Healthy outlook for hospital technology group

AZV - 30 years in the making

Robert Grey’s father passed away from a secondary hospital infection. Later, in 1986 it was to become the driver for Grey to found and lead Azure Healthcare (AZV) - then known as Austco Communications - a company that designs and manufacturers nurse call systems for hospitals. The hardware-based nurse call system was the first in the world to include an anti-bacterial component, attempting to reduce hospital infections.

As chief executive, Grey’s passion for the company and its products is renowned, and a key reason why the company has ongoing strong relationships with the approximately 8000 health care facilities that utilise its products and services. Grey, aged 59, owns approximately 30% of AZV, and has been described as “having the energy of a 20-year-old”.

Over the years there have been many changes; however none more significant than the recent transition from a pure nurse call hardware provider to an integrated software and hardware provider. In the US, the market for this software-based system is growing at 20% per annum and is 5-10 years ahead of any other country. In response AZV has commissioned a new manufacturing facility in Dallas to win share in this huge growth market. The lead time from the Perth factory was a constraint to growth, and from a cost and marketing point of view the Dallas site makes a lot of sense.

How nurse call systems work

At its most simple, the call system involves a button for the patient, which alerts the nurse with a light and/or sound. Newer technology allows call buttons to reach phone-like devices carried by nursing staff, improving the speed and efficiency of response. This technological shift, using both hardware and software, allows the sytem to cater for a far greater range of capabilities and responsibilities within a hospital. The main objective is to create efficiencies by removing as many of the manual processes as possible.

History

Before looking further into the current opportunity it is worth considering the ups and downs the company has endured, and Grey’s influence over it. The business was initially named Austco Communications, and in 2007 it was acquired by ASX-listed TSV Holdings. At the time of acquisition Austco was in good shape. With a successful expansion overseas, it appeared that strong growth would continue. It was also the beginning of the transition for health care facilities to move towards software based nurse call systems.

However unfavourable market conditions and poor performance by the new management team led to problems. The major issues were with TSV’s legacy businesses; however capital constraints and a distracted management team led to reduced performance from Austco. As economic conditions continued to decline, so did earnings, and TSV had large impairment write-downs to its balance sheet as a result of other non-performing acquisitions.

After the takeover by TSV, Grey had spent his time fishing and perfecting his golf swing. However, after a few years watching his former business decline he saw an opportunity too good to refuse. In June 2011 TSV Australia (a subsidiary company) went into administration. He then returned as executive chairman and brought a new team with him. Grey had been buying up shares, displaying confidence in the industry and company opportunity. His first move was to shift the new management team’s attention to make Austco the sole focus.

Making the shift to become an integrated software and hardware provider

In late 2011, the name changed to Azure Healthcare (AZV), costs were taken out, and $2m was raised to fund R&D for software development.  The 2011 Chairman’s address stated: “We aim to be a major participant in patient-centric communication and data systems in the health care market.”

The speed of the turnaround reflected the competence of management and also excellent foresight of Grey to identify that the industry was moving towards software-based solutions. There was substantial growth in FY2012, and then 23% revenue growth in FY2013, and a near doubling of profit to $1.16m. It is the recent first-half 2014 result though, that has made the loudest statement about where the company is heading – revenue was up 42% to $16m and NPAT increased 239% to $2.2m.

Enhanced business model

Prior to the recent transition the difficulty with the business was many care facility developers are focused on price, rather than the unique differentiators of the product.

The new combined software and hardware product offers AZV the chance to sell directly to key health facility management who are more likely to see the value of the anti-bacterial casing, and the value of Grey’s industry knowledge and expertise.

In Australia, the regulations call for the manufacturer or an appointed representative to take responsibility for maintaining the system, allowing AZV to stay in regular contact with the customers through their reseller base.

Both locally and internationally these relationships should only be enhanced by the industry shift with software sales providing a far greater opportunity for maintenance revenues.

Hospitals also tend to stick with who they know. Both because of the relationship and also because the nurse call system needs to be integrated with a hospital’s existing systems. The company’s credibility is high as the hardware product has a reputation of longevity, and hence providing another reason to justify it not been the cheapest option.

From a sales perspective a successful push into middleware roughly doubles the average sales into a hospital. Margins will also continue to increase with a greater proportion of software vs hardware. The company will also look to eventually move into licensing which would provide a substantial source of recurring revenue for the company.

SEDCO acquisition

The acquisition of SEDCO occurred whilst it was in receivership. Whilst it was a positive to take out a competitor, the real benefit was the acquisition of 2000 site relationships, and AZV has also made a profit in selling of its inventory. The acquisition price appears to have been close to $500k which is clearly a bargain that has already paid for itself.

Value proposition for health facilities

Ten years ago the average stay in hospital was 7-10 days. This has now reduced to 2.5 days, however the 7-8 hour time for admission and discharge hasn’t changed. But AZV systems provide hard evidence of reducing this time from 7-8 hours to 90 minutes. The massive efficiency is created by cutting out the manual processes. The larger the facility, the greater the efficiency savings.

The ability to demonstrate the efficiency as well as saving lives to senior management of health care facilities has made the sales process significantly easier.

Nathan Buzza

After Grey, the next most important factor in AZV success has been key management team member Nathan Buzza, who is overseeing development of the firm’s IP software. Buzza was actually the third employee of Austco back in the early days. However in 1991 he founded Commtech Wireless, a provider of middleware (a system that acts as a hub, connecting critical data sources to communications systems). In 2008 he sold the business to Amcom for a large amount. His experience is vital and he is a crucial factor in the company’s ongoing success. Whilst some may question his recent sell-down of his AZV holding – the fact is he acquired the stake at 3 cents, and it is hard to question someone locking in an 800% profit. All other evidence would suggest he remains a committed member of the team. 

