DMD Digital (TSXV:DMG-H): Cheap – but what else?

This has been my hardest post to publish yet. I debated whether or not I should publish information on a company that does not meet my quality standard. I had to think about what my ultimate goal for this blog is. I came to the conclusion that my goal is to learn myself, while also contributing my readers’ learning. In this sense, I think full transparency is best. I should talk about stocks that meet my quality standard, as well as stocks that do not.

I am by no means trying to identify “short” candidates. I am only saying there are things about the business I do not understand. And remember there is a difference between a high quality company and a high quality investment. A low quality company can make a great investment if bought at the right price.

I think being able to reject stocks is a prerequisite to becoming a good investor. The reasons for rejection deserve close scrutiny. I think I can enhance everyone’s learning by subjecting my reasons for rejection to close scrutiny.

One of my original thoughts was to use this blog as a platform so that company executives would be more willing to talk to me. This is what made the decision hard. By showing my willingness to publish both positive and negative views, executives may deny access. Ultimately, obtaining corporate access is not a primary goal for the blog, and this is why I have chosen the path I did. Besides, good companies should have nothing to hide and be willing to tell their story to anyone who will listen. So here’s to everyone learning!

With that preamble, the subject of this blog post is DMD Digital Connections (TSXV: DMG-H). Here are the things that cause me to question the quality of DMD:

  • A weird debt structure
  • High regulatory risk
  • Weak publishing partners
  • Listing on the NEX exchange
  • Aggressive stock option grant in 2016

Business:

DMD owns a database containing the names, emails, specialties, and addresses of physicians, nurse practitioners and physician assistants. DMD is a database licensee authorized by the American Medical Association to maintain AMA physician professional data for mailing purposes. It is important to note that the AMA does not provide email data on physicians. DMD accesses email addresses through partnering with online content publishers that focus on the medical industry. When someone signs up for an email newsletter on a partner site, DMD cross references the name with its list of names from the AMA. If there is a match, the email is “authenticated” and DMD is now able to provide its customers (pharma companies) with a verified email for a physician.

The company has added to its email list offering with an offering known as Audience Identity Management. This tool allows pharma companies to figure out who is visiting what pages on their website even if the user is not logged in. The tool also helps to combat ad fraud. It allows medical publishers to prove to advertisers who their audience is (and that it contains their target; physicians).

Audience identity management works as follows: 1) when a physician or nurse signs up at a publishing partner, there is a tag embedded in their browser, 2) the web page that wishes to track who is visiting has a reader embedded in the Javascript, 3) when the reader on the website encounters a tag, it communicates with DMD’s server to provide more information on who the visitor is (ie. name, specialty, address, email, they can also get a practitioner number which can be joined with data bought from IMS to figure out the prescribing history of the doctor).

The audience identity management tool (AIM) has been a huge success for DMD and I estimate most of the company’s growth has been attributable to this product over the past two years (DMD has gone form $21M of revenue in 2014 to $41M in 2016).

The AIM tool has been such a large success for DMD because there is no other tool like it on the market right now. The AMA makes public who the other Database licensees are: Medical Marketing Service, IQVIA, Redi-Mail Direct Marketing, J Knipper, Veeva Systems, and QPharma:

  • Knipper and QPharma are focusing their business on samples and making sure drug companies are in compliance with sending out free samples by authenticating doctors receiving samples against the AMA list.
  • For IQVIA and Veeva, the AMA list is part of a much broader offering; the goal of this offering is to identify who future Key Opinion Leaders will be with advanced segmentation. They do not appear to have offerings that allow a website to identify a user without them logging in. But it is worth noting that both companies are very large relative to DMD and have much greater resources.
  • Medical Marketing Service has an email list; MMS also has a tool for publishers to identify their audience, but my impression is that it requires a user to login (unlike DMD which does not require login).
  • Redi-mail has an audience tracking tool that can work without login, but it only works when the user has your app installed on their phone or tablet (as opposed to DMD which does not require an app download as it works with tags embedded in the browser).

Debt

As of the most recent financial statements (Q2 ended June 30, 2017), Cegedim had debt on its balance sheet of $6.7M. On the asset side, DMD has $0.3M of cash and $8.8M of restricted the cash. The debt has a weird covenant which means that DMD cannot pay out any of its cash it is generating until the debt is fully paid off. DMD recently renegotiated the debt so that it will not be fully repaid until October 2021. This means that shareholders will not be able to gain from any dividend or share buybacks until at least 2021.

Weird, but it gets weirder. Under the previous agreement, DMD had to pay the higher of US$125,000 per month or 1/12 of 35% of the last annual audited EBITDA. In 2016, DMD earned an operating profit of C$7.3 million and amortization was C$1.1 million so that EBITDA was C$8.4 million. The average USD/CAD fx rate during the year was 1.3249 so the EBITDA in US$ was US$6.3 million (C$8.4M / 1.3249). So based on the agreement DMD should have paid the higher of US$125,000 per month or US$184,000. The US$184,000 is equal to the annual EBITDA of US$6.3 million divide by 12. However, DMD did not pay the higher amount; they paid the lower amount. DMD paid C$1.987 million of debt repayments during the year which is equal to US$1.5 million (or US$125,000 per month). I’m willing to admit the debt covenants are complicated and I may be misunderstanding them – but any investor in DMD should be asking management about this.

