Digirad is a microcap equity that is embroiled in a high amount of uncertainty, but we think when you sift through the noise, there is relatively little risk here at current prices, and see a security at least double the current price in a year.
Digirad’s current core business operates within the broad niche of mobile radiology. They have two main businesses that underpin this market segment. The first is Mobile Healthcare. Here the company purchases large MRI systems that are encapsulated within a tractor trailer. They then move these systems around the country to small, largely rural hospitals that either have a temporary need for them (a remodel), or do not have enough patient volume to justify their own purchase. In these instances, Digirad will run a route where the systems comes 1 day a week, with a technician to process the local health care facilities' patient volume. Digirad keeps the return on their systems high by maximizing utilization. Local hospital don’t have a large capital equipment sitting idle for much of the week and with cost containment pressures this is a win-win.
In their second business they focus on a proprietary camera that they have developed (but since have outsourced production of) that they 1. Sell into the hospital setting 2. Mount this camera in a van and much like the above market segment they run routes to cardiologists’ small practices that can then stack their patients on a given day to do cardiac imaging procedures. The doctor is billed a fixed fee, and they in turn bill insurance providers earning a spread on the procedure. With no capital commitment by the doctor this becomes a sticky and valuable profit center. Digirad’s cameras are extremely small, and thus are suited for this type of operation. Within the mobile segment of this operation Digirad does not sell its camera to other mobile providers. They do however sell the camera to hospitals and clinics.
There are some other small cardiac monitoring businesses, but I’ll leave those out since they aren’t germane to the thesis.
When Digirad acquired the mobile business from Gores Group a few years ago it was hailed as a windfall acquisition. The deal was done at a low multiple, and it allowed Digirad to harvest a vast quantity of its NOL’s. As part of that acquisition Digirad acquired a high margin sales and service operation that represented Phillips Imaging sales and service territory for the upper Midwest region. This was a high margin (low capital intensity) book of business, but last year Phillips exercised its contractual right to terminate the agreement. Our understanding is that Phillips had decided to take the business in house on a worldwide basis. There was real value lost to Digirad shareholders, and given the levered balance sheet the equity began to sell off. To management’s credit they were able to harvest a reasonable high single digits sales price for the operational footprint of the business (from Phillips) and used the proceeds to retire an equal amount of debt.
Digirad has paid a healthy dividend, and with the loss of the Phillip’s contract and the debt outstanding there has been much speculation that they would cut their dividend (it yields 17.5% today) But they have maintained the dividend and also managed to pay down a marginal amount of debt last quarter. Frankly at this price we believe a dividend cut is more than priced in and they may be better off to cut it and use the funds to de-lever the balance sheet. Despite paying the dividend and publicly proclaiming that they would continue to do so the stock has drifted lower and lower.
Enter Jeff Eberwin, Chairman of Digirad (and activist HF manger of Lonestar value). Over the last few months the Digirad story takes yet another turn. Instead of focusing on their core business, Eberwin and the board announced that Digirad would convert to a holding company, with an activist bent. They would target small public microcaps and merge them into Digirad and centralize the public company costs. The first kickoff transaction is with a prefab housing material manufacturer that Eberwin also controls. If you believe his slides, post the transaction Digirad’s current dividend would be 3X covered (from todays 1X) and would have a much less levered capital structure.
We think Jeff has every reason to make this first transaction work. Not only because it will give him a currency and credibility to do more, but also because he personally granted Carlo Cannell (a large Digirad shareholder) a put on his holding at $1.50 per Digirad share.
We think Jeff is smart enough to know that the market is pricing in skepticism, and he has to over deliver. We don’t believe Digirad is over levered and could easily cut the dividend to manage the balance sheet. At this level of cash yield, and a smart capital allocator at the helm we think that as soon he Eberwin demonstrates himself as a good actor, the stock should rerate to about 2X the current price. Carlo Cannell isn’t a wall flower, he’s also a large holder. After the conversion was announced Cannell bought more stock. See a recent letter he issued on another name http://www.cannellcapital.com/wp-content/uploads/10.11.18-letter-to-REI-Chairman.pdf, he's not a shy guy.
Legacy DRAD has about 20 mm shares out. And 11 mm of net debt. They recently reaffirmed EBITDA guidance in the 8-9 mm range, and FCF in the 4-5 mm range. In a crunch DRAD could cut the dividend and retire debt, defer cap-ex, or sell some trailers and shrink the business. We doubt they will ever be in a situation where they are forced to issue equity.
While the legacy company is levered 3 turns, we see many levers to manage this. We also believe, while tight, the company can still cover the dividend 100% (or close) as evidenced by the last Q where they actually paid down 500K of debt (as well as declared the dividend). If the current business can’t grow then its probably only slightly undervalued down here. But…..enter the HoldoCo conversions and the fact that we think the Camera business is underperforming. Eberwin has proposed converting Digirad to a “vehicle”.
Eberwin has proposed merging ATRM holdings with Digirad as a “kickoff transaction” He proposes only issuing 1 mm shares of common stock, and the resulting entity will now have much reduced leverage, dividend coverage of 2-3X and if all holds true the stock should re-rate or yield 17% with ample divi coverage. The synergies from corporate functions are large, and it’s the crux of his long-term thesis. See a link to the complete deck and a relevant slide included below.