Since my initial article in Seeking Alpha back in October 2012, there have been two events that reinforce the company's business proposition and beg the question of current valuation. After all, we are talking about the business of acute health care, which on the surface is not sexy, particularly in light of Obamacare just around the corner. However, sequential quarter earnings increases coupled with low multiples continue to draw my attention, particularly since this is the breakout year for University General Health System (UGHS.OB). The first significant event was Q3 2012 results, which yielded a robust $11.7 million in net income on revenues of $31.9 million versus Q2 of $5.1 million of net income and revenues of $26.5 million.
Why is this trend significant? First, quarterly earnings and cash flow continue to increase at an increasing rate. While I do not expect this to continue indefinitely, UGHS is on a growth path that should take the company well into 2014-2015. In addition, the margins continue to widen, which implies the company is getting some leverage as they scale the business and revenues rise. Third, this is all organic growth, which brings me to the next catalyst, one that was virtually ignored by the market.
UGHS made three separate announcements in December: two acquisitions and the construction of a new hospital. The first was a sleep and imaging center in Baytown. According to the press release, "The acquisition is expected to contribute $5 million or more in annual revenue, and an estimated $1.6 million in adjusted EBITDA (a non-GAAP measurement) annually to operating results as a hospital outpatient department of the Company's flagship hospital in Houston."
The second transaction, which was significantly larger, was the purchase of South Hampton Community Hospital, based in Dallas. This is significant for at least two reasons: it is the second major hospital system now owned by the company, and it validates the longer term strategy of being able to duplicate the business model in other cities and regions of the country. The company's strength is turnarounds and being able to operate acquisitions more efficiently and profitably than the prior owners, so this reinforces the idea that UGHS could continue to grow through acquisition with a national presence in the next five years.
While beauty is in the eye of beholder, it appears that the terms were very favorable for the company. The hospital was purchased for what looks like a significant discount to its net asset value. UGHS paid $30 million, of which $1.5 million was in equity, whereas the remaining $28.5 million was in the form of a promissory note from Houston National Bank at a rate of 4.25% with a 10-year balloon. In addition, the company will spend $1 million or so to upgrade the facility. While one might conclude that leveraging the company's balance sheet is incurring more risk, the company publicly announced guidance of $15 million in adjusted EBITDA for South Hampton (now called University General Hospital- Dallas) in 2013. Should the company achieve these results, it will have a meaningful impact on cash flow and earnings in 2013 and beyond. Also, if Houston is the model, I expect UGHS to make several acquisitions in hospital outpatient departments (HOPDs), which should add additional revenue and EBITDA to the Dallas operations.
UGHS announced on 12/21/12 that it has "executed agreements to acquire an interest in approximately 31 acres of undeveloped land from Musgrave-Grohman, Ltd., an Abilene, Texas-based real estate developer, to establish a multi-purpose medical complex on Pearland Parkway in Pearland, Texas, a large suburban city in the greater Houston metropolitan area. The acquisitions are subject to customary closing conditions, including a $20 million financing commitment for the hospital portion of the complex. The Pearland facility is expected to include a 50-bed general acute care hospital, a full-service 10-bed emergency room and an 8-bed intensive care unit, four operating rooms, and an endoscopy and cardiac catheter lab. The complex is also expected to include a 50,000 square-foot medical office building, providing physician offices adjacent to the hospital."
Pearland is a fast-growing suburb in the southeast section of Houston. There is little or no competition in Pearland, as there is no existing hospital there. The parties involved are working with multiple sources to secure the additional debt and equity financing that will be required to complete the project. While this is a longer term project and probably will not show up until late 2014 or early 2015, it clearly has the potential to drive another phase of growth.
UGHS will not have to fund the initial part of this transaction, as the acquired land is the catalyst (with an estimated value of $11 million), and there is no upfront payment. The operating assumption is that UGHS will own part of the land company and 100% of the hospital operations, yet this will require only a small equity contribution from the company, assuming they get the financing in place. This is consistent with the strategic model used to build the Houston hospital and now Dallas.
Assuming there were no hiccups in the 4th quarter of 2012, I believe the year end 2012 results of $120-125 million in revenue with earnings in the $23-25 million range (excluding derivative expense) are attainable. I still believe the that the company can achieve a run rate of $225-250 million top line and $45-50 million in net income by Q4 of 2013. Even if UGHS is slightly below these numbers, the multiples of EBITDA and earnings are well below any peer group measure. As an example, let's assume that the $14 million of EBITDA that was achieved in Q3 of 2012 stays consistent throughout 2013, which would give UGHS $56 million. However, that does not include the Dallas acquisition, which would add an additional $15 million, as was mentioned earlier, putting the total EBITDA at over $70 million. Keep in mind this does not account for any organic growth or future acquisitions (as well as the possibility of contracting margins or other factors that would cause a slowdown in growth.
For 2013, let's assume that an industry average multiple of EV/EBITDA is approximately 6.5x. Taking the $70 million of EBITDA x 6.5 multiple and you arrive at $455 million, less net debt of $130 million (including all capital leases and debt from the Dallas acquisition), which results in $325 million/380 million shares outstanding, or $0.86 per share. This is a conservative case for a few reasons, including but not limited to that the capital leases were added in, I am using an industry average 6.5x when the company is growing at a much higher rate (cumulative quarterly EBITDA growth rate from Q1 of 2011 through Q3 of 2012 of over 45%), etc... Looking at this under a different lens, if you take a simple 5-6x EBITDA of $70 million, you arrive at a share price $0.92-$1.11.
But this is only part of the story. Another part of my focus is on EBITDA margins, which were 35% in the third quarter of 2012, much higher than industry averages. In addition, net margins were in the 17-20% range. It remains to be seen whether these margins can be maintained as the company continues to grow both organically and through its acquisition/turnaround strategy. However, the conclusion I draw is that by any metric-multiple of EV/EBITDA, EBITDA, net income, or even cash flow- the company is significantly undervalued relative to its peer group, assuming there are peers that can be compared to UGHS. For the moment, even with Obamacare looming and the potential for margins to decline, it appears the company is firing on all cylinders with respect to a middle market acute care provider. There are a myriad of issues, including but not limited to the number of shares outstanding, the fact that it is a penny stock under 40 cents a share, there is debt and convertible preferred stock outstanding, the ability to acquire and successfully integrate more facilities, etc... Yet it is difficult to find any micro cap company that can earn $23-25 million or more in a given fiscal year, particularly given the dramatic turnaround from 2011, in which the company showed a loss. Furthermore, given the projected growth for 2013, UGHS will have significant free cash flow on a monthly basis, which gives them the ability to pay down debt, fund future acquisitions internally with no further dilution, and even the ability to buy back stock if it makes sense.
The bottom line is that this management team is a group of long term, strategic thinkers who have proven the ability to execute and manage rapid growth while continuing to improve margins through efficiencies and cost-cutting measures. UGHS clearly merits a closer look, and it may be just a matter of time before it gets "discovered" by the investment community.
Disclosure: I am long UGHS.OB. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.