Description

Summary: Allied Healthcare (AHCI) has an attractive asset-light model -- 100% tangible ROIC and minimal capex. Stock is cheap trading under 5x fully-taxed NI/FCF with 40% of market cap in cash. What makes the stock different from countless other cheap micro-cap stocks is that AHCI operates a relatively stable business and fundamentals are actually improving with double digit earning growth expected in '09. However, mgmt appears determined to make a big acquisition at 4-5x EBITDA rather than buying back their own shares at 2x. I realize that the material risk in capital allocation may put off many (if not most) members here, but I also think this idea may appeal to some. Stock sorely needs an activist shareholder as mgmt does not own much share (<1%) and investor base appears generally opposed to mgmt's plan.

Business overview: Allied Healthcare is a UK based provider of healthcare staffing. Homecare staffing makes up 75% of revenue and has been growing nicely (double digit in the last 5 quarters). Nursing and hospital staffing make up the rest and have seen a steady decline but show signs of stabilization in recent quarters. Over 70% of revenue is paid by UK government via local authorities (thus no central agency like those in US) and private pay makes up the rest. Industry is fairly fragmented with majority being small local mom-n-pop operations. According to the company, top 5 players account for 20% of market share and AHCI is #2.

Stable and improving core business: The core homecare market is growing 6-7% PA (10% in '08) driven by demographics and government push for more in-house care vs. more expensive hospital care. Most of the homecare business is under 3-5 year contracts, which produces a stable recurring revenue stream. Under new CEO who joined in early '08, AHCI had decent double digit growth in the core segment, only hidden by the fact that the other two segments had continued to slide. Encouragingly, the two struggling segments (now a much smaller part of the overall business) appear near stabilization, and the core segment should continue to see growth in '09 (12% constant currency in Q1) driven by better execution and vendor consolidation. Mgmt believes they should get steady pricing increases, and spoke on the recent call of pushing through a 5.5% pricing increase in Apr '09. I have my doubts about the level of the pricing increase given government budget constraints everywhere, but that is not central to my thesis and will be merely icing on the cake. Mgmt is also doing a nice job in reducing SG&A expenses -- SG&A declined sequentially through '08 and Q1 '09. There are plenty of opportunities for margin improvement -- SG&A as % of sales in '08 was 26% vs. 20% in '04, and op margin was 4.3% in '08 vs. 8.5% in '04 despite gross margin actually improving from 28% to 30%.

Decent Model: For $300M revenue in '08, AHCI only needed $5.3M working capital (excluding cash) and $8.5M PP&E. With $12M EBIT and average invested capital of $11.4M (excluding goodwill) in '08, this implies a 112% pre-tax ROIC, which is pretty remarkable considering op margin at 4.3% was almost near trough level of 3.9% in '07 (still 83% ROIC) and 8.5%/7.5% in '04/'05. Frankly, the high ROIC is a bit puzzling and worrisome as barriers to entry is minimal in this space, and AHCI's mgmt had acknowledged that scale does not really give them any benefit over smaller local competitors. I take comfort in the fact that gross margin had been fairly stable over the years (around 30%) indicating minimal price competition and ROIC based on book (including goodwill) is much lower. The asset-light model also leads to low capex needs, with normal maintenance capex ~$1M. With D&A exceeding capex, FCF is actually more than NI, although the company will spend around $5M in an IT project over the next 2 years.

Cheap valuation: AHCI is trading at 6x '08 EPS of 20c, and I think they will earn 22-25c in '09 (depending on forex), so stock is trading under 5x '09 and 2x EV/EBIT on non-peak margin. FCF is close to NI. $22M of cash vs. market cap of $54M.

What's the catch? CEO repeatedly said on conference calls that priority of the cash is to do deals. It is likely that they may be after their largest competitor Nestor (NSR LN). This makes no sense as 1) the deal does not add any strategic value other than "growing market share and top line" and 2) CFO suggested they may have to pay 4-5x EBITDA while their own company is trading under 2x. Partially alleviating the risk is that

• Investors appear to overwhelmingly object any acquisition -- the most recent conference call was dominated by disgruntled investors including a couple of top 5 shareholders, while mgmt does not own any shares.
• NSR has a market cap of 29M GBP. Factoring in a reasonable premium, the take-over price will significantly exceed AHCI's cash, and it is not exactly easy to raise debt to do deals in today's markets.

I don't want to sugar-coat the risk, which is real and significant -- a friend who has spoken to mgmt believes they are determined. Quite a shame that the company is not buying back shares at current level.

Catalyst

If mgmt gives up on the acquisition idea (either voluntarily or under pressure), it will be a huge positive.