Regulatory risk

Given the business model, there is a high amount of regulatory risk involved. Privacy laws are subject to change. DMD acknowledges this risk in its filings: “There are a large number of legislative proposals pending before domestic and foreign governments concerning privacy issues related to Internet-based business. It is not possible to predict whether or when such legislation may be adopted.”

The Digital Advertising Alliance is attempting to set standards for how people are tracked online. One of the key components is that data is de-identified. This is not what DMD is doing as a specific part of their offering is about providing personal contact information.

List of publishing Partners

The list below is all the websites I could find that specifically mention DMD in their privacy policy. Once a physician signs up to receive emails from one of these websites, they are giving permission for DMD to track them using tags and to sell their email address onto Pharma companies.

I’d note that none of the websites appear to be the most prestigious in their field. There is nothing from Annals of Internal Medicine, or Nature, or Mayo Clinic Proceedings, or Journal of Pediatrics or Journal of Clinical Investigation – you get the point… I would say the list is mostly second or third-rate publishers trying to make a buck.

GlobalRPh.com, Aesthetics CME (continuing medical association), Fidelis partners – career search, PAH.tv (pulmonary arterial hypertension), Endocrine society, Diabetes in control, Oncology tomorrow, HMP Global, Delta Healthcare providers, Statnews.com, Gomerblog.com, The Oncologist, Medoptions.com  Clinical Oncology – www.clinicaloncology.com,  Healthline, Broadcastmed, Global Neurology Academy, Stem Cells Translational Medicine, The Doctor’s channel, Healthjobsnationwide.com, Global Women’s health academy, Reachmd.com, medlexicon.com, ehealth-news.com.

Another point of note is that Wolters Kluwer is a competitor in that they offer data on physicians. Wolters Kluwer owns Lippincott Williams & Wilkins (LWW) which publishes several medical journals. These journals are higher quality than any publisher DMD partners with.

NEX Exchange:

DMD is a bit strange as the company trades on the NEX exchange. The NEX exchange is a rung below the TSX venture exchange, meaning most companies on it are dormant or not active. DMD is on the NEX exchange because the company stopped filing financial statements for a period of time. The company was late to file its 2011 financial statement because of a dispute with its auditor over fees. While this is obviously a red flag, I am willing to give them the benefit of the doubt as they were able to drastically reduce audit fees when they switched from their old auditor (KPMG) to their new auditor (Guimond Lavalee). See Figure 1.

The NEX exchange has lower listing maintenance fees than the venture which is likely why DMD has stayed listed on the NEX. DMD easily meets requirements around net tangible assets and operating income to list on the Venture exchange if it chose to.

In terms of financial reporting and incentive compensation, it is important to note that there is no difference between being listed on the NEX versus the Venture. Financial reporting and stock based compensation is governed by securities laws and not the exchanges. The securities laws do not differentiate between NEX-listed and venture-listed issuers. Both sets of issuers require need audited annual statements, interim statements and MD&A. An Annual Information Form is optional for both sets of issuers.

Stock Options:

DMD made a very large option grant in 2016. The company has 199 million shares outstanding and made a grant of 16 million shares. This represents 8% of shares outstanding. Note that the maximum annual grant of stock options in a 12-month period allowed by securities laws is 10%; DMD is getting very close to this level. It is important to note that DMD has not always been a serial issuer of options. The grant in 2016 was the first large grant since 2009. At this point, it is unknown whether or not grants will start recurring on an annual basis. Of the 16M shares, 8.7M shares went to the Board, CEO, CFO and COO.

The job boards on the internet disclose that there has been a large executive management shake-up at the company. It is possible that the remainder of the options may have gone to some of the new executives.

The amount of options granted is concerning. So is the strike price. On the date the options were granted, DMD shares were trading at $0.20. One would think the strike price should be at least $0.20. But NO! DMD decided to issue options to its executives with a strike price of $0.15. This practice is legal; but just barely. The maximum discount you can put on option grants for shares under the price of $0.50 is 25%. DMD issued its options at precisely a 25% discount. So basically management will make money on these options as long as the share price does not decline by MORE than 25%.

It is important to note that related parties own 25.4% of shares outstanding at DMD. The shares have not been earned through options grants over time, they have had an interest since the beginning.

The Company’s website: http://www.dmdconnects.com/

Author Ownership: No TSXV: DMG-H

Read Disclaimer:

This article is for informational purposes only. This article is based on the author’s independent analysis and judgment and does not guarantee the information’s accuracy or completeness. The information contained in this article is subject to change without notice, and the author assumes no responsibility to update the information contained in this article. The information contained within this article should not be construed as offering of investment advice. Those seeking direct investment advice, should consult a qualified, registered, investment professional. This is not a direct or implied solicitation to buy or sell securities. Readers are advised to conduct their own due diligence prior to considering buying or selling any stock.

Qualitysmallcaps.com is not engaged in an investor relations agreement with DMD Digital Health Connections Group nor has it received any compensation from DMD Digital Health Connections Group for the preparation or distribution of this article.

The author of this article has acquired and may trade shares of DMD Digital Health Connections Group through open market transactions and for investment purposes only.

