Description

Medical Facilities Corporation (DR-CA) is a unique special situation that offers solid absolute value and a robust dividend yield.  Medical Facilities Corp is a $417MM market capitalization (U.S. dollars), $573MM enterprise value corporation that generates all of its income from six limited liability entities, each which owns a specialty surgical hospital (SSH) or an ambulatory surgery center (ASC).  DR is unique in several aspects.  Shareholders of DR have a controlling stake in all but one of the facilities with a large minority interest that is owned by practicing physicians at the facilities.  Medical Facilities is headquartered in Toronto, the stock trades on the Toronto Stock exchange in Canadian dollars, the company pays its dividends in Canadian dollars, yet all of the company’s operations are in the United States and the company’s financial statements are reported in U.S. dollars. 

DR’s specialty surgical hospitals are located in South Dakota, Oklahoma, and Arkansas while its ambulatory surgical center is located in California.  ASCs provide only outpatient facilities whereas SSHs are licensed for both inpatient and outpatient surgeries.  The facilities provide rooms, staff, surgical materials and supplies, and other support necessary for scheduled surgical, pain management, imaging, and diagnostic procedures and derive their revenue primarily from the fees charged for the use of these facilities.  The centers focus primarily on a limited number of clinical specialties such as orthopedic, neurosurgery, pain management and other non-emergency elective procedures.  Additionally, two of the company’s specialty surgical facilities provide primary and urgent care to their communities.

Investment Positives:

• Medical Facilities Corp. is a special situation that has been orphaned due to its historical corporate structure, Canadian domicile, market capitalization, and noisy income statement.  DR became a publicly traded company in 2004 as an “Income Participating Security” or IPS such that public inventors would buy one IPS that represented i) one common share and ii) C$5.90 aggregate principal amount of 12.5% subordinated notes.  The company converted to a traditional share structure in 2011.  Effectively all of DR’s assets are in the United States and the company reports in U.S. dollars yet the stock trades in Canadian dollars and pays their dividends in Canadian dollars.  Research coverage is sparse with only RBC and Cannaccord Genuity currently covering the stock.  Institutional ownership is low at 32%. While the cash flow and EBITDA of Medical Facilities have historically been stable, the income statement is volatile due to mark to market changes in the value of the company’s exchangeable interest liability and the company’s convertible debt.  All of this can lead to large quarter to quarter non-cash swings that have no effect on cash flow.

• Medical Facilities is an attractive absolute value offering a 10.8% trailing levered FCF yield, a 9.5% current year FCF yield and a robust and well-covered dividend yield of 6.8%.  Both trailing and estimated FCF fully deducts the payout of minority interest.  The closest comparable to DR is Surgical Care Affiliates (SCAI) which offers a trailing FCF yield of 4%, or less than half of DR after fully deducting MI.  Treating both MI and exchangeable interest as debt the stock trades at 5.9x 2014 and 5.8x estimated 2015 EBITDA.  If one chooses to subtract the annual MI payout from EBITDA and then remove the MI balance sheet liability then the stock effectively trades at a higher level of approximately 7.6x estimated 2015 EBITDA.  DR has been a weak performer and the Canadian dollar has fallen over 25% since 2011 while the company’s EBITDA has been relatively stable and FCF has increased.  Considering that all of the company’s operations take place in the United States and the company reports in U.S. dollars I believe the trading has been inappropriate.    

• Medical Facilities is a high-quality operator with a sound portfolio of SSHs and ASCs that have generated stable and robust EBITDA margins over time.  From 2008 to 2014 the company increased revenue from $199.4MM to $311.8MM and grew revenues in both 2009 and 2010 with only a $1.5MM drop in 2011.  EBITDA has grown from $80.7MM to $97.2MM while the company has paid out a generous dividend on a monthly basis.  Operating margins have consistently been in excess of 20%, EBITDA margins have consistently been in excess of 30%, and fully deducting MI margins have still been in excess of 20%.  The business has proven defensive.  Only a small lagging impact (down $1.5MM) in revenues is seen from the prior recession with DR’s revenues growing in 2007 and 2008 with the company consistently generating enough FCF to cover their dividend.  The company has an attractive payor mix with Medicaid accounting for only 2% of revenues.

My initial price target for Medical Facilities Corp. is based on a 5% implied dividend yield or $22.50 per share.  This currently implies 42% total return upside.  While there is no “firm catalyst” for the position my belief is that investors are paid to wait receiving a safe 6.8% dividend yield.  With the stock recently under pressure, management also announced a share repurchase of approximately 2% of their shares outstanding. 

There are multiple risks to an investment in Medical Facilities:

• Reimbursement cuts from Medicaid, Medicare, and commercial insurance are the primary risk to the company.

