Description

7/20/2015

Recommending purchase of Liberator Medical (LBMH $2.47)

Reasons for recommendation

1)      Predictable, cash generative business trading at wide discount to market (11.5x 2016 EPS using estimated cash EPS)

2)      Longer term M&A potential

3)      Stock has likely been over-penalized for near term legal risks

4)      Current dividend yield of 5.7% with potential for dividend growth over time

L     Longer Term Tailwind From Demographic Trends, Aging Baby Boomers

5)      Limited float and large short holdings can create exaggerated up moves on even moderately good news, particularly when combined with relatively high borrow cost

Ko

Why this opportunity exists

Combination of litigation and large sales by largest holder, with current information vacuum

Background

Liberator was posted to VIC in February 2011 by rjm59. The company is primarily a distributor to end users of external catheters, used for incontinence/immobility, and secondarily of ostomy kits. The company bills roughly $160/month on average for a full month supply of external catheters ($1,982 annual per customer). While gross margins for the business are high, SG&A is relatively high, and customer usage prevents more expensive treatment for urinary infection. In 2014 Medicare reimbursement was 73.4% of Liberator’s revenue. This creates some reimbursement risk in the event Medicare initiated competitive bidding. However at roughly a $200 million market size, with the Liberator the largest distributor of catheters earning less than $10 million in annual profit, it is hard to see why Medicare would make the substantial investment in competitive bidding for what would likely be nominal overall cost savings.

Customers are primarily won via television advertising, with some recent expansion into other media outlets. Typically about half of initial orders turn into a long term customer. Management thinks the relatively high initial churn has a lot to do with affordability – customers realize their co-pays are higher than they can afford and end up re-using disposable catheters (this can lead to urinary track infection). The company is gradually getting better at identifying customers who qualify for additional government funding. The company has also qualified more third party insurers in recent years, which is improving its ability to convert leads – in the past some customers were turned away due to their insurance carrier.

The company’s core competencies are billing (Medicare and third party payer) and customer service. The company recently added 19 employees and currently has 338 employees. In addition to its billing and service capabilities, Liberator’s core asset is its customer list, which it has built over more than eight years of targeted advertising with annual spend ranging from a few million when the company was smaller to $14 million in 2014, following a spend of $9 million in 2013 and $13 million the year before. The elevated advertising spend in 2013 didn’t manifest in higher sales until 2014 – it’s reasonable to expect reasonably good sales trends over the balance of this year, given the elevated advertising spend last year.

Liberator loses a portion of its early customer additions to churn, as customers find they can’t afford co-pays, or find their private insurance coverage was not what they expected, etc. For those customers who stay on, the average customer life is about 10 years, creating a highly predictable revenue annuity. Liberator is also continuing to work on improving its network coverage with private insurers, to reduce incidents where it has to turn away business due to non-coverage.

Longer term, given demographics (aging baby boomers), longer lifespans, and dietary trends, it’s reasonable to expect that the market Liberator serves will grow at least at the rate of the broader economy.

Recent Litigation

Liberator’s stock has fallen 29% since it was disclosed in its December 10-Q (first quarter) that the company had been named as a defendant in a Qui Tam (whistleblower) suit. The suit, which is available at the Pacer website, names two manufacturers, Coloplast and Hollinger, and eight suppliers including Liberator, and broadly charges that catheter and ostomy suppliers moved customers to Coloplast and Holligner products in exchange for rebates. If proven, rebates in exchange for moving customers would likely constitute kickbacks under Medicare rules, and be grounds for nullification of Medicare claims. There are some additional nuances –in some cases for example Coloplast provided customer lists and telephone marketing support, which the complaint claims were non-monetary kickbacks.

The whistleblowers were former Coloplast employees and among their demands is compensation for retaliatory firing by Coloplast, purportedly in response to the lawsuit. Coloplast, which is a multi-billion dollar Netherlands company, is the primary target of the lawsuit. This also appears to be a Qui Tam case where the Justice Department has decided to ‘intervene’, based on the current lawyers on the case. That means the Justice Department will lead settlement discussions and will represent the case if it goes to trial. The majority of cases where the Justice Department intervenes end in settlement. The dollars tend to be smaller than cases brought independently, but the likelihood of some payout is substantially higher.

I’ve gone carefully through the complaint, and while I’m not a lawyer, I didn’t see any evidence of a quid pro quo between Liberator and the two suppliers. The complaint spends a lot of time discussing why a quid pro quo could have existed (marketing support, rebates, etc) – but provides no evidence that one did exist. While it’s clear Liberator sold a lot of Coloplast and Hollinger products, they also sold a lot of products made by other manufacturers. In addition, Coloplast has what appear to be some of the better external catheters on market, so barring some very explicit internal document, it’s hard for me to see how it could be proven that the company’s weren’t simply providing customers with one of the better product options. At this point none of the internal documents for supplier companies posted as exhibits to the complaint strike me as all that damaging either. It’s also worth noting that many of Liberator’s suppliers offer rebates, which are mentioned in passing in Liberator’s quarterly and annual reports.

That said, I suspect the company would prefer settlement to a jury trial given the uncertainty of outcomes with a jury. In theory violations of the false claims act, which essentially says you can’t bill Medicare if you are breaking Medicare rules, are subject to treble damages. So in trying to assess a worst case, it makes sense to take a guess at how damages could be construed.

