Trading Below Book Should Offer Downside Protection

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Trading Below Book Should Offer Downside Protection

Brian Marckx, CFA

Q4 2012 Financial Results

Electromed Inc. (ELMD) reported financial results for the fiscal 2012 fourth quarter ending June 30, 2012 on September 24th.  Revenue disappointed relative to our estimates for the third straight quarter.  The company again cited adverse reimbursement factors for the lackluster revenue while also noting that this is despite the fact that the number of prescriptions continues to grow.  As has been noted in the past, reimbursement amount for SmartVest can differ among third-party payers (most notably between Medicare and private payers) as can the reimbursable diagnoses.  Although ELMD does not disclose the proportion of prescriptions related to Medicare claims (which are generally reimbursed at a lower rate and have longer collection times compared to private payers), the implication is that this is a meaningful amount.

As we initially noted in our Q3 update, another contributor to revenue underperforming our expectations is the slower net growth of the size of the sales force - while ELMD is still adding headcount, the pace has been slower than management had previously expected (in early fiscal 2012 ELMD guided towards 27 - 30 reps by fiscal year-end), at least some of which is likely a result of the turnover in Q2.  In addition, there's a learning curve for newly hired reps which means there is typically some lag between the date of hire and when reps reach optimum productivity.  Nonetheless, the delay in growing the sales force seems to be a significant impediment to revenue and earnings growth.  ELMD notes in the Q4 earnings release that they currently have 22 sales reps, which is actually down from the 23 that they had about 12 months ago (and compares to 21 at 3/30/12 and 22 in mid-May 2012), but plan to add 6 to 8 more reps by the end of fiscal 2013 (6/30/2013).

ELMD has taken a very discerning approach to adding headcount in areas of the country that offer the most opportunity for growth (i.e. the most bang for the buck).  Factors such as population density as well as the local insurance reimbursement environment have both been components used to guide their domestic expansion strategy.  Electromed has been similarly discriminating relative to experience, ability and certification (i.e. most are respiratory therapists) when it comes to hiring its sales staff.  While this strategy has helped optimize sales efficiency, the process has clearly taken longer to implement than initially expected.  In August 2012 ELMD announced the hiring of an experienced Director of Sales to facilitate the identification of high-opportunity territories and the hiring of qualified sales people to service those areas.  This hopefully bodes well for a resurgence of growth in the size of the sales force and directly related growth in revenue and earnings.      

         

Revenue

Q4 revenue of $4.58 million was down almost 8% y-o-y (down 4% sequentially) and consisted of $4.17 million (-10% y-o-y) from the Homecare segment, $153k (+43% y-o-y) from International and $259k (+9% y-o-y) from Government/Institutional.

The relative weakness in the Homecare segment continues to reflect the reimbursement factors as well as stagnation in growth of the sales force.  As noted in the past, our modeled revenue growth estimates continue to reflect the expectation that ELMD continues to add sales headcount.   

 

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Total revenue came in about 13% less than our estimate, despite International and Gov't/Institutional sales coming in slightly better than our numbers.  ELMD recently took steps to facilitate growth of their International business including signing distribution agreements with Linde Healthcare and Leader Healthcare FZCO for the German and parts of the Middle East region, respectively, which seems to be paying dividends (we note, while Int'l sales fell 10% for the full year, they were up 14% over the final 9 months of fiscal 2012).  

Gross Margin

GM came in at 70.4% compared to our 73.5% estimate.  Electromed's GM can jump around from quarter-to-quarter based on the mix of reimbursement rates and, as noted in the past, this relatively low GM is not expected to persist over the longer-term. 

Operating Expenses

Excluding approximately $400k in severance costs related to the retirement of Bob Hansen, SG&A came in at about $2.8 million, or 60.5% of sales, compared to our 59.2% estimate.  Similar to Q2 and Q3 where revenue also came in meaningfully below our estimate, the higher than modeled SG&A as a percent of sales is likely mostly attributable to the fixed-cost portion of SG&A which is more exposed with revenue coming in below our estimate.  ELMD continues to invest in support infrastructure and personnel - mostly customer service, reimbursement and billing - activities which are essential to growth of the business.  As we've noted in the past, we expect these fixed expenses in SG&A to be leverageable as revenue grows - but in the case of the past three quarters where revenue falls short, these expenses are highlighted and crimp the bottom line.

R&D expense was $215k in Q4, well below our $305k estimate.  We continue to model R&D expense at low-to-mid single digit % of revenue.   

Net Income / EPS

Excluding severance expense, net income and EPS were approximately $120k and $0.01, compared to our $248k and $0.03 estimates.   

Cash

Electromed exited fiscal Q4 with $1.70 million in cash and equivalents, compared to $1.39 million at the end of Q3.   Cash from operating activities was an inflow of $506k in the most recent quarter, which benefitted from a $241k reduction in A/R.  Stripping out the increase in working capital, cash from operating activities was an inflow of $286k.  For the 12 months ending 6/30/2012 cash used operating activities was $1.17 million and was an inflow of $1.09 million ex-changes in working capital.  As we've noted in the past, the increase in working capital (particularly A/R) is reflective of the long collections times characteristic of the industry.  

Along with the cash balance there's about $3.1 million in borrowing capacity under the revolver.  The bank debt includes up to $6MM under a revolver, $1.5MM term loan A (monthly principal, due 12/2014) and $1MM term loan B (monthly principal, due 12/2012).  Terms of the revolver allow ELMD to borrow up to 60% of eligible A/R less balance on the term loan B.  Assuming A/R continues to grow at the recent pace (A/R grew ~$1.3MM in fiscal 2012) and capex uses on average another ~$210k/quarter (capex was ~$850k in fiscal 2012), cash balance plus short-term borrowing capacity represents about 27 months worth of operating cash (includes capex and monthly principal payments) - this assumes ELMD continues to successfully roll over the bank loans.  If, when and how much cash ELMD may need to raise to fund growth of the business (mostly working capital) will depend on a number of things including timing of A/R collections and capex and inventory investments.  Raising capital is not a near-term need, however and we do not view this as a significant concern. 

Valuation and Recommendation

We now look for revenue of $21.1 million (implying growth of ~8%) in fiscal 2013, down from $23.3 million prior to Q4 results.  Our 2013 EPS estimate has moved from $0.21 to $0.14.  The downward revision to our 2013 estimates as well as our out-years mostly reflects the delay in building the sales force.  Management is guiding for 28 to 30 reps to be onboard by fiscal 2013 year-end - our financial model more conservatively assumes approximately 24 to 26 reps are detailing by the close of 2013.  EPS in our out-years moved from $0.30 to $0.24 in 2014, and $0.38 to $0.30 in 2015.  With the close of fiscal 2012, we now model out to year 2016 (EPS estimate of $0.38).      

We continue to value Electromed using Hill-Rom's (HRC) long-term PE/G ratio as a comparable.  Hill-Rom's long-term PE/G currently sits at 1.3.  We model ELMD to post EPS of $0.38 in 2016, implying a five-year (2011 - 2016) CAGR of 23%.  Based on a 1.3 PE/G, ELMD should trade at about 30x 2013 EPS or ~ $4.00/share.  The stock currently trades at about $1.50.  We think the stock trades significantly below fair value with market value now below book value (stock currently trades at ~0.8x book value).  The combination of the company being (at least intermittently) cash flow positive and the stock trading below book value should provide further downside protection in our opinion.  We are maintaining our Outperform rating. 

Please visit Brian Marckx's coverage page at scr.zacks.com to access a free copy of the full research report.

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