Description

Medquist (MEDQ) provides health information solutions and services to meet clients’ medical document management needs. Medical document management includes medical transcription as well as other services and products related to health care information management such as coding, digital dictation systems, handheld units, and speech recognition. The company has over 2,700 clients in the U.S. and operates over 110 client service centers and satellite offices. Headquarters are in Marlton, New Jersey.

MEDQ possesses a very strong balance sheet and generates a large amount of free cash flow. Specifically, it ended the third quarter with $144 million in net cash and has generated over $60 million in free cash flow in the last twelve months on a current market cap of $611 million. Moreover, approximately 88% of revenue is from recurring contracts.

Price: $15.78
Shares: 37.2 million
Market cap: $587 million
Total debt: $0.1 million
Cash: $144 million
Aggregate value: $443 million

LTM Operating Cash Flow: $80 million
LTM Capital Expenditures: $18 million
LTM Free Cash Flow: $62 million

Year-end is December 31.

MEDQ processes nearly 3 billion lines of transcribed text annually for its clients, which is nearly 5 times the volume of its largest competitor. Philips Electronics holds a 70% stake in MEDQ, which it acquired in June of 2000.

MEDQ has gross margins of 25% and operating margins of 13%. Based on the amount of cash that MEDQ is capable of generating both historically and in the future, shares of this company are currently very cheap.

Price/LTM Free Cash Flow: 9.5x
Aggregate Value/LTM EBIT: 7.1x
Price/LTM Revenue: 1.2x

Risks

Pricing pressure. Small competitors in the medical transcription business, based both in the U.S. and abroad, have been seeking to increase the number of their clients via aggressive pricing tactics. MEDQ believes that its own specialized products differentiate it from the competition, but the recent weakness may signal that customers are more willing to look to alternative providers. I believe that increased or sustained pricing pressure represents the key risk facing MEDQ and thus ought to be the area of primary concern for potential investors.

Management change. Chairman and CEO David Cohen, who had been with MEDQ for 30 years, announced in January of 2003 that he would retire upon the expiration of his employment agreement in July of 2003. The company announced on August 28, 2003 that Timothy Stack would replace Cohen as the new President and CEO. The loss of such an experienced leader is obviously a challenge for the company, but Stack has extensive experience in the medical industry as head of several major hospitals and provider organizations, which should allow him to grasp quickly the needs of MEDQ’s clients. Further, Stack used to be a director of MEDQ, so he should already have a solid understanding of the business.

Acquisitions. MEDQ has historically grown its business through a lot of acquisitions in addition to internal development. Indeed, it has acquired 50 companies since 1994, when it purchased its first medical transcription business. The company’s most significant recent acquisition was Lanier Healthcare in July of 2002. Lanier derives revenue from the sale and implementation of voice-capture and document management solutions and maintenance service of these products. It is not clear how much synergies Lanier provides, and the acquisition has resulted in higher expenses for MEDQ. Management must make more progress on integrating this acquisition. Investors should also be wary of further acquisitions which could distract management – especially at a time when opportunities in the core business remain attractive.

Delay in filing 10K. MEDQ delayed filing its 10K on Tuesday, March 16. It cited a continuing review of potential improper billing practices. It is going to record a reserve of $1.5mm regarding the billing issues, although the exact amount of the reserve will not be known until the review ends. MEDQ says it believes some clients have been overcharged, while others have been undercharged. 10K should be filed by March 30.

Catalysts

Stock drop is an over-reaction. MEDQ stock was hammered in October and November following the announcement of third quarter earnings. It appears as though Wall Street was disappointed, as all too often tends to be the case, by the company’s inability to show stronger growth. However, the current lowered expectations on Wall Street provide MEDQ with easier targets to meet. The price has again been hit hard in March - especially now that the filing of the 10K has been delayed. The company is probably holding too much cash on its balance sheet ($3.86 per share), which could be more effectively deployed by paying a dividend (repurchasing stock would make sense but may be less likely due to the already high level of ownership by Phillips).

Turn in hospital industry cycle. MEDQ is currently hampered by an unusually difficult operating environment for the U.S. hospital industry. As a result, the company has experienced reduced unit volumes for its higher priced applications. However, MEDQ will certainly be a major beneficiary when trends in the hospital industry turn positive.
Rollout of digital platform. MEDQ will continue the rollout of its digital platform, which is currently one quarter behind schedule. Despite the current challenges, MEDQ’s gross margin of 24.5% in the third quarter were an 80 basis point improvement from the same period last year. As the digital platform gains traction with customers, the company will be able to improve gross margin going forward.
Cost cutting. SG&A expenses represented 6.5% of revenue in the third quarter and increased over last year. CEO Stack has only had a few months on the job, but it is likely that he will be able to reduce costs as a percentage of revenue over time and as more progress on integrating acquisitions is made.

Catalyst

1. Stock price drop is an over-reaction
2. Filing of 10K
3. Turn in hospital industry cycle