Liberator does not disclose sales by supplier, but based on the court filings it appears likely that sales to the two suppliers approached $100 million over the last five years, prior to which the company’s sales were quite small. How many of these sales would have occurred absent the alleged illegal rebates? Given what already appears to me to be very thin evidence, let’s say the parties settle on 20% of sales or $20 million. And say those products sold at a 20% average mark up to the most likely substitutable products – so $4 million in billing above what Medicare would have paid had the substitution not occurred. Under the strictest application of the treble damages, Medicare and the co-plaintiffs could ask for payment of $12 million. In reality however, based on a review of other Qui-Nam cases, treble damages appears to be more of a starting point for negotiation. Keep in mind that if the number gets too high, it would be in Liberator and its codefendants’ interest to litigate, and it is fairly unlikely the justice department wants to devote substantial resources to a lengthy court battle with eight catheter suppliers most people have never heard of.

Ultimately a settlement amount is pure speculation, and you can come up with a wide range of estimates, but my best guess based on a review of other Qui Tam cases is a settlement below $5 million – or below $3 million tax adjusted. Anything higher than that and I think Liberator will opt for a trial, which admittedly would drag the issue out for another year.

A penalty in that ball park would be a serious black eye for the company, as it represents about half of full year 2014 earnings. That said, the stock has lost more than $60 million in market cap since the beginning of this year. It has more than priced in a settlement of this size. As far as ability to pay a settlement of this size, the company has nominal debt, $9 million of cash on hand, and is highly cash generative.

The other question is whether a settlement would change the economics of the business going forward. There is nothing to suggest that would be the case. But even assuming that going forward Liberator and its competitors were constrained in their ability to accept rebates going forward, I believe the benefits would at least partly by shifted to lower product costs.

Financial model and Valuation

Liberator earned $0.08 in the first half of 2015, $0.05 in Q1 and $0.03 in its seasonally weak Q2. Note that Q2 would have been closer to $0.04 absent elevated legal expense related to the Qui-Tam litigation. Those litigation expenses will likely continue through the third quarter, but should subside with the settlement of the lawsuit. Ex legal earnings this year should be close to $0.18 on a GAAP basis, based simply on the normal trajectory of the back two quarters each resembling Q1, where the company earned just under $0.05. So Q1 thru Q4, ex legal, should approximate: .045, .035, .04, .04 = 0.16. Based on recent ad spend, which is a good predictor of future earnings, 2016 EPS should be somewhat higher, likely around $0.17-$0.18.

Cash earnings are somewhat higher still. That’s because Liberator expenses its capitalized advertising expense over six years, but the economic value of that advertising extends about ten years. That value can be seen by tracking the income earned from advertising spend, which Liberator discloses in its filings. For example, in 2010 the company spent $10,808 in cash in advertising. That spend produced the following revenue:

2011: $14,385 (maximum yield on advertising spend in prior year)

2012: $12,446 (down 13% from 2011)

2013: $11,511 (down 8% from 2012)

2014: $10,319 (down 10% from 2013)

So four years after the initial ad spend, the resultant revenue is down roughly 40%. With that in mind it appears the more appropriate rate of amortization period is 9-10 years or is 10%-11% per year. Using the more conservative 11% amortization adds back roughly $3.5 million in annual advertising expense, or $0.04 per share after adjusting for the company’s 38% tax rate. With that in mind, cash earnings in 2016, ex legal expenses, would be around $0.21. That puts the stock at a relatively attractive PE of 12x 2016 cash EPS.

Liberator remains an interesting M&A target

In August 2012 bought 180 Medical, another distributor of medical products including catheters, for $321 million, which according to earlier comments on VIC was 8x revenue. I haven’t confirmed this multiple, but even if it was four times revenue, that would put a plausible M&A value on LBMH north of $5 per share.

http://www.convatec.com/aboutus/news-and-media/media/2012/convatec-completes-acquisition-of-180-medical,-leader-in-home-delivery-of-intermittent-catheters

http://www.reuters.com/article/2012/08/31/us-180medicalholdings-convatech-offer-idUSBRE87U19420120831

Large short position could fuel price momentum on positive news

Of a 28 million share float (a little more than half of outstanding shares), 2 million shares are short. Typically under 100,000 shares trade per day. If buyers come into the stock, there could be some additional tailwind from short covering. This may have contributed to some of the prior periodic stock price surges.

Key Risks

Millennium, who provided financing to the company several years ago thereby becoming the company’s largest shareholder, has sold aggressively, including what appeared to be a 2 million share block sale on June 26 (not yet reported on sec.gov). The fund likely still holds roughly 2 million shares, and could put further pressure on the stock near term if it continues to sell. That said, the fact that they were able to sell so many shares so quickly without completely tanking the stock price is encouraging (shares only traded down a few cents on their end of day block sale).

Legal penalties – the eventual settlement of the whistleblower case could have a larger cash settlement than expected, and could also impose limitations on future rebate activity which would hurt margins going forward. That said, the legal issue has to do with rebates incentivizing improper customer switching or upselling, as opposed to more general rebate programs, so it’s not clear any settlement would substantially change the business. In addition, if there were changes to rebating, the company might be able to offset those losses by negotiating lower base prices.

Catalyst

Settlement of Litigation

improved Earnings