A benefit of micro-cap companies is that Mr. Market can be really slow in reacting to important news. Auxilio (AUXO) announced the acquisition of a small IT managed service company called Delphiis on Tuesday that will add important information security and HIPAA compliance services to Auxilio's managed print services. The acquisition is adding more value to AUXO customers and makes their services more compelling to potential clients. The market seems unperturbed by the news since Auxilio is under the radar and the financials of Delphiis will not be made available until September.
Delphiis enhances Auxilio's moat and adds plenty of potential for improved margins, higher cash flows and revenues. Without Delphiis, Auxilio's recurring revenue model, growth potential and highly aligned management/board provide for an asymmetric risk/reward -- including Delphis, Auxilio's risk/reward profile increases making it more of a "Heads I win big, tails I don't lose too much." We see the value gap quickly closing as Delphiis integrates into Auxilio's current operations and new managed print service contracts continue to mature.
Overview
Auxilio is the only managed printing service provider that works with hospitals and hospital systems. Hospitals off-load all of the responsibilities of strategy, purchase of equipment and oversight of anything print related to AUXO.
Even as hospitals and health care centers move to electronic medical records as a result of the Healthcare Reform Act, there continues to be a large amount of paper that is produced at hospitals. To give a better idea of the inefficiencies present with paper volumes at hospitals we have included the slide below.
(Source: Auxilio Presentation)
Paper is unlikely to be completely phased out at hospitals. We like to think this is similar to the newspaper industry. Although newsprint has been decreasing, it is unlikely that it will be phased out anytime soon. The reason is much more behavioral than anything else. For a hospital there are many different moving parts and likely has certain ways of doing the functions necessary to run the hospital. Paper continues to be the preferred method of communication with lawyers, patients, regulators, etc,. Huge change would be needed to direct hospital workers to choose electronic formats as the preferred methods of communications with the previously mentioned entities. It could be even said that the information becomes more accessible through electronic medical records (EMR) which could lead to more print volumes.
Hospitals and hospital systems have to cut costs due to the revenue reductions from Medicare and Medicaid reimbursements starting in 2014. They are then looking at reduced revenues of about 15%. Strategies are then necessary to help reduce expenses to keep up with the revenue reductions and the amount of paper produced is an area that can be an easy target for expense reduction. But, many hospitals do not have the expertise to strategically reduce paper volume and more likely interested in off-loading any non-health related functions to others who have the expertise and the scale to keep the costs low. This is where Auxilio shines. They have the expertise to create the strategy and the personnel to implement management/reduction of the print volumes and costs of health care institutions. Auxilio even guarantees that they can reduce printing costs anywhere from 10-30%. To give an example, AUXO's largest client Catholic Healthcare East is on track to save $10-$15 million over the next five years while AUXO receives 20-25% in gross margin.
Delphiis Acquisition
Hospitals have the duty to comply with the Health Insurance and Portability Accountability Act ("HIPAA") and keep their records secure. HIPAA compliance is a large pain point for hospitals since it requires keeping track of all printed paper, electronic data and that copy machines are properly secure. CEO Joe Flynn noted that a CFO of a large hospital system said that "I view every piece of paper coming through a print device as a potential HIPAA violation."
If a hospital is found to be breaching HIPAA or HITECH, related fines range from $25,000 to $1.5 million for a single breach (here). Clearly, the Delphiis team and software will add to Auxilio's current managed print services helping clients comply with HIPAA. Potential prospects could also view the Delphiis acquisition as an even stronger case to using Auxilio's services.
We have searched and found that equipment manufacturers such asXerox and Cannon provide consulting, secure print applications and other ways to keep up with HIPAA compliance. The only problem is that these services are not their main focus, equipment is.
Xerox provides complete services to transition to the new ICD-10 regulations required by HIPAA, however, they do not focus on cutting costs, nor give a guarantee of cost savings. Auxilio continues to be the only company exclusively focused on healthcare industry and on cost cutting - customers notice. With Delphiis, Auxilio will now have the IT security and HIPAA compliance. Auxilio can continue to win share as being a vendor neutral service provider.
What is largely unknown, so far, is the exact financial condition of Delphiis and at what point it accretes value to Auxilio shareholders. On the recent call describing the acquisition Joe Flynn mentioned that Auxilio will post Delphiis' financials in September. The reason being that as a small start-up private company, Delphiis did not have to abide by GAAP accounting, which Auxilio must translate. We do not really get upset with this since management and the board are happy and have sizable minority stakes in Auxilio. They would not have done the deal if it would be diluting them severally.
Even taking a step back, the $2.7 million does not look outrageous for getting a talented team led by Mike Gentile, software IP and access to Delphiis client relationships. This is not a transaction that made Mike Gentile and other Delphiis founders rich but as Gentile said in the call that the acquisition "Provides Delphiis a compelling opportunity to enter the public market much sooner than on a stand alone basis." Long-term shareholders then can take comfort knowing that the team is in for the long haul and less likely that Auxilio paid a ridiculously high price.
