CRH Medical Corporation Stock Report

CRH Medical Corporation

Revenue and earnings per share had increased rapidly in 2015 and 2016 after the company raised substantial capital in late 2014 and made a transformative acquisition followed by additional smaller acquisitions. The book value per share increased partly due to issuing shares at a price higher than book value. Growth is much slower in the trailing year ended Q4 2017 with modest growth in adjusted earnings per share and a decline in GAAP earnings per share.

CRH Medical Corporation (CRH, Toronto, CRHM, U.S.)
Report Author(s): InvestorsFriend Inc. Analyst(s)
Author(s)’ disclosure of share ownership:  The Author(s) hold no shares
Based on financials from: Dec ’17 Y.E.
Last updated: 05-Mar-18
Share Price At Date of Last Update:  $                               3.15
Currency: $ United States
Generic Rating (This rating does not consider the circumstances of any individual investor and is therefore not specific advice for any individual): Speculative Weak Buy / Hold at U.S. $3.15 and Canadian $4.07
SUMMARY AND RATING: The graph of revenues and earnings per share shows extremely rapid growth but note that this was due to relatively recent acquisitions that have materially changed the nature of the company. And note that growth is much slower in 2017 and adjusted earnings per share declined year over year in the last half of 2017. There may not be opportunities or the ability to continue to make acquisitions at anything near the recent rate. The Value ratios based on trailing year figures appear to support a rating of Buy. Management quality appears strong operationally but we have some deep concerns regarding disclosure and recent changes in mix and the magnitude of fee reductions caught them by surprise. The insider trading signal is neutral. The insider ownership is a positive. Executive compensation is probably reasonable and much of it will only be realised if the share price recovers and rises substantially. The outlook is for an earnings decline in each of the next four quarters due to government-mandated fee per case reductions but then likely a resumption of very strong growth. The company has good economics, although the profitability on the new fee schedule remains to be seen, and competitive advantages. It is a small company. Overall, would rate this as a Speculative Weak Buy/Hold at U.S. $3.15 or Canadian $4.07. We would not risk a large exposure to this company.
DESCRIPTION OF BUSINESS: (Updated March 8, 2018 – not updated for the 2018 AIF which is not yet available)) Despite head office being in Vancouver and despite trading primarily in Toronto (it trades in the U.S. also), investors should view this as a U.S. company since all of its revenues and the great majority of its costs occur in the U.S. This is a small company with only 17 full-time employees plus about 150 contracted Registered Nurses Anesthesiologists. In 2017, 90% of revenues were derived from its anesthetic services business. The company provides full service anesthetic services for gastrointestinal endoscopic procedures on an exclusive contract basis to ambulatory (walk-in) surgical centers. The company bills private insurance companies or Medicare or Medicaid or the patients directly rather than the surgical clinics. Medicare / Medicaid effectively sets its fees but different insurance companies pay differing percentages of the fee and it appears the remainder is only sometimes collected from the patients. About two thirds of patients pay through commercial medical insurance and one third through Medicare / Medicaid. CRH has transitioned most of the commercial payers to a contracted system that apparently results in small drop in fees but presumably provides more assurance of getting the “work”. The staff providing the services are contracted specialized registered nurses. At the end of 2016 the company provided these services at 27 Gastrointestinal-focused ambulatory surgery centers using a team of about 150 qualified registered nurses under the supervision of an anesthesiologist medical director. The patient count is about 202,000 annually. The remaining 10% of revenues were derived from the company’s longer standing business of providing gastrointestinal physicians with a patented single-use disposable hemorrhoid banding technology.  The company markets direct to physicians and at the end of 2017 had trained 2,686 physicians to use its system in 1,034 clinical practices.
ECONOMICS OF THE BUSINESS: The two lines of business (the hemorrhoid banding product and the anesthetic services) are profitable and provide recurring revenue. Neither business requires much in the way of ongoing capital expenditures. Overall, the economics of the business appear to be strong although the strength has been reduced significantly by the lower fee schedule effective January 2018 as well as by changes in its payor mix.
RISKS: The annual report lists many risks including operational and competitive risks. In our view the more important risks would include potential medical liability and regulatory risks. Also as we have recently seen they are at risk as to the amounts that government and other payers pay for their service. They are not free to set their own price. There is a risk of additional write downs of some goodwill due to the lower prices it will charge effective January 2018. Technology may also be a risk as it is possible that scanning or swallowed camera technologies could displace the need for colonoscopies.
