Description

Context:

• Above TEV excludes minorities because Street focuses on EBITDA - NCI given SGRY's partnership model. I'll be explicit in write up on which TEV and/or EBITDA I'm using. EBIT and multiples above are CapIQ consensus so ditto on treatment of those metrics
• Stock peaked above $14 in the beginning of the 2018, fell to less than $6 after Q2, and has tripled off August 2018 lows to today (feels like when crap caught a bid in the short squeeze in 2018)
• My prior USPH write-up is probably useful as SGRY's model and accounting is fairly similar, including meaningful payments to minorities in the financing section of the cash flow statement that seemingly go ignored

Summary Thesis:

• Broken PE Roll-up: SGRY is a broken PE roll-up / IPO followed by additional PE transactions post IPO (this bullet may be enough for some of you to put the short on)
• Competitively Challenged: peers are better capitalized and are often affiliated with larger health organizations, giving them multiple advantages
• Poor Unit Economics: low organic growth, value accrues to doctor partners, FCF is non-existent, and returns are below the cost of capital
• Overvalued: premium valuation vs. prior deals for cash generating businesses with superior balance sheets, nonsense valuation relative to replacement cost, and as mentioned above no FCF
• Improving Trading Dynamics: stock has been squeezed, but over-levered capitalization will either outpace earnings or PE will exit and float will free up

Business Background:

• Owns and operates a network of surgical facilities on leased properties, consisting of over 100 ambulatory surgical centers (“ASCs”) and approximately a dozen surgical hospitals
• Debt-financed private equity roll-up and came public in a disappointing IPO that priced well below the anticipated valuation range
• Earns revenue from facility fees related to healthcare services performed in its centers
  • The fees vary depending on the type of services provided but in most cases cover the use of an operating room, a recovery room, equipment, supplies, nursing staff and medication
  • However, the fees do not include professional fees charged by the patient’s surgeon, anesthesiologist, or other attending physician, which the doctors bill directly to the patient or third-party payer
  • Physicians are partners practicing independently rather than employees, so SGRY is more or less providing a commoditized box for partner case volume
• SGRY doesn’t normally own the land and is on the hook for long-term property and equipment lease obligations

Bull Case:

• Outpatient surgery volumes will continue to grow and take share of total surgeries due to improved procedural efficiencies and cost benefits relative to inpatient settings
• ASCs’ will successfully target higher-value / higher-margin specialized treatments or procedures
• Physician’s will benefit from increased flexibility (can schedule without having to accommodate hospital’s acute and emergency workload)
• Larger operators will further consolidate a fragmented market
• Note that the above points might be true for the industry as a whole; but SGRY's assets, competitive position, capitalization, and valuation negate the bull case

Broken PE Roll-up:

• SGRY paid up for assets, including from other sponsors. Couple examples:
• Symbion (2014)
  • SGRY was backed by HIG at the time (pre-IPO)
  • It acquired Symbion from Crestview for $792 million pre-IPO
  • The deal was done at ~10x EBITDA after NCI, but CFO less capex and minority dividends was only $12 million (i.e., assuming 5x turns of debt to finance the deal, the levered equity yield was 3%)
• National Surgical Healthcare ("NSH") (2017)
  
  • SGRY acquired another PE-backed company, Irving Place Capital's National Surgical post-IPO for $760 million, also ~10x
  • At the time of the NSH deal Bain bought H.I.G.'s 54% stake for $19 (great job guys! three year's later and still below water!) and invested $295 million in the form of preferred shares (more on these later) to finance the deal
  • Cash flows undisclosed...
• The deals have left SGRY as a stranded, overvalued collection of second-tier assets with an unsustainable capital structure that prevents it from being an acquisition target itself

Competitively Challenged:

• Handful of larger peers aligned with larger hospital / healthcare providers
  • Tenet Healthcare Corporation owns 95% of United Surgical Partners International (“USPI”), which owns interests in 255 ASCs (more than double the count at SGRY)
    • USPI has 80% greater case volume per unit than SGRY
  • UnitedHealth Group’s OptumCare acquired Surgical Care Affiliates (“SCA”), which operates 210 ASCs, in the beginning of 2017
    • SCA volumes per unit in 2016 (last data available that I could find) exceed SGRY’s unit volumes today
• Larger absolute scale in terms of number of units and higher turnover on a per unit basis, plus affiliation with larger health organizations, gives competitors scale advantages with regard to bulk purchasing power and negotiations with payers
• Also, multiple studies show that hospitals and health systems now employ an increasing number of physicians, up from ~25% in 2012 to ~44% in 2018 (source)
  • These physicians are more likely to refer patients to surgeons and outpatient facilities within the same hospital or health system
  • Not only are SGRY’s volumes lower than peers today, but generating referrals could prove to be more difficult and costly for SGRY than the competition
    
    • Captives get organic leadsas mentioned above
    • Doctors take pay to sign, then churn out. Underinvestment and no M&A capacity post the NSH deal led to a shrinking physician network and negative SSS in 2018. Management blamed it on aging doctor population and retirement. The reality is that they have to pay more / continue M&A to attract and keep doctors than competitors like USPI and SCA

Poor Economics:

• Low growth
  • Recent slides put SGRY end markets at 2% organic growth at best
• Partner Payments
  • Often doctors have an ownership stake in a facility
  • Distributions paid to doctors or other financial partners with ownership interests in facilities (“non-controlling interest” or “NCI”) have been a fairly consistent percentage of company gross profits (~22%-28%) and cumulatively have exceeded the cash generated by SGRY for the last five years ($364m paid out vs. $348m in OCF minus capex)
  • Said another way, the share of unit economics retained by SGRY after payments to partners in its facilities has failed to cover corporate expenses, capital spending, and interest on the company’s large debt burden
  • Suggests that doctors are compensated on the individual unit’s economics rather than SGRY’s consolidated profits, and the value clearly accrues to physicians, which limits operating leverage

• Terrible FCF Profile
  
  • As discussed above, the minority payouts have exceeded cash flow
  • Furthermore, SGRY has been dependent on M&A to grow so that is really capital spend

• ROICs
  • SGRY's cost of capital is in excess of 10%
  • Even if you take the Street's rosy forecasts with 6.4% topline growth in 2020E followed by 8% growth in 2021E (remember the balance sheet is fairly full although covenants would allow a little more debt, and end markets grow 2% at best) and 200bps of adjusted EBITDA less NCI margin expansion you have ~7% returns

Overvalued:

• The terrible economics and balance sheet would be enough to short this at almost any positive equity value
• Pure-play Comps
  • There were three public pure plays as recently as 2015-2016: USPI, Amsurg before merger with Envision (great post on this name by SwissBear), and SCA. Given peers were acquired, bulls probably expect a similar outcome
  • These peer companies converted EBITDA less NCI to levered FCF to common shareholders at a rate of ~25% (i.e., they actually had positive FCF) with gross EBITDA leverage of 3.4x and EBITDA less NCI leverage of 5.2x (all incl preferreds)
  • SGRY has negative levered FCF to common conversion with gross EBITDA leverage of 6.3x incl preferreds / 5.3x excl preferreds and EBITDA less NCI  leverage of 9x incl preferreds / 7.5x excl preferreds (using the LTM adjusted covenant EBITDA that has significant add-backs and adjusts for recent deals)
  • Deal Multiples
    • Tenet acquired its initial 50.1% interest in USPI for 12.5x EBITDA less NCI with rights to acquire the remaining 49.9% at 9.5x, which results in a blended multiple of 11x for 100% of the business
    • Prior to the announcement of Amsurg’s merger with Envision, which had other business lines, Amsurg traded at 11x EBITDA less NCI
    • OptumCare acquired SCA at 13x EBITDA less NCI
    • SGRY’s own biggest acquisitions (i.e., for the assets that make up its business today) ranged from ~7.5x-10x, highlighting the lower quality of the assets
    • Third party firm HealthCare Appraisers says that 64% of observed multiples for controlling interests in multi-specialty ASCs were between 7.0x-7.9x in 2018 and only 7% were 8.0x or higher
    • At 8x Street '20E EBITDA less NCI (despite its terrible balance sheet, lack of cash flow to common shareholders, and small scale relative to competitors) value is negative. At 10x it's 60% lower. Given the massive leverage a turn makes a big difference, but SGRY should clearly trade at a discount to these assets
• Replacement Cost
  • To triangulate valuation another way, according to third party construction estimates from 2013, new build costs ranged from $4.9-$5.2 million for a new 12,500 square foot ASC (other sources suggest much lower per square foot costs in suburban/rural markets where SGRY is located)
  • Adjusting per square foot costs for six years of construction inflation implies SGRY’s consolidated centers would require $400-$650 million of investment to recreate, which makes sense in the context of the ~$400 million in plant, property, and equipment on its balance sheet
  • For comparison purposes, SGRY’s enterprise value including its partners share of the consolidated facilities (since the PPE is gross) is nearly $5 billion
  • Who would pay $5 billion for SGRY when they could build the same number of new, state of the art facilities from the ground up for one-tenth of the cost
  • SGRY’s balance sheet is bloated with goodwill from the company’s history of debt-funded acquisitions rather than the tangible assets you’d expect to see at a facilities operator with such a large valuation
• Comments on Capitalization
  • Since SGRY is structured as a holding company, it's responsible for 100% of the debts and obligations of the facilities in which it is the general partner, even if it doesn’t own all the partnership interests (i.e., SGRY’s net share of the economics must service the gross debt load and obligations)
  • The terrible cash conversion has led to in-kind payments on the Bain preferreds compounded at 10% annually rather than cash dividends
    • The problem is that the preferred balance is now $386 million and accrued $35 million in the last twelve months - that increase in the preferred is greater than the increase in the company's adjusted EBITDA less NCI YoY annualized ($3.2m increase YoY, or $12.8m annualized). What this means is the capital structure is outrunning EBITDA growth
    • The conversion price is $19, but Bain cannot be forced to convert until $42 so they could continue to accrue 10% and cram down the common
  • In April 2019 SGRY re-financed 8.875% notes with 10.000% notes and can only redeem 40% of the notes at a 10% premium - lenders clearly don't have confidence in the financial situation