Growth opportunity
There are approximately 6,700 hospitals and hospital systems in the US and all of them are likely trying to find ways to cut costs. Of those 6,700, there are approximately 2,000 hospitals with the size that Auxilio intends to focus on. These larger hospitals will be able to reap larger cost savings from print management services. The Delphiis acquisition should provide more potential value for prospects, thus a better chance Auxilio can continue to gain market share. Auxilio can further add value services which grows and diversifies revenue.
The beauty of AUXO's business model is that it takes very few individuals at corporate to sell the service. There are currently only 2 individuals on staff for sales. One for the east coast and one for the west coast and referrals are often used. The sales individuals have the extensive contacts with CIOs of hospitals and also have the skills to describe the value proposition to those individuals. Furthermore, a number of directors on AUXO's board has significant industry experience and contacts that have been providing steady business to the company.
First mover advantage is at huge advantage here since long-term contracts are signed and there is a high likelihood that these contracts are renewed. Competitors then have a much higher barriers to cross as AUXO continues to acquire relationships with hospitals.
Quality
The company currently has masked earnings due to the nature of margins growing as contracts become mature. Irrespective of that fact, the company has been generating returns that are extremely high. This is a service company that requires very limited assets to produce high returns. AUXO's asset light operations produced the following in 2013:
ROA - 11%
ROE - >60%
ROC - >1,000%
We expect these numbers to increase significantly in the next few years as contracts continue to mature and margins grow from 17% to >25% including the higher margins from Delphiis. SG&A are roughly $6 million or 13% of revenues, however, as the company gains more scale that percentage should continue to decrease in relation to revenues.
Moat
Currently the only competitors are equipment manufacturers such as Xerox, Cannon, HP, Epson, etc,. These companies are incentivized to sell equipment and not necessarily interested in integrating the equipment into the hospital's system or helping the hospital reduce their printing costs. So what AUXO commonly finds is that hospitals are being oversold with equipment and undersold on strategy. The CEO states that hospitals often times have the capacity for 200% more volume than the hospital actually produces. Hospitals usually do not know any different and then are forced to pay more per page in costs. AUXO provides the necessary strategy to reduce equipment costs, provide printing software suggestions, and the training to end-users necessary to reduce printing volume.
One area where Auxilio is able to reduce costs is through equipment. The company is not an equipment manufacturer and is not reliant on any one equipment manufacturer. That allows them to use equipment that is already present, get rid of unnecessary equipment and purchase equipment from other vendors that would be best for reducing costs for the hospital.
In this current climate for healthcare hospitals are more likely to purchase a service that allows them to drive down cost. There currently no other companies that provide the same service that Auxilio provides which means that hospitals currently have limited options in managing their print. The only alternative would be to hire in-house a team or person who could manage their printing, however, Auxilio benefits from expertise and scale as they continue to grow.
Being the first mover, we believe that Auxilio has significant leverage. As the company grows they lock clients into their model. It then becomes a much more difficult proposition for a competitor to take a hospital from Auxilio once they are in for a few reasons. First, they have on-site Auxilio personnel at each client site. These personnel are then the expert of the hospitals' printing infrastructure and also have created relationships with hospital personnel. A competitor would have to provide a value proposition higher than Auxilio either by offering more of a cost savings or better customer service which would be difficult.
Auxilio also benefits from the contacts of their employees and directors. Many of the directors have many years experience working in the hospital industry and have significant lists of contacts that they can call on to sell Auxilio's service. Take for instance William Leonard who eventually became the head of Aramark Corporation. The company provides services to a majority of hospitals in the US and Leonard has a long list of previous clients to draw from.
The key here is that the directors are properly incentivized for the long-term. Many of the directors we speak of have significant minority stakes in Auxilio, so it is in their best interest to utilize any resource they have to grow the business. That means that competitors are immediately at a disadvantage not having the same access to industry contacts. So we do not see a large equipment vendor having the contacts or the deep knowledge of hospitals to compete with Auxilio.
Sustainability
Companies with recurring revenue models are the best companies to invest in since cash flows then become more predictable. Auxilio normally signs contracts with durations of 3 to 5 years and since the company has full-time employees on-site it is likely that hospitals will renew their contracts. We say this because Auxilio creates a relationship with the hospital and becomes part of the hospital's new norm. As we stated before, having a full-time employee onsite makes it very difficult for a competitor to steal share. In the last few years there have been only hospital that has not renewed their contracts and that is due to wanting to do it themselves in-house. So a nearly 100% retention rate bodes well for AUXO's long-term prospects.
A similar service model with a different industry would be with Applied Materials. That company produces equipment needed to fabricate and manufacture the silicone wafers for technology companies such as Samsung, etc,. An Applied Materials (AMAT) engineer is on-site with the customer that assures that the equipment is properly working and support. Applied Materials is a cyclical business, yet has relatively sticky relationships with customers. We believe the same is true with AUXO and their clients, however, the company is much smaller, does not have the drawbacks of quick innovation in tech, is not cyclical and also provides a service in a recession proof arena.