Winning a plum US contract

Rauland is the largest nurse call provider in the US with approximately 40% of the market. Whilst its position outside the US is much less dominant, it is a much larger company than AZV with revenues over $100m.

AZV’s win of the US-based Health South contract in August 2013 caught everyone by surprise. Health South is one of the largest healthcare providers in the US, with a reputation for delivering high quality patient rehab services.   Rauland has far greater software experience than AZV, so the win is a large endorsement of AZV, its management and its new service offering. The five-year agreement to provide service to 100-150 hospitals is also a large kick to earnings, with only a very small component included in the first-half 2014 results.

Competitive landscape

On a revenue basis, AZV has around 3-4% of the total nurse call market, however the amount of installed systems makes it one of the largest worldwide.

The global healthcare nurse call market is expected to grow from $586.8m in 2013 to $712.9m in 2014, with expectations of continued 20%-plus annual growth. The US market represents about $275m.

With such a strong industry growth proposition, there is always going to be new competitors coming into the market. And there will continue to be significant levels of M&A activity. This is where the company’s barriers are relevant and where it needs to be assessed whether a larger competitor would see more value in a takeover of AZV rather than trying to squeeze them out. So the company’s existing relationships with 8000-plus facilities is significant, especially when considering that health-care facilities traditionally represent “sticky” customers.

It has been a 12-18 month process to gain UL1069 certification – enabling greater sales opportunities in North America for Tacera.The company has also spent over $7m in R&D developing the IP software over recent years.

The company’s hardware is also a major differentiator when compared to the larger software (middleware) based firms, who don’t have the same hardware manufacturing experience/expertise.

Hills... takeover?

Whilst the focus is on the fast growing US market, there is also an interesting situation playing out locally: Hills Holdings (HIL) is making noises about an aggressive entry into the domestic health market backed up by acquisitions of Questek and Merlon. These companies are both significantly smaller than AZV with a lower quality product/service offering. Each have revenue of approximately $9m and both were bought at roughly 2.5 times revenue.

HIL has a market capitilisation of approximately $500m, and recently sold its steel business. AZV would be the next likely target; however whether it can justify a premium to the current market cap of $60m is anyone’s guess. The proposition does as a minimum provide some downside protection for AZV shareholders.

The points to consider of the value proposition for a HIL acquisition of AZV are listed below.

• Our FY14 NPAT forecast of $3.7m represents significant growth vs the FY13 result of $1m
• AZV already spent $7m R&D on Tacera software IP, with another $3m forecast for this year. This is R&D that HIL will have to spend, if they continue in their current form.
• HIL likely to find out that their acquisitions have given them a service offering that is sub-par when compared to AZV.
• An acquisition of AZV would make HIL the dominant domestic player and prevent them from having to under-cut current contract prices. For example HIL recently won a South Australian contract over AZV by dropping its price by $0.5m – this now becomes a high-risk project, as there execution capabilities are not yet proven.
• Could save an additional $1m on board costs.
• HIL would have cross selling benefits from its existing products.
• In summary, combining these factors the FY14 NPAT of $3.5m suddenly becomes worth $6m in a takeover scenario.  

Risks

• Key man risk – particularly Robert Grey and Nathan Buzza
• Technology risk – competitors and execution of software based solutions
• Competitors – large players entering market
• Regulatory – Healthcare spending
• Capacity – More of a constraint than generating sales
• Servicing Capability – To keep up with growth, especially as greater maintenance work with software
• Liquidity – Chairman/CEO owns 30%, and high level of director ownership
• Currency – Revenues increasing overseas. In FY13 roughly 50% of revenue in Aus/NZ, 30% in Nth America with a smaller percentage in Asia and Europe

Outlook

There is clear evidence in the continued huge demand for AZV services. It would appear that the constraint to growth will be capacity rather than sales related. The new manufacturing facility in the US will assist in combination with huge investment in software R&D.

With the industry growing annually at 20%, it would appear that 25% annual revenue growth is a conservative base case assumption for AZV revenue growth. With the additional kicker of continued margin growth through greater software sales, it really does pose the question that for companies looking at acquisitions it would make sense to act quickly as the current market conditions would suggest a significantly higher AZV share price in 12 months time.

The shift to becoming a successful software provider remains in the early stages. The sales split is still only 75/25 hardware vs software with the company aiming for a 50/50 split.

Financials

R&D Over $7m has already been spent on developing the software IP, with a forecast spend of $3m for FY14. Significantly, all of this is expensed rather than capitalised.

Revenue Growth  With the industry growing at 20% and clear evidence of AZV growing above market rates we have forecast 25% annual growth. The 42% 1H revenue growth would suggest that this may be a conservative assumption.

Margins Will continue to increase as a greater proportion of software sales flow through. Moved from 100% hardware, to be currently 75% hardware and 25% software. The eventual aim is to have a 50/50 split.

Tax Expense Currently benefiting from accumulated tax losses. We are forecasting a 10% tax rate for FY15 and a 16% rate for FY16.

Net cash Strong balance sheet, and the high cash conversion from reported profit to free cash flow will see the net cash position continue to increase.

Summary

We have an outperform recommendation, with a $0.39 discounted cashflow valuation and price target. Our assumed weighted average cost of capital of 13.2% allows for the high risk nature of the software business. In regards to share price catalysts, it will be important for the market to see further traction with the software sales, and gain confidence that margin growth and 25% annual revenue growth is achievable over the next couple of years.