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We recommend a long position in Auxilio, Inc., a small firm that provides hospitals with IT security services (ITSS) and fully outsourced managed print services (MPS), because we believe it is worth far more than its current share price of $1.01.
A paucity of attention and analyst coverage, which is a common problem in the microcap space, has resulted in a market price that neglects the synergy between Auxilio’s MPS and ITSS divisions as well as the potential for Auxilio to continue expanding its market share in the MPS sphere.
According to our analysis, the company is undervalued even under pessimistic assumptions.
Auxilio, Inc. is the only managed print service (MPS) business that exclusively serves hospitals and health systems. Hospitals are paper-intensive businesses that lack a centralized cost center to manage their arrays of printers, scanners, and multi-functional digital devices. Auxilio, Inc. places on-site teams of print experts to streamline hospitals’ print infrastructure. By reducing paper volume, improving process efficiencies and driving down costs, Auxilio, Inc. guarantees cost savings of 10%-30% to the hospitals it serves. The entire process is fully outsourced and hospitals need only pay a single invoice. Auxilio, Inc. serves a growing national portfolio of over 220 hospital systems across 34 states with more than 4,400 affiliated medical, clinical and administrative support facilities.
In addition to its MPS business, the company has recently entered the IT security space through its acquisitions of Delphiis (July 2014) and Redspin (April 2015). The combined IT security platform currently services over 135 hospitals and 500 business associates to safely secure Patient Health Information (PHI) and ensure HIPAA compliance.
In FY 2014, the company recorded $44 million in net revenue, gross profit of $8.2 million (margin of 18.7%), $4.1 million in EBITDA (margin of 9.3%), and $3.8 million in net income (margin of 8.6%). Revenue has historically grown at a 4-year CAGR of 26.3%. Auxilio, Inc. has an Equity Value of approximately $25.7 million and an Enterprise Value of approximately $21.0 million.
The stock is undervalued for the following reasons:
- The market underestimates the vitality of the managed print services industry as well as the company’s ability to significantly expand its market share in that industry.
- The market has been slow to react to the company’s newly-formed IT security platform and the significant cross-selling potential that it brings when combined with the MPS segment.
- The market’s valuation has overemphasized the company’s current profitability while underemphasizing the company’s growth potential and future profitability.
When taken together, these factors suggest that the company is undervalued by more than 50%.
Upcoming catalysts include:
- Auxilio’s planned expansion into the Midwest and select markets as the company further grows its customer base.
- Auxilio’s planned cross-selling of services between its MPS and ITSS customers.
- The IT security segment’s growth resulting in higher overall margins for the company.
Catalyst #1: Auxilio’s MPS Market Penetration
Before diving into the details, let’s first discuss the overall state of the MPS industry. Many believe that physical printing will disappear in the future. Total print volumes are already declining as digital alternatives become cheaper and more effective. For example, many college students prefer their laptops for note-taking instead of pen-and-paper. Physical newspaper rolls have nearly gone extinct as people increasingly rely on the internet to read the news. A growing number of Institutions have transferred their documents to electronic databases. Is there really a future for managed print service providers?
This trend, whether true or not, does not concern Auxilio and its healthcare niche: hospitals are printing more, not less. Paper is still the most reliable form of communication for doctors. When electronic systems are down due to natural disasters or technical failures, paper documentation saves the day. The release of patient information to lawyers, employers, the government etc. is always on paper. Electronic Media Records (EMR), rather than replacing paper documentation, has actually resulted in higher print volumes by creating print-on-demand opportunities for medical records. Meanwhile, hospitals are hungry for efficiencies that will reduce the cost of health care. On top of that, there is an aging baby boom population placing further strain on an already overburdened healthcare system. Who will step in to ease the burden and cut costs? Auxilio will—by allowing hospitals to outsource the management of their print and IT infrastructures.
But Auxilio has not only chosen a ripe industry—it has positioned itself to dominate the competition in that space. The company’s numerous competitive advantages include:
- Being the only company in the market that exclusively serves hospitals and health systems. In this respect, Auxilio is unmatched by any of its competitors.
- Being vendor-neutral, which means that it is not restricted to any single equipment vendor. This allows Auxilio to choose the printer and copier hardware and software that best meets the customers’ needs.
