Description

Infusystem (INFU)

Infusystem is an orphaned microcap that has a fatigued shareholder base but a fundamentally sound and growing business.  Over the last few years the business has been plagued by an overpaid management team that executed at suboptimal levels.  However, an activist group has come in over the past 12-18 months, restructuring the management team and board.  The activist group got in at prices around $2.25 a share and recently made a take private offer at $1.85, which was rejected by the board.  The combination of the rejected bid and a turnover of the shareholder base that was hoping for a deal has caused the stock to fall below $1.40 a share.

While we don’t think this is an exceptional business, we do think it is a good one with minimal downside at current prices.  Under conservative assumptions, we see upside in the range of 60-150% over the next two to three years.  If things go really well, it’s not unreasonable to see a stock price north of $4 or $5 a share, but we think this is less likely.  We believe the addition of good governance and an owner-operator mentality to the board, coupled with the economics of the core business, provide robust downside price protection.

Summary of the Business

Infusystems is the largest third party operator of infusion pumps in the US, serving primarily the cancer market.  At some point, most folks have been in a hospital room and seen the array of pumps and IV’s at a patient’s bedside.  Infusion pumps are those that deliver many IV medications to the patient and can be programmed to deliver specific doses over specific times.  With regards to cancer, much research indicates that continuous infusions (small doses over long periods) is a superior way to deliver chemo for specific cancers because it’s easier on the body and mitigates side effects.  Specifically, for colorectal cancer, the medical outcomes provided by infusion pumps have been found to be far superior to other forms of chemo delivery.

There are a handful of pump makers and each manufacturer has a slew of models and generations of pumps.  These devices are FDA regulated and use specific tubing, power supplies etc.  The pumps need to be certified on a yearly basis by an approved vendor in order for them to be used on patients and to be eligible for Medicare reimbursement.  Infusystems has this capability to do this for its in-house fleet of 26,000 pumps and on a contract basis for others.

This business isn’t rocket science but there are still a number of operational and compliance issues that must be addressed.  Given all these complexities, it’s not a trivial task for small providers to run this function in-house as there are a host of maintenance, compliance, billing and other requirements to simply operate these devices in a complaint manner.  In addition, Infusystems already has relationships and integration to most of the country’s major health insurers.

Much like large and small companies outsource their IT needs, healthcare providers outsource the logistics and support surrounding their infusion pumps.  As the largest operator, Infusystems has all the systems and inventory to serve providers of any size.  They also have a smaller operation that acts as a broker in these pumps, but the core function is to get a pump in the field and collect revenue from an insurer.  Their long-term profitability will be directly linked to the number of pumps in circulation and the utilization of these pumps.  Unless a healthcare provider can operate the devices at extremely high utilization, it make more sense to outsource the function to a provider like Infusystems.

While renting out the pump is an important piece of the execution challenge, making sure the service and support to patients is in place is just as critical.  Infusystems also manages the service aspects of their devices, providing patients with assistance with everything from resolving error codes on the pumps to dealing with a chemo spill.  For an idea of the level of service that is provided, watch these informational videos on the company’s site.

https://www.infusystem.com/education.html

Core Markets

Infusystems’ primary market is in colorectal cancer (70-80% of revenues) and they have established relationships with 1600 oncology clinics and are starting to leverage those relationships into other types of cancer.  The case for continuous infusion across all cancers isn’t there yet, but there are some indications that are starting to cross over. With an aging population that continues to embrace colorectal risk factors (red meat, processed foods etc), we don’t see the demand side of the market abating.  A valid risk that has been highlighted has been if infusion therapy is found to be ineffective.  There is a lot of evidence, at least around colo-rectal cancer, that infusion therapy is far superior to other forms of chemo delivery.  Any change in protocol from the current norm would take years to study and get through FDA approval.  We see no indication that anything is even in the pipeline.  

Outside of cancer, continuous infusions are often prescribed for pain management.  This is actually a Medicare approved (for cancer) use per forms provided by the Centers for Medicare and Medicaid Services (CMS) (which I pulled for infusion pumps).  With regard to pain management, the company already has the relationships with insurers but will need to re-create the clinic relationships within orthopedics or other specialties that require these services.  In order to provide pumps for cancer pain, they can probably leverage many of their existing relationships.  I view this as a long-term opportunity, which will require cash and not produce significant revenue in the near term.