• Admissions can ebb and flow and elective procedures have displayed a soft degree of cyclicality.

• Physician-owned hospitals have been controversial due to the belief that they actively “manage” their patients in order to see the “best-insured” patients focusing on high reimbursement procedures.  The Affordable Care Act of 2010 effectively banned construction or expansion of physician owned specialty hospitals with only “special exceptions.”

• While EBITDA has grown over time, EBITDA margins have been under pressure with drugs and supplies in addition to salaries and benefits increasing as a percentage of sales.  Management claims that this is not a trend and first quarter margins rebounded sharply but over the long term the direction is concerning.

      Facilities

Medical Facilities Corporation currently has controlling interests in five specialty hospitals and one ambulatory surgical center.  DR’s ownership interests vary from 51% to 65% for the facilities.  Non-controlling interests in the centers are indirectly owned by physicians practicing at the centers.  Upon acquisition by the corporation in the SSHs located in South Dakota, Oklahoma and Arkansas, the non-controlling interest owners were granted the right to exchange up to 14% (5% in the case of Arkansas Surgical Hospital) of the ownership interest in their respective centers for common shares of DR.  This exchangeable interest is treated as debt in the enterprise value calculation. 

DR’s payor mix is attractive with Blue Cross/Blue Shield accounting for 32% of revenues, Medicare accounting for 32% of revenues, other private insurance/self-pay accounting for 22% of revenues, Workers Compensation accounting for 11% of revenues, and Medicaid accounting for 2% of revenues.  In particular my work has pointed to South Dakota being a very favorable reimbursement environment.

Below is a summary of the company’s six facilities:

Black Hills Surgical Hospital (BHSH) – Black Hills Surgical Hospital is located in Rapid City, South Dakota and has been operating as a licensed specialty hospital since 1997.  Black Hills focuses primarily on orthopedic and neurosurgical procedures.  BHSH was originally built in 1996 and is approximately 75K square feet with 11 operating rooms, 26 overnight rooms and a clinical staff of 166.  There are currently 93 physicians who have medical staff privileges at Black Hills.  In 1998 MRI and CT services were added and in 2001 a 20K square foot addition with 18 overnight rooms and support facilities were completed.  BHSH produced sales of $76.7MM and income from operations of $23.1MM in 2014.  50.9% of procedure volumes were orthopedic, 23.9% were neurosurgery, and 6.3% were pain management.

Dakota Plains Surgical Center (DPSC) – Dakota Plains Surgical Center is located in Aberdeen, South Dakota and is attached to an orthopedic clinic that is the primary office of the orthopedic physicians that account for 95% of the hospital’s admissions.  DPSC has been operating as a licensed specialty hospital since 1998 and focuses primarily on orthopedic procedures.  The facility ranks number two in the state of South Dakota for the number of hip and knee replacements.  DPSC has approximately 19K square feet with three operating rooms, 15 beds and clinical staff of 46.  There are currently 110 physicians who have medical staff privileges at the facility.  In 2001, radiology services, including MRIs were added.  The hospital is owned by Dakota Plains Surgical Center, LLP which is 64.6% owned by DR.  DPSC generated revenue of $14.5MM and income from operation of $5.2MM in 2014.  79% of procedures at DPSC were orthopedic procedures, 12.4% were classified as “other” and 4.3% were neurosurgery procedures.

Oklahoma Spine Hospital (OSH) – The Oklahoma Spine Hospital is a licensed specialty hospital that offers scheduled surgical, pain management, and diagnostic procedures.  The hospital focuses on a limited number of clinical and surgical specialties including neurosurgery, pain management, orthopedic surgery and podiatry.  OSH is a 61K square foot facility and 104 physicians have medical staff privileges.  The facility has seven spine operating rooms, four pain management procedure rooms, fourteen pre-op and post-op outpatient beds, seven recovery room beds, and a 7,500 square foot, off-site physical therapy service that is owned and operated by the hospital.  2014 case mix was 71.6% neurosurgery, 28% pain management and .42% were classified as other.  2014 OSH revenues were $63.9MM and operating profit was $11.7MM.

Sioux Falls Specialty Hospital (SFSH) – Sioux Falls Specialty Hospital is located adjacent to the campus of Avera McKennan hospital in Sioux Falls, South Dakota.  SFSH was originally built in 1985 and is approximately 76K square feet with 13 operating rooms, 35 overnight rooms and a clinical staff of 190.  There are currently 207 physicians that have medical staff privileges at Sioux Falls Specialty Hospital.  In 1996, SFSH expanded its services to include a Recovery Care Department to accommodate the postoperative needs of patients undergoing more extensive surgeries and in 1998 radiology services were expanded to include MRI.  In 2009 SFSH commenced operation of an open upright MRI facility and in 2011 the hospital commenced operation of a primary care clinic.  The hospital is owned by Sioux Falls Specialty Hospital, LLP which is 51% owned by MFC.  SFSH produced revenues of $88.2MM and income from operations of $36.1MM in 2014.  62.5% of procedures were orthopedic, 9.2% were pain management and 8.7% were ear, nose, and throat.

