I’ve been making my way through a list of founder-led small/micro-caps that I found on Travis Weidower’s blog, Egregiously Cheap. I came across American Shared Hospital Services today (AMS), which looks pretty damn cheap from an earnings and free cash flow standpoint. Although the business is in the healthcare space, and has some warts on it including little/no growth, low float and high debt levels, AMS spits off a decent amount of free cash flow and could be set up to return some to shareholders in the form of dividends or buybacks. I’m still digging through, and although at first glance it doesn’t look like I’ll be buying any shares yet, this founder-led business looks interesting enough to add to the watch list and continue to monitor.
Company Info:
Ticker: NYSEAmerican: AMS
Price: $2.85
Shares Outstanding: 5.8mm
Market Cap: $16.5mm
Cash: $5mm
Debt: $21mm (including capital lease obligations)
Enterprise Value: $32.5mm
TTM EPS: $0.38
P/E: 7.5x
TTM FCF: $8mm
EV/FCF: 4.1x
Business Description
American Shared Hospital Services (AMS) is a medical services company that provides radiosurgery and radiotherapy services. AMS outsources medical devices to hospitals and surgery centers for the treatment of brain conditions, as well as ancillary services such as Image Guided Radiation Therapy (IGRT) and Proton Beam Radiation Therapy (PBRT).
The company’s largest business segment is their Gamma Knife Operation, which accounts for 76% of revenues, and consists of AMS financing and installing Gamma Knife systems in hospitals, and being reimbursed either on a ‘fee per use’ agreement, or revenue sharing agreement, depending on the customer.
Here’s a quick breakdown of Gamma Knife operations:
AMS currently has 16 Gamma Knife units located throughout the US, and one in Peru. Industry info indicates there are around 118 units located in the US, and 330 worldwide.
To give a brief primer, Gamma Knife is a non-invasive radiosurgery instrument that is used to help control malignant and nonmalignant tumors, as well as vascular and functional disorders in the brain. The idea behind the product is that the instrument doesn’t harm surrounding or healthy tissue, and involves no scalpel or incision. In fact, it’s not even a knife. Usually following a Gamma Knife procedure, patients are in and out of the hospital within a days time, and back to their normal routines shortly after treatment. Here’s what they look like:
Gamma Knife treatment is not widely adopted, with only a few hundred devices in operation throughout the US, compared to a hospital count of over 5,500. My guess would be that reimbursement levels have a lot to do with it (Medicare’s Gamma Knife reimbursement rate was halved in 2013, but now appears to be back to normal levels), as well as the type of patient treated with Gamma Knife surgery. Currently, Medicare treats 35-45% of all Gamma Knife patients worldwide. In addition, there’s a capital intensity to the business. The total cost of a Gamma Knife or IGRT facility usually ranges from $3.0 million to $5.5 million, including equipment, site construction and installation. AMS will spring for the equipment, but the medical center generally pays for site and installation costs.
This is not a hugely profitable or fast growing business.
A breakdown of the Gamma Knife segment gets a little more involved from here:
American Shared Hospital Services conducts their Gamma Knife business through an 81% indirect interest in GK Financing LLC (‘GKF’).
The remaining 19% of GKF is owned by GKV Investments Inc., a subsidiary of Elekta, the Swedish manufacturer of Gamma Knife.
GKF is a non-exclusive provider of Gamma Knife financing services
GKF is managed by its policy committee, composed of one representative from the Company, Ernest A. Bates, M.D., ASHS’s Chairman and CEO, and one representative from Elekta. The policy committee sets the operating policy for GKF, and has selected a manager to handle GKF’s daily operations. Craig K. Tagawa, Chief Executive Officer of GKF and Chief Operating and Financial Officer of ASHS, serves as GKF’s manager.
The joint venture later shows up on the income statement and in my discussion about valuation, due to the distributions to non-controlling interests that AMS is responsible for making. In addition, you read that correctly….AMS Chairman and CEO is on the committee setting the rules for financing the company’s largest business segment. Hmmm.
Moving forward, AMS business model operates as such:
AMS typically provides the medical equipment to their customer, along with planning, installation, marketing and reimbursement services.
The majority of customers pay on a ‘fee per use’ basis, on 10 year terms, with a fee arrangement ranging from $6,000 – $9,300 per procedure.