Searching for yield with Becker Milk (TSX: BEK/B)

The Becker Milk Company (TSX: BEK/B) has lots of things to like about it:

  1. For starters, it is a simple company. Becker owns real estate. Becker owns and manages 57 properties with a total of 73 retail store units and two residential units. Of the 73 retail units, 46 are leased to Mac’s (a subsidiary of Alimentation Couche Tard; TSX:ATD/B), 20 are leased to other tenants and 7 are vacant. One property is in metro Toronto and the rest are in Southern Ontario.
  2. Another thing to like about Becker is the balance sheet. Becker has net cash on its balance sheet of $4.5 million as of Oct 31, 2017. The company also noted it sold two properties subsequent to Oct 31 which would increase its net cash on balance sheet to approximately $5.5 million. It is extremely rare for a real estate company to not be leveraged to the hilt. Becker is impressive in this regard.
  3. Becker is small and likely underfollowed as a result. The market capitalization of Becker is $28 million. The company only has five employees.
  4. Management pays itself a reasonable amount. While it is arguable whether or not Becker has enough scale to justify the cost of a public company, the CEO pays himself a total package of about $225,000, there is a vice chairman who is paid $115,000, and the CFO is paid $48,000.
  5. In late-2013, there was an offer for the company at $21.00 per share by Firm Capital. The current share price is $15.70. The current shares are trading below what a third party willing to buy the whole company was willing to buy them for. It’s important to note it is not an exact comparison as Becker has sold 10 properties since 2013.

As I dug into the company, there were a couple of things that stood out:

  1. Environmental liabilities. Becker has 13 properties with a gas bar on them. Gas stations cause problems because of contaminants that can find their way into the soil. There are two major repercussions if a site is contaminated: 1) it scares away lenders and makes it more difficult to find financing, and 2) limits ability of owner to change use/zoning until site is remediated.
  2. 85% of Becker’s revenue comes from Mac’s which poses significant concentration risk.
  3. There is a dual-class share structure in which the shares traded on the TSX are non-voting. A takeover offer can be made for the voting shares without making an offer to the non-voting shares (ie. there is no coattail provision).

Valuation. Becker’s trades at 0.86x book value and a dividend yield of 5.1%. While these measures suggest Becker’s may be on the cheap side, it by no means an eye-popping bargain.

Environmental Liabilities

In terms of environmental liabilities, the vast majority of Becker’s obligations are in the past. I do not expect there to be any major future liabilities related to environment remediation. To explain, a bit of a history lesson is required.

Becker sold its dairy and convenience store operations to Silcorp in November of 1996. Silcorp was subsequently acquired by Alimentation Couche-Tard (TSC: ADT/B), so that the convenience store operations now reside within Couche-Tard. While Becker sold the convenience store operations and dairy, the company retained its real estate. The real estate is now the primary asset of Becker.

As part of the sale to Silcorp, Becker agreed to remediate certain sites which included gas stations in return for indemnification from future environmental liabilities. Between 1997 and 2008, Becker spent between $10 and $15 million on environmental remediation. In the late 90s/early 2000s, Mac’s and Becker were names co-defendants in a series of lawsuits related to environmental liabilities with total claims of $10.5 million. The indemnification held up, and Becker did not pay any material amounts related to these lawsuits.

More recently, Becker re-initiated a strategic review in Q2/FY14. As part of the review, Becker completed an initial environmental review on all of its properties. A more in depth review was completed on about half of the properties where it was deemed warranted. At the end of the review, Becker reduced the fair value of its property portfolio by $850,000 for additional remediation obligations (or an undiscounted value of ~$1.5 million). While disappointing, this future obligation is much less than the $10-$15 million Becker spent on remediation between 1997 and 2008.

One more point on environmental remediation. Another lawsuit was brought against Becker/Mac’s in 2016 for $1.7 million. Becker believes the lawsuit is unwarranted and the damage claimed is actually from another property and not the one owned by Becker and operated by Mac’s. Becker has filed their defense and the plaintiff has yet to take any further action.

Given the amount Becker has already paid related to environmental remediation, and that Becker has already come through a series of lawsuits unscathed, it increases my confidence that Becker will be able to handle any future issues with regard to environmental remediation without any major liabilities.

Customer Concentration

As noted above, Mac’s is a major customer of Becker’s. In their year ended April 30, 2017, Couche-Tard made up 85% of Becker’s revenue.

While this is a large amount in any case, it is even more significant when there is a history of tumultuous relations. As mentioned in the above section on Environment, Mac’s and Becker’s were named as co-defendants in a series of lawsuits. As part of this ordeal, Mac’s filed a claim against Becker’s and Becker’s filed a counterclaim.

Between 2005 and 2008, Mac’s announced its intention to renew leases, but refused to enter into negotiations with Becker’s on rent increases. The whole situation was messy and ultimately had to be resolved in mediation. And even after agreements were agreed to in principle, there was a lag in implementation, and Becker had to threaten further legal action.

Ultimately, there were new leases agreements signed in 2008. But this did not happen without Becker’s and Mac’s going through mediation. The agreement in 2008 covered 58 of 64 leases and saw annual rents paid to Becker increase by a total of 8%  in 2009 (relative to 2008). This can be thought of as making up for an annual increase of roughly 2% per annum between 2005 and 2008.

Post 2008, relations ran smoothly for a few years, but based on Becker disclosures, Mac’s started being difficult to negotiate with again in 2012. Since 2012, Mac’s has generally agreed to renew/extend leases. However, Mac’s and Becker have not been able to negotiate a new rental price, and as a result Mac’s has continued to pay what it was paying under the previous agreements. At the end of April 2017, it got to the point where Mac’s has renewed a total of 40 leases since 2012, but rental amounts have yet to be negotiated (for context, Mac’s leases a total of 56 sites from Becker’s; so 40 of the 56 sites do not have a current lease agreement as it relates to rental price).

