Dynacq Healthcare: Speculative Opportunity But Not For Faint Of Heart

| About: Dynacq Healthcare, (DYII)

Summary

This company owns a single hospital which is facing heavy operational losses and complex litigation, but several facts point to possible investment opportunity.

First, the litigation might be a potential source of value. This is supported by the management’s commentary and actions.

The management wants to shut down or sell the remaining operations so that it can liquidate the company and possibly reap gains from the favorable outcome.

Secondly, it is likely that the stock is still undervalued as the current market cap is roughly 60% of the NCAV value (including the litigation liability).

The thesis though is speculative and relies heavily on the outcome of the litigation which might be lengthy and thus the "ice cube" could melt before resolution of the cases.

Company Introduction

Dynacq Healthcare (NASDAQ:DYII) is a holding company that through its wholly-owned subsidiaries owns and operates a general acute care hospital in Pasadena, Texas, which is specialized in several types of surgeries. The company used to operate several other hospitals in the past, but has since sold or discontinued their operations. The current hospital is in a continuous operational loss, and the management made it clear that it is seeking to discontinue it as well.

If it is successful in this effort, it is likely that the management will either liquidate the company or take it private in order to resolve the outstanding litigation connected to several cases that were performed in the hospital. These are connected to the "stop-loss exceptions" in the Texas healthcare law surrounding reimbursements of healthcare costs incurred by patients covered by the regulation of Texas Department of Workers' Compensation.

The company was listed until 2012 when it stopped complying with the price requirement of NASDAQ. Now it trades OTC. It continued to file with the SEC, but is currently behind its reporting schedule as the latest 10-Q is from January 2016. The company did though file an 8-K regarding its operations in October and thus is more likely than not to announce material information through the SEC.

The company's financials are audited by Briggs & Veselka, a major audit firm in Texas. The audit though does not include an examination of evidence for the amounts and disclosures, therefore it is limited in its nature. Given the history of DYII's corporate governance (which was subject to a class action and fraud allegations in the past), it might be that the accounts should be taken at a discount in order to prevent any possible over-reliance on the amounts.

Investment Thesis

The above description is already showcasing that this is going to be a speculative investment opportunity, but I believe that due to the following points, investors might be interested in having the stock on a watch list at the very least:

  • The company's potential liquidation value could be much higher than the current market capitalization. While the operations are loss-making and likely already destroyed a significant amount of the company's value, if the litigation goes in the right direction, the net current assets could be valued at $17.2 million. The current market capitalization is $1.16 million.

  • This of course relies on the success with the legal cases, but this stream of arguments is supported by an independent valuation of the business that was done during the most recent shareholder lawsuit (former board members versus Mr. Chan, the current CEO) in 2015. The plaintiffs settled and were paid out of their holdings of the stock at $0.48 per share, which is significantly higher than the current price of $0.08 per share.

  • The owners also seem to realize the value of the company as they tried to take it private just a year ago. Mr. Chan and his mother have initiated a tender offer ($0.10 per share) for all of the outstanding shares. The tender was not successful in the end, but it shows that they might believe there is some value here.

  • Moreover, while the aforementioned litigation is a liability, it could also become an asset. There are a significant number of cases that have not yet been resolved where DYII stands to receive compensation. These are all accounted for by a reserve and therefore do not show on the balance sheet. Should these cases end in favor of the company, it could receive roughly $38 million.

On the other hand, the risks here are obvious:

  • The company faced several shareholder class actions in the early 2000s and an internal investigation in 2012. These were all connected to the company's accounting. This was all under the watch of a previous CEO, who died in 2012 and whose son is now the sole board member and the CEO of the company. Prior to becoming a sole board member, previous board members sued him and the company for allegedly not stopping his father from "receiving improper financial benefits". The lawsuit was settled out of court (in 2015), but it might be that the allegations could be true.

  • He and his mother own 68% of shares, which pose further governance risk as there could be little regard for the minority shareholders.

