Description

I recommend taking a short position in Orthodontic Centers of America (OCA). Quite simply, I believe that OCA’s operating and financial results are very suspect. Moreover, OCA has a dubious business model and is outrageously valued at its current price ($26.40). Below is an explanation of why the company’s business model is lacking and why I believe that OCA drastically overstates its earnings. Companies such as OCA with glaring accounting and reporting issues will be severely punished in this market when they are exposed—it is only a matter of time. OCA’s behavior is pretty much par for the course in the physicians practice management industry, which does not exist anymore because all of the companies have gone bankrupt. OCA is still standing and to the casual observer seems to be a healthy, growing company that represents the exception in the industry. Look again. The following is primarily derived from my examination of the company’s SEC filings.

OCA describes its business model as a provider of integrated business services to orthodontic and pediatric dental practices. OCA’s true business model is acquiring an ownership stake in (what OCA terms “affiliating” with) orthodontic practices primarily in the U.S. and in a few foreign countries (Japan, Mexico & Spain). As of March 31, 2002, OCA had 367 affiliated practices, 869 affiliated centers and 617 affiliated practitioners. Out of this total, 118 practices, with 264 centers and 156 practicioners were acquired in the acquisition of Orthalliance, a struggling competitor, in November of 2001. A “practice” is your typical plain vanilla orthodontic practice. After OCA acquires a practice, it generally opens multiple centers, or offices, per practice so that the orthodontist who runs the practice can see patients in various geographic areas within a given city. Often, there is a practitioner who works within the practice but is not an owner in the affiliated practice (there is typically one orthodontist per practice and the second person in the practice--if there is a second person--is a non-owner dentist that performs orthodontic work). These practicioners are generally considered associates or employees of the practice. So, to sum up the above, OCA has 367 practices. There are on average 2.37 centers or offices per practice and 1.68 practicioners per practice.

OCA’s strategy, as quoted from their 10-K, is to “focus our recruitment of orthodontists and pediatric dentists with existing practices on those who generate less than $500K of annual patient revenue prior to their affiliation.” Also, according to OCA’s 10-K, the average U.S. orthodontic practice in 2000 earned revenue of $713K and pre-tax income of $350K in 2001. Therefore, OCA is targeting significantly below average orthodontists for affiliation. When OCA “affiliates” with an orthodontic practice, it signs an agreement whereby OCA pays the orthodontist currently running the practice an upfront fee and enters into an arrangement whereby OCA provides a wide range of services to the practice including marketing and advertising, management information systems, staffing, supplies and inventory, scheduling, billing, financial reporting, accounting, and other administrative and business services. In approximately 95% of OCA’s service agreements, the orthodontist does not have control over the practice's business management, including such matters as advertising, hiring and termination of staff and the purchase of equipment and supplies. OCA is also generally responsible for billing and collecting patient fees and once the funds are collected, they are generally deposited into a bank account that OCA establishes and maintains. OCA generally has sole signatory authority over these bank accounts and the exclusive responsibility for any disbursements to the orthodontist.

In exchange for the upfront fee and the services listed above, OCA is entitled to receive 40% of an affiliated practice’s operating profit post-affiliation. The orthodontist supposedly retains the other 60% of operating profit. In addition to receiving 40% of the operating profit of a practice, OCA is reimbursed for all direct expenses of the practice.

Below is an explanation of how OCA calculates the upfront fee that they pay to a practice upon “affiliation”:

OCA affiliates with a practice by entering into a service agreement with the practice. A typical practice that OCA affiliates with has less than $500K of revenue pre-acquisition and a 40% operating margin. Therefore, the operating profit is $200K and OCA is entitled to 40% of that operating profit post-affiliation ($200K * 0.40 = $80K). OCA pays an upfront fee of between 4x and 5x their pro-forma share of operating profit for the practices, or $320K to $400K. This fee is paid in a combination of cash and stock (usually 75/25 cash/stock). The stock vests over a 180 day period. OCA records this expense under cash flow from investing activities and debits the balance sheet for an intangible asset of the same amount. That intangible asset is then amortized over 25 years, which is what OCA deems the life of the service agreement with the orthodontist.