The remaining customers operate on a revenue sharing basis, where AMS receives all or a percentage of the reimbursement (less physician fees) received by the customer. This is where reimbursement risk can come into play
Of the 17 operating Gamma Knife units deployed by the company, 9 customers are on revenue sharing agreements, with the remaining 8 on a fee per use basis. On the customer side, one customer accounted for 21% of revenues for 2017, and five customers accounted for 50% of revenues, adding in some customer concentration risk
The business of outsourcing this type of equipment is capital intensive, but provides a sticky customer base, and recurring (albeit unpredictable) revenue stream throughout a typical 10 year agreement. At the end of a contract, customer’s can either renew or terminate.
Long term contracts and high utilization rates have allowed AMS to earn steady – but unspectacular – organic revenue growth over the last five years of around 3% per year, despite Gamma Knife customers continuously rolling off old contracts.
While one may look at this business model/arrangement and be intrigued by the recurring revenue, backlog, sticky customer base, preferred provider status and large installed base, in reality, this is a business is subject to regulatory risk, lack of pricing power, low provider switching costs by customers, and market saturation (low growth). In addition, there are some huge question marks surrounding the 80 year old Chairman and CEO who’s been collecting a large salary for the last decade plus.
So why would anyone be interested in AMS?
It’s cheap and spitting off a decent amount of cash. I’d categorize AMS as ‘deep value’ with some growth optionality/potential.
In addition, one may be able to point to the following reasons for the mispricing:
Micro cap in the healthcare space – subject to cuts in reimbursement rates, regulation etc.
Small following (626 Seeking Alpha followers, few analysts covering)
Small size and illiquidity – market cap of $17mm
High insider ownership and low float – insiders own 41% of the business
Founder and CEO Ernest Bates is 81 years old and owns 11% of the business with his son serving as the VP of Sales and Business Development – may be tough to achieve a change of control – investors could worry about the founder just milking the business
High debt levels in the form of capital leases – $21.3mm in short term debt, long term debt and capital leases (about $5mm cash so $16mm net debt)
High depreciation charges somewhat depress earnings – in line with many medical services businesses, should be valued on a free cash flow basis due to depreciation being a non-cash charge
Financial results have been impressive despite the company operating in a slow growth industry subject to plenty of competition and regulation risk. AMS has been able to transform their business from a loss-making enterprise looking back five years to a business generating lots of free cash flow with a strict focus on costs and paying down debt in order to increase book value. For the trailing twelve months, AMS generated $8mm in free cash flow.
Earnings per share have also grown at an enormous clip since 2013 (and up 50% in the last year alone), while book value is up 20% during that same time period.
AMS has been able to achieve this by increasing revenues, and keeping SG&A to a minimum. Of note, 2017 results were boosted by a favorable tax benefit of about $0.19/share, but that seems to be a one-time boost to earnings.
Moving forward, I’d expect to see organic revenue growth in the 3-4% range, 12-14% operating margins, and further cuts in operating costs keeping EPS flattish or increasing at a steady clip. Free cash flow should continue to remain steady as long as Gamma Knife units are placed on contracts. More on valuation below.
Optionality/Growth Potential
Where the story gets interesting is when investors take into account potential revenue and earnings growth from the company’s Proton Beam Radiation Therapy segment (PBRT) containing the Mevion radiation units. This is the deep value ‘plus optionality’ I mentioned above.
Mevion is a type of proton therapy system designed to make the treatment of cancers accessible for patients worldwide. AMS currently has one Mevion unit in operation at Barnes hospital, and has placed deposits on two additional units for which the company owes large balances – this is why the debt levels are so high (along with capital leases).
I won’t get into the specifics of the technology or treatment benefits, but building and housing a Mevion unit is incredibly capital intensive, as the total cost of a single room PBRT system usually ranges from $25.0M to $35.0M, inclusive of equipment, site construction and installation. As a first mover, AMS has a purchase/cost advantage in buying the machines (able to get them for around $11mm where retail customers pay around $20mm), but there is still a significant cost to the hospital to undertake the construction of the therapy room that houses the machine. This cost has been estimated to be around $7-$15 million. Not a small expense for budget-conscious hospitals. With that said, getting even one of the machines placed and operating would materially change the revenue, earnings and cash flow profile of the business. AMS would be worth multiples of the current share price. However, I think this is probably too big of a risk to underwrite.
