Ergoresearch Ltd. – Another Diamond in the Quebec Rough

If you have been so kind as to have read some of what I’ve written on this blog, you may remember that I had a chance to invest in a Quebec microcap trading at just two times earnings. Alas, for reasons I either can’t or don’t want to remember, I passed on buying PCI. If I had bought when I originally found the company, I’d be looking at almost a 300% return in under a year. If I had bought it when I had wrote about missing the opportunity, I’d still be looking at over a double.

I don’t intend to make the same mistake again. 

Ergoresearch Ltd. manufactures and sells orthotics, selling from their Equilibre clinics. The company produces foot orthotics, as well as the OdrA, a type of knee brace used to relieve knee osteoarthritis, and the PowerKnee, the world’s only motor-powered prothesis for above-the-knee amputees. In addition to selling these products, the company has researched and developed technological solutions to better enable the diagnosis of problems and manufacturing of orthotics.

The company also recently began treating sleep apnea at several of their Equilibre clinics.

The company has a few things going for it that make it an enticing investment: valuation, growth, and a skilled management team committed to shareholders.

Valuation

Ergoresearch is classically cheap. Over 40% of the market cap is in cash or short term investments (10 cents per share). Valuing inventory and property & equipment at just 60% of carrying value is worth almost 4 cents per share. The company has no debt. EV/TTM EBITDA is currently 10.1x, but profitability and revenues are growing.

Growth

It may not seem like it if you just look at the past financial results, but the company will be growing in the coming years.

The most recent quarter continued a trend of the company increasing revenues to the point that sales are flat year over year; Ergoresearch completed the closure of its unprofitable home care division in January of 2016 which has affected YoY numbers. The fourth quarter should see an increase in revenue year over year for the first time since that closure.

The company has also identified an opportunity to branch into a new product/service base, sleep apnea. Services had commenced at four locations as of February, with the plan to begin service at the other locations this spring. The company hasn’t announced news of it, but the clinics should all be offering to treat sleep apnea by now.

Management

As far as I’m concerned, management is doing all the right things.

With shares trading at a steep discount (16% discount to book value right now), management has spent considerable cash buying back shares. In 2016 the company purchased the maximum amount they could under their NCIB. Under the new NCIB, Ergoresearch has bought back another 225,000 shares. Seeing as I’m a buyer at these levels, I am happy to see management understands buying back stock offers an excellent use of capital. If the share price continues to lag around current levels I expect Ergoresearch will max out the NCIB once again, decreasing the shares outstanding to just under 69 million.

Before this, management had shown they are skilled at growing sales, including growing by acquisition, and with the cash the company has on hand I believe that some time in the next few years we will see management once again on the hunt for acquisitions.

Management has also undertaken cost cutting efforts in order to improve the profitability of operations. Despite an increase in costs associated with starting the sleep apnea services, the company’s expenses for the first three quarters had decreased by $138,000.

The company now has lower costs, no debt, increasing sales, new products/services to sell, more cash than liabilities and a shrinking share count.

Not to mention, management has put their money where their mouths are. The CEO owns over 21% of the company, with another 15% being held by directors. I have full faith that they are going to want to make the value of their shares rise.

Prediction Time

There’s a lot going on at Ergoresearch so I’ll try my best to make some safe predictions.

I expect revenue for the fourth quarter to come in flat with 2016, so full year 2017 revenues will be just over $14 million. In 2018 however I expect organic growth from the current product lines of roughly 5%, and the sleep apnea business to contribute ~$500,000, meaning revenues will come to $15,324,000.

Operating expenses this year will increase in the fourth quarter (due to implementing sleep apnea services at more clinics) and stay mostly flat in 2018 (because G&A go down when not starting new services, and continued efficiency gains, but more sales equals more cost of goods sold). I’ll estimate these numbers at $14,215,000 in 2017 (flat with 2016) and $14,580,000 in 2018. Remember that these numbers include depreciation. Financial expenses I’ll predict are flat, $122,600 for 2017 and 2018.

It looks to me like the company has turned the corner and should be growing earnings from this point on. EBITDA for 2017 should be around $831,402 (13.5x EV/EBITDA at today’s prices), and almost $1.5 million in 2018. With no major changes that would affect the cash balance, and a 12x EV/EBITDA multiple, I have a target price of $0.34 by the end of 2018. That would be a 36% return. 12x EV/EBITDA is also likely too low of a multiple for a company showing the growth and improvement that Ergoresearch is, but I want to see that the story works with even a conservative multiple target.

ergoresearch stock
From Tmxmoney.com

Story

That would be what I expect with just the fundamentals of the stock. But the chart above suggests to me there is more to this stock than an EBITDA multiple. I believe the business is better positioned now than it was in 2014, when the stock traded over $1. That was probably unjustified, but so is the punishment the stock has taken since. Once the company shows revenue growth and improved profitability, which should be every earnings release starting with the upcoming Q4 announcement, the stock should jump higher.

And of course, a press release that Ergoresearch has made an acquisition will throw all of these numbers out the window and the stock will probably fly past my targets. I don’t expect any acquisitions until after the first half of fiscal 2018 as Ergoresearch digests the sleep apnea implementation and continues to invest heavily in research and development. That said, when Ergoresearch states the priorities and development plan, this is what is listed first:

Strengthened by our cash position, pursue the exploration of potential acquisitions or partnership in Quebec and across Canada.

Conclusion

Within Canada, there are several almost micro-climates. One everyone knows is Alberta. Another is Toronto or Vancouver (if a company is at all related to housing). The one that most do not think of is Quebec. I think most avoid investing there for a couple reasons, but the biggest is that it’s tougher to understand companies in Quebec and they’re unwilling to do the work. Why research a company where you have to wade through terms like “Équilibre orthèses et biomécanique” or “Langelier Orthèses Chaussures”. Why not skip all the translating and invest in companies from the rest of Canada.

This bias has led to some good investment opportunities, and unlike with Perlite, I won’t be missing out on this one.

Ergoresearch stock is very low volume, and as such it can be difficult to acquire a full position. I did all of my buying under 30 cents over the course of a couple weeks. As with any illiquid holding, make sure to use limit orders.

Disclosure: Long ERG.

 

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