So in summary, there has been a history of poor relations between Becker’s and Mac’s, even though Mac’s is Becker’s major customer. Currently, 40 of Mac’s 56 leases with Becker’s have expired and a new price has not been set. The amount of expired leases has been increasing each year since 2012.

This could ultimately be positive, as it means Becker’s has been under-earning and should see an increase to its rents once the leases are re-negotiated. In any event, Mac’s appears to be the one with the bargaining power at the negotiation table.

Share Structure

It is important to be aware that Becker’s share structure is made up of 540,750 common shares and 1,267,710 Class B Non-Voting shares. The class B shares are the shares traded on the Toronto Stock Exchange. The common shares are the voting shares and are 100% controlled by the founders and their families (Bazos, Panos, Pottow).

Class B shares do not have the right to participate in a takeover bid made for the common shares (ie. there is no coattail provision). Theoretically, this means that an acquirer could make an offer for the common shares and not have to make an offer to the Class B shares. In my opinion, there is not a whole lot of strategic value to controlling the company’s assets. So such a bid for only the common shares would be unlikely. Any acquirer would likely want the assets for the cash flow they generate. In this sense, Class B shareholders are protected because they participate in dividends equally with the common shares.

Valuation

Becker’s trades at 0.86x book value and has a dividend yield of 5.1%.

Book Value

To determine if book value is  valid measure, we have to consider the assets on the balance sheet. By far, Becker’s largest asset is its property making up about $32 million of its total $37 million in assets.

Since adopting IFRS accounting in 2012, Becker has included the change in fair values of its real estate portfolio in its income statement each year. This has the effect of including the real estate portfolio at “fair value” on Becker’s balance sheet. When it comes to valuing commercial real estate, the most important variable is known as the capitalization rate (“Cap Rate”).  Fair value is calculated as net operating income / cap rate. So if net operating income is $50,000 and we use a 5% cap rate, then fair value would be $1,000,000. Important to note that net operating income is rents less operating expenses such as property taxes, management fees etc. Operating expenses in the calculation of net operating income do not include interest expense or depreciation and amortization.

The cap rate Becker has used to calculate the fair value of properties on its balance sheet is currently 7.9%. At April 30 2017, Becker valued its properties at $31.3 million. Based on the 7.9% cap rate, this means they should generate operating income of $2.46 million. When we look at the income statement (see below), we see property revenue of $3.66 million, property operating expenses of $0.54 million, and admin expenses of $1.32 million.$3.66 million less $0.54 million less $1.32 million is equal to $1.80 million. I think the reason for the difference is that not all of Becker’s admin expenses should be included in the calculation of net operating expenses (for calculation of operating income). I think it is reasonable to exclude audit fees as well as wages paid to the three named executives and three directors. In total, this amount adds up to nearly $575,000. If we add this to the $1.8 million above, we get much closer to operating income backed out from the cap rate of $2.46 million.

The history of the capitalization rates Becker’s has used can be seen in the graph below. At first glance, the 7.9% cap rate seems somewhat high, which would mean that perhaps the ‘fair value’ is actually understated on Becker’s balance sheet.

However, upon further examination, the cap rate appears to be appropriate. We can check the cap rate for sensibility by looking at cap rates published by the major commercial brokerage firms. For Q3/17, Colliers noted that the cap rate for a strip mall in Ottawa Ontario is between 6.25% and 7.00%. Cushman Wakefield estimated a non-anchored strip plaza in London Ontario traded between a cap rate of 5.75% and 7.00% in Q3/17. Becker does not disclose exactly where its properties are, other than saying that only 1 is in metro Toronto and the rest are in Southern Ontario. I think it is likely that a significant number of Becker’s properties would be in locations more rural than London or Ottawa, which would make a higher cap rate reasonable.

We can also test the cap rate assumption for reasonableness by examining recent dispositions from Becker’s portfolio. Over the past 5 years, every single property that Becker has sold has been at a loss. This means that the proceeds Becker has received have been less than the amount recorded on the balance sheet. This would suggest that the capitalization rate being used may actually be too low, rather than too high.

During the first six months of FY18, Becker has sold $1.8 million of properties. This is more than the total of the past 5 years displayed in the table below. Becker also disclosed that there was a positive adjustment to fair value of its properties during the first six months of FY17. The reason for the positive adjustment is that properties were “transferred to held-for-sale at values higher than their previously appraised values.” This suggests that the properties Becker has sold more recently have been at higher values than recorded on its balance sheet.

I did all of this work with the intention of being able to come to the conclusion that the amounts for property recorded on Becker’s balance sheet are either too high or too low. However, there does not appear to be any clear evidence this is the case. I think the cap rate chosen by management (7.9%) and the associated fair value of properties is reasonable.

Dividend Yield

In terms of a dividend, Becker currently pays C$0.80 per share and has done so for the past 4 years. This represents a fairly attractive yield of 5% on the current share price of 5%. However, it is important to note that Becker’s dividend is being “topped” up by asset sales. Over the past 4 years, total free cash flow (before asset sales) has been about $700,000 less than dividends paid. This is a cumulative ~$0.40 per cents or $0.10 per annum, implying an “organic” dividend of $0.70 per annum. On an organic basis, the dividend yield is still fairly attractive at 4.3%.