Valuation

What first got me interested in this stock is the valuation, which seemed normal on a P/E basis, but very abnormal on a per practice basis. OCA has 52.877 fully-diluted shares outstanding and the current price is $26.92 per share for a fully-diluted market cap of $1.423 billion. Debt is $125 million and cash of $16.5 million gives an enterprise value of $1.531 billion. Given that there are 367 practices, this works out to a value per practice of $4.17 million. But OCA is only entitled to 40% of the practice’s operating profit, so the implied value per practice is really $10.43 million ($4.17 / 40%). This seemed like a huge value for practices that were generating less than $500K of revenue prior to their affiliation with OCA, but the forward P/E of 17.5x certainly seemed reasonable for a high-growth company. I could not figure out what OCA was doing to take a practice that was being valued at between $0.8 million and $1.0 million at the time of affiliation ($500K * 40% operating margin = $200K * 4x – 5x) with OCA and turning those practices into $10 million businesses in the public markets. And how could earnings be so substantial?

Business Model

So what is OCA doing to create a value per orthodontic practice of approximately $10.4 million when these practices were earning less than $500,000 of revenue and between $100,000-$200,000 of profits, all of which was essentially paid as a salary to the practice’s key employee, the orthodontist, prior to acquisition? And what do the orthodontists receive in return for giving up 40% of their business’ profits? And how does OCA take the worst performing orthodontists in the industry (a good number of them are probably the laziest), pay them with a big upfront check and stock that has virtually no vesting period, and then make them the most productive in the industry? Here is how the company explains its value-add:

· OCA stimulates demand for orthodontic services through marketing and advertising through radio, TV, print and internal marketing promotions. OCA spent an average of $75,250 in 2001 per affiliated orthodontist on advertising and marketing in 2001 (up from an average of $66,439 per affiliated orthodontist in 2000 and $66,426 per affiliated orthodontist in 1999). This compares to the national average of $4,820 per orthodontist for traditional practices in 2000.

· OCA boasts that “our innovative office designs permit an affiliated orthodontist to treat patients without moving from room to room. Our proprietary patient scheduling system groups appointments by the type of procedure and dedicates certain days exclusively to new patients”. Pretty impressive, huh?

· OCA provides its practices with “advanced technology” to increase the efficiency of affiliated orthodontic centers and to improve integrated business services. OCA claims that its operations are supported by computer systems, including patient scheduling, billing and collection, financial and statistical reporting, accounting, inventory control and purchasing.

· OCA also provides an on-line inventory order system, which allows its affiliated orthodontic centers to order supplies directly from vendors through our private computer network. The order system is designed to reduce supply costs, associated administrative costs, shipping time and storage requirements, and to improve the accuracy of orders placed and the flow of information between vendors and our affiliated orthodontic centers.

While the average orthodontist treats 50 patients per day, OCA affiliated orthodontists treat 76 patients on average.

So why are people so eager to get their braces from OCA affiliated practices? While almost all orthodontic practices require a 25% down payment from patients at the start of treatment, OCA requires no down payment (although the Orthalliance practices do require a downpayment of 25%). OCA attracts clients because it is cheaper as well. The fees charged by OCA per patient treatment averaged $3,197 in 2001 vs. the national average of $4,216. OCA’s average fee of $3,197 is slightly lower than the average orthodontic fee in 1991 ($3,221) for all U.S. orthodontic practices, so OCA is about ten years behind the rest of the industry in terms of pricing. In 2001, approximately 13% of the fees paid to OCA practices were paid by a third party payor and the remainder was paid by the patients out-of-pocket.

