MEDQUIST INC MEDQ
April 27, 2010 - 3:29pm EST by
mitc567
2010 2011
Price: 9.71 EPS $0.62 $1.30
Shares Out. (in M): 38 P/E 16.0x 7.5x
Market Cap (in $M): 365 P/FCF 5.8x 5.8x
Net Debt (in $M): -25 EBIT 42 70
TEV ($): 340 TEV/EBIT 8.1x 4.9x

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Description

 

Mequist Inc. (MEDQ, $9.71) is a leading US provider of medical transcription services to hospitals.  It trades at a free cash flow yield of about  17% ($63.5MM FCF/$368 Mkt Cap) and an EV/EBITDA of 5.8x.   Based on MEDQ's completed restructuring and business prospects I believe the stock has the ability to at least double over the next two years.

 

The Company

Mequist is one of the six largest medical transcription companies in the US.  MEDQ went thru a three plus year period from late 2003 to mid 2007 without being able to file financial statements due to the use of improper billing methods.   In the fourth quarter of 2005, MEDQ paid their customers $65 million to settle this issue.  MEDQ's primary owner during this time was Phillips Electronics, one of the world's largest medical equipment companies.   When MEDQ re-emerged with public financials it had approximately $175MM of cash and no debt on its balance sheet.  However, the business had deteriorated while it was in transition and had negative EBITDA.  Phillips decided to divest its stake and mid 2008 sold its 69.5% to CBAY Holdings for $215 million in cash, and convertible and promissory notes.  CBAY (CBAY, AIM) is a medical transcription company controlled by Steve Cohen of SAC Capital, a well known hedge fund with a great track record.   The transaction with CBAY is strategic in nature, since CBAY has a large presence in India doing medical transcription patients' records.  As part of the deal, CBAY agreed to provide MEDQ all of its transcription and editing work done outside of the US.

MEDQ has grown cash flow markedly over the last few years despite middle single digit declines in revenues.  This has been accomplished by substantially improving margins over that time period by moving its physical transcription activities to India.  MEDQ has also reduced selling, general and administrative expenses by about 500 basis points.  In its most recent 10-K, the Company indicated that it has won a number of meaningful sales contracts.  We believe that MEDQ's revenues will at least remain stable for 2010 and 2011 as new sales arrest the declines caused by churn of existing customers.  Shown below are two tables.  The first is the historical and projected annual Income statements for MEDQ.  Second is a table with the main assumptions with regards to the 2010 and 2011 projections.

 

FYE

FYE

FYE

FYE

FYE

FYE

 

2006

2007

2008

2009

2010

2011

             

 Sales

 $    358,091

 $340,342

 $326,853

 $307,200

 $307,200

 $307,200

 Cost of Sales

       280,273

   260,879

   230,375

   206,265

   199,784

   199,784

 Gross Margin

         77,818

     79,463

     96,478

   100,935

   107,416

   107,416

 S, G & A

         53,675

     62,288

     50,855

     33,441

     30,720

     30,720

 R & D

         13,219

     13,695

     15,848

      9,604

      9,841

      9,841

 Depreciation

         11,802

     10,988

     11,950

      9,504

      8,666

           -  

 Amortization

          5,829

      5,511

      5,554

      6,168

           -  

           -  

 Legal and Restruct

         16,443

      8,839

   100,691

     18,833

           -  

           -  

 Operating Income

        (23,150)

    (21,858)

    (88,420)

     23,385

     58,188

     66,854

 Equity inc of aff co

             874

         625

         236

      2,015

      1,400

      1,400

 Other income

               -  

           -  

         438

           -  

           -  

           -  

 Int Inc/(Exp)

          7,628

      8,366

      2,438

        (134)

           80

           80

 Pretax Income

        (14,648)

    (12,867)

    (85,308)

     25,266

     59,668

     68,334

 Income Taxes

          2,294

      2,339

    (16,513)

      1,975

      1,942

      3,371

 Net Income

        (16,942)

    (15,206)

    (68,795)

     23,291

     57,727

     64,963

 EPS

 $        (0.45)

 $    (0.41)

 $    (1.83)

 $     0.62

 $     0.88

 $     1.73

 Avg FD Shrs out

         37,484

     37,488

     37,549

     37,556

     37,556

     37,556

 

