Description

We believe Fonar Corporation (FONR) represents a unique and lucrative investment opportunity. The stock has been driven down by short term issues mostly related to the Covid Pandamic that will be resolved in the next year or so driving the shares to fair value which we believe is substantially greater than the current share price.

Fonar's founder, Raymond Damadian, who passed away in August of last year, is considered to be one of the co-inventors of MRI technology, along with Professor Paul Lauterber of Stony Brook University. They simultaneously in the 1970's discovered a way to use NMR (Nuclear Magnetic Resonance) technology, long used in the chemistry lab to identify molecules, to form an image of the internal soft tissues of the humand body. It might be considered one of the single greatest inventions in Medicine in the tewntieth century. Just think how much doctors rely upon it today to diagnose everything from brain tumors to sprained ligaments. It's one of the most critical tools available to doctors today.

Besides the discovery and bulding of the first MRI, Dr. Damadian invented the Fonar Upright Multi Position MRI. This is a monumental concept. The traditional MRI produces images of the spine and brain in the reclining position. The flaw here is that the reclyning scan  does not properly image the spine or other body structures when they are under stress. With the Upright MRI images can be taken when a person is standing up, sitting and positions in between and the stresses on various points on the spine and the flow of cerebrospinal fluid can be seen under more reall life conditions and the patient can be more accurately diagnosed. The Upright MRI scans a patient in numerous weight-bearing positions; standing, sitting, in flexion and extension, as well as the lie-down position. This means that an abnormality or injury, such as a slipped disk, may be scanned in a wight-bearing posture, which is much more likely to provide the  position in which the patient experiences pain.

As additional example of the power of the technology occurred in 2011. Using the Fonar Upright MRI in Dr Damidian imaged and measured the cerobrospinal fluid flow in eight MS patients. His study showed that leakage of cerebral spinal fluid could be responsible for the brain lesions leading to MS. In addition, other studies have been published in prestigious medical journals showing the distinct difference in the flow of cerebraspinal fluid in the upright versus suspine position.

There is unquestionably considerable clinical medical evidence that the Upright MRI provides medical benefits not duplicated by any other MRI because its just simple common sense that positioning plays a critical role in accurately detecting clinically significant pathology. Addtional examples include Arnold-Chiari syndrome, which affects 200,000 to 500,000 Americans, fallen cerebral tonsil disease, scoliosis, abdominal prolapses, and inguinal hernias.

It's also important to keep in mind and emphasize that MRI imaging, unlike an x-ray or a Cat Scan, does not use dangerous cancer-causing x-rays but is based on subjecting the body to a magnetic field and measuring the vibration of various carbon hydrogen bonds across the human body. 

The MRI equipment business is intensely competitive with such large manufacturers as General Electric, Philips N.V., Hitachi and Siemens.

Timothy Damadian, the founder's son, is now the CEO of the Company and worked with his father at the Company since 1985. He worked his way up on the Company and is clearly qualified to run the Company. He became CEO of the Company in 2016, prior to his Father's passing. I am always weary of situations where a scuucessful father passes the reins to his son who then methodically runs the business in to the ground. I don't believe this is the case here.

Fonar Corporation is the first, oldest and most experienced MRI Company in the industry. Fonar introduced the world's first commercial MRI in 1980. The Company conducts buisness in two segments. The medical equipment segment sells the Standup MRI and the physician management and diagnostic services segment (HMCA) manages MRI scanners in New York and Florida. HMCA, which by far provides the bulk of the Company's revenues, provides management services, billing and collection, credentialing services, compliance, purchasing, IT services, pesonnel management, medical record management, office space, repair and maintenance and basically everything needed to manage and run the imaging business. In addition to acting as a management company HMCA directly owns and operates five imaging facilities in Florida. The Company manages 40 MRI scanners; 25 in New York and 15 in Florida. By the end of the year the Company expects to add two additional scanners, one in each state. 

As mentioned above, Fonar is also engaged in the business of designing, manufacturing, selling and servicing MRI scanners, which utilize nuclear magnetic resonance technology for the detection and diagnosis of human diseases, abnormalities, and other medical conditions and and injuries. Fonar first introduced the "Open MRI" in 1980, which eliminated the intense fear of being enclosed for 30 minutes in a metal coffin with the sounds of grenades exploding in the background while the scan is conducted. For those of us who are cluster phobic this was the ultimate nightmare. Most recently they introduced the much more useful and practical Upright or Standup MRI.