Accounting Post-Affiliation

Once OCA affiliates with a practice, the accounting is as follows (two hypothetical practices and then how these practices are accounted for at the corporate level—all taken directly from a recent OCA slide given out at an investor presentation).

1. OCA is entitled to 40% of an traditional OCA practice’s operating profit
2. OCA is entitled to approximately 17% of an Orthalliance practice’s revenue

Hypothetical Practice level Financial Results

OCA Practice Orthalliance Practice
Revenue $1,000,000 $1,000,000
Expenses ($400,000) ($500,000)
Operating Profit $600,000 $500,000
% OCA’s portion of oper profit 40% of oper. profit 17% of revenue
$ OCA portion of oper profit $240,000 $170,000
Doctors’ portion of profit $360,000 $330,000


How these Two Practices are Then Accounted for at OCA Corporate

OCA Corporate

Not in OCA’s Income Statement
Gross Revenue $2,000,000
Less: Doctor’s portion ($690,000)

Included in OCA’s Income Statement
Net Revenue $1,310,000
Expenses ($900,000)
Operating Profit $410,000

Note that OCA only shows net revenue in its income statement. Nowhere in its filings can you get the gross revenue number.

Earnings Quality?

My next focus was on earnings quality to figure out the disparity between the P/E, which seemed reasonable, and the value per practice, which seemed astronomical. OCA is projecting $1.54 of EPS for 2002. Below is a build-up of OCA’s projected earnings and a reconciliation of these earnings on a per practice basis.

Projected 2002 EPS $1.54
Fully-Diluted Share Count (as of Q1) 51.787 million
Implied Net Income $79.8 million
Effective Tax Rate (as of Q1) 37.7%
Implied Pre-Tax Income $128.0 million
D&A (Q1 annualized) $21.8 million
Interest (Q1 annualized as a proxy) $5.4 million
Estimate of Corporate Overhead (conservative) $10.0 million
Practice level EBITDA contribution $165.2 million
Total practices as of 3/31/02 367
Per practice EBITDA to OCA $450K
OCA’s stake in practice EBITDA 40%
Implied practice level EBITDA $1.125 million

So, in order for OCA to legitimately meet its $1.54 EPS projection, the average practice would have to earn $1.125 million of EBITDA. At an operating margin of 55% (taken from their website as the average mature practice operating margin), this implies average revenue per practice of $2.05 million. OCA has successfully avoided giving average practice level operating results for the past few years. According to OCA’s SEC filings, “newly developed orthodontic centers typically generate operating losses during their initial 12 months of operations”. I believe that at least 95 practices, or a full 26% of OCA’s total practices as of 3/31/02, were most likely generating operating losses as of 12/31/01, making the earnings projection more difficult to believe.

How Can This Be The Case?

The financials statements indicate that OCA is hiding costs on its balance sheet (capitalizing an inordinate amount of expenses). OCA has never reported free cash flow (operating activities – investing activities) on an annual basis, despite the wonderful economics that management describes. Below is a description of the various balance sheet accounts that I believe OCA uses to obfuscate economic reality and keep expenses off of its income statement.