 

 

Proj. Fin Ratios

Q1 10

Q2 10

Q3 10

Q4 10

2010

Q1 11

Q2 11

Q3 11

Q4 11

2011

Sales Growth

0%

0%

0%

0%

0%

0%

0%

0%

0%

0%

Gross Margin %

35%

35%

35%

35%

35%

35%

35%

35%

35%

 

S,G and A

10%

10%

10%

10%

10%

10%

10%

10%

10%

10%

R and D

3%

3%

3%

3%

3%

3%

3%

3%

3%

3%

Depreciation

3%

3%

3%

3%

3%

3%

3%

3%

3%

 

Inc Taxes/Op. Inc

6%

6%

6%

6%

6%

6%

6%

6%

6%

5%

 

 

Industry

Mequist is one of the six largest medical transcription companies in the US.  While the Company estimates that the total US market is close to $7 billion in size the top ten competitors only capture about 15% of the overall business.  The six largest competitors are Spheris, Transcend, Webmedex, Nuance (Focus Infomatics subsidiary), CBAY Systems and Medquist. 

The US medical transcription industry is very highly fragmented, with much of the work being done by "in-house" employees at healthcare facilities.  MEDQ believes that this work is not being done in a cost effective manner and that there exists a large opportunity to sell its products and services into this market.  Many of the outsourced medical transcription organizations (MTSO's) do not have the economies of scale or sophistication to provide reliable clinical documentation in a cost effective manner.

MEDQ's goal is to exploit its cost and technical expertise edges to win additional business with current and new customers.  The move by the US government to increase the adoption of electronic health records (HER) for all Americans by 2014 will provide a rising tide for all companies in this sector.  This particular mandate is based on the International Statistical Classification of Diseases and Related Health Problems, 10th revision (ICD-10) that the US government adopted under President Obama's administration.  MEDQ is well positioned to benefit from this mandate.  MEDQ currently does business with over 30% of the non-federal acute care US hospitals.  Additionally, they have the largest customer base of any provider of technology-enabled clinical documentation services in the US, currently serving over 1,500 hospital systems, clinics and large group medical practices, including approximately 40% of hospitals with more than 500 licensed beds.

Spheris Acquisition

Spheris, which is in chapter 11 bankruptcy, is being jointly acquired by CBAY and MEDQ in a section 363 sale by the court.  CBAY is acquiring the India based subsidiary which generates about $18MM to $20MM of annual revenue and approximately $2.5MM in EBITDA.   MEDQ is acquiring the US domestic business of Spheris, which generates about $140MM in annual revenues and in excess of $20MM in EBITDA.   The announced purchase price is $116.3MM and represents about 5.5X trailing publically reported EBITDA (numbers only available through June 2009).   The deal was structured with a payment of $98.8 million in cash and an unsecured principal note in the amount of $17.5 million issued by Medquist Transcriptions, Ltd and should close later this month.

Spheris' revenues have been declining in the 15% per annum range prior to the acquisition.  We estimate that MEDQ should be able to gradually arrest this decline by the middle of 2011.  There should be significant operating synergies between the combined entities and most of those should be achieved through headcount reductions.  Our estimate is that this transaction should be accretive to earnings starting in the fourth quarter of 2010.  We have attempted to model what the combined entity will look like post transaction.  The major assumptions used to project Spheris revenues and profits are as follows:

Financial Ratios

Q1 10

Q2 10

Q3 10

Q4 10

2010

Q1 11

Q2 11

Q2 11

Q2 11

2011

Sales Growth

-15%

-15%

-15%

-10%

-14%

-5%

-3%

0%

0%

-2%

Gross Margin %

31%

32%

33%

35%

35%

35%

35%

35%

35%

35%

SG&A

16%

14%

7%

7%

7%

7%

7%

7%

7%

7%

Depreciation

4%

4%

4%

4%

4%

4%

4%

4%

4%

4%

Taxes / Op. Inc

7%

7%

7%

7%

7%

7%

7%

7%

7%

7%

 

Please note that numbers for Q1 2010 are estimates and not actual numbers.

