Giving up on Azure

Azure Healthcare (AZV) has again disappointed the market with lower than expected profit guidance due to high US expansion costs.

Previously guidance was given for revenue and gross margins to be higher in the second half despite the usual first half seasonality. This hasn't occurred and the lack of disclosure around the extent of the increased R&D costs is very concerning. It is difficult to believe this is something management worked out in the last few weeks of June. 

Net profit after tax (NPAT) guidance of $0.8-$1m is a huge miss.

This comes on the back of the earlier downgraded profit guidance.

In September Robert Grey sold 20 million shares ($9m at 45 cents per share). The buyers were mainly institutional investors who had been led to believe the outlook for the company was excellent with high growth.

Before selling his stock, Grey was quoted as saying they will double US revenues every year for three years. It would be interesting to hear if he is still willing to back these claims.

For the downgrade announced on Friday in an attempt to explain the result an additional $2.1m expenditure on research, development and technical product support was referenced. Further there was $0.9m in duplicated factory and setup costs, which they have described “the company has prudently opted to expense rather than capitalise.”

Given the company's track record it is difficult to have faith in their commentary that a large amount of costs could be capitalised as assets in the balance sheet – Which would then improve the reported profit result.

It is also difficult to see how the statement below that was made at the half year result (2 months into the 2^nd half) can lead to a potential second half loss?!

“Ordinarily the Azure business has a financial performance which is weighted more strongly in the first half of the financial year. This is because there are more production and working days and higher demand for our products in the lead up to Christmas. For the first time in recent years, we are experiencing a reversal in this trend, with stronger demand and product delivery occurring more in the second half of this financial year”.

We first recommended Azure as a "buy" at 30 cents on March 12, 2014. After a 50 per cent increase we moved to a "hold" around the time MD Robert Grey sold one-third of his holdings. After a further decline we moved back to a "buy" recommendation and have been wrong since.

Robert Grey remains a large shareholder with approximately 18 per cent. 

Transitioning to the US and new product range

We recently wrote that patience would be required as the company develops its new 4^th generation software products, and transitions to the US.

Patience doesn't include putting up with missed targets and vague management commentary around earnings expectations.

They have now said the transition will take another 12-18 months, and with no further guidance on what costs that will involve we can only assume they are likely to again disappoint the market at the next earnings result.

At the half year result there was also a mention of $5.5m of deferred revenues that could be expected to be reported in the next 6-18 months?

If the company was confident with its R&D program they would guide the market towards what the future costs will be, and the likely positive impact of the new software product range.

The upside scenario

Management commented “The board is fully committed to increased research and development for the company's 4^th generation software products, which will provide increased product integrations, critical information dashboards and workflow solutions translating into higher future software and recurring revenues. The board's view is that this will position the company at the forefront of technology once completed”

The 8500 client base and potential to license software products would obviously provide significant upside if successfully rolled-out.

At some stage there will be a potential cost saving exercise of about $1m from closing the Australian operations. For FY17 the high R&D costs are also forecast to reduce.

Outlook

Given the track record, it is hard to take this seriously but management stated “The anticipated 2015 result represents a transition period for the Company, with continued revenue growth for Azure following further significant project wins in Australia, the US and other key markets”

“Azure is continuing to make good progress across its operations, and we expect this will translate to higher returns for shareholders over time”

Given working capital requirements there is a risk the company will need to raise equity.

Management credibility has obviously taken another large hit, and if they want the support of the market again, they will need to provide a lot more details around what they are trying to achieve and start meeting targets.

Valuation

Given the lack of detail around future R&D costs, and the timing of the new software products we are not willing to look too far into the future.

FY15 reported profit range of $0.8-$1.0m won't provide any share price support even after today's decline to 16 cents.

We view a normalised NPAT of $2.8m or earnings per share of 1.5 cents. This is taking the lower end of the FY15 guidance ($0.8m) then adding back the $0.9m of duplicated manufacturing costs, and $1.1m of the R&D cost.

Our target price is 18 cents which is applying a PE multiple of 12 times to our assumption around normalised earnings.

Our future earnings assumptions have all been drastically cut and we won't change this view without very firm evidence to the contrary.

We have a "sell" recommendation for Azure with an 18 cent price target.

Is it fair to shareholders

At Eureka Report we take every care to make sure our ‘calls' on stocks are of the highest quality. As part of this process we make exceptional efforts to engage with and understand the plans of senior management.

If a stock does not perform as we might reasonably have expected, we believe it is our duty on your behalf to explore every avenue open to us.

On this basis, our editor in chief Alan Kohler has begun inquiries into whether there are grounds for a class action regarding the company's failure to meet its continuous disclosure obligations.

To see Azure Healthcare's forecasts and financial summary, click here.