Author Ownership: No TSX: BEK/B

Read Disclaimer:

This article is for informational purposes only. This article is based on the author’s independent analysis and judgment and does not guarantee the information’s accuracy or completeness. The information contained in this article is subject to change without notice, and the author assumes no responsibility to update the information contained in this article. The information contained within this article should not be construed as offering of investment advice. Those seeking direct investment advice, should consult a qualified, registered, investment professional. This is not a direct or implied solicitation to buy or sell securities. Readers are advised to conduct their own due diligence prior to considering buying or selling any stock.

Qualitysmallcaps.com is not engaged in an investor relations agreement with The Becker Milk Co nor has it received any compensation from The Becker Milk Co for the preparation or distribution of this article.

Vigil Health (TSXV: VGL): A Quality Microcap

Vigil Health is the subject of my first post. Vigil trades on the TSX-Venture exchange and is relatively illiquid given the market capitalization is C$15 million. I reiterate the following post is not meant to be investment advice, but rather some thoughts around a quality small/micro cap company. I have provided some work on valuation for my own reference.

Summary

  • Vigil’s core end-market (senior housing) will likely be under continued pressure to cut costs over the coming years due to there being a single dominant payer (Medicaid). Medicaid itself will be under pressure to reduce costs to help stem the massive US federal deficit.
  • Vigil is in a unique position to help the industry save money by offering a lower-cost nurse call and wander management (ie. memory care) system. Vigil is able to offer a lower cost solution because:
    • Vigil offers a bundled nurse call and memory care system. Other providers have nurse call and need to partner to provide memory care which implies two layers of margin and a higher cost to the customer.
    • Vigil focuses on the senior housing market. Many providers have a focus on the hospital market which requires higher end systems with more integration capabilities. As a result, these competitor systems have a higher cost.
    • Vigil sells through its direct sales force to large corporate customers. Many providers sell through distribution, which again implies another layer of margin and higher cost to the customer.
    • Vigil is a small company with limited overhead. A Government of Canada website discloses there is only 17 employees. Linkedin says 27 employees. Either way, it is small!
  • Recent share price weakness has been due to a slowdown in revenue growth that first happened when Vigil reported Q1/FY18 results in August 2017. This revenue slowdown is expected to be temporary because:
    • Both bookings and backlog are currently strong which signal future revenue growth.
    • Vigil operates in a very large market and there is room for deeper penetration.
    • There is lots of opportunity for Vigil to broaden its product offering and expand into adjacencies.
  • Chairman Greg Peet owns 28% of shares outstanding. Peet has a strong track record having sold A.L.I. Technologies to Mckesson and Contigo Systems to Vecima Networks.
  • Strong balance sheet with $1.9 million of cash and no debt. Vigil has been cash generative in each of the past 5 years.
  • Valuation is reasonable at about 15x FY17 earnings.

What they do (ie. the basics)?

Vigil focuses on software solutions for the North American senior housing market. The company has a system used for patient monitoring that enables emergency and nurse calls. Its marquee offering is used for patients with memory impairment or dementia. These patients are unable to use a traditional method of pushing a button or pulling a string to call a nurse. Vigil provides software and associated sensors to monitor patients in a non-invasive manner and alert nurses when their patterns of behavior or movement are not normal.

Industry

It is important to begin any discussion about a company with thoughts about the industry. As Warren Buffet famously noted, “I’ve said many times that when a management with a reputation for brilliance tackles a business with a reputation for bad economics, it is the reputation of the business that remains intact.”

Vigil serves the senior housing market. The two key drivers of the senior housing market will be: 1) number of seniors, and 2) price paid per a senior.

Number of Seniors: The aging of the boomers will contribute a tailwind to the industry for many years to come. This can be seen in two charts from the US Census Bureau. The first chart shows the growth rate of people aged 65+ versus the growth rate of the total population. The population aged 65+ is projected to grow at a much faster rate than the total population between 2010 and 2030. The second chart shows the history and projected future of the total population aged 85+. The number of people over 85 in the USA is projected to grow from roughly 5.7M in 2010 to 9.0M in 2030 (annual growth rate of 2.3%).

Price paid per Senior: From a pricing perspective, the overall health of the industry is more uncertain. This is because of the very high costs associated with Nursing homes and the dominant role that Medicaid plays in paying for these costs. Genworth (an insurer) notes that the median price for a private room in a long-term care facility now totals $90,000 on an annual basis. The Kaiser Family Foundation notes that 64% of nursing home residents receive coverage from Medicaid. This is an astronomical number. In 2015, Medicaid spent a total of $54 bn on nursing facilities. Nursing facilities are part of a broader bucket of Medicaid spending called Long-Term Services and Supports (LTSS) which includes Home and Community Base Services (HCBS). In 2015, a total of $158 bn was spent by Medicaid on LTSS.

When looking at the total LTSS Medicaid spend bucket, an interesting divergence has occurred over the past 15 years. While total spending has increased, it has been almost entirely driven by HCBS. The institutional bucket of spend (which includes nursing homes) has shown very little dollar growth (see chart below). My interpretation is that there has been pressure to reduce spend in high-cost facilities or environments (ie. nursing homes) and transfer that spend to lower cost environments (ie. home-based care).

The providers of senior housing have adapted to the pressure on nursing home spending by altering the mix of units being constructed. There has been a growing number of independent living units (ILU) and assisted living units (ALU), while the number of nursing care beds (NCB) has been relatively flat. There has also been growth in Continuing Care Retirement Communities which are aimed at providing the full continuum of care all within a single community. Note that the data in the chart below is from a joint publication by Ziegler (a specialty investment bank) and Leading Age of the top 150 non-profit providers of senior housing. It is likely the trend would be even more pronounced if for-profit providers were included.