 

Combined company

The combined company will benefit from both economies of scale and a reduction in duplicative headcount.  MEDQ has done a stellar job over the last three years increasing gross margin and reducing selling, general and administrative expenses.  Where MEDQ has been weak has been in maintaining and growing sales.  This was due to a combination of the fallout from the overcharging debacle and MEDQ's ability to lower prices to its customers without negatively impacting profitability by its move to using Indian labor and facilities for transcription.  This slide has begun to change and in its most recent 10-K the Company announced that it has won a number of new contracts which will add to revenues in 2010. We believe that the combined business can generate EPS of at least $2.00 per share in 2011 with free cash flow (EBITDA - Capex - Interest - Taxes) of greater than $90 million.  This would translate into a free cash flow yield of 24% based on today's market capitalization of MEDQ.  It also means that MEDQ should be able to repay all of its acquisition related debt by the end of 2011.  We have included a projected income statement for the Company for 2011 below. 

 

Medquist/Spheris

       

 

Income Statement (in USD$)

Proj

Proj

Proj

Proj

Proj

 

Mar

Jun

Sept

Dec

FYE

 

2011

2011

2011

2011

2011

         

 

 Sales

 $112,737

 $110,615

 $109,167

 $105,902

 $ 438,422

 Cost of Sales

     73,306

     71,926

     70,985

     68,862

    285,079

 Gross Margin

     39,431

     38,689

     38,182

     37,041

    153,343

 S, G, & A

     10,260

     10,067

      9,947

      9,632

      39,906

 Research and Development

      2,529

      2,482

      2,461

      2,369

       9,841

 Depreciation

      3,706

      3,636

      3,582

      3,484

      14,408

 Amort of intang assets

      1,635

      1,635

      1,635

      1,635

       6,540

 Cost of Restructuring

           -  

           -  

           -  

           -  

            -  

 Operating Income

     21,302

     20,869

     20,557

     19,921

      82,649

 Equity in inc of affiliated co

         700

         700

         700

         700

       2,800

 Other income

           -  

           -  

           -  

           -  

            -  

 Interest Income (Expense)

     (2,155)

     (1,605)

     (1,055)

        (505)

      (5,320)

 Pretax Income

     19,847

     19,964

     20,202

     20,116

      82,529

 Income Taxes

      1,330

      1,303

      1,283

      1,245

       5,162

 Net Income

     18,516

     18,661

     18,919

     18,871

      77,367

 EPS

 $     0.49

 $     0.50

 $     0.50

 $     0.50

 $      2.00

 Average FD Shares out

     37,556

     37,556

     37,556

     37,556

      37,556

         

 

Financial Ratios

       

 

Sales Growth

-1.6%

-0.8%

0.0%

0.0%

-0.6%

Gross Margin %

35.0%

35.0%

35.0%

35.0%

35.0%

S, G, & A

9.1%

9.1%

9.1%

9.1%

9.1%

R and D

2.2%

2.2%

2.3%

2.2%

2.2%

Depreciation

3.3%

3.3%

3.3%

3.3%

0.0%

Inc Taxes / Op Income

6.2%

6.2%

6.2%

6.3%

6.2%

Days Receivable

           -  

           -  

           -  

           -  

            -  

         

 

         

 

EBITDA

     26,602

     26,169

     25,857

     25,221

    103,849

           

Risks

  • 1. MEDQ can't properly integrate the systems and business of Spheris causing revenues and profitability to suffer
  • 2. The distraction of the acquisition causes MEDQ to lose focus of cost controls and revenue growth at the Company.
  • 3. Increased competition.
  • 4. Increased use of voice recognition software instead of human transcription.

Catalyst

 
  • 1. Introduction of sell-side analyst coverage. It is unusual for a company with a market capitalization of $365 million to have no real coverage.
  • 2. Increased earnings and free cash flow from acquisition of Spheris.
  • 3. Dividends of excess free cash flow to investors. The Company has a history over the last two years of returning excess cash to investors. This has amounted to $4.08 per share paid out in total for 2008 and 2009.
  • 4. Sale of the business. SAC Capital will look at some time to monetize it's invest in MEDQ. If MEDQ continues to trade at lower multiples of cash flow it would make a nice leveraged buyout candidate due to the recurring revenue nature of its business.
  • 5. Obama administrations $14 billion commitment to the increased use of electronic based medical records.
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