Every year, OCA’s 10K states that “our capital expenditures consist primarily of the costs associated with the development of additional orthodontic centers”. OCA’s 1999 10-K stated that “the average cost of developing a new Orthodontic Center is approximately $255,000, including the cost of equipment, leasehold improvements, working capital and start-up losses associated with the initial operations of the Orthodontic Center”. Obviously some of these costs, such as start-up operating expenses, should not be included as capex, but to be ultra-conservative, I am assuming that each practice actually costs $255K to build. OCA developed 36 new centers in 1999. This implies total required capex of $9.2 million. OCA’s total purchases of property, plant & equipment were $22.5 million in 1999. The average cost of building a new center in 2000 according to OCA’s 2000 10-K was $255K. In 2000, OCA developed 18 new centers. Therefore, the total capex for these centers should have been $4.6 million in 2000. OCA’s total purchases of property, plant & equipment were $20.3 million in 2000. The average cost of building a new center in 2001 according to OCA’s 2001 10-K was $325K (prices went up a lot since the prior year I guess). In 2001, the company developed 28 new centers. Therefore, 28 practices should have required $9.1 million of capex. On property, plant & equipment alone, OCA spent $22.1 million in 2001. Cumulatively, from 1999 to 2001, OCA spent approximately $42 million of unidentified capex (how is Orthodontics so capital intensive)? Where did the rest of the property, plant & equipment go each year? How can capital expenditures “consist primarily of the costs associated with the development of additional orthodontic centers” when in 1999, 2000, and 2001, the cost of developing new centers only accounts for 41%, 23%, and 41% of total property, plant & equipment purchases, respectively?

One naturally assumes that OCA acquires a practice with an upfront fee then receive an annuity stream of operating profits from the practice. Not the case. In OCA’s 2000 10K, the company states that in 2000 it “made payments to orthodontists or orthodontic entities with which we affiliated in earlier periods, with a total acquisition cost of about $34.2 million”. OCA deems these payments to orthodontists with whom they are already affiliated “amendments” to the service agreement. In its 8-K filed on 5/9/02, OCA states that “investment in intangibles generally represents consideration paid to our affiliated practices in return for amending or initiating service agreements with us.” “We currently anticipate that cash flow from investing activities for fiscal year 2002 will be between approximately $(35) million and $(45) million. We believe that the majority of this investment will be directed toward growing existing centers, extending service agreement terms with our existing affiliated practices and de novo growth internationally.” Why is OCA making such large payments to orthodontists that they had affiliated with in prior years? If OCA adds so much value and the doctors are so pleased with the arrangement, why does OCA have to amend the service agreements? If the service agreement is really for 25 years, why do they have to “extend” it? Perhaps it is because OCA is stripping all of the profits out of the practices through hourly service fees and other expenses that OCA allocates to the practices so that OCA actually records significantly more than 40% of the practice’s true operating profit. I believe that instead of having the orthodontists take 60% of the operating profits, it compensates them through the intangible assets account, which gets amortized over 25 years, and therefore barely reduces reported earnings. The orthodontists would have no idea about the accounting, as OCA collects all receivables anyway. As long as they are getting paid, what do they care how many fees and costs OCA decides to allocate to their practice or if their practice is even profitable? Even if the payments are lumpy and in the form of amendments to service agreements, the doctors do not care.

The issue of “amending service agreements” brings up more issues related to the quality of OCA’s earnings. How can Ernst & Young allow the company to amortize the intangible assets over 25 years when OCA is constantly amending & extending the service agreements, which clearly indicates that the asset has a much shorter life than 25 years? OCA does not disclose this in its filings, but when it affiliates with an orthodontist through a service agreement, although the service agreement may have an average life of 25 years, the orthodontist’s employment agreement and non-compete is only for seven years. It is obvious that the only asset of a practice is the orthodontist. How can OCA claim that the service agreement is for 25 years, then?

The intangible assets account on the balance sheet seems inflated, too. The intangible assets account represents the excess of the purchase price over the tangible assets of the practice being acquired. As of 3/31/02, the net amount of intangible assets on the company’s balance sheet was $229.1 million. Accumulated depreciation was $34.9 million as of 3/31/02. Therefore, gross intangible assets are $264.0 million. The company currently has 367 practices, but 118 were acquired in the Orthalliance transaction. Therefore, net of the practices acquired from Orthalliance, the company developed or acquired 249 practices (the Orthalliance acquisition was booked as goodwill, not intangible assets). This results in intangible assets per practice of slightly greater than $1.0 million. However, the intangible assets recorded in a transaction are only supposed to represent the excess of purchase price over the tangible assets acquired, so the actual purchase price would be higher than $1.0 million per practice. Given that OCA has stated that it acquires the average practice for approximately $320K-$400K (newly developed practices are obviously cheaper), this does not add up unless OCA is continually paying the orthodontics through the intangible assets account.