Trading Dynamics:

• Bain may sell down its 50%+ stake soon (PE has a timetable), which would open up float and loosen trading dynamics
• Bain is close to converting their preferred (conversion price = $19), but this is already accruing rather than paid in cash. Therefore, conversion doesn't improve cash flow for common, yet increases shares out by 40%! $386 million balance / $19 conv px = 20 million shares on 50 million outstanding. Alternatively, Bain may not convert since it is not compelled to do so until $42, and could continue to accrue its preferred interest at 10% claiming an increasing stake of any residual equity value at a given multiple (e.g., if the stock is at the same place next year, Bain will have accrued 10% more preferred value and get 10% more shares)
• SGRY could issue shares to begin to repair their capital structure - this creates reflixivity based on the share price. Let's say they raised $250m today under recent registration and paid off high cost 10% notes (can only pay off 40% at 10% premium) and then used the rest to pay remaining notes, that would save ~$23m in interest expense, but LTM cash burn after minority payouts is $33m so still not cash flow positive and have added to shares out by 27%...today's price is also at a premium to superior, cash flowing assets and would be lucky to hold. Even at these elevated levels, the issues are not repaired
• Summary = this stock has been getting a pump treatment (claimed a successful transformation in PR on recent executive changes, presented at JPM, re-affirmed adjusted EBITDA guidance which doesn't convert to FCF anyway) and has been squeezed

Miscellaneous:

Executive Turnover

• Sep 2017 - CEO
• Jan 2018 - CFO
• Aug 2018 - Chief Accounting Officer
• Sep 2018 - EVP/COO
• Apr 2019 - board member declined to to stand for re-election
• Apr 2019 - EVP/Strategy and Transformation
• Jun 2019 - EVP/Chief HR
• Jan 2020 - CEO stepped away from CEO role and became Chairman (might not mean anything, but was spun as a successful transformation yet the company still burned cash through the first nine months of 2019)

Risks:

• Bain pumping to get out
• Tight float / squeeze (although short interest is falling now)
• Capital raises at inflated valuations (although this could end up increasing supply of shares and given the balance sheet and share price today not sure how helpful it is)
• Non-sense M&A deal
• Organic growth picks up

Catalyst

Capitalization outgrowing earnings, any operating hiccups given leverage, dilutive equity issuances, too much debt + time, Bain deciding to dump shares