Description

18% margins, 200%+ pretax ROC, secular grower, 7% distribution yield, high single digit FCF multiple to the equity, honest secular grower.

Doing my best to plagiarize as much as possible from company literature I present the following:

Futuremed is Canada’s leading value-added distributor of consumable nursing supplies and specialized furniture to the stable and growing nursing home sector.

Market leading position
• Canada’s leading distributor of nursing supplies and specialized furniture and equipment to nursing homes
• Full service, value-added distributor to over 815 individual nursing homes
Stable and growing cash flow profile
• Approximately 70% of revenues come from disposable products that generate recurring revenue (think incontinence pads and rubber gloves)
• Long-term track record of consistent revenue growth, with a 10 year CAGR of 29.4%
• Three year EBITDA CAGR of 19.1% and EBITDA margins of 17.7%
Positive industry fundamentals
• Nursing homes are highly regulated and funded by provincial and federal governments that are committed to universal healthcare coverage
• 85+ age demographic is the fastest growing segment of the Canadian population
High barriers to entry
• Loyal and diversified customer base with stable multi-year arrangements
• Lowest cost supplier in its markets with over 700 supplier relationships
• Due diligence calls with existing customers confirm that customers view Futuremed as a partner as opposed to a supplier
Strong growth opportunities
• Expansion of private label product line (higher margin) and enter into new markets such as the dental and physician nursing supplies distribution
• Strategic acquisitions to expand geographic coverage in new regions such as Quebec and Atlantic Canada
I suppose I could end the write-up right now, but for some reason I have a feeling that plagiarizing company literature and sticking it on VIC may not be enough to count towards my annual submission requirements.

Futuremed was started back in 1985 by the current CEO, Ray Stone. Onex, a well known public Canadian merchant bank took the company private a few years ago, and initiated an IPO in December as a method to monetize their investment. Ray Stone continues to hold about 4% of the company (same amount he owned after Onex bought him out), and Onex no longer has a position. As for why Onex sold, I have no unique insight other than to state that as a merchant back they are in the business of buying and selling companies.

Futuremed is dominant in the company’s home market on Ontario, with 80% market share. After establishing itself in Ontario, Futuremed entered the Alberta market in 1997 (73% market share), BC in 1998 (31% market share), Manitoba 2001 (26% market share), and Saskatchewan 2004 (26% market share). Management is focused on increasing market share in all of it’s geographies to a figure that resembles the Ontario figure of 80%, but I would classify this as a stretch target as opposed to an achievement that is actually expected to happen. The company has publicly stated that if it enters the untapped regions of Quebec and/or Atlantic Canada it will be via acquisitions.

Over the past decade healthcare expenditure in Canada have been growing at a high single digit CAGR while medical and nursing supply sales to Ontario based LTC facilities have grown at about a 5% CAGR. Going forward the LTC eligible population is increasing in size, new LTC facilities are being built, and Canada’s finances are strong. As such I would argue it is reasonable to assume that FMD grows organically at approximately 5% per year, with some upside available from increasing market share in recently entered Western provinces. Accretive acquisitions (and management has stated they won’t be made if they aren’t accretive) would be pure gravy.

I would think that for those of you who have read this far, this obvious question is why others have not entered this business given the attractive economics. First I will discuss new entrants (Eg. You or I opening up Wannabefuturmed from scratch).

This is a business where the devil is in the details. Futuremed carries 5,400 SKU’s and has exclusive Canadian distribution rights to many of the products the company carries. Deliveries to LTC facilities take place on a weekly basis, and the typical order size would be equivalent to about $500. In an effort to minimize storage space, LTC facilities have essentially outsourced their warehouses to FMD. FMD has a 99%+ successful delivery rate and is the low cost operator as a result of tremendous buying clout. As a result FMD has never lost a major customer and 8 of the 10 largest customers have been with the company for at least 15 years.

Ignoring the fact that FMD is already the low cost operator, I was told outright by FMD customers that they would not consider switching suppliers for price discounts of 5-10%. The risk of not receiving supplies on a timely basis is a nursing home’s worst nightmare (the repercussions of running out of incontinence pads are obvious), and the two cliques I heard most often were “Why fix if it ain’t broken” and “There are lots of suppliers who will show up and promise you the world, but we all know it is another thing to deliver on that promise”.

As for the economics, the numbers are great for FMD, but probably less so for a startup. FMD gets a bit of margin juice from private label supplies (currently about 10% of disposable sales) and obviously benefits enormously from buying clout. If you look back three years, FMD gross margins were only about 23.7% (on a revenue base of about $80m or a fifth less than now). From my research I will suggest that a small start-up would have to offer price discounts of at least 10% (I actually think it would be higher) to steal customers, and would also lack FMD’s buying power. While a guess at best, this would suggest a new entrants gross margins may be about 15% lower (10% lower ASP, 5% higher buying prices as compared to FMD when they were at $80m in revenue). This would leave one with about a 9% gp rate.

So assuming you could steal about a third of FMD’s disposable customers by year 3, you would have a business with about $27m in revenue (based on 5% industry growth over the next thee years). This would provide you or I with a gross margin in absolute dollars of around $2.5m dollars. Assuming our delivery costs were in line with FMD’s (3% of revenue), we would then have $1.6m pretax to cover the warehouse rental costs, sales commissions, warehouse and admin staff, and other business related expenses associated with running a national distribution company. Oh yeah, we would also have had to fund at least a few million bucks of working capital to carry the 5,400 or so SKU’s required to displace FMD as a one stop supply shop. I hope by this point I have convinced you to keep your day job.

The other potential threat is from larger industry players that currently supply the hospital and related markets. This is obviously a much larger market, as the average order by a hospital would be in the range of $50,000, or 100x the avg size of a FMD order. The obvious threat is Source Medical, Canada’s largest player in this market. Source Medical had been 50% owned by Cardinal Health of the US, although Cardinal took over full ownership in Dec 1995 when they purchased the remaining 50% from MDS Inc.

Source’s sweet spot are hospitals, labs, and large continuing care facilities. FMD management readily acknowledges Source has been trying to capture market share in the LTC market for the past 20 years. I would rank this as the largest potential threat to the success of this investment given Source would have buying power and logistical expertise that match and possibly surpass that of FMD. Without being able to offer assurances that Source will not suddenly emerge as a stronger competitive threat, I find some comfort that Source has had limited historical success to date.

I will confess however that I also have lingering concerns that under new ownership Source may suddenly emerge as a stronger competitor. I am not entirely certain why Source was never more successful in this market. My hunch is that they have never made it an area of focus give the relatively small size of the market (remember FMD is a dominant Canadian company with a disposable revenue stream of only about $70m). Surprisingly Source has never even successfully poached a FMD sales person, which is probably the first thing I would do given this is an industry where customer intimacy ranks highly in winning new accounts. As an existing investor in FMD, monitoring Source’s activity in the sector ranks highly on my continuing due diligence activities.

With respect to capital requirements, I tell no lies, capex has averaged less than $100k per year over the last five years for a company generating around $18m in EBITDA. Current market cap is $175m, and annualized Q1 FCF is around $19.5m, for an FCF yield to the equity of 11% excluding any potential growth. Working capital is also relatively modest at around 8% of revenue. The company is an income trust, so you are going to get the cash returned to you either via regular dividends or special dividends.

Catalyst

7% distribution yield
Single digit FCF multiple to the equity
Good business with attractive economics