Arkansas Surgical Hospital (ASH) – Arkansas Surgical Hospital opened in 2005 as a physician-owned specialty hospital located in North Little Rock, Arkansas.  Orthopedic and spine surgeries make up the bulk of services provided by the hospital. Additional services include cosmetic and breast oncology surgeries as well as pain management and diagnostic imaging procedures.  Management notes that ASH is “ranked #1 in Arkansas” by Healthgrades for joint replacement and spine surgeries.  Additionally management notes that Carechex ranked ASH “in the top 1% nationally in patient satisfaction for overall hospital care and overall surgical care.”  ASH has 167 credentialed physicians and over 300 employees.  The hospital is comprised of 41 in-patient suites, 9 operating rooms, 22 pre-op beds, 18 post-op beds, 2 pain management treatment rooms, X-ray, CT, MRI and myelography services, pharmacy, lab services, and an on-site restaurant.  ASH produced $60.5MM in revenues and $14.4MM in income from operations in 2014.  58.6% of procedures were orthopedic, 32% were neurosurgery, and 4% were pain management. 

Surgery Center of Newport Coast (SCNC) – The Surgery Center of Newport Coast is a licensed ambulatory surgery located in Newport Beach, California.  It has been operating since 2004 as a “Medicare Deemed Multi-Specialty Facility” accredited by the Accreditation Association for Ambulatory Health care.  The facility is approximately 7K square feet in size and has three operating rooms and one procedure room.  SCNC specializes in general surgery, gastroenterology, gynecology, orthopedics, podiatry, otolaryngology, pain management, and plastic surgery.  SCNC generated $8.2MM in revenues and $2.2MM in income from operations in 2014.  58.9% of procedures were orthopedic, 15% were gastroenterology/urology, 12% were obstetrics/gynecology, and an additional 12% were in pain management.

Balance Sheet & Estimates

Medical Facilities has a solid balance sheet although mark to market accounting creates noise in the income statement that has no effect on the cash flow statement or the company’s distributions.  This is one of the primary reasons the opportunity exists.  Treating exchangeable interest as debt DR currently has a total of $153.9MM in gross debt and $104.5MM in net debt. The largest portion of “debt” is the exchangeable interest liability which currently equates to 5.8MM shares and is valued at $78.4MM.  DR has $35MM in 5.9% convertible notes due 2019, $5.4MM in short-term and $35MM in long-term debt attached to the individual facilities and $3.1MM in capital leases.  Cash is $49.1MM while minority interest is $51.7MM.  DR has an undrawn CAD $50MM line of credit.  At YE 2014 DR had net NOLs of $101.9MM and net deferred income tax assets of $38.2MM.  I have modeled a $6.2MM benefit from deferred taxes in both 2015.   

I am modeling flat margins and a sales increase of 2.5% in 2015 and 1% in 2016.  For the first quarter of 2015 revenues rose 3.7%, EBITDA margins rose 320 basis points and EBITDA-MI margins rose 220 basis points.  In the first quarter total surgical cases increased by 4.9%, pain management procedures rose by 7.2% and payor mix improved.  I believe my full year estimates are conservative.

Management

DR management is competent and conservative.  Dr. Donald Schellpfeffer is the CEO of Medical Facilities Corp. and Sioux Falls Specialty Hospital.  Dr. Schellpfeffer is one of the original founders of Sioux Fall Specialty Hospital and has been the CEO of the hospital since 1985.  He has over 30 years of experience as a physician.  Michael Salter has been the CFO of the company since its founding.  Mr. Salter was an accounting and financial consultant for Advisory Services Inc. in Scottsdale, Arizona from 2001-2003 and was Corporate Controller for Olympus Hospitality Group from 1998 to 2001.  From 1980 to 1995 Mr. Salter was employed by Alberta Energy Company where he held a number of positions in accounting, finance and risk management.  

Catalyst

There is no near-term identifiable catalyst for Medical Facilities Corp.  I do not believe this is required as investors are paid to wait and collect a 6.8% dividend yield.  The stock offers a 9.5% FCF yield on current year numbers and trailing FCF is higher.  In today's market these are extremely generous levels and DR should be an excellent compounder from current levels for patient capital.