Let's consider the Company's most recent performance:

(Dollars in Millions)

                                                2022           2021         2020          2019         2018

Revenue                                     97.6           89.9          86.7          87.2          81.5

Gross Margin.                            47.0.          43.4.         45.4.         43.2.         39.5

                                                  48.2%        48.4%       52.4%       49.4%       48.5%      

Net Income                                 17.2          13.7           11.7          20.5           24.5

EPS                                             1.75          1.45           1.18          2.22           3.10                    

Revenues have increased over the past five years as they have added more centers under management and gross margin has been fairly stable but once the pandamic hit in 2020 operating expenses substantially increased. The number of procedures per center significantly decreased as doctors deferred elective procedures and the health of customers deteriorated. But, despite the significant stress on its operations the Company maintained solid profitability and cash flow. Keep in mind that the revenue generator is HMCA. In 2022 equipment sales accounted for less than 1% of sales. So we must think of Fonar as an MRI center management business, despite the fact that the Company will continue to put effort in equipment sales.

Let's consider the most recent results for the second quarter of fiscal 2023 (year-ending June 2023). Total revenues for the quarter decreased 2%  to $24.3 million versus last year, but income from operations decreased 35% to $4.2 million and net income decreased 44% to $0.32 per share versus last year. The problem was SG&A expenses increased 38% relative to the comparable quarter last year. The increase was almost exclusively due to more reserves being placed on management contract and management fees and other receivable due to the COVID-19 pandemic. In addition, workforce shortages both for MRI technologists and administrative staff prevented the Company from meeting patient demand. This challenge of hiring qualified medical personnel is prevelant across the industry. The good news is the demand for MRI scans continues to increase. In addition, Fonar was recently able to hire an additional 19 MRI technologists,

What is impressive about Fonar is that despite this operating challenge, which is improving each quarter, the Company continues to be a cash flow machine. During the first six month of the 2023 fiscal year it generated almost $11 million in free cash flow, which on an annualized basis translates to about annual free cash flow of $3 per share. At $16.60 the stock is selling for about 5.5 times free cash flow.

With this type of cash flow generation, one would expect the balance sheet to be in excellent condition and it is! As of 12/31/22, the Company had $49.5 million in cash ($6.85 per share), a current ratio of 8.8  and no long term debt, other than lease liabilities. The Company had $14 in net current assets and almost $18 in tangible book value. 

Obviously as COVID-19 impacts continue to decrease, procedure volume increases, hiring conditions improve and the health of its customers improve earnings and cash flow for Fonar will improve. But, consider its valuation under current conditions. If we account for the cash on the balance sheet, the Company sells for much less tha 10 times depressed earnings, less than 4 times free cash flow and barely above net current assets. Arguing that these shares should sell for 50% more is not a difficult argument to make.

A final positive note: The CEO and EVP were public buyers of the common shares in September, 2022 at a price in the vicinity of $14. They each purchased 4,700 shares in the open market. 

Considerations:

Now come the my concerns:

1) Management controls the Company without having a majority of the economic interest in the Company with its ownership of super-voting B and C shares. (Other significant holders of the common shares include Kanye Anderson Rudnick Investment Management with 10%,  Renaissance Technologies with 6%, and Dimensional Fund Advisors with 5.6%. )

2) Reduced reimbursement rates from Medicare would have a material negative impact on the Company.

3) Eventhough equipment sales are insignificant, the Company faces major competition in the sale of its scanners from large well capitalized competitors like GE.

4) The Company depends on referrals from unaffiliated doctors for its scanning revenue. 

5) Other changes in healthcare legislation and reimbursement rates could significantly impact the Company. Healthcare is constantly changing and laws may be inacted that could be unfavorable to the Company's business.

The bottom line is the Company has wheathered  the storm of COVId-19 and even lower Medicare reimbursement rates, but has maintained strong cash flow and a pristine balance sheet. Any recovery, which appears imminent, should materially improve its results and the share price

Catalyst

1

1) Continued recovery in elective medical procedures.

2) Culmination of the COVID-19 Pandemic

3) Easing of hiring conditions for healthcare professionals.

4) Continued growth in the number of centers under management.