- Offering a program that is fully outsourced. Unlike most other competitors, Auxilio’s MPS program essentially operates as a department in the hospital with full-time, on-site staff. As a result, Auxilio is able to provide services and supplies much more quickly and efficiently than its competitors.
- Offering a risk-free program that guarantees cost-savings for the hospitals. Before serving a hospital, Auxilio performs a detailed assessment of the hospital’s print infrastructure—for free. The results of this assessment show the hospital how much money can be saved by employing the company’s services. Furthermore, the company assumes all costs related to a customer’s print environment with no upfront costs.
- Cultivating strong relationships with its customers as it works directly with hospital personnel on a daily basis. Of the company’s many competitive advantages, this is perhaps the most compelling.
As of July 2015, Auxilio’s customer base included only 220 hospitals out of a total market size of 6700 hospitals. A year and a half ago, Auxilio serviced only 80 hospitals, indicating a CAGR of over 80%. Auxilio now plans to reach out to hospital systems in the Midwest, which we expect to result in many new customers. Hospitals are likely to have robust demand for cost-saving and outsourcing services. With so many hospitals left for Auxilio to win (>6400) and so little true competition to slow Auxilio down, we believe the company is very likely to capture a large share of the market in a short amount of time.
Auxilio’s CEO, Joseph Flynn, expects the company to achieve a 10% market share within the next few years. Our model assumes an 8% market share in five years.
Catalyst #2: Cross-Selling Opportunity between MPS and ITSS Customers:
First, let’s cover some background on Auxilio’s recent move into healthcare IT security. According to the Cyber Security Market Report, a journal published quarterly by Cybersecurity Ventures, the healthcare IT security space is forecasted to reach $10 billion by 2020.
There are a few key drivers to this market:
- Security breaches are rampant and costly. Over 29 million patient records have been breached since 2009 and over 7 million records were breached in 2013 alone. Each lost record costs the hospital $233—more than in any other industry. While stolen credit cards trade at only $1 on the black market, patient records trade at $50.
- Government regulations further intensify the demand for IT security. For example, the Electronic Health Care Record (EHR) Incentive Program components of Medicare and Medicaid provide incentive payments to hospitals for the “meaningful use” of certified EHR technology. In addition, the HIPAA Omnibus Final Rule requires hospitals to prove a low risk of Patient Health Information (PHI) being compromised.
- Healthcare IT departments are understaffed and overburdened, and thus challenged to deal with security issues without assistance.
Both Delphiis and Redspin specialize in healthcare security, perform security audits and prepare risk assessments. Redspin is unique in its Penetration Testing service—that is, mimicking the actions of a cyber-attacker to test the IT system for vulnerability.
Most of Auxilio’s pre-existing MPS customers would benefit from managed IT security services, which is why Auxilio expects a great deal of cross-selling to take place. If this is the case, Auxilio’s IT security segment will gain enormous traction right off the bat. There is tremendous synergy between the two service lines.
We believe that Auxilio’s cross-selling efforts are likely to succeed because:
- The company has experience and expertise in working with healthcare providers
- The company’s IT security offerings are specially tailored to meet the needs of hospitals, such as annual HIPAA analysis and regulatory compliance.
- The company has strong relationships with clients and has earned their trust by consistently offering qualify service. Auxilio’s MPS team already works full-time on hospital campuses if they were the hospitals’ own employees. Adding IT services to that picture would be a smooth transition.
- More specifically than having trusted relationships with clients, the company is trusted with the management of the client’s hardware, software, and information systems. Implementing security systems, executing penetration tests, and performing regulatory and risk assessments all require the company to work intimately with hospitals’ hardware and workflow processes—which the MPS already does. Adding IT security services to the mix would merely be a logical extension.
To illustrate the significance of this cross-selling ecosystem, the table below encapsulates the implied share price from our model if no cross-selling takes place:
These numbers are much closer to the company’s actual share price over the past year (though still higher), which is consistent with our hypothesis that the market has been slow to price in Auxilio’s cross-selling potential.
Here is what the table would look like if cross-selling does take place:
This assumes that 80% of Auxilio’s 220 pre-existing MPS clients become IT security clients over the next 10 quarters. Cross-selling seems to add anywhere from $0.30 to $0.40 to Auxilio’s intrinsic per-share value across the range of DCF assumptions. Keep in mind that our model only takes into account the existing 220 MPS customers; it ignores any cross-selling that might take place with new MPS customers in the future or any cross-selling of MPS services to the 135 IT security customers that came with the acquisitions of Delphiis and Redspin, for that matter. Thus, the true implied share price is likely to be even higher than our estimates.