In order to believe in the thesis here, you’d have to understand the timeline of events dating back six years to 2012, when AMS put down their first deposit for their Mevion single-room proton therapy machine. AMS was expected to treat their first patient in December of 2013, and stated on the conference call that quarter:
“So we are seeing where our potential services increase weekly. We are probably in negotiations with over 10 hospitals or more about putting in a Mevion unit…I think clearly…the proton business is going to explode in the next six months…”
Fast forward to today, and AMS has just one Mevion unit in operation, with about 21% of their total revenues ($4mm or so) being derived from PBRT fractions. The amount of fractions is actually increasing at a solid clip, with the company reporting 2,516 fractions for the six months ended 2018, up from 2,509 in the same period the prior year, but again, they have not deployed anywhere near the 10 units they were hopeful about placing.
In addition to their one operating unit, as mentioned above, there are two additional Mevion units on which AMS has placed deposits and owes large balances.
These machines are not currently in place with any customers. At the same place where the investor’s optionality lies – in the growth of the proton therapy business – also holds the biggest risk to an investment in AMS. To give a quick back of the napkin estimate of the potential of this business segment; management has stated that each additional Mevion unit would generate around $6.5mm in EBITDA. Not bad for a $32mm EV business. So if AMS were able to hit their 10 unit threshold for Mevion devices (their guidance from 2013), you’re looking at around $65 million in EBITDA for the PBRT segment. Again, this business is currently has an EV of $32mm. Just placing the two machines on deposit would make a material difference.
With that said, it’s not yet clear whether the technology is being adopted by hospitals, or if the two additional units will be placed with customers moving forward. There seems to be lingering skepticism surrounding the product since very few are in existence right now. In addition, as mentioned above, because the Mevion units are considered ‘single room’ therapy treatments, hospitals need to spend around $7-15mm building out a facility to house the unit. For a non-life saving technology (from what I understand), hospitals probably won’t be in a rush to underwrite that expense.
Management Team
Let’s discuss the management problem. This is quite similar to an investment I have in Ecology and Environment Inc. (EEI), where the founding members are all above the age of 70, and a change of control was desperately needed (which EEI has begun to receive through an activist campaign). AMS has yet to see any activists step up and buy controlling blocks of shares, my guess is because of the small size of the business.
I was pretty surprised when reading the proxy. The CEO is incredibly overpaid. The top three executives pull in over $1mm in salary. With no capital being returned to shareholders, on the surface, compensation appears egregious.
Here’s a look at the comp table:
However, AMS comes across as very conservative when issuing bonuses, stock options and restricted stock, which is something.
Notes from the proxy:
The base salary of our Chairman and CEO has not been increased in 12 years and that of the Vice President of Sales and Business Development has not been increased in 11 years. Our Chairman and CEO reduced his salary by 10% in 2013, and such reduction remains in effect as of the date hereof.
The Company has not paid cash bonuses (other than sales commissions) to the Named Executive Officers in six years. One sales commission was paid in 2016 to the Chief Operating and Financial Officer.
The Company has granted options to the Named Executive Officers once in nine years.
In 2016, the Compensation Committee retained an independent compensation consultant to advise the committee on the competitiveness of the executive compensation program. Based on the independent compensation consultant’s findings the Compensation Committee for the first time in 11 years increased the salary of the Company’s Chief Operating and Financial Officer by $25,000 in 2017.
In 2017 the Board adopted a performance-based incentive plan that awarded restricted stock awards that vest solely on the basis of pre-determined, objective metrics.
The Named Executive Officers own a significant number of shares and options of the Company’s common stock, and the directors and officers as a group own approximately 36% of the issued and outstanding shares, which directly aligns their interests with that of the other shareholders.
None of the Named Executive Officers has an employment agreement.
Dr. Ernest A. Bates M.D. Founded the American Shared Hospital Services in 1977 and has been its Chairman of the Board and Chief Executive Officer since 1983. He owns 11.8%.
The management team is also a bit incestual, with Founder and CEO Ernest A. Bates having employed his son Ernest R. Bates as the VP of Sales and Business Development. There doesn’t seem to have been any impropriety up to this point, but these are always things pay attention to. Shareholders can’t be too happy with no capital returns, an overpaid CEO hiring his son, and potential catalysts to unlock value that aren’t being applied.
Of note, there is a shareholder rights plan in place until April 2019, under which the company made a dividend distribution for each share of common stock. The rights become exercisable should a third party acquire 15% or more of the company’s common stock.
The CEO seems to have a lot on his plate as well, serving on various medical boards, having an active speaking career, and trying to operate AMS. A change of control is needed in my opinion.
