Medical Facilities Corporation: Market Overreaction Presents A Strong Investment Opportunity

Summary

• MFC’s undervaluation as compared to industry peers, obscurity (small-cap, low coverage), recent dividend cut, and historically low share price signals an investment opportunity.
• We think MFC has too much debt but not an unserviceable level. Interest rates are low and the healthcare services industry carries only a low-to-moderate investment risk.
• MFC has been experiencing declining margins and we think they have bottomed-out. Assuming no-growth, we think the intrinsic value of MFCs shares lies somewhere around USD$6.68.
• The market is overreacting and with a substantial investment horizon, we are bullish on MFC.

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Screening for Value

Medical Facilities Corp (OTCPK:MFCSF) is trading at a 10-year low, has a price-to-book ratio of 0.75x, and is trading at forward multiples substantially lower than comparable companies. We don’t normally like to use forward-looking statistics, but it was necessary for this company due to their recent losses. MFC is obscure- a micro-cap stock with little analyst coverage and a corporate structure that is not easy to understand for the layman. Their recent dividend cuts (press release) from $0.844 annualized per share to $0.28 have driven the poor market sentiment towards this stock. This leads me to believe that there may be a strong investment opportunity in this stock driven by its poor valuation and the obscure nature of this stock.

The Valuation Model

The valuation model values the free cash flows of the corporation attributable to shareholders at the corporation’s cost of capital and assumes no growth. We calculate zero-growth cash flows from a historical average of adjusted EBIT margin multiplied by trailing 12-month revenue. Then, we add cash, subtract debt attributable to shareholders, and subtract the effect of diluting financial instruments to obtain a valuation of the firm.

Company

Description- MFC is a Canadian incorporated holdings company with controlling interests in 13 hospitals throughout the USA. Of these, 5 are specialty surgical hospitals (SSH), and 8 ambulatory surgery centers (ASC). SSHs are specialized surgical centers that perform scheduled surgical, imaging and diagnostic inpatient procedures where patients may stay overnight, if necessary. ASCs provide outpatient procedures where patients stay for less than a day. MFC generates revenues from the provision of facility services and non-controlling interests of its facilities are primarily owned by physicians in the hospitals. Its growth strategy is both from organic and inorganic growth.

MFC was set up and listed in Canada as an income trust because there were tax advantages in doing so in the early 2000s. Additionally, the private healthcare services market is much more attractive to investors in the USA as compared to Canada. This is why MFC is structured the way it is.

Source: Q3 2019 MD&A

We like MFCs business model- roll-up multiple medical facilities, put people with business acumen in charge of the operations but continue to give the medical professionals a stake in the success of each facility. They operate in the healthcare services industry, which carries a low-to-medium risk and may have good long-term prospects due to an aging population. Aside from MFC’s credit risk, we them as having a low-to-medium business risk.

Risks & Recent Challenges

Facility location- One thing we do not like is the scattered location of their facilities- we see little opportunity for them to realize procurement & operational efficiencies.

Outpatient care trend- There is a trend toward outpatient care versus inpatient care because technological advancements have reduced the recovery period for many surgical procedures. MFC highlighted this trend in their 2004 IPO prospectus and this is expected to continue. Unfortunately, the vast majority of MFC's facilities are designed for inpatient care and have overnight rooms. This will negatively effect their capacity utilization and ROIC if they are unable to generate revenue from their overnight rooms. We see this as a low risk because the vast majority of profits and revenue comes from surgical procedures.

Underperforming facility, UMASH- MFC wrote down UMASH by $29.5m in 2019 due to performance far below expectations. UMASH's revenue was down 47% in Q3 2019 as compared to Q4 2019. This facility is now burning cash and in our view destroying value, which is why we were happy to see them reduce their interest in UMASH from 87% to 32% as of February 26, 2020 (press release). The underperformance of this subsidiary represents a low risk- we believe the company is more valuable without this facility.

Underperforming subsidiary, Nueterra- In addition to UMASH's write down, MFC wrote down a cash-generating unit representing 7 ASHs (MFC Nueterra in the above table) that it had acquired in 2018 due to subpar performance. However, this subsidiary only represents a small portion of MFC's cash flow, and management seems to be responding quickly to this issue by selling off one of these ASHs earlier this year (press release).