INSIDER TRADING / INSIDER HOLDING: (Based on data from September 1, 2016 to March 7, 2017). On December 12 a director exercised 25,000 options at 27.5 cents and kept those shares to hold 1.1 million shares. On December 27 a director sold 16,000 shares at U.S. $ 2.50 to hold 222,000 shares.  This level of activity does not provide any real signal and so we will consider the insider trading signal to be neutral.
WARREN BUFFETT’s CRITERIA: Buffett indicates that all investments must pass four key tests: the business is  simple to understand and predictable (marginal pass as the business seems relatively simple but the accounting is complex due to the large minority ownership), has favorable long-term economics due to cost advantages or superior brand power (pass due to proprietary products and the steady nature of the business), apparently able and trustworthy management (pass), a sensible price – below its intrinsic value (pass), Other criteria that have been attributed to Buffett include: a low  debt ratio (pass), good recent profit history (pass) little chance of permanent loss of the investors capital (pass) a low level of maintenance type capital spending required to maintain existing operations excluding growth (pass)
MOST RECENT EARNINGS AND SALES TREND: The growth in adjusted earnings per share in the past three quarters starting with the most recent (Q4, 2017) was  minus 21%, minus 5%, plus 35% and plus 23%. Revenue per share growth in the past four quarters beginning with Q4 2017 was 24%, 4%, 33%, and 59%. But note that this includes a substantial noncontrolling interest so that the revenue growth to common would be somewhat lower. Overall the recent revenue growth has remained strong. Earnings per share “growth” has turned negative.
Earnings Growth Scenario and Justifiable P/E: The current adjusted P/E of 10.9 is pricing in very little growth.
VALUE RATIOS: Analysed at U.S. $3.15 (Canadian $4.07) The price to book value ratio, in isolation is not attractive at 3.5 and note that the company itself paid premiums to acquire the practices such that the tangible book value per share is negative and we are therefore paying premiums on premiums. However, this is a company that is valued for its earnings and the book value is not of much relevance. Based on earnings adjusted to add back the amortization of intangibles as well as modest acquisition expenses, and to eliminate currency gains and losses and a recent unusual charge to pay off some high-interest debt and (phew) to add back a write-off of goodwill in Q4 and to deduct a gain related to a reduced earn-out obligation, the  P/E ratio is attractive at 10.8. The P/E based on GAAP earnings would be quite unattractive at 36 but we believe the adjusted figure is the more relevant figure. The adjusted ROE is extremely strong at 34%. The stock is now pricing little growth, Overall, the value ratios, in isolation, would indicate a rating of Buy based on the adjusted P/E ratio and the ROE.
Symbol and Exchange: CRHM, U.S. CRH, Toronto
Currency: $ United States
Latest four quarters annual sales $ millions: $100.2
Latest four quarters annual earnings $ millions: $6.6
P/E ratio based on latest four quarters earnings: 36.1
Latest four quarters annual earnings, adjusted, $ millions: $21.9
BASIS OR SOURCE OF ADJUSTED EARNINGS: We added back amortization of the value of purchased contracts (which normally are unlikely to be declining in value although with recent fee reductions they may be) plus any unrealized foreign exchange plus acquisition expenses. Also added back an early debt repayment fee in Q2 2017. All these items we tax-effected assuming a 25% income tax rate.
Quality of Earnings Measurement and Persistence: Overall the confidence with which adjusted earnings are measured is somewhat low. However, the company does reliably generate cash and we expect earnings to grow after a pause or contraction in 2018 due the lower fee schedule.
P/E ratio based on latest four quarters earnings, adjusted 10.8
Latest fiscal year annual earnings: $6.6
P/E ratio based on latest fiscal year earnings: 36.1
Fiscal earnings adjusted: $23.2
P/E ratio for fiscal earnings adjusted: 10.2
Latest four quarters profit as percent of sales 21.9%
Dividend Yield: 0.0%
Price / Sales Ratio 2.36
Price to (diluted) book value ratio:                                         3.50
Balance Sheet: (Updated Q2, 2017 The assets consist largely (83%) of the intangible value of the contracts and goodwill that were purchased to acquire the anesthetic services businesses that have become its main business beginning December 2014. The remaining assets are mostly trade receivables (6%) and cash (5%) and deferred tax assets which result largely from expenses that were not yet tax deductible (4%). The assets are financed as follows: 25% debt, 38% common equity, 24% non-controlling equity, 9% earn-out obligations, and 3% accounts payable.