Perhaps the most dubious balance sheet account is “advances to affiliated practices”. Every OCA 10-K describes this account as follows: “advances of about $40,000 to newly-affiliated practices during the first year of an affiliated center’s operations, which advances bear no interest and typically are repaid during the second year of the affiliated center’s operations”. As of 3/31/02, the total amount of “advances to affiliated practices” on the balance sheet was $33.6 million. At $40K per practice, this balance sheet account suggests that 840 practices all have full drawn-downs on this advance (none have paid any back even though they are so profitable). OCA only has 367 practices and even if you go by affiliated centers, OCA only has 869. In the 2001 10-K, it states that “of the advances at December 31, 2001, approximately $3.8 million was to affiliated practices that generated operating losses during the three months ended 12/31/01.” At $40K per practice, this implies that 95 practices, or 26% of total practices, were generating operating losses as of 12/31/01. Another way to look at is that in 2001, the company advanced $7.9 million to affiliated practices. At $40K per practice, this was sufficient to fund 198 practices.

OK—So When Does OCA Crack?

I can not imagine how any institution can be long this stock in this environment, even if they were not aware of the issues raised above. OCA has been slapped on the wrist in the past for aggressive revenue recognition and had to restate its 2000 financial results (the cumulative effect of which was to reduce the reported net income by a whopping $50.6 million). Without this accounting change, OCA would have reported net income of $47.7 million in 2000, so the accounting change represented 106% of net income. This company obviously has massive accounting issues, so when they are exposed by a source with more authority than myself, the stock is toast. I can not speculate as to when this will happen, but as with Tyco and Enron, these things take time.

A few pieces of evidence suggest to me that judgment day is coming sooner rather than later. OCA is struggling for growth. The acquisition of Orthalliance was completely illogical. The company is being sued by 55 Orthalliance orthodontists and the number of Orthalliance orthodontists that join the suit and choose to turn down a large upfront bribe from OCA increases quarterly. At 12/31/01, the number of orthodontists from Orthalliance suing OCA only numbered 38. These orthodontists do not want to be associated with OCA—I do not blame them. I can not speculate as to how these suits will turn out, but they challenge the legality of OCA’s business model, so if they are successful, OCA could be in a lot of trouble.

OCA’s growth prospects are dim. Only 200 accredited orthodontists graduate in the U.S. every year and the number of orthodontists practicing in the U.S. has remained at about the same level since 1989. OCA has begun to expand internationally, which is essentially a joke in my opinion. Here is what OCA had to say about international expansion in its 8-K—“We are very excited about what is occurring internationally. At this time, we are not going to provide separate income statement data for our foreign affiliates. We can tell you that our goal is to add between 15 and 20 affiliated orthodontic centers in Mexico and over 10 affiliated orthodontic centers in Japan during 2002.” There are 20 OCA affiliated orthodontists in Japan, 2 in Mexico, 2 in Spain, and 2 in Puerto Rico for a total of 26 OCA affiliated orthodontists internationally. According to OCA’s 10-K, as of 12/31/01, these 26 orthodontists had taken down $9.4 million of “advances to affiliated practices” from OCA. That averages out to $361K per orthodontist—far more than the $40K per practice that OCA describes in its 10-K. This is in addition to the upfront fee to acquire OCA’s share of the practice that was paid to the orthodontists. I am not quite sure how OCA management could possibly be excited about this. Other growth initiatives such as raising patient pricing are likely to severely affect patient volumes (who wants to go to an orthodontic factory if you are paying the same price as a legitimate practice where the orthodontist will spend time with you). All of the growth initiatives are dubious and with the Orthalliance transaction, the company showed its hand—I believe that they will fold soon.
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