CA - Medical Facilities Corporation: A Good Example Of Why Valuation Matters

2023-11-21 13:21:35 ET

Summary

• Medical Facilities Corporation once was a monthly-paying dividend company that I invested in and wrote on, though this was 4 years ago at this point.
• I give you an update on Medical Facilities Corporation today, which is now a company with a quarterly dividend, and one that is significantly below the current risk-free rate.
• I view Medical Facilities Corporation as a "HOLD", and do not consider it a good idea to "BUY" it.

Dear readers/followers,

Over 4 years ago, I wrote my last article on the Canadian Medical Facilities Corporation (MFCSF), which at that point was a monthly-paying Canadian dividend stock. The reported 4Q19 in my last article and changed their payout model to a quarterly as opposed to a monthly sort of payout model.

The company has not recovered to levels where I owned it or found it attractive yet. However, since my article, which was a hold, the company has outperformed the S&P500 by a factor of more than 2x - which in my view warrants at least an update to see what, if anything, I did wrong and could have done differently.

I made it clear almost 4.5 years ago at the time, why a distribution cut was a no-go for me.

This contributor's interpretation is that the company will cut the distribution if they see that the current level, over the long term, is unmanageable given the profit from their facilities. A distribution cut from Medical Facilities Corporation can be seen as a sign that their expectations, long-term, are broken - and this would require another consideration of whether the company deserves investing.

(Source: Medical Facilities Article )

This is an update article after 4+ years, and we'll see if the company, which by the way has a market cap of less than $200M, is worth any sort of look here.

Updating on Medical Facilities Corporation - seeing what has happened in 4 years.

I don't mind showing my mistakes - and Medical Facilities Corporation certainly was an investment mistake on my part - it hasn't recovered from the last bullish ratings I gave the company, and highlights to perfection why a focus should be on valuation. W hy even for this company, investing at a low valuation could have resulted in significant outperformance but why invest before everything negative materialized in the company.

MFC is still a partnership - a partnership with physicians, owning a fairly diverse portfolio of decent surgical facilities in the US, The company manages, as of this time, a $72.3M EBITDA on an adjusted basis from over $414M worth of revenues from 152 physician partners.

Their model includes direct physician involvement in facility management, which has shown the company to result in superior processes and efficiencies. The company also manages a JV, MFC Nueterra, that provides operational support and procurement benefits to further increase efficiencies.

The total company portfolio is comprised of interest in facilities in 8 states, including 4 specialty surgical hospitals in Arkansas, Oklahoma, South Dakota, and Cali.

Reviews for these facilities are high - and implied in most ways to be a very solid sort of facility.

Like most REITs and companies that depend on the demographic trends in the nation, the company refers in large part to an overall growing healthcare demand, as well as an overall aging population.

In terms of payor mix, the company gets over 50% of its sales revenue from private insurance , which is favorable to Medicare/Medicaid. The overall mix for the company is also improved from the last time I reviewed it, with only ASC's and SSH's.

Part of the company's journey back towards the top, with a 100%+ total RoR in around 4 years, has been the buyback of significant amounts of shares during times of very poor returns and low valuation.

It can be argued that the company's troubles, following its significant dividend cut and normalization of operations, have mostly been solved. We're at a net debt of less than 1.9x to LTM EBITDA, a net debt/equity of less than 0.95x, and a current ratio of 1.4x. The company also has over $35M of cash and equivalent, and these numbers are inclusive of IFRS 16 lease liabilities. So to say that Medical Facilities Corporation is in dire straits or in a worrying situation, would be wrong, as I see it.

The company's balance sheet is showing non-trivial improvements, aside from the aforementioned leverage in metrics such as RoA, which have not deteriorated. From the income statement and KPI perspective, the company has shown meaningful fundamental strength in margins, including the FCF margin, and the record of profitability. It would be wrong to state that the company has recovered - the gross and operating margins are still in decline, but much of this has to do with not necessarily what the company is doing, so much with what the macro has been doing. The improvements in revenues and the stability in EBIT are, as I see it, at least showing that their balance sheet is in no immediate danger.

However, there are many factors that would make this company unfortunately uninvestable in this environment, even after showing us this sort of overall outperformance.

First off, the company yield is coupled with the company risk profile. When talking about this sort of business in a high-interest rate environment where you can get over 8% from an IG-rated Pref or similar investments, you would expect this company to yield somewhere north of at least 8.5%. It yields less than 4% , and not monthly but on a quarterly basis. In order to weigh up for this single fact coupled with the company's low market cap and other factors, I would need to see a significant and undeniable upside in either the medium or long-term that would cause me to invest in this potential above others at this time.

It should not surprise you given this company's history and given what's available on the market today aside from this, that this is not a potential I see at this time.

This was also, by the way, the mistake that I made with regard to this company last time I actually invested in it. While it can be argued that the yield at the time and the upside were substantial, if you really dig down deep into the fundamentals and future potentials at the time, you can see, with difficulty (I argue) the potential impact of downturns, rate increases, inflation, and overall cost increases. It was these impacts that I failed to account for sufficiently in my thesis, which led to the "autopsy" I last posted in my previous article on the business.

For the latest reported period, the company's results were decent enough. We're talking about 3Q23 here reported on November 9th . The company's revenues were almost $105M, though this excludes the MFC Nueterra ASCs, and the company managed an increase in EBITDA of 13.7% to $17.7M. The overall improvements here and the lack of any sort of substantial dividend (no, a sub-4% isn't what I would consider "substantial" from this company or in this environment), means that the company can direct its contextually considerable cash flow and EBITDA to paying down debt and doing buybacks. This is also what the company did, repaying $3m on the corporate credit facility and buying back over 155k common shares.

