Description

We have been taking advantage of a sharp decline in the stock price after a misunderstood conference call and a weak market environment. The street viewed the company's guidance for 2004 as disappointing and quickly unloaded the stock. Part of this sharp decline was driven by one analyst setting unrealistic expectations for 2004. In our mind the story is rather simple and today's share price does not reflect the breakup value inherent in the company's recurring revenue, sticky installed base of customers or its tremendous growth prospects.

In a March 3rd healthcare IT article in the Wall Street Journal, a survey of almost 500 US hospitals showed an expected 14% annual increase in capital spending with 72% of the participants saying digital radiology is their #1 need. VWKS with their acquisition of Amicas has become a major player in this space. In the radiology arena, VWKS has a PACS (Picture Archiving and Communication System) offering bundled with their RIS (Radiology Information System) product. PACS allows the x-ray experience to be totally digitized. Importantly, due to the number of images now taken in many of the new x-ray machines, the only way to view these images is with a PACS system. PACS prevents the loss of patients' x-rays, allows for the portability of x-rays to another physician, and quickens the process of patient care. On the financial side, PACS cuts out most of the cost of film, film processing, and personnel. Most hospitals and imaging centers can talk about 18-24 month ROI when buying PACS from VWKS.

In the company's medical unit, they are currently beta testing their new EMR (Emergency Medical Records) product. EMR is also a very hot product right now, listed in that same article as the 3rd most needed product in hospitals today. EMR digitizes all patient files and records and allows for paperless charting of patients diagnosis. Practices that have installed EMR have shown the following types of results: 1)transcription costs declined from $5.93 per visit to $0.25 per visit; 2) more accurate coding and charge capture increased revenue per patient visit by 20%; and 3)overall operating expenses declined dramatically.

These products are two examples of new offerings competing in very large markets. PACS is a $2B+ market over the next 2 years and $6B+ over the next 5 years. EMR is $1B+ market over the next 5-8 years. VWKS has also released updated practice management software for small offices and is working on updating their practice management offerings for larger offices. The EMR and RIS/PACS opportunities come on top of a business that does $80-90M of recurring revenue each year from their installed base of products and $20-30M of new sales revenue a year from some of their other software products.

VWKS has decided to make the necessary changes to its headcount to help support these growth opportunities. VWKS will be adding almost 100 employees (going from 675 to 775) to help take advantage of the current Healthcare IT market. These employee additions will depress earnings for the 1st part of the year as they go on to the payroll immediately, and will probably take a few months to start producing revenue. As a result, the numbers will get sequentially better each quarter and the company should exit the 4th quarter with an annualized run rate of $20-25M in EBITDA.


MANAGEMENT


We believe VWKS management is motivated to create shareholder value. In early 2003, the company facing less certainty than today's situation was aggressive buyers of its stock under $3.50. Insiders have also been recent purchasers around the $4+ range. We point out that PracticeWorks, spun off from VitalWorks in 2001, was sold in 2003 to Kodak for its dental digital radiography software offering. We believe VWKS's management is as motivated to create value as PracticeWorks's management, and has every bit the digital radiography software and installed base strategic allure.


VALUATION SUMMARY


We think today's price of $3.85 gives the company minimal credit for its installed base as a potential asset to a strategic buyer. Due to the stickiness of the customer base and the value of the real estate in HCIT market, most acquisitions take place in the area of 3-4X revenue. Based on depressed 03' revenue number of $111.5M, that would suggest that VWKS is worth $6.50-$9.00 in a sale today. Looking at the situation from a worst-case EBITDA perspective, VWKS current business (not assuming anything for PACS or EMR and prior to employee additions) should do about $15M of EBITDA. If a strategic industry buyer acquired VWKS, we estimate there are $25-30M of synergies on the conservative side ($10-15m for R&D, public company costs, management costs, trade show costs, personnel cuts etc.). Based on recent acquisition multiples and an understanding of the strategic value of the company's installed base, high barriers to entry business and recurring revenue characteristics, we feel VWKS is worth $6-8 if it were sold today. However, we think this represents a depressed valuation range. Importantly, we believe the intrinsic value of VWKS toward the latter half of the year should be a lot higher given the strong earnings and revenue inflection we anticipate at that point.

Today's price reflects none of the upside in this company and provides a highly compelling risk/reward valuation. As a software company, VWKS has incremental EBITDA margins of 50+% on their radiology offerings and allows for 2005 to be a blockbuster year. What does that mean? While we do not wish to throw in an EBITDA estimate at this point, we point out that based on VWKS's market opportunities in PACs and EMR, VWKS could generate $50-$100 million of annualized EBITDA in the next 2-3 years growing at 30% on a current $170-180 million enterprise value!

As reference, in the middle of the 2002 bear market VWKS traded at 3.5X revenue and 15X EBITDA. VWKS currently trades at approximately 1.3X our 2004 revenue estimate and 6X our projected 4th quarter run rate of EBITDA. For comparison purposes, MRGE (a PACS/RIS company) trades at 4.6X 2004 revenue and 13.1X 2004 EBITDA. VWKS has a healthy balance sheet ($10 million of net debt), a sizable NOL and plays in 2 of the largest growth markets in today's healthcare world.

Catalyst

Execution, execution, execution... the street now views VWKS as a "prove it story", any meaningful positive news will cause the stock to spike

Any mention/discussion of growing pipeline, backlog, and prospects

Announcement of large order on PACS business

Earnings inflection in the next quarter or two

Management going out to the street to tell its story

Announcement of 1st EMR order after beta testing finishes

Sale of company to a strategic buyer