LMD.V: Apteryx, Other Catalysts Offer Upside in 2017

By Brian Marckx, CFA

TSX:LMD.V
OTC:LEDIF

Q4, FY2016 Financials: 2016 Ends On Whimper, But Apteryx and Other Catalysts Offer Upside In 2017…

LED Medical (LMD.V) (LEDIF) reported financial results for their fourth quarter and full year ending December 31st. Despite seasonality of dental capital equipment sales typically favoring Q4, the quarter was relatively weak for LED with revenue at the lowest level of any period in 2016 and contracting by 67% yoy and 25% from Q3. The company pointed to inability to purchase sufficient inventory due to lack of capital as a reason for the disappointing top-line number – which missed our $5.3M estimate by about 65%. As a reminder, while we were modeling a mid-single digit contraction from Q4 2015, we had also expected LED would again be able to take advantage of the characteristically strong demand for dental equipment that is typical of the final quarter of the year.

On the brighter side, LED’s cash balance was recently shored up via the sale of debt and equity - which happened concurrently with the Apteryx acquisition. While $7M of the ~$11M (gross U.S) raise was allocated to the acquisitions’ upfront payment, much of the remainder will be used to fund operations – presumably including to beef up their inventory (balance of which fell by a relatively large $4.9M in 2016).

Revenue for the full year was $10.2M, down 23% from 2015. Prior to Q4, revenue had increased 11% through the first nine months of 2016 from the comparable year-earlier period – so had it not been for such a poor showing in Q4, 2016 could have been another revenue growth year for the company.

But while 2016 ended with somewhat of a whimper, there are reasons to believe 2017 will return the company back to growth. In addition to the renewed ability to build imaging-related product inventory, other potential growth catalysts including VELscope disposable sales, which LED noted continued to grow in 2016, and initial contribution from recently acquired Apteryx offer additional upside. In fact as it relates to Apteryx, management noted in their shareholder letter that the integration is going well and that they “expect Apteryx to contribute significantly to revenue, EBITDA and cash flow growth this fiscal year and for the foreseeable future.” And Apteryx, as we noted in our recent investor note (and discuss in more detail below), brings other potential benefits to LED including a recurring revenue stream and synergies in product portfolios and customer call points – which means LED’s existing business lines may also directly benefit from the marriage of the two companies.

We note that our model still does not reflect contribution from Apteryx (or any potential synergies) nor for the equity raises commensurate with the acquisition. As noted in our update just following the acquisition, we will incorporate forecasted effects of the Apteryx acquisition into our model following LED’s filing of pro formas – which we think will happen within the coming weeks. But, even without any assumed Apteryx contribution, we still model revenue growth in 2017.

And as it relates to VELscope, we think (as we discuss in more detail below) the recent entry into China, coupled with additional and recently published clinical evidence supporting use and clinical utility of the device, are both potential near-term growth drivers for that business.

Gross margin, similar to revenue, was not a highlight in Q4 – in fact, at just 13.7% it was at the lowest level since at least Q4 2013. LED attributed the relative weakness to lower margin imaging sales from competitive pricing pressures as well as to “a significant year-end inventory adjustment.” It is not clear what exactly the inventory adjustment relates to and we note that there was not a descriptive non-cash item related to such that ran through the cash flow statement. Nonetheless, GM, which was 24.4% for the full year (vs. 27.2% in 2015) should have room to improve in 2017, particularly in the event of meaningful sales from Apteryx.

While we won’t know exactly what to expect in terms of margins from the company until more financial information becomes available, given that Apteryx is primarily involved in software development (i.e. typically a high-margin business), we think it is reasonable to believe LED’s overall gross margins may benefit from the acquisition.

And while imaging product sales have always carried relatively low (reseller-type) margins, LED’s proprietary VELscope and related disposables margins are believed to be much healthier. In fact LED notes in their current filings that VELscope margins have been running at about 56%. So with expectations that VELscope sales continue to grow, coupled with contribution from Apteryx, we could see a meaningful improvement in gross margins as soon as the current year.

Operating expenses in Q4 remained at roughly the same level as in Q3 – at about $1.5M. And, if we had to point to one part of the income statement that was moderately positive, it would be OpEx level – which remained well below the $2.3M quarterly average during the first half of 2016. Full-year OpEx in 2016 was $7.6M – improved from $8.8M in 2015. So while revenue and gross margin contracted by 23% and 280 basis points from 2015 to 2016, these were more than offset by the $1.2M lower operating expenses – the net result was operating loss improving (albeit barely) from $5.2M to $5.1M over the same period.

