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LMD.V: Gross Margin, Op Loss Improve With Apteryx. Cash Flow Positive in Q2

By Brian Marckx, CFA


Q2 2017 Financials: Gross Margin, Op Loss Greatly Improve With Apteryx. Cash Flow Positive in Q2!

LED Medical (OTC:LEDIF) (TSX:LMD.V) reported Q2 financial results on August 17th.  This was the first full quarter including contribution from Apteryx. As a reminder, much of the rationale for the acquisition was its expected accretion to not only revenue but also to net income and EBITDA.  The Q2 numbers suggest the acquisition may already be highly accretive on all these metrics.  Perhaps most importantly is the apparent very positive contribution to cash flow  - which we discuss in more detail below.  

Q2 revenue was $3.70M, compared to $3.66M (+1%) in Q2 2016 and $2.1M in Q1 2017 (+77%).  As the prior-year period included zero contribution from Apteryx, the 1% (or $43k) yoy topline growth was perhaps somewhat underwhelming, although it nonetheless did top our $3.4M estimate.  (Apteryx, per a Business Acquisition Report filed with SEDAR on June 9th, generated revenue of $4.9M in 2016, or ~$1.25M quarterly average).  While LED does not disclose revenue by segment, footnotes in the Q2 filing indicate that VELscope related sales fell approximately 35% yoy (or about $196k) - given that Q2 benefitted from the addition of Apteryx, we think it is likely that the digital imaging segment also experienced a contraction in revenue.

Meanwhile the Q2 filing notes that sequential revenue growth (i.e. from Q1 2017) was attributable to increased sales from digital imaging products and Apteryx.  As a reminder, the acquisition closed around mid-February and as such, Apteryx contributed only about 6 weeks' worth of sales in Q1.  Based on our calculations, it appears that VELscope also contributed (although much more marginally as compared to digital imaging and Apteryx) to some of the total revenue growth from Q1 to Q2.

Management indicates in their Q2 shareholder letter that Apteryx's XVWeb software (i.e. advanced diagnostic and treatment planning SaaS software) and the Dental Service Organization (DSO) customer channel have already contributed and represent growth catalysts.  Specifically, the company mentions that they recently signed a significant agreement with a new DSO customer with several hundred practices.  In LED's August investor presentation they cite as customers Dental Care Alliance, CoastDental and American Dental Partners.  Dental Care Associates includes 260 affiliated practices and CostalDental spans more than 180 locations.  While we were unable to find specifics in terms of the number of practices affiliated with American Dental Partners, their website indicates that they have locations in at least 20 states including CA, FL and TX.

Gross margin has also been highly positively effected by the inclusion of Apteryx - while this was initially apparent in Q1, it has become even more so with the release of Q2 results.  While gross margin in Q1 came in at 49.0%, which was the highest level in 11 quarters, the benefit of Apteryx's high margin contribution for the full quarter helped push this up another 750 basis points to 56.5% in Q2 - a level that LED hasn't seen since Q3 2013. And while we had expected substantial improvement in gross margin as a result of the contribution from Apteryx's higher margin software products, we may have underestimated the significance.  

Gross margin through 1H 2017 averaged 53.8%.  VELscope's consumables also carry a relatively high margin - incremental sales growth of which has also likely contributed to the margin expansion through the first six months of 2017.  For some context of how relatively strong the current margin level is and how the addition of the (lower margin) digital imaging product portfolio had been a drag on margins, it's worth revisiting a little bit of history.

• 2012: in 2012 the company was only selling their (healthy margin) VELscope products - in that year they generated $6.3M in revenue on gross margin of 56.5%.  This was the highest annual revenue during when they were only marketing VELscope - this is also the highest gross margin in any year to-date

• 2013: revenue then cratered 60% in 2013 to $2.5M as a result of distribution-related restructuring - the lower revenue and fewer higher-margin consumables (i.e. treatment tips) sales also reduced economies of scale and resulted in gross margin falling to 46.5% in that year 

• 2014: was the first year in which LED began selling digital imaging products - while revenue jumped 256% to $9.0M ($3.9M, or 43%, of which was from digital imaging products), which was the highest in history up to that point, the low reseller-type digital imaging product margins resulted in gross margin falling to 38.6%

• 2015: revenue grew 47% in 2015 to $13.1M.  While this is the highest in company history it was a result of 138% growth of digital imaging product sales with VELscope sales falling 24%.  With the sales mix highly skewed towards lower margin products (70% digital imaging, 30% VELscope), gross margin was crimped and fell to just 27.2% in 2015

• 2016: revenue fell 23% to $10.2M.  The sales mix (based on our calculations which are based on disclosures in the SEDAR filing footnotes) was even more skewed towards digital imaging (83% digital imaging, 17% VELscope). Gross margin in 2016 fell to 24.4%, the lowest since LED has been a publicly traded company (2011)

Operating expenses in Q2 were $2.4M (or 64% of revenue), up from $2.1M in the prior-year period and up from $1.8M in Q1 of this year.  But it is below the $2.7M we had expected.  Operating expenses were $4.2M, or 71% of revenue, through the first six months of 2017.  For context, operating expenses as a percentage of revenue were 191% in 2013, 102% in 2014, 67% in 2015 and 75% in 2016.

The sequential increase in OpEx mostly relates to SG&A functions, although R&D did tick up slightly as a result of additional Apteryx-related software development costs.  Total headcount at the end of Q2 was 54, compared to; 49 at the end of Q1 2017, 29 at 12/31/16 and 35 at 6/30/16.  Most of the increase in headcount since close of the Apteryx acquisition is in R&D and support functions with some additional personnel also added to sales/marketing.  We do expect operating expenses to increase from this level, however, given likely continued software development activities as well as an increase in commissions from growing sales.  However, there should be opportunities for operational synergies given the complementary nature of the hardware and software products which share similar call points.  As such, and combined with upside in gross margin and revenue growth, we model fairly regular improvement (although with the possibility of some quarterly lumpiness) in operating loss.  

Operating loss was just $260k in Q2, improved from $760k in Q1 2017 and from $1.0M in Q2 2016.  This is the best showing in operating loss since Q3 2013 (also $260k).  Operating loss was $1.0M through 1H 2017, which is an overall best over the first six months of any year since the company has been public.    
Cash used in operating activities was $1.1M in Q2 and $2.5M in 1H 2017.  But excluding changes in working capital - which is a better gauge of cash used or generated by the business, LED actually generated 85K in cash in Q2 and used just $772 in 1H 2017.  For context and how this compares to the respective year-earlier periods, cash used in operating activities (ex-changes in working capital) was $1.8M in Q2 2016 and $2.7M in 1H 2016.  The significant improvement, we think, is a result of the inclusion of Apteryx and resultant substantial increase in gross margin, coupled with overall expense control.  This may suggest LED is near the point of generating consistently positive cash flow.  

We also note that CapEx has been minimal - with just $74k in capital expenditures (related to the purchase of equipment), excluding the cost of the acquisition, through the first six months of 2017.  Cash balance at Q2 quarter-end was $1.5M.  

See below for free access to our updated report, including financial model, on LED Medical. 


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