EHC - Surgery Partners: Great Catalysts But A Bad Price

2023-06-24 07:24:55 ET

Summary

• Surgery Partners is a solid firm with a history of attractive growth and should benefit from demographic changes over the next couple of decades.
• The market seems to already expect this growth, making shares of the company look quite pricey relative to similar firms and on an absolute basis.
• A 'hold' rating is more appropriate for the company at this time, but if the stock falls or fundamentals improve further, it could make for a great long-term play for investors.

Having a strong catalyst for future growth can be a great benefit when you make an investment. But sometimes, that catalyst is already well priced in. Such is the case, in my opinion, when it comes to a company called Surgery Partners (SGRY). Fundamentally speaking, Surgery Partners is a solid firm, and it boasts a history of attractive growth. Over the next couple of decades, the company should benefit from demographic changes. However, the market seems to already expect this to be the case. Relative to similar firms, as well as on an absolute basis, shares of the company look quite pricey. If the stock should happen to fall or if fundamentals improve further from here, then it might well make for a great long term play for investors. But until then, I think a more appropriate rating for the company is a 'hold' rather than a 'buy'.

It's all in the name

With many companies that I analyze, you have no idea what it is that they do based solely on their name. But there are some firms that give away their business model in their name right off the bat. A great example of this involves Surgery Partners. As its name suggests, the company operates in the surgical space. Specifically, it owns and operates a national network of surgical facilities and provides various ancillary services as well. As of the end of the 2022 fiscal year, the company's portfolio consisted of 146 surgical facilities in the US that were comprised of 127 ambulatory surgical centers and 19 surgical hospitals. These facilities are located across 31 different states.

Even though the word 'surgery' might give off the impression of having to stay in the hospital for several days following a significant procedure, the largest portion of the company's operations is actually dedicated to outpatient procedures. These are procedures that don't require hospitalization and, in most cases, no overnight stay is required. Examples include musculoskeletal procedures such as spine and pain management specialties, ophthalmology related procedures, and gastrointestinal ones. Combined, these types of procedures account for 84% of all of these surgical procedures that the company's facilities offer. But other significant categories include plastic surgery and general surgery.

The company believes that there is a rather significant growth opportunity in this space right now. By their estimates , around $58 billion worth of procedures that have historically been inpatient are either shifting to or are likely to shift to being outpatient. There are significant benefits behind this. For instance, under the musculoskeletal category, it's estimated that the medical system can save around $3 billion per year by shifting 50% of joint cases to ambulatory surgical centers. This is very promising for Surgery Partners because about 80% of its facilities perform these types of procedures. For cardio, the company did not provide an estimate of the overall savings potential. But they did say that 60% or more of their facilities have the potential for cardio procedures. Both of these types of procedures are also incredibly valuable when you measure them on the basis of direct contribution margin per minute of operating room time.

This $58 billion growth opportunity is great to see. In fact, if it comes to fruition, it will nearly double the overall market opportunity for the company from the roughly $90 billion that it stands at today. The good news is that management has not needed to wait for this opportunity to play itself out in order for the company to perform well. In recent years, financial performance has already been quite impressive. From 2018 through 2022 , for instance, Surgery Partners saw its revenue grow from $1.77 billion to $2.54 billion. Personally, I think this is fantastic growth when you consider that, during the COVID-19 pandemic, many procedures, particularly those that were not emergency based, were delayed.

Even though the company has done well to grow its top line, its bottom line has been a bit of an issue. In each of the past five years, the firm generated net losses. However, that loss has narrowed significantly over time. In 2022, for instance, the company reported a loss of only $54.6 million. That compares to the $238.1 million loss reported five years earlier. When it comes to other profitability metrics, however, the picture for shareholders has been far more attractive. Operating cash flow has been all over the map. But if we adjust for changes in working capital, we would see that number increase almost every year, from $111.4 million in 2018 to $319.5 million in 2022. Meanwhile, EBITDA for the company grew from $234.8 million to $380.2 million.

For the current fiscal year, growth on the top line continues to impress. Revenue of $666.2 million in the first quarter of the year beat out the $596.2 million reported the same time last year. This growth was driven largely by an 11.7% rise associated with patient service revenues. A 10.3% increase in days adjusted same facility revenue, combined with acquisitions, helped to fuel this. When it comes to the adjusted same facility revenue figure, the company attributed the rise to a 4.8% increase in revenue per case and a 5.3% rise in same facility case volumes. This means that, not only are people paying more for surgical procedures, more people are getting them.

On the bottom line, the picture has been a bit more complicated. As you can see in the chart above, the firm went from generating a net profit of $12.2 million in the first quarter of 2022 to generating a net loss of $24.9 million the same time this year. Operating cash flow went from $79.8 million to $74.5 million, while the adjusted figure for this declined from $88.6 million to $63.1 million. The only profitability metric to show an improvement during this time was EBITDA. According to the data provided, this rose from $77.1 million to $90.1 million.

Fundamentally speaking, the picture for shareholders looks positive. I already talked about one catalyst that should help the company moving forward. However, when I first started writing about this business, I had a bit of a concern. I know from my research in the past, for instance, that surgical procedures are most typically done on people aged between 46 and 64. This may seem odd, because you would think that most procedures would be done on those who are oldest. But there are two issues here. For starters, those who are elderly are less likely to get procedures done because they are closer to the end of their lives. And second, the number of people who are older than 64 starts to decline rather rapidly.

In this country, we are seeing more and more people reach retirement age. My concern was that, even though there might be this transition from inpatient to outpatient procedures, that this would be offset by fewer people getting surgical procedures. When I dug deeper into this, however, I found some reassuring data . In 2020, about 25.5% of individuals in the US are aged between 45 and 64 (I could not get just 46 to 64 data, so this is close enough). By 2050, this percentage will drop, but only modestly, to 25.3%. Over the same window of time, the total population of the country should climb from 335.9 million to 375.4 million. This would mean that the total number of people in the prime age range for surgeries will increase by 9.3 million from 85.7 million to 95 million. So what was initially a fear of mine has turned into a second attractive catalyst.

Even though this is the case, I will say that I'm not incredibly bullish on Surgery Partners at this time. It is true that, for the current fiscal year, management is forecasting EBITDA of $430 million or greater. This would represent a nice increase over the $380.2 million reported last year. And it would also imply adjusted operating cash flow of about $319.5 million. Using these figures, shares of the company look rather pricey on a forward basis, and they look pricey using data from 2022. Both of these can be seen in the chart above. In the chart below, meanwhile, I compared the company to five similar firms. And using both of these metrics, Surgery Partners ended up being the most expensive of the group.

Takeaway

Based on historical fundamental performance, combined with the nature of the catalysts this should help to propel future growth, Surgery Partners seems to me to be a great growth opportunity for long term investors. Having said that, I don't believe that the company is attractive enough to purchase at this time. Even with the catalysts mentioned and the company's solid operating history, shares of the business look pricey. This is true both on an absolute basis and relative to similar firms. So given these circumstances, I do believe that a 'hold' rating is the best that I can give the company at this time.

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