Value trap? I’m sure many of you are saying “No duh, Davy! The stock’s only down 10% today after cutting the dividend.” But I’ve actually been looking at this stock for a few months now. Generally, I usually don’t post about stocks on my watchlist unless they get added to the portfolio.
That said, I bring up LCA-Vision (NASDAQ:LCAV) - and don’t forget Horizon Lines (HRZ) - as a reminder of the importance of avoiding mistakes as opposed to the all-consuming drive to pick winners. It is very similar to the concept of unforced errors in tennis. A tennis player can go a long way in that game just by keeping the ball in play and avoiding forced errors. The same principle is doubly valid for sound investing.
LCAV’s Q1 2008 results pretty much put me off the stock. Result deterioration was fairly dramatic, liquidity situation is worsening due to ARS, and the FDA kicked the down dog with public hearings over bad procedures in the past. Subsequent to Q1, the company took out $19M of debt and of course, today announced a massive divvy cut from $0.18 per share to $0.06.
My previous research (from mid-April):
LCAV performs laser corrective eye surgery through 74 LasikPlus vision centers located in 33 states. The company estimates its market share at about 15% in a highly fragmented industry where over 60% of laser corrective procedures are performed by individual surgeons and hospitals. LCAV is the largest publicly traded competitor in this space.
- Significant operating leverage cuts both ways. The company’s costs are high and fixed to a certain degree. Management estimates a 10% decline in procedures industry-wide for 2008. During the last economic downturn (2002 – 2004), procedures dropped off nearly 20% over two years. Any significant drop-off flows directly to the bottom-line and lead to losses. I would guesstimate fixed costs anywhere from $200 - $270M for 2008 (~$247M in 2007). Revenues for 2007 came in at $292.6M.
- The company, in defending its marketing results, implied that its sales force is not performing up to expectations. Management has announced a sales training program to address this issue. But any difficulties in closing sales will only exacerbate any industry-wide slowdown.
- Big exposure to a US recession. Laser correction procedures are elective and for the most part, not covered by health insurance. Expect a reduction in business during a recession. LCAV also has a joint venture in Canada but the vast majority of business is derived from the US.
- Balance sheet encumbrances: at first glance, a
balance sheet with no debt and $60M of cash (over $3 per share) would
be attractive. There are several weak points:
- ~$39M of non-cancellable operating leases carried off-balance sheet. If this is treated as debt, the debt-to-equity ratio is 0.71 as opposed to the zero now showing. In any case, the liability ratio is higher than suggested by the balance sheet.
- The company holds $18.3M of its short-term holdings in floating auction rate securities. $2.25M was reclassified as long-term investments after auction failure and another $2.3M failed last month at auction. While there is minimal risk of total loss, the company’s access to liquidity and working cash is affected.
- The company carries ~$53M of long-term property, plant, & equipment assets. The vast majority is of questionable value on a non-ongoing concern (i.e. liquidation) basis. Over $40M of PPE consists of leasehold improvements, equipment and equipment under capital leases. Considering LCAV operates a specialized laser corrective business in an extremely fragmented industry, many of these assets may not be attractive in other contexts and recovery factors could be low in liquidation.
- The company insures itself through a wholly-owned captive insurance unit. LCAV have reserved $8.5M for insurance claims but the company’s total liability exposure is opaque.
- “Subprime” credit risk – the company offers financing through a third-party company but for those who do not qualify, LCAV provides financing and carries the patient loans on its own balance sheet. Considering these patients could not qualify for the third-party loan, it would be fair to consider these as riskier credits and the company reflects this by carrying its patient receivables at a 17.5% discount rate. For 2007, company-financed receivables comprised ~7.5% of revenues.
- Because the procedures are elective and not covered by insurance or the government, pricing is an important component of the market. As such, many providers use discount pricing to drive business and LCAV face competitive pricing pressures in many of their markets.
- Stephen Joffe, the founder of LCAV, was forced out after revealing a significant stake in competitor, TLC Vision (TLCV). Dr. Joffe is now agitating for an executive role with TLC. If successful, Dr. Joffe could use the same expertise he used to build up LCAV to compete against it with TLC.
- Huge market potential. The company estimates a potential market of 120 million corrections in the US. For reference, the industry performed over 1.3 million procedures last year, of which LCAV accounted for 192,204.
- Significant operating leverage. If laser correction surgery gains more acceptance and/or coverage from insurance and government programs, the potential for additional revenues would flow significantly to the bottom line.
- Leading market position could lead to future growth if the industry consolidates. While there are some regulatory issues that could blunt consolidation on a wide-scale basis (i.e. some states have regulations hindering corporate practice of medicine), there is probably some room for consolidation. LCAV’s primary public competitor, TLC Vision, is a loss-making, indebted company under siege by some of its investors.
- The company pays a big 5.5% dividend. Over the last 3 years, the dividend payout ratio represented 32-43% of earnings and 18-25% of operating cash flow [OCF]. This suggests the company has ample wiggle room to continue paying the dividend, even if the economy slows.
- Using the Greenblatt measurements, LCAV delivers massive returns on capital [ROC], 62% for 2007 and over 100% in 2006 (these numbers consider only capital required to operate the business). Using traditional return measures, LCAV still generates impressive numbers, 17.5% ROA and 32% ROE (with no debt).
- The company has generated copious free cash flow [FCF], averaging ~$25M over the last 5 years (10x P/FCF). The Intralase Technology upgrade is mostly completed (Q2 2008) so capex should come down from the $28M spent in 2007.
The company has been a consistent FCF generator for the last 5 years but that was during the housing bubble years. During the last downturn, LCAV lost money from 2000 – 2002 and burnt cash in 2001. With the housing bubble popping and consumer retrenchment on the horizon, it remains to be seen if LCAV can maintain a positive profile in a slowing economy.
Based on 5 years FCF of $25M, I would put a value of $19 per share on LCAV. At $20M FCF, intrinsic value [IV] drops to $15.50 per share and at $15M, IV is $11.50. As I mentioned above, the key question is what level LCAV can maintain if Americans bunker down. The operating leverage is pretty significant so a moderate slip in business could drastically affect results.
Management forecasted a 10% drop in industry procedures. Using the company’s investor presentation as a rough model, a 10% reduction in procedures could mean little to no earnings this year. Furthermore, there are concerns that LCAV is losing market share to TLC-Vision as well as regional actors and will have to match pricing discounts, which could pressure the bottom line even more.