In summary, while senior housing is expected to benefit from the continued aging of the population, there will likely be continuing pressure to cut costs given the dynamic of having a single dominant payer (Medicaid). Medicaid can use its scale to pressure a fragmented supply-base into pricing concessions. The pressure will likely be continuous as Medicaid itself will also fall under pressure to cut costs to help cope with ever-mounting budget deficits in the United States (note that Medicaid is the third largest domestic program in the federal budget after Social Security and Medicare).

This dynamic has the potential to be positive for technology providers such as Vigil. The three largest costs for a senior housing provider are labor, food, and utilities. Technology has the potential to increase productivity and bring down labor costs over time.

Competition

Vigil has three core products: a wired nurse call system, a wireless call system, and a memory care system. The core function of all three products is the same; to allow patients to communicate with their caregivers in case of discomfort, pain or emergency.  From a broad perspective, Vigil competes with all Nurse Call providers.

However, one way in which Vigil differentiates itself versus other nurse call competitors is its singular focus on senior housing. Many of its other competitors have a “hospital first” mentality. According to Centers for Medicare and Medicaid Services (CMS.gov), total healthcare spending in the United States was $3.3 trillion in 2016 (18% of United States GDP!). Of this amount, 32% or $1.1 trillion of spending was attributable to hospital care. Only 5% or $163 billion was attributed to Nursing Care Facilities and Continuing Care Retirement communities.  The much larger spending in the hospital setting naturally attracts more and larger competitors, while senior housing is neglected.

The neglect of the senior housing sub-segment can be seen in the actions of some of the large Nurse Call competitors. At a 2014 conference held by Piper Jaffray, Hill-Rom disclosed that the economics in the States for long-term care, nursing home facilities have not been terribly attractive, and as a result they do not have a lot of business in the nursing home end market. 3M seems to concur with this statement as demonstrated by its abrupt exit of its Homefree or its resident monitoring product line in 2013. It’s also worth noting that only two of the six top nurse call providers had a presence at the Argentum conference which is one of the largest conferences for companies that own operate and support professionally managed senior living communities. Tektone and Ascom had a presence, while Elpas (Tyco), Rauland (Ametek), Jeron and West-Com did not have any presence (indicating they are not actively targeting senior living).

Of the two competitors with a presence at Argentum, it is worth noting: 1) Tektone does not actually provide wander management solutions for seniors with dementia itself; it partners with Accutech, and 2) Ascom is a large company with a focus both in Europe and hospitals. Given the relative size, Vigil can provide much better service (no bureaucracy) than Ascom while providing a solution that is tailored to senior housing rather than hospitals. The complexity of care at hospitals is much higher and Ascom has spent a lot of resources (that it looks to get paid for) on integrations which are not necessary at a nursing home.

I believe that Vigil has carved out a unique niche for itself by focusing on the senior housing market. Given its small size and limited overhead, Vigil can effectively compete by offering senior housing providers a lower cost versus its larger competitors focused on serving more complex needs of a hospital. Cost is very important to providers of senior housing given the industry-wide pressure to reduce costs as a result of there being a dominant payer (Medicaid). Medicaid is able to use its scale and ability to benchmark against best-in-class providers to reduce payments to senior housing providers meaning that the cost of any technology solution is a decisive factor when deciding which technology vendor to select. Vigil can also offer a better cost than competitors who have to find partners to be able to provide nurse call and wander management. Vigil only has a single layer of margin whereas competitors who partner must split the profit between two or more parties.

Growth Opportunity

New Customers: Based on Vigil’s ongoing disclosure, it is difficult to assess new customer acquisition. Vigil groups project revenue from both new and existing customers together in the same bucket. However, we can gauge Vigil’s current level of penetration given its disclosure that its installed base consists of over 500 projects representing more than 38,000 beds.

The key question is what to use as an addressable market. According to Ziegler (a senior housing focused investment bank), there are a total of 1,060 Memory Care communities in the United States with a total of 51,000 beds. If we assumed that Vigil’s addressable market only consisted of Memory Care communities, this would imply Vigil has nearly fully penetrated the market in the United States.

However, this would be a mistake as Vigil does not just serve memory care. Vigil provides solutions across the care continuum so as to have an offering for each level of care in a Continuing Care Retirement Community. In total, when looking at independent living, assisted living, and nursing homes, there are roughly 3.2 million units across the united states (Source: Ziegler). This would imply a much lower penetration of 1.2%.

My thinking is that neither one of these numbers is right. Vigil’s core opportunity really lies in communities that have both memory care and other forms of senior housing (ie. combination of independent, assisted and nursing home). Most of Vigil’s sales come through its direct sales force. Due to its limited number of employees, it only makes sense from a resource and cost perspective for Vigil to target large providers of senior housing with a mix of housing options across the care continuum.

Existing Customer Penetration: Vigil also has an opportunity to increase spending from existing customers. As a whole, software and IT is relatively under-developed within senior housing. There are two points that support this: 1) A survey from Zeigler found that only 21% of organizations had a Chief Information/Technology Officer position, and 2) Only 20% of residential care communities use electronic health records (source: Getting to 2025: A Senior Living Roadmap; Argentum).

Vigil has demonstrated an ability to adapt its offering to appeal to adjacent markets. Vigil started off specializing in only Memory Care for skilled nursing facilities. Over time, Vigil has added additional systems so that it can offer a Nurse Call product. The company has also added systems to expand into assisted living and independent living facilities (with lower levels of care relative to a nursing home).

