Description

MedCath is a hospital company in the process of liquidating and returning all of its value in the form of cash to shareholders.  Investing in the stock today offers investors incredibly compelling IRRs (30-77% - see IRR analysis below) and returns of 11-24% with minimal risk as the company is going to distribute almost 80% of the current share price in cash to investors in under 2 months (midpoint of distribution range is $6.00/share).  Buying the stock for $7.70/share today would leave investors with a stub value of $1.70/share, which should increase to $3.04/share (mid-point) providing them with a return of 1.8x their money by the time the liquidation is complete (see returns table below). 

 The ultimate recovery to shareholders is dependent on the final value of

(a) the net assets remaining in the company upon completion of the liquidation process,

(b) the resolution of any penalties related to the US Department of Justice’s investigation of the implantation of ICDs (implantable cardioverter defibrillators) and

(c) the timing of the payment of the remaining net asset value to shareholders. 

(a)    Recovery Value – Midpoint of $9.04/share (range of $8.53-9.54/share)

MedCath is currently reporting its financials from a recovery perspective for shareholders and management has consistently been very conservative in their estimates.  As of their latest 10Q, management highlighted that they believe shareholders will receive $194 million in net assets plus $8 million of tax refunds (that cannot be booked today because of GAAP rules) less the after-tax value of a series of contingencies of $2.4-12.9 million and any payments for the ICD settlement.  As explained in section (b) below, our estimate for the ICD settlement is between $5-15 million after tax.  The company has not provided any guidance on this liability to date.  The table below depicts the low and high estimates for the recovery for shareholders, and given management’s history of conservatism, the high estimate is more likely to be correct than the low estimate.  MedCath’s next 10Q will likely be published on August 9, 2012. 

(b)   ICD Liability - The ICD investigation by the US DOJ has been in process since March 2010.  We think the liability should be less than $10 million. 

The investigation involves the improper billing of Medicare for the implantation of ICDs outside of Medicare’s established reimbursement protocols.  When the investigation commenced, the DOJ initially contacted over 100 US hospitals where it believed, based on the strict reading of the Medicare rules, that improper billing had occurred.  As the DOJ more carefully reviewed the issue, it came to realize the issue was much more nuanced and that some of those technical violations of the Medicare rules were permissible once the medical necessity of the ICD implantation was taken into consideration. The following articles from Modern Healthcare and Forbes provide helpful summaries of the issue and suggest that the DOJ will likely bring this to a resolution in the fall of this year (http://www.modernhealthcare.com/article/20120721/MAGAZINE/307219994 and http://www.forbes.com/sites/larryhusten/2012/08/07/guest-post-feds-turn-corner-in-icd-investigation-hospital-liability-divided-into-categories/2/).  Not surprisingly, the hospital industry and the lawyers defending them have aggressively criticized the investigation as noted in this article as an example: http://www.fredlaw.com/articles/health/HealthCareArticle_Glaser2011.pdf. 

The clearest indication of how the DOJ is proceeding with its investigation was described in technical detail in this article that appeared in the Journal of the American College of Cardiology (JACC) http://content.onlinejacc.org/article.aspx?volume=59&issueno=14&page=1270.  In this article, the author describes the investigation of an affiliate hospital of Columbia University. The hospital had 229 cases that were reviewed by the DOJ (9% of its total potential cases), and the DOJ found some violation with 34 of them or 1% of the overall cases (15% of the cases reviewed). 

Using the experience of this hospital and generalizing to MedCath, it is possible to suggest that MedCath’s after-tax payment to settle its ICD claim would be around $10 million.  We calculate this by assuming the average revenue per case would be $20,000 (this can range from $5,000 to $50,000), the average penalty would be 2x the revenues collected (could be 1-3x), the average additional penalty per case is $8,250 (could be $5,500-$11,000), and the repaid fees are tax deductible at a 35% rate. MedCath was under investigation for 8 of its hospitals, but the local physician group that bought the Arkansas hospital kept the ICD liability.  One of the hospitals was not opened until the fall of 2009 and MedCath kept only 50% of the liability for the last facility it sold (http://phx.corporate-ir.net/phoenix.zhtml?c=129804&p=irol-SECText&TEXT=aHR0cDovL2lyLmludC53ZXN0bGF3YnVzaW5lc3MuY29tL2RvY3VtZW50L3YxLzAwMDExOTMxMjUtMTItMjk2MjQxL3htbA%3d%3d).  And two of its other hospitals are acute care facilities, so their rates of ICD cases should be far lower than the pure cardiac focused facilities.  So we assume, MedCath has an average of 5 hospitals for the purpose of the calculation (shown below).  Two other factors that should further reduce the number shown below are that it is possible the minority partners in some of the other hospitals will accept responsibility for some of the ICD liability.  And, Valley Health System (the hospital reference in the JACC article) is a 451 bed acute care facility. MedCath’s hospitals under investigation averaged 70 beds.  So the average number of cases in violation should be lower for MedCath despite its hospitals being cardiac focused. 

In deciding to make a distribution at the end of this upcoming September, MedCath management made the determination that they could estimate an upper boundary on the ICD settlement.  They have made that value difficult to determine in their disclosures so as not to suggest what it is to the DOJ.  However, previously the company had disclosed a range of pre-tax contingencies with the high end of that range as $21 million.  And we believe management is holding an extra $10 million as cushion for the wind down process although they have not disclosed this.  So subtracting these values from the recently announced pre-tax holdback range of $48-$58 million, implies management is reserving $17-$27 million for the ICD settlement.  Given management’s conservatism, we think it is consistent that they would reserve over 2.5 what they believe the settlement would be. 

We have seen a number of different estimates of the ICD liability, and from our work, we think it will be less than $10 million or $0.50/share after tax.

(c)    The timing of the return of proceeds has a large impact on the IRR for the investment. 

By September 22^nd, the company will begin the official liquidation process in the Delaware court system.  At that time, the company will pay a distribution of $5.75-$6.25/share and will announce the value of the distribution likely at the beginning of September if not before then. 

Once the court process commences, the court will allow all potential claimants to come forward for a period of 6 to 9 months.  Given the liquidation has been ongoing for over 2 years, we think few additional claims will materialize.  After the initial waiting period is over, the court will permit the company to make another payment to shareholders.  We believe the company will make a payment of 75% of the remaining distributable proceeds in May of 2013.  The court process will then continue for a full three years but we believe the company will be able to pay out the remaining 25% of the likely distributable proceeds by May of 2014. 

Why does this opportunity exist?

Besides the lack of clarity around the ICD liability, MedCath’s stock is going to delist by September 22^nd and its trading books will close.  The shares can be traded through brokers but will become much less liquid.  Investors are able to capture an attractive yield for accepting the process by which the liquidation will occur. 

Catalyst