Welcome, subscribers!
We’re back with another edition of Elevator Pitches.
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In this week’s issue, we're happy to share four ideas, including:
a seasoned player in the agricultural chemicals market known for its innovative solutions in crop protection
a global leader in flexible workspace solutions, adapting to the evolving needs of the modern workforce
a manufacturer of air conditioning and heating equipment, recognized for its energy-efficient designs and sustainable technology
a healthcare operator specializing in surgical hospitals and centers, offering high-quality care with a focus on outpatient procedures.
Disclaimer: Nothing here constitutes professional and/or financial advice. You alone assume any risk with the use of any information contained herein. We may own positions in the securities listed. Please do your own due diligence.
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Let’s get to it.
River Oaks Capital detailed their new position in Medical Facilities (DR-CA), an owner of surgical hospitals and ambulatory surgery centers. After an acquisition spree went awry, an activist push led to a new CEO and Board. Now, River Oaks sees a lot of upside, which they discuss below.
Medical Facilities is the only new company we have bought meaningful ownership in over the past six months. While we also bought ownership in Bebe stores, it remains below 3% of our fund.
Medical Facilities is now our sixth largest position. The company has a market cap of $165m and has majority ownership in four surgical hospitals located in South Dakota, Oklahoma, and Arkansas, as well as one surgical center in California.
A surgical hospital offers a more personalized, high-end experience for patients who are undergoing scheduled, non-emergency surgeries .
Most of these surgeries are ‘outpatient procedures’ - meaning no overnight stay - and mainly are orthopedic and neurosurgical operations – generally hip, knee and spine. Today, around 50% and growing of ‘outpatient procedures’ are performed in surgical hospitals. This is possible due to a rapid increase in technology.
Unlike most traditional hospitals, at Medical Facilities’ four surgical hospitals you get first class amenities (e.g., a prime rib dinner). Their facilities are often referred to as hotel hospitals and typically only used by people who can afford these higher-end services.
As is common at surgical hospitals, Medical Facilities owns a majority of each hospital - 51% to 65% - while a select number of doctors who work in the hospitals own the remaining minority portion.
Medical Facilities started in 2004 when they publicly listed in Canada for tax advantages.
For years following their IPO, Medical Facilities was very attractive to Canadian retail investors as the company consistently paid a ~6-10% dividend yield - $26m-$32m per year - that helped supplement their retirement income.
In 2016, the prior Medical Facilities management team decided to change their capital allocation strategy and started to rapidly acquire new assets.
They purchased majority ownership in Unity Medical Surgical hospital in Indiana as well as seven surgical centers – smaller, outpatient-only facilities. In total, they spent over $100m, causing a large increase in debt and overhead expenses.
None of the acquisitions worked out as planned and by the end of 2019 they had to begin cutting their dividend.
These problems were further exacerbated by Covid-19, which especially hurt their seven newly acquired surgical centers.
By the end of 2020, they had decreased their dividend by 75% - down to $6m per year - causing Canadian retail investors to run for the door. The market cap, which was as high as $450m prior to their acquisition spree, plummeted to $120m.
By 2022, investment fund Converium Capital launched an activist campaign that took control of the Medical Facilities’ board and replaced the CEO and a large portion of their management team.
The new CEO, Jason Redman, changed the corporate strategy -- suspending all acquisitions, divesting non-core assets, paying down debt, cutting corporate costs and returning capital to shareholders.
Since early 2022, Jason has held true to his word as they have sold Unity Hospital and 6 surgical centers, cut corporate costs from $12m to $8m per year, paid down $12m of corporate debt, and repurchased $45+m of shares equating to 25+% of all outstanding shares.
Prior to Medical Facilities, Jason already had a history of stepping into struggling companies and quickly turning them around in preparation for a sale or new strategic direction.
Now that the short-term goals have been accomplished by Jason and his team, the remaining question is: what are the next steps?
I have spent time talking with activist shareholder Michael Rapps of Converium Capital and other large shareholders and everyone seems aligned that the goal is to return capital to shareholders as soon as possible in one of the following ways:
Four possible scenarios over the next 1-3 years:
1. Sell their ownership in all four of the remaining hospitals to a large, strategic buyer for $300+m
• This is probably the best-case scenario for Medical Facilities shareholders.
• The problem is there are only a limited number of companies - Tenet (THC), Surgery Partners (SRGY), amongst a few others - that can afford to buy all four hospitals together.
• Additionally, most of these large, serial acquirers of surgical hospitals bring in a formulaic ‘corporate’ culture.
• Recall that the doctors own a minority percentage of each hospital.
• Although the doctors do not have the right to veto Medical Facilities selling their majority ownership to a specific company, they could make the transition for the new acquirer very difficult by either refusing to work or retiring.
• It is hard to gauge how realistic this risk is as many of the doctors own the hospital and would therefore be hurting their personal equity value by not cooperating.
2. Sell their ownership in the Arkansas and Oklahoma hospitals to individual buyers at or above their historical purchase price of ~$40m each
• The two South Dakota surgical hospitals - Rapid City & Sioux Falls - are the cash cows of the company, generating ~70% of the free cash flow. The company also owns the related real estate.
• Most likely, the Arkansas and Oklahoma hospitals wouldn’t get as high of a multiple on a sale versus all four being sold at once.
• Using a conservative assumption that $60m of cash is received from the sale Arkansas and Oklahoma - assuming some of the non-recourse debt is tied to these hospitals - Medical Facilities would use the proceeds to buy back 30+% of their shares at current prices.
3. Sell their ownership in each hospital individually to local buyers
• This would also get a lower pay out than if all four hospitals were sold at once as local hospitals wouldn’t pay the same multiple as a major corporation such as Tenet or Surgery Partners.
• However, it would most likely solve the problem of doctors not being happy with the deal as the culture of the hospital would not change.
• One roadblock is Medical Facilities’ ownership in the two South Dakota hospitals each could be worth $100+m which is a very large check for a local hospital.
4. Increase the dividend
• If they can’t find a buyer at an attractive price for their ownership in the four hospitals - especially the two in South Dakota - they can use their $20-$25+m of free cash flow to equity per year to pay a 12-15% dividend yield - even over 15% if they continue to buy back shares at current prices.
• This would most likely re-attract the Canadian retail investors that fled the stock once the dividend was cut and thus increase the share price.
As mentioned, Medical Facilities currently generates free cash flow to equity of $20-$25m per year which should continue to grow at or above inflation. On a market cap of $165m, that is a 12-15% free cash to equity flow yield – 6-8 P/E ratio.
Furthermore, a strategic acquirer would be able to eliminate a large percentage of the $8m of corporate overhead costs, meaning they would be able to generate $25-$30+m of free cash flow year – not including other potential synergies.
The sale of all four hospitals for $250-$300+m seems to be quite a reasonable assumption – generating a 50-80%+ return for current shareholders.
Regarding downside protection, Medical Facilities is selling at 20+% below historically paid prices for each hospital – a large percentage of which was purchased 20 years ago. For reference, in 2015 they sold a surgical hospital they bought in 2005 for 3x the historical cost.
In summary, due to their dividend cut in 2019, being listed on the Canadian stock market, and not screening well for those searching for undervalued companies, Medical Facilities has been abandoned by investors allowing us to invest in a wonderful business at an overly discounted valuation.
We have three more ideas this week, exclusively for our paid members.