Catalyst #3: IT Security Segment Bringing Higher Margins
Auxilio’s MPS program operates on low margins ranging from 10% during the implementation phase of a new contract and 30% when contracts are under way. Historically, Auxilio’s margins have typically been in the 15%-25% range. This is one reason why the market has undervalued Auxilio: an overemphasis on historical profitability and an underemphasis on growth potential and future profitability.
That will change soon when Auxilio’s margins increase thanks to its new service line.
IT security companies generally operate at very high margins—often around 40%. Auxilio’s management expects the company’s IT security division to operate at gross margins between 35% and 50%. For our analysis, we assumed an initial margin of 35% that will gradually increase to 40% in the next five years.
Below are our projections of Auxilio’s revenue and margins over the next five years:
Gross margin increases from 18.7% to 26.0%. Meanwhile, operating margin, net margin, and EBITDA margin all nearly double by the end of FY 2020.
Here is what the projections would look like without the IT security segment:
In this case, gross margin, operating margin and EBITDA margin are flat for the most part, with net margin falling substantially from 8.6% to 3.1%. Evidently, the IT security division of the company has the potential to boost overall margins substantially. Indeed, based on the Q1 FY 2015 earnings call transcript with Auxilio’s management, it seems that margins were a motivating factor in the decision to enter the IT security space.
We used public company comparables and discounted cash flow analysis in our valuation of Auxilio, Inc. The graph below summarizes what the company’s valuation looks like under different methodologies:
As shown in the “football field” graph above, Auxilio’s current share price is considerably lower than the price implied by our DCF analysis and significantly lower than that implied by the revenue multiples from our set of comparable companies.
Public Company Comparables
To select comparable public companies (“comps”), we used the following criteria:
- Geography: US-based companies.
- Industry: business services industry with outsourcing specialty, especially MPS providers.
- Financials: enterprise value under $2 billion (except Xerox), LTM revenue under $2 billion (except Xerox and Lexmark), and at least two companies that are small and growth-oriented like Auxilio.
Even though Xerox and Lexmark did not meet the financial criteria, they still made it on the list because:
- They are direct competitors of Auxilio. Moreover many investors who look at Auxilio may compare it to these competitors.
- Their industry and business models closely resemble Auxilio’s. For example, Xerox and Lexmark sell equipment, managed print services and software—just like Auxilio. This is more important, in our view, than the size of their enterprise value and revenue.
- Their multiples and margins are similar to those of the other comparables (though the multiples are slightly lower).
EBITDA figures were adjusted for nonrecurring items such as impairment charges and write-downs. Net Income figures were not adjusted for nonrecurring items and were simply taken from each company’s filings. Forward figures for the comparables were taken from consensus estimates. While we used our own financial projections for Auxilio, but our long-term view of the company does not make a strong impact on our 2015-2016 estimates.
The following graphs juxtapose the comps’ revenue multiples with their corresponding growth rates:
Despite having highest revenue growth, Auxilio has the lowest revenue multiples, which implies that the company is undervalued.
While the P/E and EBITDA multiples suggest that the company has been more or less valued appropriately by the market, they are not as relevant as the revenue multiples and DCF. The company has historically been unprofitable with keen emphasis on revenue growth. Furthermore, the company is expected to grow its Net Income and EBITDA at much faster rates than the set of comparables, which is not reflected in the P/E and EV/EBITDA comps valuations.
Moreover, our view of the company is long-term: our analysis emphasizes Auxilio’s potential for future profitability beyond Forward Year 2, which is hardly reflected in the P/E and EV/EBITDA comps valuations; the DCF analysis is important for this reason.
Discounted Cash Flow Analysis
Our 5-year DCF analysis relies upon the following assumptions: a 10% discount rate, a terminal free cash flow growth rate of 2% (or alternatively a terminal EBITDA multiple of 2.2x), and the following free cash flow projections:
Even under a range of assumptions for the EBITDA multiple/FCF growth rate and discount rate, the company is undervalued by around 40%-70%.
