When discussing a company’s prospects with management, sometimes its more important to listen to what is NOT being said than hearing the data that management is giving. I was struck by this truth when analyzing Nighthawk Radiology (NHWK). The company is in the business of outsourcing interpretations of x-ray images and other medical diagnosis scans. Originally, the primary service consisted of professionals in an outsourcing office (typically India) being employed to do initial readings of scans done during the night. This would allow emergency rooms and urgent care centers to quickly get answers on trauma patients while at the same time improving the quality of life for stateside Radiologists who would prefer to sleep at night.

Over the last few quarters, management has begun initiatives to diversify their business mix. The company now operates five distinct business lines.

• Preliminary Scans (off-hour reads)
• Daytime final reads
• 3D Reconstructions and CCTA services
• Clinical workflow
• Business Services

In order to quickly diversify its service offerings, the company has chosen to grow by means of acquisition. In April, the company paid $53m to purchase Radlinx which allowed the company to enter the final read business. Some analysts equated this move to playing catchup to Virtual Radiologic who is the leader in this particular portion of the business. Later this summer, the company bought out the business services division of a larger healthcare organization and plans to attempt to cross sell the service to many of its current customers.

Working through the most recent quarterly report, management highlighted a 79% increase in revenue but the major portion of that growth was due to the acquisitions. Organic growth was only 24% year over year with earnings up 24% as well. Scan volume (number of images analyzed) was up an impressive 70%! Impressive until you look further into the details and find out that organic growth was only 28%.

One of the issues that left me a bit unsettled was management’s characterization of client base growth. Tim Mayleben who is the President and Chief Operating Officer was giving details on the “quality and strength of the business” when he mentioned that NightHawk was providing solutions to 753 radiology group customers and 1,469 hospitals which is 90 more hospitals than last year. Mr. Mayleben failed to mention until questioned later in the call that the number of customers they provide services to actually declined during the quarter. Upon examination by an analyst on the call, the response was that there was some consolidation in the industry and that the number of clients didn’t really matter. It struck me as passing off on an important metric simply because the statistics didn’t show a pretty picture.

While management guided lower for the fourth quarter, they were unable to truly explain what difficulties were driving lower expectations, but did fess up to not meeting internal goals when questioned by call participants. At another point, management expressed that they were happy with the diversification that was being built into the business model, but later when analyst reminded management of their goal to have non-off-hour revenue make up 10%, it was explained that this goal would not be met.

Margins were under pressure for the quarter with professional service expense rising from 34% of revenue to 38%. At the same time, it appears the number of affiliate radiologists (employed by NHWK to read the images) declined despite rhetoric from the company of organic growth. The analyst from Goldman Sachs seemed quite incredulous that management could guide next quarter lower but still have the same optimism for 2008 but questions were glossed over with management saying they believe diversification of their business will add to stability and drive growth.

At this point, NHWK holds a 26% market share in their core business. With competition coming online and venture capitalists plugging money into start-ups that will offer similar services, market share may be harder and harder to capture. The acquisitions have added a debt burden to the company and while they still have flexibility to borrow more, concerns are mounting as to the effectiveness of management’s integration skills. Currency trends are likely to work against the company as nearly all of revenue is in the form of US dollars but many expense items are international. The headwinds appear to be mounting for this misled firm and I would not want to have capital at work in the stock.

NHWK Notes

FD: Author does not have a position in NHWK