  • Waiting for the resolution of the legal cases and inability to discontinue the leftover operations might lead to further destruction of shareholder value. If the company fails to win the litigation, it could be that the stock would be trading above the NCAV value as soon as next quarter.

  • As aforementioned, the accounts might not reflect the true economic reality of the company due to the corporate governance. I am especially concerned about the deposits and bond investments in Hong Kong which account for a large part of its assets.

Due to these, I believe it is imperative that any investors that might want to get exposure to the possible upside do so at extremely cautious levels. It also might be better to just have the stock on the radar so that when a positive material information surfaces, one could try to initiate a position.

Operations

As mentioned, the company divested most of its other hospitals in the past and is now left with one facility in Pasadena. It is likely to be able to accommodate 37 in-patients and perform surgeries primarily focused on non-emergency procedures such as gastroenterology.

It is generating a deep loss that stems from the lack of revenue and possible inability of the management to cut its operating expenses (mainly compensation) as seen below:

The real cash loss then could be around $1.6 million per quarter given the annual operational cash flow as seen below:

Note: In the first three months of FY2016, the company lost only $1 million in operational cash flow.

The compensation is further propped up by related-party fees whereby Mr. Chan, the CEO, is paying himself roughly $0.6 million for "emergency services" in the Pasadena facility per year. The related party transactions should be viewed with caution as they were a core of the most recent lawsuit where the CEO has been accused of allowing his father to "receive improper financial benefits" from the company. The lawsuit was settled in 2015.

The revenue recognition of the company should also be subject to increased scrutiny due to the complex way of accounting for the insurance compensation. This especially holds true when the company was subject to fraud allegations regarding this exact topic. Two earlier shareholder class actions were dismissed by a court in 2002 and 2004, but shareholders raised a new class action in 2004 which DYII ultimately settled.

While it seems that the operations are just another source of significant liabilities, the most important thing is that the management does not want to continue to run the hospital. The management has mentioned this during the tender offer in the beginning of last year. In fact, it tried to sell the operations on a lease in October of 2016, but unfortunately the buyer did not execute the arrangement in time, and thus it is most likely still looking for someone to buy it.

Litigation

As the operations are actually a liability, the potential value of the stock could be in its legal cases.

The lawsuits originate from several hundred cases around the early 2000s where DYII claimed refunds from the insurance carriers as a normal part of the procedure. The issue with these cases though was the fact that they were a special type (stop-loss cases) where DYII charged the insurer over $40,000 per case and the patient was covered by the rules and regulations of the Texas Department of Workers' Compensation. The law stipulates that in such case the insurer should reimburse at least 75% of the requested amount.

In 2008 though the insurers started to oppose refunding these amounts and pointed out that the law also stipulates that the insurers should be liable for reimbursement only if the provider of the services (DYII) shows that they used unusually costly and unusually extensive services (so that the providers are not simply overcharging the insurers). This claim was ultimately upheld in court, but in due course, the insurers already paid for some of the DYII's cases and thus the insurers started to sue the company for a refund of these amounts.

At one point, the insurers were almost successful as the court ordered DYII to refund roughly $4 million (only a part of the total claims), but the company successfully appealed this and the court ruled that the insurers need to claim the refund via administrative hearings at the State Office of Administrative Hearings (SOAH) not via court. SOAH will then decide if the services were extensive and costly for each single case.

This is likely to be a positive development as SOAH already ruled in favor of the company on these cases when DYII first claimed the refunds in early 2000s. Further positive sign is that the management added the following line (in italic) to the litigation commentary in 2015 which was missing in the prior years.

We do not anticipate that any other carriers will pursue refund demands through district court but instead will pursue them administratively through TDWC, if at all.

Note: Taken from 10-K for FY2015

This could mean that the insurers are viewing these developments negatively and are not likely to prolong the issue further. The overall refund liability of DYII stands at $15.2 million for these specific cases.

