Description

Long MDKI and short DCAI

This is not a complicated trade although it may be volatile because the two companies involved are small cap and do not have analyst coverage. It was also written up a little bit over a year ago by hkup881 and up to today it would have been a very poor trade.

Dialysis Corp of America (DCAI) operates outpatient kidney dialysis centers. In the past two and a half months, the stock has risen from under $5 to $18.27 at the close on Friday.

Medicore (MDKI) over time has been involved in a variety of businesses but currently appears to wholly own a distributor of medical products and an equity interest in a private software company, neither of which is significant compared to its 56.8 percent stake in DCAI. That stake per share of MDKI is equivalent to about .69 of a share of DCAI, which would be worth $12.59 at closing prices Friday. MDKI closed at $8.70 on Friday.

DCAI’s current market cap is slightly over $150 million. It currently has 22 kidney dialysis centers and in the first nine months of the year it performed just under 107,000 treatments (suggesting to me about 1000 patients at 3 treatments per week) and had $29 million dollars of revenue. Net income was just under $1.5 million.

I am agnostic to suspicious of DCAI’s valuation. No doubt it has risen on the prospect of more favorable regulation and of consolidation of the industry.

I am not an expert in the sector, but I would that at the announced price that DaVita is paying for Gambro’s facilities, DaVita is paying about 1.7 times trailing 12 month sales. DCAI is currently trading at 4.2 times trailing 12 month sales or 3.5 times annualizing the most recent quarter. While it is always conceptually possible that DCAI has better patients or more profit potential per sale or some other value metric I am not properly understanding, I think that it is a hard case that DCAI is deeply undervalued. (A case for DCAI was made by otto695 in August of 2002. At that point DCAI was valued at $16 million. If I am right on patient count, using his $50,000 per patient metric, DCAI today should be worth about $50 million.)

MDKI has been involved in a multitude of businesses across time. Currently DCAI is its only major asset. It also has a medical products division which has done $612 thousand in revenues to date and has lost just under $100 thousand. It also has a 14 percent interest in a private software company called Linux Global Partners and a $400,000 receivable related to another Linux business that appears likely to be paid in August 2005 (they got paid $400,000 in August of this year on the same receivable).

MDKI has three other major aspects worth understanding. There appear to be about 425,000 in the money options; the managers appear to pay themselves about $1.3 million a year out of MDKI’s profits and lining up MDKI’s balance sheet against DCAI’s (which MDKI consolidates) suggests that MDKI has approximately $7.5 million in cash that belongs exclusively to it and no liability of any similar size. (This number is the difference between the cash reported on MDKI’s balance sheet and the cash on DCAI’s)

According to the DCAI proxy. MDKI owns 4.821 million shares of DCAI or 56.8 percent. In a recent Investors Business Daily story about DCAI, MDKI is reported to have a 72 percent stake in DCAI. In a phone call, I later had with the reporter, he claimed that this ownership level was provided by the company. I doubt he is right but it is conceivable for reasons not disclosed in the public filings that MDKI’s stake is higher than reported. My calls to the managements of both companies have thus far gone unanswered.

At DCAI’s Friday closing price, MDKI’s stake in DCAI without a tax adjustment would be worth $88 million. MDKI’s market cap at the close on Friday night was just under $61 million and maybe as high at $63 million after accounting for the options (including tax benefit and exercise proceeds). Consequently the market is putting a negative $25 million dollar value on the following:

1) $7.5 million in cash
2) $400,000 receivable from a sale of a Linux business
3) $1.3 million in annual payments to executives
4) A small stake in a private Linux concern of indeterminate worth
5) A medical supply business that loses about $130 thousand a year.


Putting a value of zero on the two businesses and treating the payments to executives as an annuity with a 7 percent discount rate and a 35 percent tax rate (which gets me just over $12 million dollars). I get a negative value of a little under $5 million. That suggests a relative underpricing of MDKI relative to DCAI in the market of almost $3 a share.

One could argue that MDKI’s holdings in DCAI are probably at a very low tax basis. But there are a variety of ways that this could be overcome – including a spinoff of the business to shareholders, or (I believe) a purchase of MDKI by DCAI. Best I can tell, Thomas Langbein, who is the CEO of MDKI and the Chairman of DCAI owns 20 percent of MDKI but only 5.5 percent of DCAI. That fact suggests to me that he would probably not want to create adverse tax consequences for MDKI holders. I have no idea if management is contemplating such a transaction.

There are two main risks to the pair trade. The most obvious is that the spread continues to widen because of the technical strength of DCAI (which is now an IBD sweetheart) or the lack of knowledge of the folks buying DCAI of the existence of MDKI (if they are genuinely purchasing DCAI for long-term value reasons).

I would add to this general trading dynamic concern that in the MDKI proxy, Thomas Langbein is listed as being the owner of an inactive broker dealer called Todd & Co. I have no reason to suspect bad behavior, but the price action in DCAI feels somewhat manipulated to me and in the world of Travelzoo and Taser, that’s a risk.

The second is that between the SOTT (something off the top) that MDKI management seems to be taking out of the company and the possibility of poor capital allocation by MDKI management that the market has it right.

On the latter point one should question why management would take a greater SOTT out of the company where they have a greater percentage shareholding. On the former point, a chart of MDKI’s share price as a percentage of DCAI’s share price for the last two years shows a strong level of reversion to a level around .7. Currently that ratio is about .48.

Because of the possibility of irrational pricing in small caps with momentum,I don’t think that this can be a very large position in any portfolio but I think that the likely of a reversion to the value of the MDKI stub being about 0 is pretty likely over time.

Catalyst

recognition by the purchasers of dcai of the existence of mdki.