To date, Vigil has focused all of its software on the interaction between the resident and the onsite nurse or caregiver. There are many other interactions at a senior housing facility where technology has applications:

  • Interaction between caregivers on the ‘front line’ and the attending or primary physician doctor. This would likely entail automation of relevant information into the residents’ Electronic Health Record. Could also include things like Electronic Medication Administration Records (eMAR) and electronic treatment authorization requests (eTAR).
  • Interaction between nurses and administrators. This could entail a real-time locating service to monitor the movements of nurses and time spent with each patient. This would allow administrators to monitor the productivity and utilization of nurses (to help with scheduling) as well as have applications with billing (ie. patients who require the most time from a nurse are charged more).
  • Interaction between residents and their families. This could include monitoring of health, or activity with automated communication/notification sent to family on an opt-in basis. It could also monitor what are known as activities for daily living, such as eating, dressing, bathing (by putting sensors on things like fridge, closet, shower) and alert family members when an increased level of care may be needed (ie. a move from assisted living to nursing home).

Balance Sheet

A strong balance sheet is essential for very small companies like Vigil. Small companies have a much more difficult time accessing capital markets than large companies. Some hedge funds will search for small/micro caps in search of funding and go short the stock so that they can buy it back on an upcoming share issuance.

Vigil’s balance sheet is solid with a cash balance of $1.9 million and no debt.

It is worth noting that Vigil has an accumulated deficit of $12.4 million on its balance sheet. This means that company has lost more money than it has made over its history. While this can be a troublesome sign, it is worth noting that Vigil has been profitable in each of the past five years (starting in FY13).

I am not worried about the accumulated deficit because Vigil is a software company. This means its capital expenditures are very low. A large reason for the accumulated deficit are R&D costs that have been expensed as incurred. The company recognizes costs related to R&D before it is able to sell the software to customers and receive revenue. Another reason for the deficit is that Vigil was too aggressive on sales and marketing expense when Vigil first IPO’d (between FY03 and FY06). The company scaled back its sales and marketing in FY07 and concentrated on specific geographies where it had success rather than full nationwide coverage.

Return on Capital

Vigil is currently reinvesting most of its money into R&D and sales and marketing. When the company gets to a larger scale, it will earn a very high return on capital because of the lack of fixed assets in the business. Vigil has tangible assets of $2.0 million which are mostly comprised of accounts receivable, inventories, and contracts in progress. There is about $1.2 million of deferred revenue (cash received from customers in advance of billing) and $0.5 million of A/P so invested capital is very low at only about $0.3 million.

This begs the obvious question; why would new competitors not enter and drive down returns on capital given the invested capital in the business is so low? The answer is that Vigil has accumulated significant expense related to R&D and developing its sales force and brand. Over the past 10 years, Vigil has spent $4M on R&D and $8M on sales and marketing.

Board and Management

Management’s interests appear to be aligned with shareholders given the chairman owns a large chunk of the company and the CEO draws a modest base salary.

The chairman of the board, Greg Peet, is an experienced entrepreneur. Peet made his name for himself by selling A.L.I. Technologies to Mckesson for $526 million. A.L.I. was a medical imaging company tat Peet grew from 14 employees in 1993 to over US$100 million in revenue per annum. Peet was also a part of Contigo Systems which was sold to Vecima networks. There is a quote from a Financial Post article about Peet that stands out, “Early-stage ventures have to be too early to a market,” he says.  “If you build a product when every other company is doing it, bigger companies will have more resources and you’ll be too late.” One has to wonder if Vigil is taking a page from Peet’s playbook by focusing on the Senior Care market while the other major nurse call providers focus on the larger hospital market. Peet’s interests are aligned with shareholders as he owns 29% of Vigil’s shares outstanding.

Troy Griffiths has been the CEO of Vigil since March 2005. He is an accountant by trade. Troy Griffiths owns 611,000 shares. He draws a relatively modest base salary of $150,000 and his total compensation package was $235,000 in the year ended March 31, 2017.

Vigil issued 394,000 options at it AGM in 2017. This represents approx. 2% of the share base. While this seems a bit high, Vigil’s market capitalization is only $12M which necessitates a rather large option grant to pay its executives fairly. It is worth noting that the strike price on the options were the same price as the closing price on the day they were granted. This is a sign of good governance as TSX Venture exchange rules allow corporate issuers to grant options with a strike price up to 25% below the closing price on the day of the grant.

Recent Share Price Movement

Vigil has most recently traded at $0.85 per share which is down significantly from its Aug 15, 2017 peak of $1.20. Vigil operates on a March 31st year-end. The company reported its first quarter of FY18 on the same day that Vigil’s share price peaked (implying the market was unhappy with the results).

What was so bad about the quarter? Revenue in the quarter was $1.49 million versus $1.66 million in Q1/FY17, representing a decline of 10%. Vigil increased its gross margin in Q1/FY18 (55% vs 52% in prior year), but this was more than offset by increased payroll related to administration, R&D, and sales and marketing. Operating income was down 56% year over year as a result of higher expenses on a lower revenue basis.

While these headline numbers seem weak, there are a few things worth point out. The first being that FY17 was a very strong year for Vigil, meaning the company was facing a tough comparison. Revenue in FY17 was up 40% y/y, while revenue in Q1 of FY17 was up 30% y/y. A second point is that while revenue was down, bookings (an indicator of future revenue) were up 38% y/y to $1.85 million, from $1.34 million.

