debt from the HDM deal has been paid down rapidly, from nearly $16 million at the end of 2013 to under $10 million as of the last quarter. Fonar's monthly-fee management business is recurring and "sticky" (switching management providers would be enormously disruptive), driving very steady and reliable free cash flows at about 11% of sales. Over the medium term, this should allow Fonar to pursue its strategy of acquiring new centers and consolidating HDM without over-leveraging its balance sheet.

Risks

Before we get into any company risks, it is important to stress that Fonar is a micro-cap stock with very limited liquidity and wild price swings. Over the past year the stock has swung between $10 and $20! Only consider this one if you are ready for that, and be sure to use limit orders when entering or exiting the stock.

Operationally, there are a few things to consider. First, despite being a first mover and holding valuable patents, Fonar is still a tiny company today, and its management team still consists of a group of long-timers, all but one of which is over the age of 76! That one, investment banker Ron Lehman (only 37), is behind much of the recent acquisition strategy, so perhaps we're seeing a step in the right direction.

MRI machines are produced by some big-name industrials: General Electric, Siemens, Hitachi, Philips and Toshiba to name a few. All of these companies have far more R&D and marketing resources then Fonar. A newer development from one of these competitors could make Upright MRI less attractive then it is today.

Also, new "Obamacare" rules have reduced reimbursement rates to MRI centers, which has slightly pressured the fees paid to HCMA. Further effects are not predictable but could continue to pressure management fees.

Finally, Fonar's equipment business has been in a long-term decline. Machine sales have fallen from over $9 million in 2010 to under $2 million in 2014, although service fees have remained steady in the $10-11 million range. Further drops here will pressure margins, as this is a more profitable part of the business. On the bright side, trailing twelve month new equipment sales are up to $2.7 million, so this unit could be on the upswing, too.

Conclusion

Fonar is an attractive micro-cap. Unusually for such a small company, it has pretty reliable and recurring revenues, as well as decent competitive advantages, to go on top of a plausible growth strategy. The stock at $12.50 is in the bottom part of its 52-week range, 64% under its 52-week high. Assuming reasonable 6-7% growth going forward, and a 10% earnings yield, I see Fonar worth about $17.50/share - 40% upside from here. We'll add it as our newest Top Buy pick under the "Aggressive" portfolio.

Disclosure: The author is long FONR.