Cash used in operating activities was $648k and $2.5M ($1.3M and $4.7M ex-changes in working capital) in the three and twelve months ending 12/31/16. LED exited the year with $875k in cash and equivalents. Subsequent to year-end and concurrent with the Apteryx acquisition, the company raised ~$10.9M (CDN$14.4M) in gross proceeds via the sale of equity and debt. We estimate that net proceeds after issuance and IB expenses was approximately $10.1M (U.S.) which, after the upfront cash payment to Apteryx, left LED with approximately $3.1M (in addition to already existing cash).

Apteryx Brings Diversified/Synergistic Portfolio, IP, Expanded Customer Base and Profitability

In September 2015 LED Medical announced their intent to acquire “100% of a growing and profitable technology company to complement LED’s existing business and provide a platform to assist LED in achieving its strategic and long-term business objectives.” The press release further noted that, “The potential transaction, if successfully negotiated and closed, would be significantly additive to revenues, and immediately accretive to EBITDA and net earnings and bring additional Intellectual Property to the Company.”

LED mentioned little after that regarding the potential acquisition until this January when they announced their intent to acquire Apteryx, Inc., an Ohio-based company which develops and sells software primarily for the dental industry. The deal closed in February.

Apteryx looks like it could be a great fit for LED given that there appears to be some potential significant synergies among the companies’ product portfolios and customer call points. Apteryx brings the dental imaging and database software that supports LED’s digital imaging hardware – providing a one-stop-shop for dental practices. Apteryx’s software licensing and recurring revenue business model will also provide welcome diversity and smoothing to LED’s capital product sale revenue stream – which is typically highly seasonal and based on the dental industry’s capex purchasing patterns.

And beyond the current benefits, which apparently also includes profitable operations, Apteryx brings a sizeable patent portfolio and software development experience which can be expected to be leveraged for future growth including from further expansion of their product offerings.

Terms:
- $10.25M acquisition price for 100% of Apteryx:
o $7M cash at closing
o $1.8M (33.9M shares @ C$0.07, ~$0.053) worth of LED stock at closing
o $1.2M cash paid in tranches over 18 months
o $450k in cash or LED stock (LED’s option) in 24 months
- Apteryx will operate as a stand-alone subsidiary of LED
- Apteryx’s founder and CEO, Kevin Crucs, will continue to run operations and joins LED’s management team

Concurrent financing:
Concurrent with the acquisition LED raised approximately C$14.4M (~$10.9) via the sale of equity and debt. Equity raise C$13.3M (~$10.0M) includes the sale of approximately 215M common shares (@ C$0.06/share) with 50% warrant (24mths, C$0.10 strike) coverage. Insiders of LED, including directors and officers, bought 9.2M of the shares sold. Debt raise via the sale of C$1.15M (~$870k) senior secured debentures (24mths, 12%) with ~2.4M common shares attached.

LED’s recent quarterly cash burn has averaged ~$1M but with the addition of Apteryx’s operations, which LED indicates generates positive cash flow, this level of cash burn could come down. And while LED will also pay an additional $1.2M cash to Apteryx over the next 18 months, we think their cash balance could represent a fairly lengthy runway to fund operations depending on contribution from Apteryx. We will know much more about Apteryx’s financials, including cash flow, when LED files historicals for the pro forma combination.

Apteryx
Apteryx, located in Akron, Ohio, was founded in 1995 by Kevin Crucs. The company develops software primarily for the dental and medical imaging markets. The company’s competitive positioning includes development of custom software applications to meet the needs of their customers and to do so in a relatively short turnaround time. Per the company’s website, “Apteryx specializes in image processing; synthetic imaging and generation; data and image compression; encryption and data security; neural networking; check processing systems, network and communication applications and services; tools and utility applications and services; real-time video imaging; hardware and peripheral integration; proficient in several programming languages for a number of different hardware platforms; design and implementation of several networking and distributed systems applications for inventory management and other large-scale programs; large-scale software projects.”

