What you will learn
- An example of how to analyze a small company in an unfamiliar industry
- How to incorporate growth initiatives into your projections and valuation
- How to triangulate intrinsic value using both DCF and EBITDA multiples
Investors can hardly find a comprehensive article about this company on popular financial websites. However, this overlooked firm has been consistently making money over the last two decades while also maintaining a strong balance sheet in a recession-proof segment of the healthcare sector with a positive outlook. On top of this, it’s cheap on an absolute and relative valuation model. I’m talking about American Shared Hospital Services (AMS) that currently stands at about $2.47 per share.
AMS is a healthcare company, which engages in leasing radiosurgery and radiation therapy equipment to healthcare providers. In other words, the company’s business is the outsourcing of stereotactic radiosurgery services and radiation therapy services. AMS typically provides the equipment, as well as planning, installation, reimbursement and marketing support services. The market for these services primarily consists of large and medium-sized medical centers.
Specifically, AMS provides Gamma Knife units to fifteen medical centers in the U.S. in the states of Arkansas, California, Florida, Illinois, Massachusetts, Mississippi, Nebraska, Nevada, New Mexico, New York, Ohio, Oregon, Tennessee, and Texas. Electa AB from Sweden is the manufacturer of the Gamma Knife unit.
Additionally, AMS owns and operates a stand-alone facility with a single-unit Gamma Knife facility in Lima, Peru where it treated its first patient in Peru in July 2017.
Furthermore, AMS has been providing proton beam radiation therapy (PBRT) and related equipment to a customer in the United States (Orlando, FL) since April 2016. Its PBRT system (MEVION S250) is made by Mevlon Medical Systems Inc. based in Littleton, MA and received FDA approval in the second quarter of 2012. It’s worth noting that Mevion recently completed a $150 million financing transaction, which ensures that Mevion will continue its operations in the foreseeable future.
Moreover, AMS provides radiation therapy and related equipment, including Intensity Modulated Radiation Therapy (IMRT), Image Guided Radiation Therapy (IGRT) and a CT Simulator to the radiation therapy department at an existing Gamma Knife site in Massachusetts.
To sum it up, AMS owns seventeen Gamma Knife units. Currently, it contracts and provides sixteen Gamma Knife units, one PBRT system and one IGRT unit in operation while it also has one idle Gamma Knife unit.
Last but not least, AMS continues to develop its design and business model for “The Operating Room for the 21st Century” through its 50% owned OR21, LLC. The remaining 50% is owned by an architectural design company. However, OR21 LLC is not expected to generate significant revenue from this project in the next two years.
Products & Procedures In-Depth
Most investors are not familiar with the company’s medical equipment, so we will delve more into it.
Gamma Knife stereotactic radiosurgery, a non-invasive procedure, is an alternative to conventional brain surgery and/or radiation therapy can be an adjunct to conventional brain surgery, radiation therapy, or chemotherapy. Compared to conventional surgery, Gamma Knife radiosurgery usually is an out-patient procedure with a lower risk of complications and can be provided at a lower cost. Actually, Gamma Knife radiosurgery has gained acceptance as an alternative and/or adjunct to conventional surgery due to its more favorable morbidity outcomes for certain procedures as well as its non-invasiveness. Typically, Gamma Knife patients resume their pre-surgical activities one or two days after treatment.
The Gamma Knife treats patients with 201 single doses of gamma rays that are focused with great precision on small- and medium-sized, well-circumscribed, and critically located structures in the brain. The Cobalt-60 sources coverage at the target area and deliver a dose that is high enough to destroy the diseased tissue without damaging the surrounding healthy tissue.
In 2000, Elekta introduced an upgraded Gamma Knife which cost approximately $4 million. This upgrade included an Automatic Positioning System™ (APS), and therefore involved less health care provider intervention. In early 2005, Elekta introduced a new upgrade, the Gamma Knife Model 4C. The cost to upgrade existing units to the Model 4C with APS was approximately $200,000 to $1,000,000, depending on the current Gamma Knife configuration.
During 2006, Elekta AB introduced a new Gamma Knife model, the Perfexion™ unit, which treats patients with 192 single doses of gamma rays. The Perfexion can perform procedures faster than previous Gamma Knife models and involves less health care personnel intervention. In 2015, Elekta AB introduced an upgrade to the Perfexion called Icon.