Competition

Infusystems’ primary competition comes largely in the form of hospitals that maintain the function in-house.  As there is a growing need for hospitals to become more efficient, I would think there is plenty of opportunity for them to gain at least some share of the hospital market since they already serve some large institutions that you would think could do it themselves.  In addition, much like radiology clinics, I believe that local operators will be unable to keep up with the increased complexity and slimmer margins (due to CMS mandates) and will be forced out of the business or into the arms of an Infusystems.  Most of these providers can lease the pump, but are not capable of providing the level of support to the end patients that Infusystems can.  This is a key differentiator for a provider since these problems at the patient level would invariably land back on their laps, and is the key factor that makes this activity not profitable for a provider.

Financials

In underwriting this investment, we are looking to acquire the core colorectal cancer business for an attractive to cheap multiple in a steady state.  The hope here is that the new board will be able to bring executional improvements to the business which will result in the following:

1. Increase in market share of colorectal cancers

2. Growth in adjacent markets (other cancers and pain management)

3. Tighter control of working capital

4. Harvesting value of NOLs

If they can achieve mild success in any of the above three areas you will have a company with higher earnings, and likely a higher multiple.

Debt:

The company has a fair amount of debt, and in large we think for now that’s a good thing.  It has about $29M of long-term debt and a market cap of about $30M.  With the stated goal of plowing most of FCF into paying down debt (and demonstration during the last Q), we think a number of positives emerge. 

These include:

1.   Company can’t grow too fast (covenant on cap-ex)
2.   Interest payments will go down
3.   Cost of debt will go down as they de-lever
4.   Even if the valuation stays stable over the next few years, the debt pay down value should accrue to equity holders, providing added downside protection on the share price

Valuation

In our valuation analysis, we looked at three different scenarios.  Our standard practice is to look at valuations on a three-year forward basis and the calculations below are our projections for INFUs stock price at the end of 2016.

In the low case, we assumed the company neither grows now makes any meaningful improvements to its operating metrics.  While possible, we think unlikely since this has been the mandate of the activist group and we are already seeing improvements.

The base case, one which we think is 80% likely, includes moderate growth in the topline, slight improvement in margins, and slightly better management of working capital.  We are not asking for a lot to go right.  The major assumption is there is no draconian effect from CMS, which is what current market indications suggest (and priced in).

The high case is one which we think is unlikely as well, but implies accelerated top line growth, better margins and excellent management of working capital.  If this happens, you are likely to get great earnings, free up $10M of working capital, and a better multiple which could put you at a stock price north of $5.  Again, unlikely, but possible.

Based on 2016 Estimated pre-tax FCF

Share Price: $1.38

Low

Base

High

Risks

The biggest risk to the thesis and likely a main reason the stock is down is the continued uncertainty around CMS reimbursement rates going forward.  Infusion pumps were recently included in the competitive bidding process and I actually think this is a net positive for the company over the long-term.  CMS isn’t in the business of making a category unprofitable, just more efficient.  This works in Infusystems’ favor as I simply don’t believe that any other player in this niche market has the ability to operate more profitably than them.  Hospitals don’t have the focus to do it and small players don’t have the scale.

If Infusystems isn’t able to earn in excess of their normalized cost of capital here, I don’t think the vast majority of the industry can.  To the end, most regional players should be forced out of the market by CMS action over time by both the decrease in price and increased compliance costs.  The market has a way of over-discounting the draconian effects of CMS, and I think the worst case scenario is already priced into the stock.  For now at least, the CMS situation only affects about 1% of Infusystems’ revenue, but the market is discounting it as if the whole revenue stream is subject to a cut in the near-term.

The other key risk, which was mentioned before and I think is relevant, is that this company has never managed to handle working capital well.  A big part of the valuation is the cash build from FCF, so if this indeed gets gobbled up as they grow then the numbers won’t be nearly as attractive.  However, we have modeled for some of that, but we are hoping management can improve upon their historical working capital management.

Catalyst