Description

Medical Facilities Corp. is an undervalued company with strong cash flow where there has been a positive change in capital allocation and corporate strategy. Medical Facilities trades at an attractive valuation of only 7x P/FCF, has a large and active stock buyback in place, and is trying to sell one or all of its underlying facilities (which based on comps, would fetch much more than the implied value today).  When looking through to the facility level EBITDA, which I would argue is most applicable to an acquirer,  shares are trading at only 4.9x EV/EBITDA.  If their two larger, more valuable facilities (Black Hills and Sioux Falls) were to sell for 8x EBITDA and the remaining facilities at 6x EBITDA, shares could be worth up to 16.30 CAD.  In a more optimistic scenario, if their larger facilities sell for 10x EBITDA, and the remaining facilities 7x, shares could be worth up to $20 CAD.

Background

Medical Facilities Corp. owns 4 surgical hospitals in the United States but the stock trades in Canada.  Historically, Medical Facilities paid a very large annual dividend in monthly distributions, yielding 6-8% and even above 10% at times.  This large dividend attracted a retail shareholder base and things hummed along nicely until 2019.  Subpar acquisitions financed by debt were underperforming and the dividend was outpacing profits forcing the company to slash the dividend by 75%.  This led the shareholder base, which largely owned the stock for the dividend, to rush for the exits pushing the stock price down over 65% in 6 months.

Not long after all this happened in 2019, COVID further impacted the business and outlook beginning in early 2020 and the stock languished for some time.  Although partly due to government assistance, the company delivered strong FCF and paid down debt considerably in 2020 and 2021.  With a cleaner balance sheet, manageable dividend payout, and improving business prospects the company was finally in a position to more effectively allocate excess FCF. 

Strategy Change

 Some institutions took notice during this period and began purchasing stock, appointing their own board members (now a majority of the board), and eventually replacing most of the management team.  The new institutional shareholders had clear goals: end all acquisitions, divest non-core assets, and put excess FCF towards buying back stock.  The company publicly announced this strategy change in September of 2022 and repurchased over 10% of the company in a tender offer.  Since then, the company has pursued further corporate costs cuts, continued repurchasing stock (100k-150k shares/month), and is still exploring more divestiture options for non-core assets.

When you cut through all the obvious negative shareholder sentiment and focus on the financials, it’s easy to see why institutional investors took notice and are so eager to divest non-core assets and repurchase as much stock as possible.  The company produces lots of FCF and nearly all of the FCF comes from two high-performing, orthopedic-focused surgical hospitals.  The stock also trades at only 4.9x EV/EBITDA and 7x P/FCF.  These multiples are attractive on an absolute basis due to the steady, durable profits and long-term tailwinds of their orthopedic-focused surgical hospitals.  The multiples are even more attractive on a relative basis.  The closest comparable is US-listed Surgery Partners (SGRY) which trades at over 17x EV/EBITDA and regularly acquires smaller, less-attractive surgical hospitals/ASCs than Medical Facilities at 8x EBITDA or higher.  While SGRY itself is not a perfect comparable due to its larger size, operational expertise, and an effective roll-up strategy, the multiples they are willing to pay for facilities is very relevant. 

There are also many other transactions in the ASC space that further support valuation ranges of 7-10x EBITDA for smaller transactions and 12x EBITDA or more for much larger practice groups or higher quality facilities.  While not apples to apples, some recent transactions are well above 12x:

• Nov 2023: Tenet Healthcare (owner of USPI, large ASC/surgical hospital owner) sold 3 SC hospitals to Novant Health for $2.4B.  Facilities generated ttm Adj EBITDA of $150M, so transaction was at 16x EBITDA.

• Feb 2024: Tenet Healthcare sold California hospitals to UCI Health for $975M.  These facilities generated ttm Adj EBITDA of $71M, so transaction was at 13.7x EBITDA.

These transactions are both for acute-care hospitals, rather than surgical hospitals, but point to health transaction multiples, especially among the larger players.  Interestingly, Tenet chose to keep their ambulatory and other surgery facilities associated with the SC hospitals sold to Novant, perhaps showing their preferred facility type.

Given these huge disparities, continuing to divest non-core assets, direct all excess FCF to share repurchases, and eventually sell some or all of the facilities should result in very attractive returns for shareholders.  Simply selling the existing business at 8x EV/EBITDA would result in a return of over 70%, but smart capital allocation until selling the facilities will be very accretive and further increase returns.  I also believe the top performing facilities are likely worth 10x EBITDA or more given their strong operating histories and orthopedic-heavy procedure mix.  The most accretive scenario could be selling one or both of the smaller facilities, generate somewhere around $50-60M of net proceeds (ballpark if sold at 6-8x EBITDA) then do another large tender offer prior to selling the two crown jewels at 10x+ EBITDA.

Financials

There are a number of non-cash charges in the financials as well as distributions to minority holders at the facility level.  In calculating FCF or EBITDA, I think it’s best to start with total adjusted EBITDA then deduct payments to minorities, corp share of leases, etc.  There is also a sizable exchangeable interest liability on the BS that should be ignored if you’re using Medical Facilities actual ownership of the facilities.  This is simply an option that minority holders at some of the facilities have to exchange their facility ownership for shares in Medical Facilities.  I assume they will not be converted but if they were it would be accretive to Medical Facilities shareholders as we would own a larger percentage of the facility at a relatively attractive conversion rate. It’s also important to remember that the financials are in USD, yet the stock trades in CAD.  So a conversion on either the market cap or financials must be made to calculate correct multiples.

Summary

In summary I believe this is an attractive special situation where selling pressure has led to a large price decline that has nothing to do with the business fundamentals.  And now with the right capital allocation strategy in place to take advantage of the undervalued stock, prospective returns over the next 2-3 years look very attractive as they execute and eventually sell some or all of the facilities.

Risks

-Even though Medical Facilities has majority ownership in each facility, any acquirer will likely want to make sure the minority owners are ok with having a new owner.  There is a risk minority groups at each facility could be a hindrance to a sale of their facility.

-While I think inflation-related cost pressures are mostly behind them, they have been a headwind to operating margins the last couple of years and that could persist longer than I expect.

Catalyst

-Continued share buybacks and future tender offers

-sale of one or all of the faclilities

-or alternatively, if a sale of the facilities is not feasible, reintroduction of large dividend of the majority of FCF