The Gamma Knife treats selected malignant and benign brain tumors, arteriovenous malformations, and functional disorders including trigeminal neuralgia (facial pain). Research is being conducted to determine whether the Gamma Knife can be effective in the treatment of epilepsy, tremors, and other functional disorders. Based on the most recent available data, an estimated percentage breakdown of Gamma Knife procedures performed in the U.S. by indications treated is as follows: malignant (61%) and benign (23%) brain tumors, vascular disorders (4%), and functional disorders (12%).
AMS is the biggest player in the Gamma Knife business with seventeen Gamma Knife units (14 of them are Perfexion units) having approximately 14% market share in the U.S. while stating in the company’s annual report:
“…there are no competitor companies that currently have more than 3 Gamma Knife units in operation.”
“AMS is the world leader in providing Gamma Knife radiosurgery equipment, a non-invasive treatment for malignant and benign brain tumors, vascular malformations and trigeminal neuralgia (facial pain).”
Proton Beam Radiation Therapy
Proton beam radiation therapy (PBRT) was first clinically introduced in the 1950s and has recently emerged as a more clinically beneficial alternative to conventional linear accelerators for certain tumors. Specifically, its main advantage compared to photon-based systems is that PBRT delivers higher radiation doses to the tumor with less radiation to healthy tissue.
PBRT currently treats prostate, brain, spine, head and neck, lung, breast, gastrointestinal tract, and pediatric tumors. In excess of 160,000 patients have been treated with protons worldwide. In the past, the introduction of PBRT in the U.S. was limited due to the high capital costs of these projects. However, things have changed and the capital costs have dropped significantly over the last years. Therefore, AMS believes that:
“…the current development of one and two treatment room PBRT systems at lower capital costs coupled with the level of reimbursement for PBRT from the Centers for Medicare and Medicaid Services (CMS) will help make this technology available to a larger segment of the market.”
Lastly, the radiation therapy business currently consists of one IGRT system that began operation in September 2007 at an existing Gamma Knife customer site.
IGRT technology integrates imaging and detection components into a state-of-the-art linear accelerator, allowing clinicians to plan treatment, verify positioning, and deliver treatment with a single device. This provides faster, more effective radiation therapy with less damage to healthy tissue.
IGRT captures cone beam imaging, fluoroscopic and/or x-ray images on a daily basis, creating three-dimensional images that pinpoint the exact size, location, and coordinates of tumors. Once tumors are pinpointed, the system delivers ultra-precise doses of radiation which ultimately leads to improved patient outcomes.
There are approximately 3,900 linear accelerator-based radiation therapy units installed in the U.S., and it’s estimated that a majority of these units provide Intensity-Modulated Radiation Therapy (IMRT), IGRT, or a combination of this advanced radiation therapy capability.
Radiation therapy services are provided through approximately 2,300 hospital-based and free-standing oncology centers.
The Advantages Of AMS’ Business Model
The total cost of a Gamma Knife (one treatment room) or IGRT facility usually ranges from $3 million to $5.5 million, including equipment, site construction, and installation. The total cost of a single-room PBRT system usually ranges from $25 million to $35 million, including equipment, site construction, and installation, which is significantly lower than the cost of approximately $150 million for a PBRT system a couple of decades ago.
AMS pays for the equipment while the medical center generally pays for site and installation costs with the typical contractual period being 10 years.
Although a customer can choose to purchase equipment directly from the manufacturers, the major advantages to a health care provider in contracting with AMS for its services are:
1) The medical center avoids the high cost of owning the equipment. By not acquiring the equipment supplied by the company, the medical center is able to allocate the funds otherwise required to purchase and/or finance the equipment to other projects.
2) AMS does not have minimum volume requirements, so the medical center avoids the risk of equipment under-utilization. The medical center pays AMS only for each procedure performed on a patient.
3) For contracts under revenue-sharing arrangements, AMS assumes all or a portion of the risk of reimbursement rate changes. The medical center pays AMS only the contracted portion of the revenue received from each procedure.
4) The medical center transfers the risk of technological obsolescence to AMS. The medical center and its physicians are not under any obligation to utilize obsolete equipment.
5) AMS provides planning, installation, operating and marketing assistance and support to its customers.
