It's a pretty standard practice to start the search for new investment opportunities by using screeners to filter the candidates. Then, once filtered, one can go candidate by candidate and find those that for one reason or another seem more attractive.
In the course of screening, some valuation measures can be used. One of the most common would be EV/EBITDA, since it takes into account a company's indebtedness and is also less vulnerable to one-off effects or accounting rules distorting net earnings.
Sometimes, however, these screens can lead us astray. This is so because the EV/EBITDAs out there are not all that reliable. This is the story of one of those times.
Here's the story
In the course of my screening activities, I don't actually screen for EV/EBITDA. But out of the list I got this time, Amsurg (AMSG) thrilled me. Here was this rather fast grower that, surprisingly, supposedly traded at just 5.5 times EV/EBITDA.
Not only that, but the company itself seemed to be the Wal-Mart of surgery, running Ambulatory Surgery Centers (ASC) at much lower costs than comparable services rendered in hospitals, and yet showing strong margins.
The stock seemed like some kind of dream. But something had to be wrong... there aren't usually that many obvious gems with market capitalizations north of $1 billion. All of those grounds have been covered and then covered some more.
One of the very first obvious problems was that the growth, which had attracted me, was not really organic. Amsurg bought ASCs by the boatload and is expected to continue doing so in the future. This one would never appear on an automated screener and thus had to be picked by hand.
But there were much more significant problems with the stock, namely its valuation. Basically speaking, the EV/EBITDA and the company's operating cash flow and free cash flow were all illusions.
Why was this so?
The illusion stems from how Amsurg structures its business. Basically, it grows by acquiring ASCs but then keeps the physicians around as partners. So the ASCs are only partly owned by AMSG, but AMSG mostly consolidates them in full in its P&L. This has the effect of greatly inflating revenues, operating profit and EBITDA. And due to an accounting rule, it also has the effect of greatly inflating operating cash flow and free cash flow, because operating cash flow considers 100% of the cash flow generated by AMSG's ASCs even though AMSG does not own 100% of those ASCs. Then, AMSG considers as a financing cash flow the amounts paid to its physician partners.
The end result of this can be seen below in the P&L and cash flow statement:
What this means is that either AMSG's EV or EBITDA needs to be corrected to account for the physician's ownership of most of the cash generated by AMSG. Since it's hard to estimate the value of the physician's interest in the ASCs, I'll try to estimate a more realistic EBITDA by removing the values paid to the physicians.
Ordinarily, EBITDA would be income from operations + depreciation, for simplicity. Using the last 6 months and annualizing the values, we'd come to around $368.4 million. However, in the last 6 months AMSG also paid out $91.5 million to its physician partners. Annualizing that would give us $183 million. This means that a more realistic EBITDA for AMSG would be $368.4 million less $183 million, or $185.4 million.
Given that AMSG's market cap is $1145.8 million and it carries $576.1 million in net debt, its EV is thus $1721.9 million, and its "more realistic" EV/EBITDA is thus 9.3. It is thus no longer impressively cheap.
AMSG might have lots going for it, namely the ability to provide a service (surgery) at a much lower cost than competitors, which will play well in a world where containing health costs is an absolute priority. Also importantly, the U.S. population is aging and that also plays well into the demand for AMSG's services, boosting volume (though this might change when the population ages enough, as for instance colonoscopies are no longer recommended after turning 75).
All this is true, but still AMSG's valuation and profitability is sometimes an illusion, produced by the way it's structured and how that leads to it displaying somewhat misleading figures for its operating profits, EBITDA, operating cash flow and free cash flow.
As it stands, even though I like the underlying story, the stock seems fairly valued to me.