Amsurg Corp. (AMSG) owns and operates “ambulatory surgery centers” (also known as outpatient or same-day surgery centers) in partnership with physicians throughout the United States. I came across the company in mid-July when I read an article by John Reese, the founder and CEO of Validea Capital Management and author of The Guru Investor: How to Beat the Market Using History’s Best Investment Strategies. I’ve enjoyed other articles by John so when I saw a Globe and Mail article he penned titled “My favourite free-cash-flow stars,” I added a few to the list I keep of companies to investigate.
Here’s what John wrote on AMSG:
This Nashville-based company operates a network of more than 200 ambulatory surgery centres across the United States in partnership with physicians. AmSurg is a free-cash-producing machine, sporting a free cash flow yield of 26.3 per cent.
Its ability to turn free cash into profits is part of why the model I base on the writings of hedge fund guru Joel Greenblatt is so high on the stock. It likes AmSurg’s 22.1-per-cent earnings yield and 107.1-per-cent return on capital, and, all in all, sees AmSurg as the second most attractive stock in the U.S. market right now.
This sounded great, so I did what I always do first: I headed over to GuruFocus.com for a quick overview of the company’s 10-year financials. Below is the chart of the company’s free cash flow over the last 10 years (from GuruFocus). I’ve edited it to remove some information extraneous to the purposes of this commentary.
[Click all to enlarge]
Amsurg 10-year Free Cash Flows (Gurufocus.com)
This chart shows that the free cash flows that John discusses in his article have really come about in the last two years. While free cash flows have been above $200 million in each of the last few years, they were less than 1/3 of this prior. Moving up the charts, we see that the result is due to massive corresponding increases in net income.
The company operates in a mature industry -- has there been a spike in operations I am unaware of? -- yet its profits have taken off. But as this chart shows, the company’s net profit margin has been stable.
Amsurg 10-year Net Profit Margin (Morningstar.com)
Perhaps this is the result of a merger that resulted in a massive increase in revenues. Let’s check revenues:
Amsurg 10-year Revenues (Morningstar.com)
So revenues grew a bit and net profit margin declined a bit, but the company shows significantly higher free cash flows stemming from significantly higher net income? Quite a conundrum. Time to turn to the company’s filings to see what’s going on.
You can check out the 2010 10-K filing here. The key is at the bottom of the income statement:
Amsurg Income Statement (clip)
Morningstar and Gurufocus calculate the net profit line off the bottom of the income statement – net earnings attributable to AmSurg common shareholders. However, the company begins its cash flow statement with a different line – net earnings - taken before the minority/noncontrolling interest deduction.
The company hasn’t always done this. It only started in – you guessed it – 2008, when the company’s free cash flows skyrocketed. This wouldn’t normally be a problem. Prior to 2008, the company would start with the equivalent of the net earnings attributable to Amsurg common shareholders, and then add back the earnings attributable to noncontrolling interests, getting to the same starting point as the 2009 and 2010 figures. But because the company distributes an amount to noncontrolling interests (its physician partners) that is essentially equal to earnings attributable to noncontrolling interests (and this fits under Cash Flows from Operations), the effect on CFO is close to neutral, which is why CFO prior to 2008 was so lower.
But why does CFO jump in 2010? Here’s what the company said in its 2009 10-K:
The Company adopted certain updates to Financial Accounting Standards Board (“FASB”) Accounting Standards Codification Topic 810 Consolidations, or (“ASC 810”) , which were effective January 1, 2009 … ASC 810 generally requires the Company to clearly identify and present ownership interests in subsidiaries held by parties other than the Company in the consolidated financial statements within the equity section but separate from the Company’s equity … It also requires the amounts of consolidated net income attributable to the Company and to the noncontrolling interests to be clearly identified and presented on the face of the consolidated statements of income … The implementation of the updates to ASC 810 also results in the cash flow impact of certain transactions with noncontrolling interests being classified within financing activities. Such treatment is consistent with the view that under ASC 810 transactions between the Company (or its subsidiaries) and noncontrolling interests are considered to be equity transactions. The adoption of the updates to ASC 810 have been applied retrospectively for all periods presented.
In 2009 when the company adopted ASC 810, distributions to minority shareholders were no longer included in Cash Flows from Operations, but rather in Cash Flows from Financing. Thus, Free Cash Flows (defined as CFO – Capital Expenditures) suddenly skyrocket because the company suddenly recognizes all of the cash flows from operations and tucks the payments to its physician partners away elsewhere.
So to suggest that AMSC is a great investment because its free cash flow yield is so high is to miss the fact that the free cash flows reported by the company in 2009 and 2010 (and presumably going forward) aren’t really the company’s free cash flows. The bulk (~2/3) are earmarked to be paid out to the physician partners. This free cash flow cannot be used to pay down debt, repurchase shares, issue dividends, or grow the business -- so how “free” is it?
AMSC may be a great investment, but it would be a mistake to base a purchase on the company’s superficially strong free cash flows.