- The company loses one or more of its key customers
- MPS market share expands much slower than expected
- The ITSS segment fails to kick off like we had hoped
The Company Loses One or More of its Key Customers
The two largest customers accounted for ~35% of the company’s revenues and the three largest customers accounted for ~40% of the company’s revenues. If the company loses these key customers, many quarters will pass before the MPS division grows back to its former size. This by itself would lower our estimate for the company’s intrinsic per-share value from ~$1.52 to $1.33, reducing the premium over the current share price to ~30%. There is also the potential for the market to overreact when it lowers expectations. We have confidence in Auxilio’s ability to retain customers, but this is still a possibility worth mentioning.
MPS Market Share Expands Much Slower Than Expected
Our assessment of the company has the MPS segment doubling its market share within the next 5 years. We think that is reasonable given the many reasons already stated—competitive advantages, ripe industry, robust demand, etc.—but what if we are wrong?
The company is currently servicing over 220 hospitals, or about 3.3% of the total addressable market of 6700 hospitals. If the company can acquire only 150 additional hospitals over the next five years, then the company is more or less valued appropriately at its current price. If the company fails to acquire any new customers over the next five years, then the company is overvalued by about 35%.
Even so, that’s only a 35% downside compared to a potential 50% upside. If this risk is enough of a concern, put options with strike prices in the $0.80 – $0.90 range will mitigate potential losses.
The ITSS Segment Fails to Kick Off
We expect the ITSS segment to take off quickly by selling to MPS customers. This is one of the key components of our investment thesis. But we could be wrong.
If 80% fewer MPS customers become ITSS customers and it takes 80% more time for those MPS customers to become ITSS customers, there is still room for a 15%-20% gain. However, it is possible for our assumptions to be off by more than 80%. After all, the company’s ITSS segment is relatively new and untested, albeit quite promising in theory. Whereas our MPS market share assumption is supported by the fact that company has already been growing its market share at a rapid pace with a formula that has proved successful in winning new deals, our assumptions for the ITSS segment are essentially predicting the beginning—not the continuation—of a trend. Until we see cross-selling happening for real, we are making a bet.
The Worst Case Scenario
Let’s consider the event of a perfect storm in which all of our assumptions are wrong (but to a degree that is still plausible):
- The MPS and ITSS segment margins are both >30% lower than in our base case
- MPS revenue is flat for the next 5 years due to minimal growth in market share
- 80% fewer MPS customers become ITSS customers and it takes 80% more time for those MPS customers to become ITSS customers
- Cross-selling is the only source of growth in the ITSS segment. In other words, the ITSS segment gains zero new customers who are not already loyal MPS clients
In this “worst case scenario,” Auxilio’s implied share price is in the $0.40 – $0.50 range, or a roughly 50% – 60% discount to the current share price.
Unfortunately, Auxilio has very little “balance sheet protection”. The company’s $5 million cash balance provides just ~$0.20 of cash per share. Tangible assets minus liabilities is only $3 million compared to the company’s $26 million equity value and a simple liquidation analysis of the company suggests a per-share liquidation value of around $0.02 to $0.09. Finally, the company could potentially sell off its Redspin and Delphiis divisions for prices similar to what it paid to acquire them (~$2.5 million and ~$2.7 million, respectively).
To protect against this extreme downside, put options can be purchased at strike prices in the $0.70 – $0.80 range.
Overall, there are many reasons to be bullish on this company.
Managed Print Services Potential:
- The healthcare MPS industry is juicy and has robust demand for Auxilio’s MPS services.
- The company has so far addressed only a tiny fraction of the total addressable market.
- The company has many competitive advantages that will allow it to capture this market opportunity.
- Auxilio has already announced plans to expand into the Midwest, where there are hundreds of hospitals that the company has previously ignored.
IT Security Services Potential:
- The IT security industry is juicy, especially in the healthcare space, and there is robust demand for Auxilio’s IT services.
- The company’s services are high-quality and specially tailored to meet the needs of hospitals, such as annual HIPAA analysis and regulatory compliance.
- There is an impeccable ecosystem for cross-selling to MPS customers who already trust Auxilio with handling their hardware, software, important documents, and infrastructure. These customers are also accustomed to working with Auxilio’s staff on a daily basis.
Based on our financial projections and valuation of the company, an investment in the company poses minimal downside risk and significant upside potential. The company is undervalued by over 50% under our base case assumptions, over 100%-200% under more aggressive assumptions, and valued appropriately under more pessimistic assumptions.
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Johnny Stricklett, Analyst
UMD, Smith School of Business 2018