The Medicare Impact
The company’s Gamma Knife, PBRT, and IGRT customers receive payments for patient care from the federal government and private insurer reimbursement programs. Currently, in the U.S., Gamma Knife, proton therapy, and IGRT services are performed primarily on an outpatient basis. Gamma Knife patients with Medicare as their primary insurer, treated on either an in-patient or outpatient basis, comprise an estimated 35%-45% of the total Gamma Knife patients treated nationwide. PBRT and IGRT patients with Medicare as their primary insurer are treated primarily on an outpatient basis and comprise an estimated 45% to 50% of the total radiation therapy patients treated.
That said, the Medicare rates have risen both for Gamma Knife and for PBRT since 2015, as quoted in the company’s quarterly report:
1) Gamma Knife: Effective January 1, 2015, the Centers for Medicare and Medicaid (CMS) established a Comprehensive Ambulatory Payment Classification for single session radiosurgery treatments, which increased the reimbursement rate from approximately $4,100 to $9,700. Additionally, the 2016 total CMS reimbursement rate of approximately $8,800 increased to approximately $9,000 in 2017 and increased to approximately $9,100 in 2018 for a Medicare beneficiary Gamma Knife treatment.”
2) PBRT: The hospital based 2016 Medicare delivery code reimbursement rate for PBRT established by CMS is $506 for simple without compensation and $1,051 for simple with compensation, intermediate or complex treatments. The 2017 scheduled CMS rates are $494 for simple without compensation and $994 for simple with compensation, intermediate or complex treatments. The 2018 scheduled CMS rates are $522 for simple without compensation and $1,053 for simple with compensation, intermediate or complex treatments. Patients typically undergo 25-40 delivery sessions.”
Consistent Growth and Healthy Balance Sheet
AMS has been consistently increasing its revenue since 2014, reaching $19.7 million in 2018 compared to $15.4 million in 2014. Most of that has been coming from its Gamma Knife units that typically generate approximately 70% of the annual total revenue. However, growth slowed significantly in 2017 and 2018.
Revenue growth aside, AMS has been consistently profitable every year over the last fifteen years excluding 2013-2015 (where the losses were mostly driven by non-operating items). Its COGS have increased relative to sales, though, which has meant that EBITDA hasn’t grown with revenue.
We also project that this is not going to change this year, so we forecast that revenue and net income will be approximately $20 million and approximately $0.9 million, respectively, in 2019. In other words, 2019 will be flat.
Furthermore, AMS has been consistently delivering both positive operating cash flow and significant free cash flow every year over the last fifteen years. And this consistency must not pass unnoticed either. This is largely the result of the fact that excluding the expenses for the purchase of additional equipment, AMS’ business is a low CapEx business and primarily includes maintenance expenses for the medical equipment. The service commitments for the Gamma Knife and PBRT equipment are carried out via contracts with Elekta AB and Mevion respectively.
Specifically, in 2018, operating CF and free CF were approximately $8.1 million and $6.5 million respectively, while we estimate that operating CF and free CF will reach $8.5 million and $7 million respectively in 2019.
One of the things helping their cash flow is their relatively limited capital expenditures:
When AMS buys new, expensive pieces of medical equipment, they immediately obtain and capitalize a long-term lease for it. This helps smooth out their cash flow significantly.
Let’s turn to their balance sheet to see this in action.
As you’d expect, they have a fairly sizable amount of debt and capital leases. They also have some operating leases, which are small enough that we can ignore them. I.e., capitalizing them and treating them as financing rather than operating activities won’t really impact the valuation. See the notes below for details.*
The company’s Current Ratio — their ability to cover their current liabilities with their current assets — has improved and is above 1, which is not awe-inspiring but is also not immediately troubling. The trend is certainly in the right direction.
Looking at their Total Debt (which includes capital leases) to Total Assets, you can see they’ve improved their capital structure. And if you consider net debt, which nets out their $2M in cash, it improves to more like 25%.
One last thing I’d note is that for a company whose whole business is to be asset-intensive so that their customers don’t have to be, they get a fairly poor return for it:
So, in summary:
- Their cash flow looks pretty good.
- They are solvent and their debt ratios are improving.
- Returns on assets (and capital) are low.
