- By Praveen Chawla
"For a value investor, price has to be the starting point. It has been demonstrated time and time again that no asset is so good that it can't become a bad investment if bought at too high a price. And there are few assets so bad that they can't be a good investment when bought cheap enough." - Howard Marks (Trades, Portfolio)
TSX:DR) (OTCPK:MFCSF), in partnership with medical doctors, owns a controlling interest in surgical facilities in the United States. The company's portfolio includes controlling interests in four specialty surgical hospitals located in Arkansas, Oklahoma and South Dakota, as well as an ambulatory surgery center in California. It also has a non-controlling interest in a specialty surgical hospital in Indiana.
In addition, through a partnership with NueHealth LLC, Medical Facilities owns controlling interests in six ambulatory surgery centers located in Michigan, Missouri, Nebraska, Ohio, Oregon and Pennsylvania. The specialty surgical hospitals perform scheduled surgical, imaging, diagnostic and other procedures, including primary and urgent care, and derive their revenue from the fees charged for the use of their facilities. The ambulatory surgery centers specialize in outpatient surgical procedures, with patient stays of less than 24 hours.
The hospitals and surgical facilities are mostly majority-owned partnerships that roll up to the parent company, Medical Facilities, using the equity method of accounting.
Accounting is not straightforward as minority owners (i.e., physician owners) get their cut at the facilities (hospital) level before corporate-level expenses, such as interest on the debt, are deducted. Thus, the minority share is preferred equity since they get paid before the common shareholders.
Revenue and share prices increased at a solid clip between 2010 and 2018. Cracks in Medical Facilities' story started to first appear in the fourth quarter of 2018 as revenue started to stall while operating expenses began to increase. The company started missing analyst estimates in the third quarter of 2018.
Chart 2: Thomson-Reuters.
Since the company earns in U.S. dollars, but reports financials and pays dividends in Canadian dollars, exchange rates can also affect the numbers.
In first-quarter 2019, management blamed "case-mix and payor mix" for drop-in operating income. On May 9, 2019, CEO Robert Horrar said:
"While our case volume was up, the composition of a case mix and payor mix was different. In fact, this past quarter shows impact that changes in our payor and case mix can have on our financial results. Changes in payor and case impacted our revenue growth for the quarter and our operating results."
In the second quarter of 2019, the other shoe dropped. On Aug. 8, 2019 Horrar commented on the company's write down of the Unity acquisition.
"However, weaker contributions from two of our facilities, due to changes in the case mix or payer mix weighed on the overall quarterly revenue. In fact, the decreases at these two facilities amounted to $5.1 million with Unity's decrease of $3.1 million having the largest impact. Due to the continued case mix challenges at Unity, we made the decision to recognize a non-cash goodwill and intangible asset impairment charge of $29.5 million in the second quarter."
In the third quarter of 2019, investors ran for the hills as the company cut its annual dividend from $1.11 in 2017 to 28 cents going forward into 2020. The CEO gave investors the following bitter pill to swallow on Nov 7, 2019.
"We are obviously disappointed with our results over the past few quarters, resulting in a payout ratio in excess of 100%, which is not sustainable. Therefore, we have taken a difficult step to cut the dividend."
To summarize, a combination of weak revenue, less profitable work and a bad acquisition (UMASH) wreaked havoc on Medical Facilities' stock. This was followed by the Covid-19 pandemic, which cratered the volume of elective surgery, the company's bread and butter.
The company reported that overall surgical case volume for the recent quarter was down 38%. The largest decrease was in outpatient cases, which decreased by 42%. Volume patient cases decreased by 25% and observation cases decreased by 20%. Case volumes were most heavily impacted in April but began recovering the latter part of May, with continued improvement in June. Part of the revenue was made up of generous stimulus payments from the government.
Despite these challenges, revenue has held up relatively well and distributable cash flow is coming back. This is a good setup for value investors since, when momentum investors flee, it creates value opportunities. However, the crowd is not always wrong, so due diligence and realistic expectations are crucial.
Chart 3: In Canadian dollars.
Chart 4: In Canadian dollars. (Non-controlling interest in cash flows of the facilities is deducted in determining cash available for distribution as distributions from the facilities to the non-controlling interest holders are required to be made concurrently with distributions from the facilities to the corporation. )
The following chart illustrates the income statement for Medical Facilities since 2014, showing it has been consistently profitable.
Chart 5: In Canadian dollars.
The current balance sheet based on GuruFocus data (in Canadian dollars) is shown below:
The company has total long-term debt of around $174.4 million (including the corporate credit facility and convertible debentures, but excluding exchangeable interest liability.) The company carries an exchangeable interest liability of about $20.5 million to represent minority interest, which may be convertible to common shares.
Chart 7 - Source: Quarterly Report. (U.S. dollars)
The company has a $150 million line of credit with a syndicate of three Canadian chartered banks, which matures on Aug. 31, 2023. The credit facility can be used for general corporate purposes, including working capital and capital expenditures, financing acquisitions or repurchasing common shares. As of June 30, $84.8 million was drawn and remained outstanding for the credit facility. The proceeds drawn from the credit facility were primarily used for the acquisition of UMASH and its underlying property through RRIMH in 2016 ($48.8 million), (UMASH has recently been sold) the acquisition of the MFC Nueterra ASCs in 2018 ($20 million), and the repayment of the convertible debentures upon maturity in 2019 ($16 million). As of June 30, the company was in compliance with all of its debt covenants.
I have attempted to value Medical Facilities using two methods. Using the GuruFocus two-stage discounted cash flow calculator, I applied an 8% discount rate and a 3% growth rate for 10 years and 2% for the second decade. I got a present fair value of CA$15.79.
Chart 8: Canadian dollars.
The other valuation method I used was the median price-to-sales justified price. This gave me a value of CA$19.61.
So both methods indicate deep value compared to the current stock price of CA$4.52.
Medical Facilities has been known to be a high dividend payer. However, it had to cut its dividend in 2019 by 75%. This caused many dividend-oriented investors to exit the stock. Because the stock has dropped so much, however, the dividend yield is still respectable at about 5.7%.
Medical Facilities is a deep value, underfollowed stock that is recovering from the triple whammy of a poor acquisition, a divided cut and now the pandemic.
It will take time to recover. While the stock could potentially be a multi-bagger, it will take time and a dynamic management team that can make good acquisitions. The last two acquisitions were value-destructive, so it's critical that the acquisition engine be improved. The growth runway for the company is good due to the aging demographics in the U.S. and there will a lot of opportunities to exploit. The company has over CA$100 million in cash and is now retaining a majority of distributable cash. My target for Medical Facilities' stock price is between $9 to $12 in the next three years, provided the company can start making accretive acquisitions.
Disclosure: The author is long Medical Facilities.
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This article first appeared on GuruFocus.