Digirad (DRD): A Cheap Microcap Transitioning into a Holding Company
MEMBER WRITE-UP BY LONG SHORT VALUE
Digirad is an attractive microcap special situation investment because the valuation is extremely low, there is a high likelihood of the proposed acquisition closing, and the underlying value proposition of Holdco structure is compelling. Digirad announced on September 10th that they would be converting to a Holdco structure and acquiring ATRM, a modular homebuilder and specialty lumber company with an investment fund segment. The logic behind this structure change is to cut public company accounting, legal, management and board costs and potentially save millions of dollars that will flow to the bottom line of the joint company. I believe these savings will be real and expect a large uptick in EBITDA delivered from a combined company. Cutting costs especially the types proposed are usually an easy way to drive profitability. My valuation of the company suggests in a central case shares could yield a 100% return over the next year, and in my high case shares could yield a return of 179% over the next year (see details in the valuation section). This investment does not come without risk. Major risks include deal risk, underlying performance risk of the operating businesses, and the risk of a dividend cut.
To fully understand the risks and potential rewards of Digirad you really need to understand the recent history. This history is also largely the reason that this attractive opportunity exists. Digirad itself was a promising small cap healthcare imaging company a few years ago. The company completed a transformative acquisition on January 5th of 2016 by acquiring DMS Health Technologies which was poised to roughly double the revenue and EBITDA of the company. The acquisition did not end up as attractive as it was originally held out to be. Margins in the space were pressured and top line revenues struggled to grow as originally projected. On top of a lackluster DMS Health Technologies acquisition, the company lost a major servicing and sales contract with Philips Healthcare in October of 2017, which materially impacted their revenues and profitability. This eventually led to the sale of their MDSS services contract to Philips Healthcare in February of 2018 for a consideration of $8 million. This was a major hit on the underlying business and the stock price crashed from $3.50 down towards its current price of $1.35. This led to a bit of soul searching on what would be the path forward, as the remaining Digirad business was a stable cash flowing business, but lacked growth pathways. That is in part where the idea of the proposed acquisition stems.
All of the companies involved in this transaction are companies that the Chairman of the Board, Jeff Eberwein, has been involved in. This transaction seems to be Jeff’s brain child, to bring together a few businesses that he has financial stakes in into one corporate Holdco in which Jeff will be the sole capital allocator. Jeff will retain the Chairman of the board position in the new Holdco structure. Jeff is the founder and investment manager of Lone Star Value Fund, an activist investment firm, which will also be acquired as part of the ATRM acquisition. Jeff’s track record recently is mixed, but he has a great pedigree (Goldman Sachs and Soros Funds) and has had success as an activist, most notably with Hudson Global. Jeff is going all in on this new HoldCo, putting together two companies he is on the board and his investment fund stake into one vehicle. Without a doubt, the fate of his financial success, track record, and career success resides on Digirad successfully transitioning into this new Holdco structure.
|Post Acquisition Segments||Current Company||Business Risks||Risk Level|
|Healthcare Imaging||Digirad||Healthcare Regulation Changes||Low|
|Modular Building||ATRM Holdings||Housing Downturn, Interest Rates||High, Cyclical|
|Investment Funds||Lone Star Value Funds,
Ascent Oil Funds (merged into ATRM)
|Fund Underperformance. Oil fund and activist fund.||Medium, Performance Based|
|Searched Services Center||None, will be created to provided cost savings||None||Very Low|
Healthcare Imaging (Legacy Digirad)
Digirad is broken into three segments: diagnostics services, diagnostic imaging and mobile healthcare. Diagnostic services segment (49% of revenue) is a mobile business that provides diagnostic equipment to physicians on a short term basis. Diagnostic Imaging segment (10% of revenues) sells and services nuclear gamma cameras. The mobile healthcare segment, which is the legacy DMS Healthcare (41% of revenue), provides mobile health and imaging equipment to hospitals and healthcare providers. The business is profitable on an EBITDA basis, but they have struggled in several recent quarters to post a profit on a net income basis. This gap between positive EBITDA and flat to negative net income is largely a result of previous capital investments that allow for higher current depreciation than the required cap-ex investment. This core business should operate at a relatively stable EBITDA margin around 6-10% for the foreseeable future. The level of growth has been in the low single digits to the mid teens over the last few years. On a go forward basis I assume a mid-single digits average growth for the overall business, in part due to the overall market that they participate in, and in part due to the limited growth prospects baring any acquisitions or incremental capital investments.