Insider ownership is high, which means that insiders’ interests are aligned with shareholders’. Specifically, insiders own 41.9% of the company with the Founder, Chairman and CEO Ernest Bates (82 y/o) owning 11.8%. It must also be noted that the CEO and his son together own 13.2% while Raymond C. Stachowiak (61 y/o) is the second-biggest shareholder with 12.6%.
Business Growth Drivers
There are a handful of key drivers for growth in the next quarters such as:
1) Higher reimbursement rates both for PBRT and Gamma Knife from Medicare effective 2019, as quoted below:
“CMS’s proposed 2019 proton therapy (PBRT) delivery code rates per daily session are $530.43, a 1.6% increase ($522.31 in 2018) for a simple treatment without compensation, and $1,081.08, a 2.6% increase ($1,053.52 in 2018) for a simple treatment with compensation, or an intermediate or a complex treatment. Also, CMS is proposing a 2.9% increase in the comprehensive reimbursement rate for the Gamma Knife in 2019.”
The contracted portion of AMS’s revenue is largely based on the reimbursement rate. So, when the reimbursement rate is up, the contracted portion is higher.
2) AMS has been working to develop its Proton Therapy business pipeline. Specifically, AMS has made deposits to purchase 2 additional PBRT systems in 2019-2020 and is actively seeking to sell them to new markets replicating Orlando Health’s success, as quoted from the latest quarterly report:
“As of September 30, 2018, the Company had commitments to purchase two MEVION S250 PBRT systems for $25,800,000 and the Company had $2,000,000 in non-refundable deposits toward the purchase of these two PBRT systems from Mevion Medical Systems, Inc.
“On July 21, 2017, the Company signed First Amendments to two System Build Agreements for the Company’s second and third Mevion PBRT units. The Company and Mevion have agreed on preliminary construction and delivery timetables for the second and third PBRT units for which the Company has purchase commitments. The Company’s delivery timeframe is triggered by the United States Food and Drug Administration’s 510K clearance of Mevion’s recently developed treatment nozzle. The Company is actively seeking sites for these units but, to date, has not entered into agreements with any party for either placement of a PBRT unit or the related financing. The Company projects that it will be required to take delivery of the second and third PBRT units no later than 2019 and 2020, respectively.”
Actually, management expects to make deals for these two PBRT systems in 2019 and the potential customers include the UF Health Cancer Center in Orlando, FL that has already one PBRT system, a hospital in Long Beach in Southern California and a medical facility in San Francisco, as quoted from the latest conference call below:
“Turning to proton therapy. We remain in active conversations to advance our business pipeline. This includes HYPERSCAN upgrade of two proton systems that we intend to place into new markets, replicating the success we continue to see in our Orlando unit.”
“Yes. Hi, the Gamma Knife numbers look exactly as I expected them to be, and the book value, it was up again a little bit and was certainly profitable. But I am still very disappointed that we don’t have a proton beam signing. I mean, we keep hearing it’s imminent. And is it imminent now?”
“I think it is, Lenny. This is Dr. Bates. We have plans to place a unit down in Southern California at a hospital in Long Beach, and we are now in negotiations with a hospital in San Francisco, our hometown, to place a proton machine there. I think things are going well. Hopefully, in the near future, we’ll announce these two placements and contracts.”
AMS’ existing PBRT generated $1.6M in Q1 ’19, so let’s say these 2 more will generate $1M each per quarter once they’re up and running, which should yield a revenue increase of $8M for a full year of operations, and $12M or more as awareness and utilization increases to where the current one is. If their total revenue today is $20M, additions of $8-12M in new revenue would be a 40-60% increase in revenue, all highly likely in the next few years.
3) AMS recently announced an agreement with Kettering Medical Center, Kettering, Ohio, to upgrade its Gamma Knife® Perfexion™ system supplied by AMS into the Leksell Gamma Knife® Icon™ system. AMS expects to complete the installation in the second half of 2019. Also, the company expects to announce two additional Icon system upgrades in its centers this year recognizing previously untapped incremental revenues.
4) Currently, AMS has one idle Gamma Knife unit. Although there are currently no commitments to place into service or trade-in this unit during 2019, the company could find a customer for it in the next months.
