Description

Summary:

The largest shareholder of Alliance Healthcare Services is trying to acquire the company for $9.60/share, a 50% discount to the price it paid for 51% of the company less than a year ago (when fundamentals were far inferior). We believe the company is worth at least 2x the public offer, and management should reject the bid or negotiate a far better sale price. Rejecting the bid may cause the stock to selloff, but will inevitably lead to a better outcome as we believe AIQ will be worth $20-30/share as a standalone company in the next 18-months.

**Please note this is a $10 stock that trades 30k shares a day so it may only be suitable for smaller funds or personal accounts.

Situation Overview

AIQ is a leading provider of freestanding and mobile radiology (70% of revenues), oncology (21%), and interventional healthcare services (9%). The company provides a cost effective solution in lieu of hospitals allocating capex and resources to provide the same services. The company has been highly acquisitive, had its fair share of PE owners, and is highly levered. AIQ was a mid-$30 stock in 2013/14 before competition and price erosion began to impact profitability. The current situation exists for several reasons, including 1) no sell-side coverage, 2) $110mm market cap with about $300k of daily value traded, and 3) Fujian Thai Hot Investment Co. (“Tahoe”), a listed Chinese Real Estate firm, owns 52% of the company.

A history of the ownership structure is below:

·         1997: AIQ taken private by Apollo for $250mm

·         1999: KKR acquires 92% of AIQ

·         2001: AIQ goes public

·         2007: Oaktree buys 4.9mm shares from KKR for $31.25/share and purchases additional shares in open market

·         3/29/16: Fujian Thai Hot Investment Co (“Tahoe”) purchases 5.5mm shares from OAK for $18.50/share, a 9% premium to the closing price prior to announcement.

·         12/12/16: Tahoe expresses desire to purchase remaining shares for $9.60/share. AIQ forms a special committee consisting of independent directors to assess the bid.

Investment Thesis:

AIQ is a deep-value/levered equity/special situations investment driven by an inflection point in fundamentals and an improving cash flow profile (40% FCF yield), which should provide a significant re-rating. We believe this outlook will ultimately drive the special committee to either reject Tahoe’s $9.60/share public offer in lieu of a significantly higher offer or the ability to continue as a standalone public company. Our key investment points are:

1.       Fundamentals have reached an inflection point with improved pricing and solid volume growth.

2.       Free cash flow generation should approximate market cap over the next three years.

3.       The investment has a fair amount of risk, but the stock’s 50% discount to peers is too high in lieu of an improving fundamental outlook.

Key Point #1: Fundamentals: The Inflection Point is Now

The bulk of our thesis rests in the company’s radiology franchise, which represents 70% of revenue and is composed of mostly MRI/PET businesses. Beginning in 2014, fundamentals began to deteriorate as AIQ aggressively cut pricing on these services in order to increase market share and fend off competition. The company also allocated significant cash flow to both acquisitions and growth capex. ASPs on its MRI services declined from $340 to $307 and ASPs on its PET/CT services declined from $943 to $880. Despite (and likely because) of the pricing strategy, quarterly SSS volume trends remained healthy, fluctuating between low and high single digits. The solid volume growth was overshadowed by pricing declines and EBITDA declined from $128mm in 2013 to $94mm in 2015. The company refers to this period as the “reinvestment years + Radiology pricing reset.” Shareholders might as well call them the dark ages as the stock price fell from $35 to a low of $7.

Note: Volume growth represents total growth. For quarterly same store sales growth, see page 15 of the investor presentation.

We believe pricing has firmed and organic volume growth should translate into EBITDA growth, which will drive stock performance. Below is commentary during the last earnings call that alludes to this dynamic:

“One of the reasons in our results, and Rhonda just mentioned this today actually, that we've talked about organic growth of the business pre-price impact is to try to give some visibility to our perspective on the ability of the core engine of the company to drive organic growth as a result of same-store volume increases and other enhancements to the existing facilities and equipment that we have deployed. And I think as you follow that maybe over the last few quarters, you see that it's -- organic pre-price -- has been a positive number. And so we're pretty confident we can grow the company now that we're getting past the heavy price pressure we've seen in the core Radiology segment, as a result of a lot of the things that we've talked about, so same-store volume growth, of course, being the most crucial because this is a high fixed cost business, so that incremental volume drops through at a very interesting contribution rate.” – AIQ CEO, 11/3/16 Earnings Call

Over the last two years, Radiology EBITDA declined from $105mm in 2014 to an estimated $95mm in 2016 even after factoring in a cumulative decline of $23mm from price impact. Now that the company has lapsed these impacts and volume growth remains strong, the company should see fairly meaningful EBITDA growth going forward.

Key Point #2: FCF Generation Should Approximate Market Cap Over Next Two Years

Over the last several years, AIQ has embarked on an aggressive growth strategy, allocating cash flow to both growth capex and acquisitions. The table below summarizes the trends over the last few years. 2016 was the last year of major capex investment thereby providing for significant FCF in 2017+. Management has publicly stated the growth capex cycle is over and the company is now entering a period where it should reap the rewards of prior investments. Whether or not they achieve meaningful ROI, they will benefit from a nearly $30mm reduction in capex.

Valuation:

Over the last three years, AIQ has traded an average valuation of 6x EBITDA. While it would be fair to knock the company given its leverage profile, several comps (most notably RDNT), have greater leverage and lack AIQ’s margin profile. Given the fundamental improvements and EBITDA growth we expect over the next 1-2 years, we would expect the multiple to revert to at least historic levels. We expect EBITDA to grow to $140mm in 2017 and $150mm in 2018. Even at 5x EBITDA, this equates to a $17-22/share price before factoring in debt reduction. At 6x EBITDA and allocating half of FCF to debt reduction, to stock would be valued at $34-40/share.  

Risks:

There are a host of risks that should not be taken lightly.

1.       The stock is currently trading at $10.45 ahead of Tahoe’s $9.60 public offer price indicating the market is expecting a price bump. If the special committee outright rejects the offer, the stock price will likely suffer a sell-off.

2.       Leverage: AIQ has 4.1x leverage. While the near term goal is to get to 3.5x, the overall amount can be uncomfortable. Additionally, management switches between listing debt paydown and growth initiatives/M&A as priorities for FCF. The $499mm term loan is due in June 2019, which is not that near but also not that far.

3.       M&A: Management has talked about further JVs and acquisitions. Some would prefer capital to be allocated solely to debt reduction:

4.       Tahoe is a listed Chinese entity with $3bn in equity and $10bn in debt. Any solvency issues could cause them to dump shares. Also, their intentions for the company (aside from the low ball bid) is not well understood. They have three board members currently and could try to exert influence. 

Catalyst

1. Response to Tahoe's $9.60 bid.

2. Fundamental improvement with price reset now lapsing.