It's correct, in my estimate, to consider the company's performance as solid here. The divestiture of the MFC Nueterra ASCs is the end of an era for the Medical Facilities Corporation - I remember that when I covered them four years ago, these were a feather in the cap of the company, and something the company considered with pride.

It also shows us how quickly things can indeed change.

When you look at this company's income cadence, you need to accept substantial quarterly volatility due to the sheer variations in non-cash finance costs.

Overall, the 3Q quarter did not mean that I was suddenly more positive about the company, nor does it mean I was more negative about the business. My view is formed by the fact that this is a below-average (yield, quality, history) smaller-cap business in a market where you can get a 5-6% yield by throwing a rock at any investment-graded high-quality bond or pref stock.

There is no word on the dividend. In the latest call, the company was opaque regarding a rise here - but obviously the company has cash to spare, given the amounts of buybacks that are being made relative to earnings.

The best thing that can be said about the DR.Un ticker is that cost pressures and wage inflation are not as serious as they were 1-3 years ago. The company no longer has to do signing or retention bonuses, which takes a chunk out of the cost side here - but this does not materially change my thesis for the company.

Let's look at an updated valuation.

Valuation for Medical Facilities Corporation - There's an upside, but I don't view it as sufficient

I bought the company not at the precisely worst time to be buying it, but certainly at a time that saw a significant downturn in the share price. While the company has, looking at OCF, never been in any sort of fundamental danger, it has still been a very poor overall performer for its long-term shareholders.

And this is quite obviously how we view a company's performance. While 18-year shareholders are not in a negative ROR, we're looking at an annualized RoR of 4.3% per year, which is substantially below the market average. At these rates of return, you might as well just buy any basic index fund and you'd end up doing better than if you invested in DR.Un.

The obvious key here is valuation. If you were to buy the company on the cheap, you can make reversal returns that beat the market - but given the company's asset concentration and exposure to what I view as one of the riskier markets out there, improved only slightly by the fact that we're talking about a specialty sector.

In fact, my thesis here is very simple. While the company can showcase improvements and realistically low valuations for what are, even with my negative view, conservative cash flows, this is so far from unique in this market that it's no longer even worth considering.

It touches clearly upon what I have said before.

Every investment needs to justify itself not just in terms of valuations and upside either peer-based or historically - which to be frank, Medical Facilities Corporation can certainly do here , but needs to also justify itself as an investment to every other investment availabl e to us.

That's where Medical Facilities Corporation fails. Even if you could argue that you own a full stake in several companies, there are very likely many, many other companies that you should be investing in prior to looking at this company.

On that basis, I can also at least mention that other analysts still consider DR.UN to be a "HOLD" with a price target on average at around $7.3 CAD, from a range of $6.7 CAD to $7.99 CAD. That means that even the analysts, which now look at the company's $8.57 CAD native price, consider the company to be not a "BUY" at this time. Depending on how you approach the valuation here, you could work your way up to a $22 CAD or even higher valuation by looking at P/S valuations for peers versus the company's own historical data - but the company we're looking at here is in many ways too different than the once-monthly-paying player we had a number of years back, and compared to many of its peers in the same market cap range, still trades at a premium. I believe the right way to approach the valuation is simple, impacted sales multiples , which at the current level are around 0.36x, to an all-time low of below 0.3x, which I would discount to 0.25x. I would also impair the revenue multiple to 0.5x until we get some clarity on the question of the quality of that sales revenue going forward (given the deterioration in gross and operating margins due to cost increases). This implies a share price of lower than $5/share and is how I reach my share price of $4/share.

I would add my voice to this chorus, and say that this company should be avoided as a major stake here. If you own it, you could "HOLD" it given the upside, but I would say that there are far better alternatives out there at this time.

Here is my thesis for DR.UN.

Thesis

• Medical Facilities Corporation is a business with the idea of partnering with physicians and surgeons to manage various specialty care institutions around North America, focused on the US.
• The company has been through multiple iterations, including being a high-yielding monthly payor that failed to hold onto this trend and had to cut down its dividend not only in yield but also went back from its monthly to a quarterly dividend model. The company instead of increasing its distribution focuses on share buybacks given the very pressured valuation at this time.
• Despite what can be argued to be an attractive overall valuation, I do not view the company as a "BUY" here - there are far better alternatives out there. At the current yield, I would "BUY" the company, barring no deterioration of fundamentals, at $ 4 CAD for the native DR.UN ticker.

Remember, I'm all about:

1. Buying undervalued - even if that undervaluation is slight, and not mind-numbingly massive - companies at a discount, allowing them to normalize over time and harvesting capital gains and dividends in the meantime.

2. If the company goes well beyond normalization and goes into overvaluation, I harvest gains and rotate my position into other undervalued stocks, repeating #1.

3. If the company doesn't go into overvaluation, but hovers within a fair value, or goes back down to undervaluation, I buy more as time allows.

4. I reinvest proceeds from dividends, savings from work, or other cash inflows as specified in #1.

Here are my criteria and how the company fulfills them (italicized).

• This company is overall qualitative.
• This company is fundamentally safe/conservative & well-run.
• This company pays a well-covered dividend.
• This company is currently cheap.
• This company has realistic upside based on earnings growth or multiple expansion/reversion.

This company fulfills maybe 1-3 of my criteria depending on how you choose to apply them, and I do not view it as justifying an investment in any case here.

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