One can likely track the progress of the hearings on the website of SOAH. I believe that I found the cases through the public search of electronic cases. You have to search for T.M.I.C., abbreviation of Texas Mutual Insurance Co., the key insurer, in the "style" column and then cases with the following abbreviations should be the ones DYII is talking about: V.H. v T.M.I.C. (V.H. for Vista Healthcare the official name of DYII's subsidiary); V.M.C.H. v T.M.I.C. (for Vista Medical Center), and possibly also V.S.C.W. v T.M.I.C. None of the cases seem to be active though, and thus, it could be likely that the resolution of this dispute is still nowhere near. Unfortunately due to the personal nature of the cases, one can't access the actual dockets.

There is also a possibility that the company could receive more from the insurers as roughly 516 cases are still in the process of determining whether the insurers should refund the amounts. This is then accounted for as an account receivable which DYII covered by an equal amount of reserve thus it is not carried on the balance sheet. The current value of the account receivables is roughly $38 million.

Assumption of Current Value

Given the fact that the company did not publish its usual 10-Qs, we are left with guesswork as to what the state of the finances might look like. By using the latest 10-Q report and conservative assumptions (unchanged burn rate, etc.), one can arrive at the following valuation:

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You can see that the result of the litigation is now likely to be crucial for the stock as it could be that the company's NCAV value has considerably shrunk if the operations have not been optimized in the wake of the significant operational losses.

As mentioned, the litigation could be now slightly in favor of the company, but one can't really be certain about that due to the complexity of the issue, but I believe that there are two other arguments that could support the notion that the stock's value should be above the current market capitalization.

  • Independent valuation implying higher share price

As a result of the settlement with the past board members that were alleging that the current CEO let the previous management receive financial benefits from the company, the plaintiffs were bought out of their shares in the company. Part of this occurred in 2014 when the group collected 530,616 shares for $27,061, implying $0.05 per share. The second part of the settlement occurred in 2015 when the group collected $137,837 for 286,386 shares, which implies a much higher share price of $0.48 per share.

One has to wonder why this increase occurred. In 2014, the operational loss was the same as in 2015, and therefore, fundamentally the company was likely in the same place. What though changed was the development of the litigation (the company won an appeal that all the cases need to go through the administrative hearings) and this could have been the reason behind this increase. While this does not have to mean that the value of the company is still the same, it certainly provides a support for the undervaluation.

  • Tender offer by the management

I believe that the management itself recognizes that there could be value in the company. Management wanted to take the company private in early 2016 by offering shareholders $0.10 per share. It was aiming to acquire 90% of the company after which it could perform a "short-form" merger and buyout the rest with the same price of $0.10 per share. After this the management mentioned that it would discontinue the operations and likely liquidate the company.

While this again does not mean that there is any value left, it is more likely than not that the litigation is going the right way as it would not be interested in buying out the other shareholders if this were not to be the case.

Risks

I have to stress again that the whole thesis now relies heavily on the litigation which seems to be in the middle of a lengthy process (administrative hearings) and that it could be that operations already destroyed most of the value left in the stock. There is also the risk that the accounts are not reflecting the economic reality (especially regarding the Hong Kong assets) and that the management will disregard the interests of the minority shareholders and extract any leftover value (or the value from the litigation) through compensation rather than liquidation of the company.

Conclusion

The bottom line is that the management is likely incentivized to close down the operations and wait for the results of the litigation. Given the tender offer, the independent valuation and the likely current standing of the cases, it could be that this means that the value of the whole company could be significantly higher than what it is trading at now.

On the other hand, a potential investment in the stock would be highly speculative due to the lack of current information about the financial position and due to the fact that it is still running the operations which could further destroy the value of the investment opportunity in the near future.

I would therefore try to either enter an insignificant statistical position or keep DYII on a watch list and scrutinize future developments.

Disclosure: I/we 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.

Editor's Note: This article covers one or more stocks trading at less than $1 per share and/or with less than a $100 million market cap. Please be aware of the risks associated with these stocks.

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