Valuation
The company grew net income YoY for the six months ended 2018 due to higher revenues and lower SG&A costs, combined with about $0.02/share in tax savings due to the more favorable corporate tax rate. AMS is cheap from an earnings standpoint, but free cash flow is the more appropriate way to value the business due to the incredibly high depreciation charges the company records. The company spends about $1mm or so per year on Capex, but depreciates their equipment at a rate of around $6mm+ per year. I don’t know much about the residual value of Gamma Knife equipment, but the company has one unit not in operation with a book value of $729k. With 16 units, I’d imagine book value to be somewhere around $16mm.
Free cash flow for the six months ended 2018 was $4.7mm, and $3.5mm for the six months ended 2017. This is a $32mm EV company. Distributions to non-controlling interest vary year by year, but have been in the range of 8-10% (based on the cash flow statement). Assuming they hold around this level, (although NCIs share of net income appears to be 41%) AMS is on track to generate nearly $1.40 of free cash flow per share (including distributions to NCIs) for the Y/E 2018. Shares trade at $2.85!
At current prices, you’re looking at a FCF multiple of 2.0x. Does a business not in danger of bankruptcy or complete disruption deserve this type of multiple? Or is this the combination of slow growth, high debt levels, regulatory risk, small size and management concerns? Reimbursement rates seem to be hovering around the same area for the company’s services, management could be replaced, and the business is still spitting off cash.
AMS also has $5.9mm in NOLs to utilize moving forward.
Back of the napkin valuation 2018:
Gamma knife revenues: $14.5mm
Proton therapy revenues: $6.5mm
IGRT revenues: $650k
Total: $21.6mm
14% operating margins – due to decreased costs from no new site openings, lower legal fees and other expenses
10% pre-tax margins – $2.16 pre-tax income
Around $0.20 FY 2019 EPS (after 30% distribution to NCI) or 14x earnings
Free cash flow of around $1.00 – $1.20/share giving a free cash flow multiple of 2.8x – 3.0x (using low estimate)
As mentioned above, the gap between free cash flow and net income is due to the incredibly large depreciation charges ($6mm+ per year the last three years) being recorded by the company. Capex is only averaging 30% of depreciation each year, and it seem as though AMS is speeding up the depreciation schedule for some of their equipment.
The biggest question I have moving forward is what will be the source of an investor’s return? Growth appears to have stalled, there aren’t many (or any) reinvestment opportunities, the management team is not repurchasing shares or distributing the cash, and there’s no activist on the horizon attempting to unlock any value for shareholders. I don’t think there is enough of a margin of safety in terms of a floor for the stock price – despite trading at about 0.5x book value. I’d be worried if they can’t place the two Mevion units they have deposits on, and/or if the Gamma Knife business continues to decline rapidly (although replacing the terminated contracts doesn’t appear to be that difficult). I think the market would react negatively to any bad news, but there is some very interesting optionality here. Getting those two units up and running would materially change the revenue and operating income profile of this already cheap business.
No position.
Catalysts:
Sale of the business
Returning capital to shareholders in the form of dividends/buybacks
Change in control/new management team
Tuck-in acquisitions (although balance sheet makes this tough)
Continued free cash flow generation
Risks:
Reimbursement rate cuts
No reinvestment opportunities
Management doesn’t return capital
Debt levels continue to creep higher (Levered 2.3x)
Multiple detracts
Customer concentration
Direct to consumer risk
Additional questions/comments/concerns I have:
Why not slow down the depreciation schedule?
Capex is averaging 30% of depreciation each year
Will there ever be a return of capital to shareholders? – I’d like to see a dividend, especially with ample free cash flow and a high CEO salary
Why has it taken so long for single room Proton Therapy to work?
What happens if they can’t place their two Mevion Systems before 2019/2020?
Costing them a $2mm deposit and $25mm payment in full
Why is GK Financing controlled by an AMS policy committee? A big chunk of earnings are being redirected to GK in the form of NCI payments of net income?
Book value of machines is only relevant if new technology has not come along to render them obsolete.
Has it?
CEO has a list of other things he is involved with, as well as being grossly overpaid ($500k for a $17mm market cap company)
Nothing here seems to be for the benefit of shareholders?
I’d love it if an activist were to get involved and push for some positive changes including reduced CEO comp, possible return of capital and/or dissolving of strange NCI arrangement
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