Fonar Corporation: A healthcare value stock with good cashflow and growth
Fonar Corporation (FONR), listed on the Nasdaq, is a US microcap healthcare company with two business units: one creates and sells MRI scanners, but it is a loss leader for the other unit, their profitable main business; providing non-medical services to diagnostic imaging facilities, e.g. billing, collections, facilities and personnel management, and marketing etc. Fonar’s founder, Dr Damadian invented and commercialised the first MRI scanner, and the company continues to innovate in the MRI space.
Business description
Fonar operates in two segments
1. Medical equipment (~10% of revenue)
2. Services to diagnostic imaging facilities (~90% of revenue)
1. Medical equipment segment: Fonar makes a loss on this segment ($3.6m in 2021), which includes selling it’s Upright MRI scanner: a unique scanner which differs from most flat bed scanners in that the patient can be scanned in many positions, which gives some medical diagnostic and patient comfort advantages. Most of the revenues of this business unit come from servicing the installed base of 39 MRI scanners, and providing upgrades etc. Total segment revenue was $8.8M in 2021.
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Fonar write up continued…
2. Services to diagnostic imaging facilities segment: Fonar created a joint
venture in 2013 called Health Diagnostics Management (HDM) with some outside
investors, which has two classes of members:
Class A: outside investors which own 39.6% of HDM
Class B: Fonar owns this: Health Management Corporation of America, (HMCA)
(60.5% of HDM)
HMCA operates diagnostic imaging centres in NY and Florida, ((~3/4 of segment
revenues), and also owns and operates four centres in Florida (~1/4 of segment
revenues) This segment as a whole is quite profitable: with an operating income of
$20.5M in 2021.
Competition
Competitors are shown in the table below: one US listed company Radnet owns
many imaging centres, and makes poor gross and operating margins. There are two
Australian companies, Sonic Healthcare and Healius Ltd: both have similar
operating margins of around 12%, lower than Fonar’s 19%. Sonic shows comparable
growth to Fonar, but it’s P/S is about 70% higher.
Medica Group, a UK based company trades a P/S of 3x that of Fonar, despite making only 23% operating margin vs 19% for Fonar: however revenues are growing 8% faster. Therefore, on almost all metrics Fonar appears to have better value than publicly listed competitors. Note
also, that the 10-year growth rate in revenue for Fonar is 11%, but the most recent five years have been a revenue CAGR of 5%.
Pricing Power: Fonar renegotiates it’s fees annually with the diagnostic imaging centres that it serves, allowing it to pass on cost increases, and increases in fees as it expands the number and type of scanners at its facilities, which allow increased amounts of scanning to be performed. The graph below shows operating and gross margins at Fonar since 2012: gross margins remain steady, and operating margins stepped up after the set up of HMCA in 2013, until 2020 when they were hit during the pandemic, but have started to recover in 2021.
According to the 8-K form, for the 9 month period ended Mar-22, vs the comparable period in 2021, revenues are up 12%, and net profit is up 7%, so the recovery from the pandemic continues. Overall, Fonar is able to maintain it’s gross and operating margins: the decline in 2020 was due to a small drop in revenues vs increases in revenues for the previous few years before this. During this period, revenues increased from $39M in 2012, to $90M in 2021, and $99M for the trailing 12 months to Mar-22.
Growth
The US medical imaging market is forecast to grow by 4.2% CAGR to 2030, as below. Fonar has an 11% 10-year CAGR for revenues, but a 5% CAGR in the last five years. Therefore, it is maintaining its share of 0.23% of the medical imaging at diagnostic centres market. The MRI scanning market specifically is forecast to grow at 6% CAGR to 2028. The stability of Fonar’s gross and operating margins suggest that it has some pricing power for its diagnostic scan services.
Durability, Quality & Risks
Fonar has contracts with the diagnostic imaging centres it gives non-medical services to, which comprises the majority of it’s revenues. Essentially, Fonar takes care of all non-medical matters for the physicians running the diagnostic centres, from arranging offices and equipment (including medical equipment, e.g. from Fonar’s medical equipment division), all non-medical personnel, administrative matters, including insurance reimbursement, scheduling patient appointments, etc, billing and collections, negotiation on consumables, diagnostic imaging and ancillary services, marketing strategies, and expansion plans. Therefore, Fonar’s subsidiary HMCA is very highly integrated with these facilities, and it would be very difficult for them to leave HMCA
and find another management company.
Fonar is paid flat monthly fees for providing services through HMCA, in 2021 making $4.9M per month through these fees, or $58.8M (66% of total revenues).
In addition, Fonar owns some Florida facilities, through HMCA, which directly bills patients: $23.3M revenues (26% total revenues). The remaining 8% of revenues comes from the medical equipment division.
The main risk to earnings is the provision for bad debts. Fonar increased this in 2020 and 2021, citing the pandemic as a reason, to about $5.5M each year. However, the figures in this report account for these provisions when discussing profits.
Risks to Fonar include a specific risk around the reimbursement of medical expenses should the law on this change in Florida: there have been attempts to change the law on this which failed in the state of Florida. The author is not in a position to comment on the likelihood of this occurring.
Capital allocation:
Management continue to allocate a small part of the annual profits to R&D on MRI: but made a strategic decision in 2013 to buy a diagnostic imaging centre. Since then, after increasing their stake in this venture in 2015, they have continued to accumulate cash on the balance sheet. In 2021, Fonar has about 40% of it’s market cap in cash and short term investments on the balance sheet, with almost no debt. They have not paid a dividend since 1999. Their stated growth strategy is to upgrade and expand existing diagnostic imaging facilities, and acquire new ones. For instance, in
2021 they acquired a facility in Yonkers, NY. In 2022, they plan to install three new facilities in New York and Florida.
