Tuesday, October 23, 2012

Electromed Q2 Misses Big On Sales Force Disruption

Electromed Inc. (ELMD) reported financial results for the fiscal 2012 second quarter ending December 31, 2011 on February 14th. Breaking the prior streak of beating our revenue estimates for four straight quarters, Q2 came in well below our numbers. In mid-January the company warned that Q2 results would be softer than previously anticipated due to layoffs of certain underperforming sales personnel (we had not updated our estimates following the pre-announcement so the miss on Q2 was not unexpected). Management made the decision to lay off about 5 or 6 sales people (~ 15% - 20% of the total sales force) during Q2 due to underperformance and not hitting sales targets, which caused a serious hiccup in Q2 revenue.

Management indicated on this morning's conference call that these positions have been filled with people that they believe can produce the rate of sales growth that they expect going forward. We expect there will be at least a few month (possibly a few quarters) period for these new hires to get up to speed and get to optimal efficiency and productivity - which (along with a temporary net drop in the sales force) is reflected in our trimming of our revenue estimates. The sales force stood at about 20 or 21 at the end of fiscal Q2 (12/31/11), down from 23 at the end of Q1 - management noted that they're shooting for about 27 by fiscal year-end (6/30/12). As we've noted in the past, a major component of ELMD's strategy to grow sales and EPS is expansion and increased efficiency of its sales force.

Q2 revenue of $4.79 million was up 2% yoy (-11% sequentially) and consisted of $4.30 million (+1% yoy) from the Homecare segment, $192k (-4% yoy) from International and $300k (+25% yoy) from Government/Institutional.

The relative weakness in the Homecare segment reflects the turnover of sales personnel. The net size of the sales force fell from about 23 at the end of Q1 (9/30/11) to 21 at the end of Q2 and is currently back up to about 23 - our revenue growth estimates reflect the expectation that ELMD continues to add sales headcount throughout the remainder of the current year and beyond. While Q2 and Q3 are typically stronger quarters, this may not be the case for the current year as a result of restocking the sales force and getting the replaced positions up to speed and productive - we expect that this might result in Q4 revenue coming in stronger than either Q2 or Q3.

Total revenue came in about 21% less than our estimate. Revenue from International, by contrast, came in significantly above our estimate and was up over 400% sequentially. ELMD recently took steps to facilitate growth of their International business including signing distribution agreements with Linde Healthcare and Leader Healthcare FZCO for the German and parts of the Middle East region, respectively. In particular, Linde in Germany could potentially move the needle on ELMD's international business as Linde is a major international distributor already calling on customers in ELMD's target market space and a significant portion of Germans have private insurance (public insurance coverage in Europe for HFCWO is spotty at best). We have made some slight upward adjustments to our International revenue estimates as a result - although there could end up being more traction in this segment than what we currently model.

Gross Margin
GM came in at 72.6% compared to our 74.0% estimate. Electromed's GM can jump around from quarter-to-quarter based on the mix of reimbursement rates and management indicated on the call that this relatively low GM is not expected to persist over the longer-term.

Operating Expenses
SG&A came in at $3.13 million, or 65.3% of sales, compared to our 58.7% estimate. There difference is likely most attributable to the fixed-cost portion of SG&A which is more exposed with revenue coming in below our estimate. ELMD continues to invest in support infrastructure and personnel - mostly customer service, reimbursement and billing - activities which are essential to growth of the business. As we've noted in the past, we expect these fixed expenses in SG&A to be leverageable as revenue grows - but in the case of the current quarter where revenue falls short, these expenses are highlighted and crimp the bottom line.

R&D expense was $250k in Q2, well below our $327k estimate. R&D expense will likely increase throughout the year, however, as Electromed works to bring new products and product enhancements to market. Prior R&D expense guidance was ~5% of revenue - on the Q2 call management noted that this will likely now be above 5% of revenue. Continually updating and enhancing their product line is another component (along with expansion of the sales force and international distribution deals) of ELMD's growth strategy.

Net Income / EPS
Net income and EPS were $25k and $0.00, well below our $345k and $0.04 estimates - the difference fairly evenly spread between the miss on revenue, lower GM and higher SG&A as a percent of sales.

Electromed exited fiscal Q2 2012 with $1.75 million in cash and equivalents, compared to $2.95 million at 9/30/2011. Cash used in operating activities was $710k in the most recent quarter, but stripping out the increase in working capital (including a $304k and $302k increase in A/R and inventory, respectively), operating cash flow was $192k. As we've repeated in the past, long collection times, typical of the industry and associated with the payment policies of many public insurers (i.e. - Medicaid), means there can be intermittent spikes in Electromed's A/R. This can be exacerbated by rapid growth, similar to what Electromed is experiencing. We continue to see no concern with the increase in or quality of A/R. ELMD used $404k for capex in Q2 - management noted that this is level of capex should come down in future quarters. Repayment of principal on the term loans used $79k.

Along with the cash balance there's about $3.5 million in borrowing capacity under the revolver. The bank debt, which was renewed in January for another year (margin went up slightly from 2.75% to 3.08% over LIBOR) includes up to $6MM under a revolver, $1.5MM term loan A (monthly principal, due 12/2014) and $1MM term loan B (monthly principal, due 12/2012). Terms of the revolver allow ELMD to borrow up to 60% of eligible A/R less balance on the term loan B. Assuming A/R continues to grow at the recent pace and capex uses on average another ~$250k/quarter (capex averaged ~$310k/qtr the last two quarters), cash balance plus short-term borrowing capacity represents about 15 months worth of operating cash (includes capex and monthly principal payments) - this assumes ELMD continues to successfully roll over the bank loans. If, when and how much cash ELMD may need to raise to fund growth of the business (mostly working capital) will depend on a number of things including timing of A/R collections and capex and inventory investments. Raising capital is not a near-term need, however and we do not view this as a significant concern.

Valuation and Recommendation
We now look for EPS of $0.12 in fiscal 2012, down from $0.18, mostly a result of the $0.04 miss in Q2. EPS in our out-years have moved from $0.27 to $0.25 in 2013, $0.36 to $0.33 in 2014, and $0.44 to $0.41 in 2015.

We continue to value Electromed using Hill-Rom's (HRC) long-term PE/G ratio as a comparable. Hill-Rom's long-term PE/G currently sits at 1.02 (up from 0.89 since our last update on 11/9/2011). We model ELMD to post EPS of $0.41 in 2015, implying a four-year CAGR of 33%. Based on a 1.02 PE/G, ELMD should trade at about 34x 2012 EPS - or ~ $4.00/share. We are moving our price target from $5.50 to $4.00/share. The stock has traded down since ELMD warned in early January and now trades at $2.87 - cheaper than where we value it - as such, we are maintaining our Outperform rating.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

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