Surgical Care Affiliates - Don't Care About This Offering

| About: Surgical Care (SCAI)

Surgical Care Affiliates (NASDAQ:SCAI) made its public debut on Wednesday, October 30th. Shares of the national provider of solutions to physicians, health systems and health care payers, to optimize surgical care ended their first day with gains of 12.9% at $27.10 per share.

I'll pass on this offering given the lack of earnings and high debt position.

The Public Offering

Surgical Care Affiliates providers solutions to physicians, health systems and healthcare payers to optimize surgical care. The company operates a network of 167 ambulatory surgery centers, 5 hospitals and one sleep center.

The company focuses on building relationships with leading participants in the healthcare system to acquire and develop facilities. Crucial in all of this is to align economic incentives while offering high-quality care at low costs. Surgical Care has partnerships with 42 health systems and some 2,000 physician partners.

Surgical Care Affiliates sold 9.8 million shares for $24 apiece, thereby raising $235 million in gross proceeds. Some 7.86 million shares were sold by the company which thereby raised $189 million. The remaining 1.92 million shares were being offered by selling shareholders.

Initially, bankers and the firm set an initial price range of $21-$24 per share. Shares were eventually sold at the high end of the initial public price range.

Some 26% of the total shares were offered in the public offering. At Friday's closing price of $26.25 per share, the firm is valued at $1.00 billion.

The major banks that brought the company public were J.P. Morgan, Citigroup, Bank of America/Merrill Lynch, Barclays, Goldman Sachs and Morgan Stanley, among others.

Valuation

Surgical Care Affiliates operates in the healthcare industry which is in the midst of a transition, focusing on cost containment and improved clinical outcomes.

Surgical Care Affiliates offers great solutions through low-cost delivery, a strategic approach to increase productivity and alignment of incentives.

The scale of the operations furthermore allows for benchmarking, best practices sharing and economies through the supply chain management. And once again, Surgical Care believe the partnership model aligns the interest of the partners within the model.

For the year of 2012, Surgical Care generated annual revenues of $750.1 million, up 4.3% on the year before. The company reported operating earnings of $149.1 million for the year. Interest expenses totaled $58.8 million as income attributable to non-controlling interests totaled $92.4 million, resulting in net losses of $20.0 million.

Revenues for the first half of 2013 came in at $370.6 million, up 5.1% on the year before. Net losses attributable to the company increased from $10.2 million to $11.2 million.

The company operates with $143.7 million in cash and equivalents. Total debt stand at $811.6 million, resulting in a net debt position of around $670 million.

Factoring in the gross proceeds of $190 million from the offering, and Surgical Care will operate with a net debt position of around $500 million. Note that proceeds will be used to repay $150 million in notes expiring in 2017, paying a coupon of 10.0% per annum. Such a move will save Surgical Care some $15 million per annum in pre-tax interest expenses.

With the equity in the business being valued around $1.00 billion, Surgical Care is valued at 1.3 times annual revenues and a non-meaningful earnings multiple based on 2012s earnings.

Investment Thesis

As noted above, the offering of Surgical Care has been quite a success. The company priced the offering at $24 per share, some 6.7% above the midpoint of the original preliminary offering range. Ever since shares have seen more upside, currently trading some 16.7% above the midpoint of the preliminary offering range.

Note that Surgical Care is a carve out from HealthSouth which has been acquired by private-equity firm TPG back in 2007. TPG stands to hold a 66.3% stake post-IPO, still resulting in tightly controlled company, possibly creating a conflict of interest.

Besides this, there are some other key risks as well. Surgical Care relies on third partners for its payments, while its total business model already relies on relationships with partners. Besides these risks, the valuation remains a key risk as well. Surgical Care is not reporting GAAP earnings, partially the result of higher leverage employed resulting in steep interest payments.

Even when adjusting for the lower leverage following the public offering, net income remains depressed, resulting in a too steep valuation multiple for me. This is especially true as the company does not aim to pay out dividends following the public offering.

I'll pass on this offering. The debt position is too high, combined with a too high valuation, especially on earnings multiples. I might reconsider if shares were to see a correction in the coming months, or if operating cash flows might have reduced the net debt position.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.