The last point is that Vigil reported Q2/FY8 results on Nov 14, 2017. Vigil managed to increase revenue 2% y/y in the quarter to $1.61 million. It is worth noting that Q2/FY17 revenue for Vigil was up 70%, so again the company was facing a tough comp. Bookings were up 37% to $1.93 million in Q2/FY18. Backlog now sits at $3.23M due to the strong bookings, and is up significantly from the low point of $2.44 million which was reported with the Q4/FY17 results.

A key point in all of this is that quarterly results can be very volatile for Vigil. The root cause is that Vigil’s revenue is made up of a split of large projects and service/maintenance/replacement billings. The large projects are not booked into revenue until the installation is complete and the customer signs off that performance obligations have been met. This creates a lumpy stream of revenue that is rather volatile for Vigil (see chart below).

Vigil’s revenue from maintenance/service/repair sales is much more stable and has been growing each year. When Vigil sells a system, it includes one-year of warranty and support (24 hr emergency client support by telephone). After the first year, facilities can purchase support and maintenance for somewhere in the range of 10% to 20% of the original price. The benefit of purchasing ongoing maintenance is that the facility gets access to the support center, software upgrades, and revisions to training and technical documentation.

The last chart puts the recent top-line weakness into context. The red-line is revenue on a trailing twelve month basis (TTM). While the trend has flattened out, this does not appear unusual relative to Vigil’s historical performance. I do not think the flat year over year revenue growth is a sign of impairment to Vigil’s ability to successfully compete in the market. Vigil’s actions appear to support this statement. Vigil is a very small company. A government of Canada website discloses that Vigil only has 17 employees. For a company this small, hiring new employees is a crucial decision and signals internal confidence in the future of the confidence. Vigil has been hiring recently as demonstrated by its higher expenses. The company also recently had a job opening for a business development associate; again signaling future confidence in the business.

Valuation

Vigil currently has 17.7 million shares outstanding and recently traded at a share price of $0.85 for a market capitalization of $15 million. Vigil’s IFRS net income in FY17 was $2.1 million which is a very low P/E ratio of 7x. However, $1.1 million of net income was related to an income tax recovery. If we exclude this amount, the P/E ratio would be ~15x, which is still cheap for a company with VGL’s growth potential (and in the context of the current stock price environment).

Given that Vigil is early in its development, it is worth estimating what VGL could potentially trade at in the future.

I think in order to invest in Vigil, you must believe that the revenue growth slowdown is temporary. I think it is reasonable to assume Vigil can grow revenue at an average of 10% over the next 5 years. This implies Vigil can grow its revenue from $6.8 million in FY17 to $10.9 million five years out. Over the past 3, 5 and 7 year periods, Vigil has grown revenue at 10%, 15% and 8%, respectively.

If we add a few other estimates to our revenue estimate, we can forecast an EPS number five years out:

  • Gross margin of 50% versus FY17 of 51% and five year historical average of 50%
  • G&A as % of sales of 11% versus FY17 level of 15% and five year historical average of 19%. I am implicitly assuming this is mostly comprised of fixed costs (ie. CEO’s salary, audit fees, etc.) that will stay fixed as the company grows its top-line.
  • R&D as % of sales of 8% versus FY17 level of 7% and five year historical average of 8.5%.
  • Sales and marketing as % of sales of 15% versus FY17 level of 15% and five year historical average of 19%.
  • Tax rate of 26% (Vigil’s combined federal and provincial statutory rate). This is relative to tax recovery in FY17 and no taxes paid over the past five years.
  • Share count increases at a rate of 2% a year to account for stock-based compensation.

The net result of these assumptions is an EPS forecast of $0.07. It is worth noting that the assumption that Vigil has to start paying taxes is a key reason for why this $0.07 EPS forecast is not higher. A 15x multiple on $0.07 would imply a share price of $1.01. While a 20x multiple would imply a share price of $1.34.

If we are more optimistic and assume 15% top-line growth, implied share price at a 15x multiple is $1.44 and at a 20x multiple implied share price is $1.92.

If we are more pessimistic and assume top-line growth of 5%, implied share price at a 15x multiple is $0.64 and $0.86 at a 20x multiple.

Note that these share price forecasts do not take into account the time value of money and are simply meant to illustrate where Vigil’s shares could trade 5 years out from now.

I’d also note that I have tried to outline reasonable valuation and growth scenarios. This comes at a time when the market is willing to price many stocks at unreasonable levels. One example is Veeva Software which is trading at above 10x sales. Ascom who is one of Vigil’s larger competitors trades at 3x sales. While I am not suggesting that Vigil should be valued at the same multiple as a SaaS company (due to a revenue mix that includes hardware and services, and not just software), I do think it illustrates how highly valued some equities currently are. 3x Vigil’s projected sales of $10.9M would suggest a share price of $1.75, while 5x would suggest $2.91.

The Company’s website: http://www.vigil.com/

Author Ownership: Yes TSXV: VGL

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This article is for informational purposes only. This article is based on the author’s independent analysis and judgment and does not guarantee the information’s accuracy or completeness. The information contained in this article is subject to change without notice, and the author assumes no responsibility to update the information contained in this article. The information contained within this article should not be construed as offering of investment advice. Those seeking direct investment advice, should consult a qualified, registered, investment professional. This is not a direct or implied solicitation to buy or sell securities. Readers are advised to conduct their own due diligence prior to considering buying or selling any stock.

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