Ceasing coverage: Azure Healthcare and Energy Action

We are concerned about potential delays in revenue uplift for Azure, while Energy Action is facing pressure on margins.

Azure Healthcare (AZV)

When we upgraded Azure Healthcare (AZV) from sell to hold back in September (see Azure upgraded, September 7), our confidence in the firm’s prospects relied on a number of factors.

We were looking ahead to Azure’s annual general meeting as an opportunity for the new board and management team to outline a convincing roadmap for the firm’s next few years. Specifically, we sought guidance around the timelines for new product releases, the outlook for research and development expenses, and the benefit to the company.

Although our clarity on these points has improved a little in the last three months, we see no near-term reprieve from Azure’s period in the stock market ‘sin bin’. While Azure wanders in the wilderness, we downgrade our recommendation to sell and cease coverage of the stock.

Changing of the guard

Azure caved to investor pressure in mid-October and removed from the board its former chief executive and executive chairman Robert Grey, incumbent chairman Greg Lewis, and non-executive director Bill Brooks. CFO and company secretary Jason D’Arcy remains a fortunate survivor of the debacle that was FY15.

The board refresh has brought Graeme Billings in as independent non-executive chairman and Brett Burns as independent non-executive director. Both men have experience in the industrial, legal and financial sectors. They may enhance the board’s corporate governance standards but their take on how to succeed in the medical technology market remains to be seen.

An uncertain growth path

Azure’s former management spent years touting its US growth prospects. When we first downgraded Azure to sell in June 2015 (see Giving up on Azure, June 29), we puzzled over how the firm could claim it would double US revenues every year for the next four years, and then disappoint investors so bitterly with its soft FY15 result.

Last week’s AGM was the new board’s time to shine and reassure investors that it retains a handle on how to grow in the lucrative US clinical software market.

Unfortunately, the meeting underwhelmed investors. The firm plans to maintain its high level of R&D investment, which more than doubled in FY15 to $5.1 million. While the firm insists on expensing rather than capitalising its investment in expansion and R&D, it confuses investors as to how much of these costs will go toward assets and how much will remain as ongoing expenses.

Azure expects its R&D investment and ongoing product line rationalisation — including what it terms as “some one-off costs” — to push the firm to an operating loss in the range of $0.3m to $0.45m for the six months ending December 31 2015. It’s a disappointing deterioration of profitability since the prior year, when management pointed to half-year profit of around $1m and growing.

Azure has rightly identified the value of transitioning to a subscription licensing model. However, its new Tacera Pulse software suite is not planned to be fully operational until late 2016, which means investors may have to wait some time to see sales growth from this channel.

It is also worth noting that shareholders refused to adopt Azure’s remuneration report at the AGM. It seems investors viewed the performance options granted to new chief executive Clayton Astles as overly generous. This does not bode well for shareholder engagement and sentiment.

Summary

We have been patient with Azure as its managers have sought a way into the US clinical workflow market. However, the competitive landscape is crowded and we see potential for delays in cost reductions and any eventual revenue uplift.

The stock is still pricing in a turnaround to net profit of between $1m and $2m, which we view as optimistic. We see lower-risk growth opportunities elsewhere in the market and will cease coverage of Azure as we downgrade our recommendation to sell.

Our final valuation of 7.3 cents comes from applying a below-market multiple of 14 times our FY16 earnings forecast of 0.52 cents per share.

PROFIT AND LOSS
Azure (AZV) - $0.099FY13FY14FY15FY16
Revenue$m22.531.335.038.1
EBITDA$m1.63.90.72.0
EBIT$m1.13.400.201.48
Net Interest $m-0.1-0.08-0.08-0.08
tax$m-0.060.540.98-0.42
NPAT (reported)$m1.03.861.090.98
NPAT (adj.)$m1.23.861.090.98
Shares on Issuem189.3189.3189.7189.7
EPS (adj.)cps0.62.040.580.52
PE ratiox16.24.917.219.2

Energy Action (EAX)

Energy management consulting firm Energy Action (EAX) has regularly missed investor expectations. The company seems stuck in a downgrade cycle and although its latest guidance is for profit to return to growth, we struggle to see how EAX can meet that promise.

The last time we discussed Energy Action, we highlighted that a restructured management team should provide some much-needed direction. Unfortunately, the business remains under pressure and we see little evidence of the kind of strategy development the firm needs to deal with competitive threats.

Energy Action expects its profitability to turn around, but management seems to believe it can achieve this with the existing structure — a business model in which the market has exposed weaknesses.

With the stock trading at more than 10 times our FY16 forecast for earnings per share, we choose to cut our losses here and downgrade to sell.

Under pressure

Although revenue grew by 25 per cent in FY15, the bulk of this growth came from the acquisition of EnergyAdvice, carried out near the start of the year. EAX has struggled to integrate EnergyAdvice which has weighed on margins for the procurement division and the group.

When we downgraded EAX from buy to hold in February 2015 (see Stock updates: EAX, GLH and RIC, February 23), we noted that it remained to be seen when the firm’s new acquisitions would boost group operating leverage. With customers moving away from Energy Action’s online reverse auction platform and increasingly favouring tenders, buying EnergyAdvice at nine times forward earnings before interest and tax (EBIT) is yet to strike investors as a great deal.

The margin weakness extends beyond procurement and throughout the group. EAX is suffering pricing pressure on various products against which it seems unable to push back. With management still preoccupied with trying to realise more value from their acquisitions, we see few plans for product innovation that could help drive better pricing.

Although Energy Action’s market share in procurement has grown, the rate of expansion of this segment has missed the expectations we laid down when we commenced coverage of this stock. The procurement market is fragmented and barriers to entry are low. Since the major energy retailers have as many as 150 energy brokers on their books, competitors can pick away at Energy Action’s business from a variety of angles. Although procurement represents less than 30 per cent of EAX’s revenue, it remains a key sales funnel for new business — so problems in this segment can have an outsized impact on the group’s prospects.

Once bitten, twice shy

Energy Action achieved net profit after tax (NPAT) for FY15 of $2.7m, at the low end of the guidance it provided in May and broadly in line with our estimates. At its AGM in November, the firm said it expects operating NPAT of between $3.4m and $3.9m in the year ending June 30 2016.

We note some disclaimers in this guidance — namely, a dependence on “normal trading conditions”, and an expectation that annual profit will be weighted more heavily to the second half of the year. In light of Energy Action’s history of missing the expectations it gives the market (which we chronicled on May 25 – see New Energy needed at Energy Action), these caveats raise the possibility that Energy Action is trying to buy more time to turn the company’s fortunes around.

Summary

Given the pressure on revenues and margins, and since the firm doesn’t see large swathes of costs coming out of its structure, our analysis suggests that any eventual turnaround will come later rather than earlier. As EAX seems more likely to confess to further profit downgrades than to positively surprise the market with an upgrade, we downgrade our recommendation to sell. We see more value in focusing on the higher-potential stocks in the Growth First model portfolio and on the firms which are stronger candidates for inclusion in that group. Therefore we will cease coverage of Energy Action with this report. Our final valuation for EAX of $0.96 is based on nine times our FY16 profit forecast of 10.7c per share.

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