Azure: A sitting duck

Azure Healthcare's interim result was towards the lower end of guidance from the AGM ($0.8-$1.2 million) with a reported net profit after tax (NPAT) of $0.9 million.

The business is growing, but you wouldn't know it from the headline numbers. Revenue from the nurse call system manufacturer and software provider was up 9.5 per cent despite a number of contract delays. The decline in reported profit is due to management's policy of expensing a majority of expansion costs.

In the last 18 months only $686,000 has been reported as an investing cash flow cost. Not bad to setup a global business with a new manufacturing facility in Dallas. Clearly a much larger proportion of operating costs should have been reported as investing costs and capitalised on the balance sheet.

With the company's new manufacturing facility in North America, we are assuming that there will be a cost-saving opportunity down the track from closing the Australian facility. There is large un-utilised capacity in the Dallas plant, and the cost of manufacturing is much cheaper.

In the first half the company expensed $1.9 million in research and development (R&D) costs compared to $1.2 million last year. Further additional expenditure in production staffing for the new US manufacturing facility was $0.546 million.

The divisional results show that the investment has not been wasted either – In the first half US revenue was up from $1.3 million to $8.1 million and net profit after tax was up from $0.087 million to $0.49 million. 

Operating cash flow conversion was strong at $1.6 million vs $1.75 million last year, and the cash balance is up from $2.9 million to $3.1 million.

In relation to the conservative accounting the company stated: “Management's policy on this has not changed so we don't confuse the market by capitalising R&D and capital expansion costs to report higher earnings.”

Where to from here?

The market needs to recognise the conservative accounting as well as the large growth opportunity in North America. If it doesn't and the share price remains under 30 cents then Azure is likely to get a takeover bid at too large a premium to knock back and the company will not be listed in 2016.

Further, chief executive Robert Grey is closer to the end of his career than the start, and he has shown he is a willing seller at 45 cents.

After the full year result in August last year, Grey sold down an approximate 10 per cent stake to a number of institutions, leaving him with an 18 per cent holding. Given Azure downgraded earnings expectations approximately three months later, these institutions naturally felt hard done by.

Whether or not Grey knew that FY15 earnings would not meet market expectations will remain unknown, but one thing we do know is that a share price of $0.26 has well and truly factored in the disappointing turn of events.

To be more specific, approximately a week before Grey sold his stock he was interviewed with Alan Kohler, and he couldn't have been more positive about the company's outlook. With the share price around 40 cents, Grey highlighted his belief that the company could double earnings each year in the US for the next three to four years. This is still the case, but there was certainly no mention of the contract delays that were revealed a few months later at the AGM.

Last year the company received a conditional takeover offer for around 40 cents. We assumed this was a local competitor; however, we believe the natural buyer of Azure should be setup to capitalise on the opportunity in North America.

Clinical workflow is rapidly growing in the healthcare sector, and Azure has one of the largest footprints of installed nurse call systems in the world. In the US there is an increasing trend to integrate software and mobile solutions. With Azure's products installed in 8,500 sites globally, there is a large opportunity to leverage these relationships with an increased range of products.

Further, the company now has UL 1069 certification (the North American standard for Hospital Signalling and Nurse Call Equipment) for its Tacera software and its products are registered with the FDA.

With an industry growing at 20 per cent per annum it has naturally sparked the interest of private equity as well as global healthcare players looking for opportunities. This strong growth rate is from the expansion of the nurse call system from a pure hardware product to an integrated hardware and software product.

Given Azure currently has a market capitalisation of $49 million (at $0.26 per share) it is a sitting duck. That is, a takeover bid of say 40-45 cents ($75-85 million) would be likely to be successful.

We expect the second half to be much stronger and forecast full-year revenue to be $36.5 million and NPAT to be $3 million.

With the growth opportunity in the US and the costs that will come out of the business, we believe Azure can achieve an NPAT of $7 million or earnings per share of 3.7 cents by 2017 to 2018.

We maintain our “buy” recommendation with a slightly reduced 44 cent valuation and price target.