Shrinking Margins- MFC has been experiencing a decline in operating margins from 33% in 2012 to between 12% and 20% in the past 2 years. This is due to increased competition, a less-profitable mix of procedures, and growing bargaining power of third-party payers (private insurance, government programs). Expanded government healthcare programs that may occur under a Democratic presidency represents a risk to MFC.

Competition- Management cites that competition is strong within the markets that they operate in. Competition is part of the reason they had two write down two of the previously mentioned facilities, however, we don't see this as a large risk moving forward for the remaining subsidiaries. A competitor opened up a facility next to BHSH last year and this did not negatively impact this facility's revenue.

Inputs and Assumptions to the Valuation Model

Source: table by author

In the operating margin analysis we adjust for depreciation of right-of-use assets before IFRS 16 came into effect in Q1 2019. We assume that they will continue to operate at margins similar to the past 8 quarters for the foreseeable future. 8 quarters was used due to the seasonality of this business; fourth quarter results are historically stronger as patients try to use the benefits of their insurance that is reset every calendar year.

Source: table by author

In addition to the operating margin adjustment we made for IFRS 16, we make a similar adjustment to include right-of-use liabilities into the firm's capital structure, as right-of-use liabilities are usually considered as a form of debt. For a medium-risk business, we normally do not like to see adjusted debt-to-capitalization ratios above 0.50x, so we are categorizing this company with a high financial/credit risk. However, investors can expect a drop in its debt servicing expense as it will roll over $41.8m of 5.9% convertible debentures into its corporate credit facility at LIBOR + 2.0% (~3.65%). The high financial risk of this firm means we will discount its cash flows using a higher equity risk premium of 5.90%.

Source: table by author

The consolidated financial statements of MFC makes it difficult to understand the share of consolidated cash flows that are going to the shareholders. For this analysis, our best assumption is that the shareholders’ share of cash flow is related to the shareholders’ share of net income. In the past 7 fiscal years, shareholders have owned 40.04% of consolidated net income.

Source: table by author using data from 2018 YE Financial Statements

Corporate debt is revalued to its reproduction value or market value using a cost of debt of 3.65%. As some of the consolidated debt is shared with non-controlling interests, it is estimated that 147.5m of the consolidated entity’s debt is attributable to shareholders. The other debt-like instruments (exchangeable interest liability, right-of-use liabilities) are incorporated into the model by reducing free cash flows by their service costs.

Source: table by author

MFC’s reproducible cost of debt was assumed to be close to what it is being charged by its largest corporate credit facility, and this may be conservative considering prevailing corporate bond yields and overall low interest rates in our current economy. We use a cost of equity that is the equity risk premium on top of the corporate’s cost of debt. Although unconventional, we like to assume that the cost of equity is related to the financial risk of the business. A tax rate of 30% was used due to the USA’s federal tax rate of 21% and an average state tax rate of 9%.

With these assumptions, MFC’s free cash flows should be discounted at a rate of 5.17%. MFC’s strong leverage is taking advantage of low prevailing interest rates. The low-cyclicality of the healthcare services industry is reflected in the low weighted average cost of capital.

Valuation Model

Source: table by author

Using the past 8 quarter adjusted EBIT margin of 15.3%, we think MFC should normally be generating $15.78m of cash attributable to its shareholders.

In a traditional discounted cash flow analysis, one would add depreciation and subtract capital expenditures to free cash flows. However, MFC's capital expenditures are highly volatile year-to-year and difficult to predict. In this zero-growth model, we assume depreciation is roughly equal to capital expenditures. Depreciation is built into the operating margin.

Assuming no growth, depreciation should be lower than its current level as MFC is continuing capital expenditures in pursuit of growth. Thus we feel that the zero-growth free cash flows are understated, but we have decided not to adjust for this effect in pursuit of being conservative.

Source: table by author

The model values Medical Facilities Corporation at $6.68 per share. Using a 1/3rd margin of safety on this valuation, it suggests that one should enter the company at no-higher than $4.45. This is substantially higher than MFC’s current share price of, suggesting that this is a strong opportunity to invest.

Closing Thoughts

We feel that the market is overreacting to recent negative news and performance- MFC has a good business model in a safe industry. Our model critically assumes that margins do not continue to shrink and MFC is able to maintain its current level of revenue. Every investment should only be made with a very long time horizon and this is no exception, but we believe that the downside risk for MFC is minimal.

Analyst’s Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in MFCSF over 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.