AUXO's business model is one that can also be morphed fairly easily. Currently, the company focuses on print management, however, the recent Delphiis acquisition shows Auxilio can add to their suite of value added service offerings in many ways.
Management Incentives
We would like to highlight that management's compensation is tied to the performance of the company. Take for instance the warrants to purchase 1.5 million shares at $1.01 in Jan 2013. We like that management has to achieve certain performance targets through 2016 in order for these warrants to vest.
Also, the management team and board members own a large chunk of the company showing that they are aligned with minority shareholders. William Leonard is one director that sticks out as a special mention. He has been purchasing shares on the open market for a while and now directly owns 5.9% of the company or 7.5% including options and warrants.
(Source: AUXO Def14A)
Valuation
It takes roughly 6-9 months before AUXO is cash flow positive with new contracts since they have to invest in personnel and some cap-ex related to the contract. This means that AUXO's current earnings and cash flows are not truly reflective of future earnings. AUXO was expecting to earn gross margins of 20-25% before the Delphiis acquisition, however, the Delphiis software and services are higher margin leading to even greater margins in the future. The past 12 months Auxilio earned $43 million in revenue. Using the previous expected margins, EBITDA would be roughly $5 million. Mr. Market is only valuing the company at 5.4 times our adjusted numbers, which we think is extremely undervalued. The company is growing, has limited downside from recurring revenues and is unlikely to find a competitor to provide a similar service.
To put the current valuation in perspective we can look at the potential value of the company a few years out. AUXO is expected to increase revenues to $100 million in three to five years without any contribution from Delphiis. We expect SG&A to reduce to 10% of revenue with larger scale, so EBITDA would be roughly $15 million. Applying a very conservative multiple of 5x to EBITDA we would end up with a market valuation of $75 million. That is 178% higher than today's market cap. Five years out that would equal a 22% annual compounded increase. A 5x EBITDA multiple looks extremely conservative considering the company is likely to have greater than 10% net margins, higher revenues and nearly all of pre-tax operating income as free cash flow. We would expect an 8 times multiple of EBITDA to be a more accurate value of intrinsic value with improved margins, cash flows and higher revenues. AUXO enterprise value including the Delphiis acquisition would be roughly around $27 million compared to $40 million at 8x normalized EBITDA or nearly 50% upside. We expect that the Delphiis acquisition integration will quickly close that gap.
AUXO's recurring revenue model indicates bond like cash flows, but with the potential for large growth. Free cash flow yield can be indicative of value, which AUXO's is in the low double digits including the dilution of the incentive shares given to Delphiis employees.
Catalysts
Delphiis should provide immediate access to cross sell their services with Auxilio's current clients and vice versa. Margins should continue to expand and the value proposition for prospect clients rises, so revenues could rise quicker than anticipated.
Margins are depressed by new contracts with hospitals and once they mature margins will significantly improve. Auxilio is currently doing a 12 month consulting contract at Beth Israel Deaconess Medical Center in Boston, which could turn into a full 3-5 year contract and higher margins. This is one of the top research and academic hospitals in the US and would further heighten Auxilio's profile among hospital systems.
Risks
The largest risk is that Auxilio's four largest customers represented 52% of their revenues in 2013. Although customer concentration is usually a negative sign, we view that the recurring nature of the business model and their full-time staff at the hospital as a risk mitigator. Keep in mind that client retention has been nearly 100% over the past 5 years. Moreover, the acquisition of Delphiis should diversify revenue, strengthen ties with current customers and allow the company to cross sell their managed print services to Delphiis' clients.
Auxilio could have trouble gaining new customers. We think this risk is mitigated by the new Delphiis acquisition which should provide more potential value to prospective clients which in turn makes them more apt to use Auxilio for their print services and IT security/HIPAA compliance.
The Delphiis acquisition could be hard to integrate and could potentially not accrete value. Delphiis is only composed of 5 individuals so we feel that an acquisition of this size should not be as complicated as an acquisition of 1,000s of employees and multiple products/services.
Auxilio also has high cash flows which could be allocated in unfriendly ways for long-term shareholders. We think that this risk is mitigated by the fact that the board and management team all own significant minority stakes in the company, so poor capital allocation is unlikely. The Delphiis acquisition also shows that the company is opportunistic in their acquisition strategy which bodes well for future capital allocation.
This company is extremely illiquid which is another risk one must consider. For those with long-term horizons and are willing to look at this as more of a marriage, like we do, illiquidity is not that big of a deal. The greater Auxilio's success the higher volume should become, which should then make selling years down the road easier.
Conclusion
Auxilio is a strong company that by itself is trading for a meaningful discount. The company's recent acquisition of Delphiis should provide many opportunities to cross sell and add value to current/potential clients. We feel that the acquisition, once integrated, provides a significant catalyst to send shares much closer to intrinsic value. As contracts mature, margins will improve. Recurring revenues, sticky clients and aligned insiders portend limited downside, so we view Auxilio to be a very attractive risk/reward investment over the long-term.