If the probability of a 40-60% revenue boost isn’t enough, here are some price catalysts:
1) Low valuation and re-rating: One of the key things that we like in AMS is its consistency to generate profits, positive operating cash flow, and free cash flow over the last fifteen years.
On top of this, revenue growth and profits are expected to continue in the foreseeable future thanks to the aforementioned growth initiatives and therefore, we believe that re-rating is very likely any time now.
2) Takeover target: AMS is the biggest player in the Gamma Knife market in the U.S., so it could become either a consolidator by acquiring smaller companies or a takeover target for a bigger healthcare company which is seeking exposure to the Gamma Knife market and/or the emerging PBRT market. Actually, we believe that the latter (the sale of the company) is very likely given also that the Founder/Chairman/CEO is 82 y.o. and his family is the biggest shareholder owning 13.2%.
On that front, many deals have taken place in the medical devices segment of the healthcare sector over the last years with some of the acquirers being Medtronic (MDT), Boston Scientific (BSX), Stryker (SYK), Teleflex (TFX), Zimmer Biomet (ZBH), Johnson & Johnson (JNJ), Becton Dickinson (BDT), Edwards Lifesciences (EW) and Abbott (ABT) to name a few. Most of them have paid above 10 times EBITDA and above 3 times annual revenue.
Now that we understand AMS’s growth prospects, we can conduct a proper valuation. But first, let’s look at some of their key valuation metrics.
Looking at its EV/EBITDA, the current 2.89x is low relative to most of its history. In the last few years, EBITDA has decreased while price has remained flat. Although it could continue to go lower, the fact that it’s at the low end of its range suggests that when the company begins showing EBITDA growth again, the price will likely increase. The multiple would likely expand, as well.
AMS’s Price to Book is attractive, at less than 1. (Book = Tangible Book in AMS’s case, too.) However, it’s traded at this level for a decade, so you can’t exactly count on mean reversion here.
These metrics don’t necessarily scream out that this is a deep value, but it also doesn’t look overpriced.
Let’s try a DCF and see what we get.
Before we can do this, let’s work through the implications of buying two new PBRTs in 2019-20. Here are the impacts:
- Revenue will increase $8M in ~2020-21 and another $4M in ~2021-22.
- Total debt+capital leases will increase $25M to $43M, or $41M net of cash. Assets will go to $82M. Net Debt/Assets will be 50%.
- If they can borrow at 6%, the lease(s) will generate another $1.5M in interest expense. (6% * 25M)
- Depreciation on PBRTs, which is straight-line for 20 years, will be $1.25M. (25M / 20 years)
- The depreciation and interest adjustments largely offset when it comes to free cash flow.
On top of these PBRTs, AMS has another $13M in committed expenditures in 2020-22 for other equipment (Gamma Knife upgrades and materials at existing customers), so that should provide more boosts to revenue in the coming years. Debt will hit $56M and Debt/Assets will go to almost 60%, however.
Its current TTM Owner Earnings FCF is about $5.15M. That’s probably about where it’ll end 2019. It’s a little hard to count on the timing of the new PBRT revenue, but let’s assume it comes in chunks of an incremental $4M in 2020, 2021, and 2022. Let’s also assume its margins stay the same, which is probably conservative. That implies $1.2M per year in new FCF for the next 3 years, with a little more growth in year 4.
So, at this rate, we’d expect OE to look something like this:
|Owner Earnings FCF||$5M||6.2||7.4||8.6||9.0|
And that really doesn’t factor in incremental growth from increased reimbursements or upgraded Gamma Knives. (Nor will we count the additional debt.)
For our DCF, let’s input $5.15M for the start value, assume a much more conservative 8% growth rate, and discount it at a relatively high 10% given its potential balance sheet risk, company size, and sector.
The projected cash flows look like:
This is a lot more conservative than what we think will actually happen.
When you discount those CFs back to the present value, you get a Present Value of those cash flows of $96M.
Add back cash ($2M) and take out debt ($43M) and a $6M minority interest, and you get an equity value of about $75M. Divide by shares outstanding to get a fair value per share of $12.75. Its current price is $2.47. Yes, this is very different, we know.
If you do a “reverse DCF” on the current $5M in FCF and a 10% discount rate to come up with the implied growth built into the current price, you get -7%. We just don’t see the company’s free cash dropping like that given the growth initiatives that are well underway.