Quality of Net Assets (Book Equity Value) Measurement: As the assets consist largely of the intangible value of contracts purchased in acquisitions, the book value is relatively meaningless and this company is valued for its earnings.
Number of Diluted common shares in millions:                                  75.1
Controlling Shareholder: There is no controlling owner. Directors and the three officers as a group own about 4.5% of the common shares.
Market Equity Capitalization (Value) $ millions: $236.6
Percentage of assets supported by common equity: (remainder is debt or other liabilities) 34.1%
Interest-bearing debt as a percentage of common equity 91%
Current assets / current liabilities: 3.2
Liquidity and capital structure: Debt is 91% as large as its equity level and the company generates adequate cash flows. It has been able to increase its debt to fund expansion. Overall it appears to have reasonable liquidity and balance sheet strength.
Latest four quarters adjusted (if applicable) net income return on average equity: 34.2%
Latest fiscal year adjusted (if applicable) net income return on average equity: 36.2%
Adjusted (if applicable) latest four quarters return on market capitalization: 9.3%
5 years compounded growth in sales/share 56.8%
Volatility of sales growth per share:  strong growth
5 Years compounded growth in earnings/share 26.1%
5 years compounded growth in adjusted earnings per share 62.4%
Volatility of earnings growth:  historically volatile
Projected current year earnings $millions: not available
Management projected price to earnings ratio: not available
Over the last ten years, has this been a truly excellent company exhibiting strong and steady growth in revenues per share and in earnings per share? In the past few years, yes.
Expected growth in EPS based on adjusted fiscal Return on equity times percent of earnings retained: 36.2%
More conservative estimate of compounded growth in earnings per share over the forecast period: 6.0%
More optimistic estimate of compounded growth in earnings per share over the forecast period: 15.0%
OUTLOOK FOR BUSINESS: The company appears set to continue growing through acquisitions. However a change in their customer mix and more importantly a reduction in the reimbursements per case from all their payers will apparently lead to a decrease in earnings in 2018, perhaps quite substantial (such as 20% or more), despite growth. Growth in EPS should resume after that. A switch to lower interest rate debt should benefit earnings going forward.
LONG TERM PREDICTABILITY: It seems reasonable to predict that the company can continue to grow in the long term.
Estimated present value per share: In this case the adjustments to earnings are substantial which reduces reliability and the company faces government-mandated price reductions which make forecasting earnings growth more difficult. Nevertheless, based on our calculation of adjusted earnings the value would be $4.57 assuming compounded average growth of 6% for five years and a terminal P/E of 15 and $6.87 assuming 15% growth and a terminal P/E of 15. Both estimates use a 6.5% required rate of return.
INDUSTRY ATTRACTIVENESS: (These comments reflect the industry and the company’s particular incumbent position within that industry segment.) Michael Porter of Harvard argues that an attractive industry is one where firms are somewhat protected from competition based on the following four tests. Barriers to entry exist? (pass based on patents, contracts and expertise). Issues with powerful suppliers? (marginal pass as it is dependent on one critical supplier in its smaller hemorrhoid banding business). No issues with dependence on powerful customers (fail as Medicare Medicaid has dictated its fees and health insurance companies are in a position to somewhat dictate the percentage of the standard fees that they pay), No potential for substitute products (marginal pass) No tendency to compete ruinously on price (pass). Overall this industry appeared to be attractive for an established incumbent but the 2018 government-mandated price reductions have put this into some doubt.
COMPETITIVE ADVANTAGE: In its now main business of endoscopic anesthetic services its advantage is likely its scale in this fragmented industry. In its smaller and longer-established business of providing a disposable hemorrhoid banding technology it has the advantage of  a patent and established users of its system. The company is working to have instruction on this banding technology included in the curriculum of Gastroenterology programs.
COMPETITIVE POSITION: We don’t have information regarding market share.