Modular Home Builder (Legacy ATRM Holdings)
ATRM Holdings has two building related segments KBS Builders (Modular Homes) and EGBL (Engineered Wood Products & Building Materials). KBS is a Maine based manufacturer of modular homes with two owned production facilities. Of the two facilities, one sits idle which might provide some upside to the overall business if they can expand. EGBL has two business divisions, EdgeBuilder that is an engineered wood and paneling maker and Glenbrook which operates a lumber yard and showroom that sells building materials in Minnesota. These legacy ATRM businesses are by far the weakest business segments within the new holdco structure. In my low case I assume zero contribution from this business on a go forward basis. Historically the business has generated negative EBITDA up until recently. With where we currently are in the overall business cycle and the state of homebuilding, you can see why the acquisition for ATRM was done at an incredibly low multiple.
Investment Funds (Legacy ATRM Holdings via Merger)
Two funds have already been merged into ATRM Holdings in July of 2018, Long Star Value, a Small Cap Activist Fund, and Ascent Oil Funds (50% ownership). While it may seem odd to have two investment funds included in the HoldCo structure, this makes sense for Jeff to put all his major business ventures into one corporate structure. As per the HoldCo investor presentation, Ascent Oil Funds have generated over $1m in fees in the first half of 2018. This segment will be a small contributor to the overall HoldCo, but it will likely cause a few upside surprises every few years with limited downside.
Shared Services Center
The new HoldCo will create a Shared Services Center (SSC) to house all the corporate functions of the underlying operating businesses including accounting, legal, public reporting, governance, and other corporate functions. This is the largest value driver for this transaction. It will eliminate a significant amount of costs out of the underlying businesses, estimated at between $2.7m to $5m of cost savings per year. This SSC is also a future source of value for additional small acquisitions, as it allows public company savings for new acquisitions.
Acquisition and Valuation
Before getting into the post deal valuation, its important to understand the likelihood and risks of the proposed acquisition and HoldCo creation executed. As I mentioned above Jeff Eberwein is the Chairman of the board for both companies involved and he is the mastermind behind the deal. With his stake in ATRM (his investment fund holds a large stake in the preferred shares) and his influence within Digirad, I find the likelihood that the acquisition and HoldCo creation not being executed as slim to none. There is always deal risks, but in this case it seems a forgone conclusion that if Jeff wants this to happen it will, as there is limited regulatory approval for an acquisition like this due to the different industries and small size. All that said I think deal risk is extremely small.
The current enterprise value of the post-acquisition business is about $63m.
|Type||Company||Outstanding Shares – #m||Price per Share||Value $m|
|Equity||ATRM Holdings (Conversion)||0.96||1.3||1.2|
|Net Debt||ATRM Holdings||10.9|
|Preferred Shares (10% PIK)||ATRM Holdings||13.7|
|Total Enterprise Value||21.1||62.7|
Post-Acquisition EBITDA and Multiples
|Post Acquisition Segments – $m||Low Case EBITDA||High Case EBITDA||EBITDA Multiple||Low Case Value||High Case Value|
|Searched Services Center||2.7||5.0||5.4||14.7||27.2|
|Total Post Acquisition||11.7||21.0||63.7||107.5|
I believe in the Central Case the enterprise value is valued at $85m, giving an equity a value of about $2.40 or an 84% upside from today’s price of $1.30 per share. At the current price the yearly dividend rate is 16%. Knowing the history of Digirad and the positioning Jeff and the management team have taken around this acquisition, I believe they will hold the dividend in all cases. Digirad’s low case EBITDA alone more that supports the $4.4m dividend. Historically Digirad has defended the dividend at all cost.
|Per Share Value – Post Acquisition||Low Case||Central Case||High Case|
|Net Debt/Preferred Shares||35.3||35.3||35.3|
|Total Enterprise Value||63.7||85.6||107.5|
|Equity Value per Share||1.3||2.4||3.4|
|Upside 1 Year Target||4%||84%||163%|
|Estimated 1 Year Return inc Dividend||20%||100%||179%|
Digirad is an interesting special situation investment due to the incredibly low current valuation, the management incentives (namely Jeff Eberwein), and the high likelihood that they continue to support the div. Based on a simple valuation model using very conservative EBITDA multiples lower than most of their peers, I conclude that shares are worth $2.40 (~73% upside), with a low case of $1.30 but the high likelihood of the dividend being held would provide a ~20% return even in the low case. Based on following the company for the last few years, and the positions that the management team has done going into this proposed structure, I do anticipate that the company holds its 16% dividend in almost all scenarios.