It is interesting to note that Richard E. Turk was appointed as a director in June 2020. He has a track record of growing medical service businesses by acquiring multiple facilities, and expanding into new states, e.g. for PRISM Vision group, where he is their chief development officer. It seems likely that he was hired for his experience, in order to repeat this at HMCA for Fonar. With a 10-year median return on equity of 25.8% for Fonar, it seems clear that it is beneficial for the company to retain earnings, and use them to expand the business rathe than pay dividends.
Management Integrity and Board History
Management salaries are fairly low relative to other companies of a similar size: e.g. in 2021 the CEO Dr Raymond Damadian earned a total of $0.45M. There are no indications of management impropriety. The table below describes Fonar’s board members.
Person
Age
2021 position
Raymond Damadian
85
Chairman, Treasurer
Died August 2022
Timothy Damadian
57
President, CEO
CEO since 2016
Luciano Bonnai
66
EVP and COO
COO since 2016, VP before that
Claudette Chan
83
Director
Sister of Raymond Damadian
Charles O’Data
85
Director
Died October 2021
Ronald Lehman
45
Director
Former board member, Health Diagnostics*. Manages acquisitions
Richard E. Turk
37
Director
Appointed 2020, acquisition experience
Fonar : Environmental, Social and Governance Factors:
Environment:
The company does not comment about the environmental impact of its operations. The iron core of their product: the Upright MRI does not require a supercooled helium gas to operate: so saving on emissions vs other helium-cooled MRI scanners.
Social
Fonar has had a tremendous historical positive social impact: by the founder’s invention and commercialisation of the MRI, which has since been copied by competitors, they have directly and indirectly enabled the diagnosis of millions of people with cancer and other illnesses, extending and saving their lives. They continue to develop MRI technology, through less focus has been placed on this in recent years with not much new innovation since the year 2000.
Governance
Fonar has a complex share structure, as shown in the table below. The key points are that the founder’s family are the top management, who control the company through their holding of the C common shares, with 25 votes/share, though these are only entitled to a fixed ratio of 28% of the dividend per A common share, which is the only share type traded on the Nasdaq. Therefore, due to the relative numbers of shares, when a dividend is paid, the ’A ordinary’ shares will receive 94% of the total dividend as a group.
Table 1: Fonar share structure, votes, and dividend fractions for each share class
Fonar was founded and led by Dr Raymond Damadian until 2016, when he stepped down as CEO, and his son Timothy Damadian took over as President & CEO. However Dr Raymond Damdian retained >99% of the class C supervoting shares to control the company, until he died in early August 2022. It is not clear who inherited the class C shares, but I am presuming that his son is the most likely candidate.
Auditor: it is interesting to note that the auditor for Fonar has not been changed since 1990: they are Marcum LLP, a national, New York based auditor. The Public Companies Accounting Oversight Board report on Marcum’s audit quality shows some deficiencies in the testing of revenues, where in some audits, the auditors did not verify the information given on revenues by a company’s internal electronic systems, but no audits with an incorrect opinion on the financial statements or internal controls over financial reporting.
Fonar Appraisal
Fonar has a total of $45M of federal, state and city net operating loss carry-forwards: these are accounted for as a $16M deferred tax asset on the balance sheet, and this is accounted for in the calculations below. Fonar may be valued in various ways:
Free cash flow plus growth:
Fonar currently has a free cash flow yield of 9%. This was calculated by taking the cash flow from operations for each year from 2017-2021, (i.e. including 2020 where cashflow was reduced due to effect of the Covid pandemic), subtracting all capex from it (purchases of property, plant and equipment), subtracting distributions to non-controlling entities. These figures were then multiplied by 0.94 to account for dividend distributions/income share of other share classes, and finally divided by the current market cap of $91M.
The free cash flow yields over the five years ranged between 7% and 10%, and they were averaged to give 9%. In the growth section, Fonar’s growth over the last five years was a CAGR of 5%, which gives a total free cash flow plus growth of 14% return for the stock at the current price.
Assuming a re-rating to a 10% market-type return
If we assume that the stock market return over the long term is 10%, then this is a margin of safety of $91M*14%/10% = 12.74M/10% = $127.4M market cap, or a 127.4-91/127.4 = 29% margin of safety.
Assuming a P/E re-rating to 12x P/E
We can also value Fonar on a price/earnings basis, considering that it has a net cash position of ~$42M. The current P/E ratio is 9x. If we assume a conservative fair rating of 12x earnings, then the market cap should be $120M, giving a 120-91/91. This gives a potential 32% upside from re-rating, even if none of the cash were to be paid out to investors.
Conclusion:
Fonar is an investment opportunity under the strategy of investing in businesses that are priced below the intrinsic value that they represent. Based on the last five years of business performance, a 14% annual return is expected, with the additional possibility of a re-rating to a valuation in line with the market, which would give an additional 32% one-off return.
Disclaimer: this is not investment advice, and is for informational purposes only. Please refer to the terms and conditions on the Real Worth Stocks website.
Disclosure: the Real Worth Stocks model portfolio has a long position in Fonar (FONR).
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The post Fonar Corporation: A healthcare value stock with good cashflow and growth appeared first on Real Worth Stocks.