RECENT EVENTS: The company continues to make acquisitions which continues to add to the size of the company. (Assets are up by 21% in 2017). The company was able to increase its line of credit maximum from $55 million to $100 million with an interest rate of 3.25%. This allowed it to pay off early some high 12%  interest debt of $15 million but it paid a penalty of $2 million to do so. In March agreed to develop a program in Washington State with an option to acquire 51% in 2018 or until June 2019. In Q1 2017 it announced that a change in payer mix at its largest practice had reduced revenue per case by 12%. In Q2 2017 there was a major change to reimbursement rates for its services that was estimated to reduce revenue per case by 8.5% in 2018 and adjusted EBITDA down by 13.5%. On November 2, the company was surprised to learn that the final cut was deeper than thought and now estimated revenues per case down by 12.5% and adjusted EBITDA down by 20%. This would reduce margins but it was not clear what the percentage reduction in net income would be. Presumably it would be quite a bit higher than 20%. But this would be offset by growth and possible renegotiations with the medical insurance companies that pay its fees. With the Q4 2017 earnings announcement it became known to us that a further 5% decline in revenue per case will occur due to increased contracting (agreed price) with private insurers. There was a write-off of goodwill in Q4 2017 driven by these revenue per case reductions.
ACCOUNTING AND DISCLOSURE ISSUES: We are deeply disturbed by the fact that their earnings press releases do no even mention net income attributable to shareholders. They appear to focus too heavily on EBITDA and even total EBITDA as opposed to EBITDA attributable to common share owners. When a reduction in revenue per case was announced they failed to provide any estimate on the impact on earnings per share. This failure continues in the release of the 2017 results. The company is required to amortise (expense) the value of its purchased contracts in its anesthesia business. Those contracts are likely to be renewed in the normal course at no additional cost,  and if so are not normally declining in value (though there was some decline due to the government-mandated fee reduction for 2018)  and so we add back that expense net of income tax. The company has gains and losses on currency and we adjust for that. The company has benefited from negative income taxes at times and we have adjusted for that. We also added back modest acquisition expenses on the basis that those could be considered to be part of the cost of acquiring businesses rather than regular expenses. We also adjusted for a write-off of goodwill in Q4 2017 and an associated reduction in an earn-out obligation. The disclosure of the medical nature of the business is very good. However, the disclosure of the billing process and the payment of those receivables by insurance companies and patients is complicated but is basically absent in the reports.
COMMON SHARE STRUCTURE USED: Normal, one vote per share.
MANAGEMENT QUALITY: This perhaps remains to be seen. We are disturbed by certain aspects of the disclosure. But the business strategy and execution does appear to be good. As recently as November 1 they had underestimated the 2018 government-mandated price reductions which were finalised on November 2.
Capital Allocation Skills: The wisdom of the newer strategy of growth by acquisition remains to be seen. All acquisitions to date were made without forecasting the full amount of the 2018 government-mandated price reductions and so the return on all acquisitions will likely turn out to be lower than expected unless offset by other factors such as better organic growth.
EXECUTIVE COMPENSATION: There are just three named executives. Salaries are not at all excessive. The stock awards appear to be perhaps overly generous. But some of those amounts will never be realized until and unless the share price recovers substantially.
BOARD OF DIRECTORS: Warren Buffett has suggested that ideal Board members be owner-oriented, business-savvy, interested and financially independent. The company has five directors. Two are doctors and all are well qualified. This appears to be a good Board from the perspective of outside share owners.
Basis and Limitations of Analysis: The following applies to all the companies rated. Conclusions are based largely on achieved earnings, balance sheet strength, earnings growth trend and industry attractiveness. We undertake a relatively detailed  analysis of the published financial statements including growth per share trends and our general view of the industry attractiveness and the company’s growth prospects. Despite this diligence our analysis is subject to limitations including the following examples. We have not met with management or discussed the long term earnings growth prospects with management. We have not reviewed all press releases. We typically have no special expertise or knowledge of the industry.
DISCLAIMER: All stock ratings presented are “generic” in nature and do not take into account the unique circumstances and risk tolerance and risk capacity of any individual. The information presented is not a recommendation for any individual to buy or sell any security. The authors are not registered investment advisors and the information presented is not to be considered investment advice to any individual. The reader should consult a registered investment advisor or registered dealer prior to making any investment decision. For ease of writing style the newsletter and articles are often written in the first person. But, legally speaking, all information and opinions are provided by InvestorsFriend Inc. and not by the authors as individuals. The author(s) of this report may have a position, as disclosed in each report. The authors’ positions may subsequently change without notice.
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