Apteryx ‘s Product Portfolio: Their products are sold through resellers (such as LED Medical) as well as through their own website. Their suite of products are compatible with hardware of many different manufacturers and designed for businesses of all sizes - from small, single-office practices to large, multi-office organizations. The following product descriptions are from Apteryx’s website (www.apteryx.com):

- XrayVision: was first launched in 1996 and has become the industry’s leading open-architecture digital image management program. XrayVision will capture, enhance and display all of your dental images. Supporting image capture from the majority of the different digital intraoral sensors available today, XrayVision also integrates with phosphor plate scanners, digital panoramic and cephalometric imaging, flatbed scanners, intra-oral and extra-oral cameras, 3D conebeam tomography and many other digital sources.

- XVWeb: In addition to being a web application used to view the images, XVWeb is a fully-functional DICOM server that can accept images from any DICOM-compliant imaging software. Although any DICOM-enabled application can be utilized, Apteryx DCV and XrayVision4 are specifically designed to work seamlessly with XVWeb.

- XVlite: XVlite will capture, enhance and display all of your dental images. XVlite supports image capture from a majority of the different digital hardware in today’s market. XVlite incorporates the latest advancements in imaging technology and Apteryx’s patented STB (Secure Tagged Block) file format, an unmodifiable, secure and “loss-less” imaging format. XVlite also exports to a number of common image file formats, including TIFF, JPEG, and BMP for universal viewing.

- XrayVision DCV: XrayVision DICOM Capture View, known as DCV, is a DICOM-based dental imaging suite that is scalable to any size organization. DCV is used to standardize the capture, storage, retrieval, and viewing of images across an entire organization. DCV supports most all imaging devices utilized in dentistry, including: Intra-oral sensors, Phosphor Plate Scanners, Panoramic / Cephalometric units, 3D / CAT scan, Tomography, Intra-oral Cameras, Extra-oral Cameras, Endo scopes, and Flatbed Scanners. DCV can act as a full enterprise standalone PACS or can serve as the capture modality that will automatically forward to an existing PACS. DCV’s open architecture enables the freedom to use a wide variety of capture devices, while maintaining the industry standards. The US Army and US Navy currently use DCV as their global solution for managing all of their dental clinics worldwide, which allows for centralized storage of all images to provide global access to patient information. XrayVision DCV has numerous bridging capabilities from a standard command line integration, data extraction and auto importing patient demographic, barcode scanning, DICOM Worklist, HL7, and custom data bridges.

Highlights of Apteryx Acquisition:

• Immediately accretive: expected to be significantly accretive to revenue, EBITDA and net income in 2017

• Software margins: while LED has yet to provide specifics, software margins are typically significant and we would expect the Apteryx margins to be substantially better than LED’s current ~25%

• Recurring revenue: software licensing and recurring revenue business model provides diversity and smoothing to LED’s capital product sale revenue stream which is typically highly seasonal

• One-stop-shop: LED can now provide a full digital imaging product solution, including software and hardware

• Synergies: complementary products which share similar customer call points should provide operational synergies

• Familiarity: the companies’ management have known each other for ~15 years and LED is a customer of Apteryx’s products. The long affiliation provides for operational and relationship related risk-mitigation, particularly given that Kevin Crucs joins as part of LED’s management team

• Expands customer base: immediately bolts on a significantly greater installed base to cross-sell to

• Growth opportunity: Apteryx brings a sizeable patent portfolio and software development experience which can be expected to be leveraged for future growth including from further expansion of their product offerings. Per LED’s 3/8/17 press release Apteryx has 23 U.S. and 41 international patents

Our comments:
We note that oftentimes M&A transactions in the micro-cap space prove shortsighted given a tendency to overemphasize a goal of product extension and underweight the importance of operational synergies. Operational friction from poor fit often has unfortunate symptoms including bloated (and duplicative) expenses, lack of unified strategy and direction, and stressed managerial relationships (among others) which is rarely a recipe for success and future growth.

We think LED’s acquisition of Apteryx is one of the exceptions where product and operational fit were carefully (and wisely) and appropriately balanced. And the fact that there has been a long courtship between the two parties prior to consummation of the marriage should lend itself to mitigation of any relationship or personality-related risks. So while we will wait to opine on the potential financial impact and influence on LED’s valuation until after the pro forma historicals are filed, we are encouraged by what we think appears to be the makings of an operationally healthy and (hopefully) financially beneficial transaction.

Our model has not been updated to reflect contribution from Apteryx nor for the equity and debt raises commensurate with the acquisition. As noted, we will incorporate Apteryx into our model following LED’s filing of pro formas – which we expect will happen within the next few weeks. Our model updates could also influence our valuation of LED Medical.

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