But maybe this also implies that we need to look at things another way. The DCF just isn’t close to the current valuation. What’s going on?
Let’s look at the business on a multiples of EBITDA basis. Today, it’s trading at 2.94x EV to EBITDA. It’s going to finish the year at around $20M in revenue with EBITDA margins of about 51%.
Let’s try our growth scenario, then. Let’s say they can add $8M in revenue in 2 years, will be able to improve their EBITDA margin back to its historical range of closer to 55%, and expand their debt by $25M. Let’s also say their EBITDA multiple is somewhere back in the 3-4x historical range.
This produces a valuation range of:
(Yes, the above chart says EBIT multiple, but as long as you use both the EBITDA multiple and the EBITDA margins, the tool works the same.)
All scenarios assume $28M in revenue and $43M in debt, but the conservative scenario assumes 51% EBITDA margins and a 3x multiple, while the aggressive scenario assumes 59% EBITDA margins and a 4x multiple. We added the $6M minority interest as “other debt” to ensure it gets subtracted from the equity value.
This seems a lot closer to how investors are thinking about the business. I’m surprised at how little people are weighing the Free Cash Flow. But in the end, the valuation will likely come down to if you believe the company will be able to secure contracts and leases for these PBRTs. If they do, their revenue will increase. Their margins should hopefully improve, and I would expect their multiple to revert back to its mean of at least 3.5x.
There are a number of important risks to consider.
First, the company might not be able to continue to secure financings for its equipment purchases at a reasonable interest rate.
Second, the market for the company’s services is competitive. AMS estimates that there are two other companies that actively provide Gamma Knife and PBRT financing to potential customers, although AMS is the biggest player in the sector and the company’s business model differs from its competitors. Meanwhile, the company’s relationship with Elekta, the manufacturer of the Leksell Gamma Knife unit, is non-exclusive, so the customers might choose to purchase a Gamma Knife unit directly from Elekta.
Third, there is constant change and innovation in the market for highly sophisticated medical equipment. New and improved medical equipment can be introduced that could make the Gamma Knife technology obsolete and that would make it uneconomical to operate.
Fourth, other radiosurgery devices and conventional neurosurgery compete against the Gamma Knife. Each of the medical centers targeted by the company could decide to acquire another radiosurgery device instead of a Gamma Knife. In addition, neurosurgeons who are responsible for referring patients for Gamma Knife surgery may not be willing to make such referrals for various reasons, instead opting for invasive surgery.
Fifth, a limited number of customers have historically accounted for a substantial portion of the total revenue, and AMS expects such customer concentration to continue for the foreseeable future. For example, in 2018, four customers in total accounted for approximately 50% of the revenue. The loss of a significant customer or a significant decline in the business from the company’s largest customers could have a material adverse effect on the company’s business and results of operations.
Many small caps outperform every year and statistically speaking, the small caps have higher equal-weighted returns over time than large caps in the stock markets. That said, investors can generate alpha in the stock markets only if they can unearth overlooked small caps that meet specific investment criteria because throwing darts in the dark will not get you there. And I’m a firm believer that this is the case with AMS at the current price of $2.47 per share thanks to the reasons mentioned above.
*Although the operating leases don’t appear substantial, we should treat them as commitments and should thus capitalize them as financing rather than operating activities. Let’s see if it makes much of a difference.
To do this, pull up their operating lease expense schedule from their latest 10-Q, and discount the payments back using their borrowing cost, which the company states is about 6%:
|Year||Operating Lease Expense||Discount Factor||PV @ 6.0%|
The balance sheet effect of this is to increase debt/capital leases by $1.2M, with the leased assets offsetting on the other side. The income statement effect is to add back the imputed interest expense to EBIT, which is 6% x $1.2M = $75K. This increases earnings just a bit, by about 2%, which isn’t hugely meaningful for our analysis and won’t impact valuation.
Disclaimer: The opinions expressed here are solely my opinion and should not be construed in any way, shape, or form as a formal investment recommendation. The author does not accept any liability for any loss or damage whatsoever caused in reliance upon such information. Investors are advised that the material contained herein should be used solely for informational purposes. Investors are reminded that before making any securities and/or derivatives transaction, you should perform your own due diligence. Investors should also consider consulting with their broker and/or a financial adviser before making any investment decisions.