Monday, July 26, 2010

The Lower Rungs Of The Income Statement

NovaMed (NOVA) owns (in partnership with physicians) surgery centres throughout the US. It has 37 such centres under its purview, with a wide variety of offered services, but primarily focused on cataract operations. The company has a market cap of just $62 million, but generally generates after-tax earnings in excess of $6 million per quarter! On the surface, the market appears to be offering this company at an enormous discount, so what could be the problem?

The company does have debt of $110 million, could that be the problem? Well, it would seem that the company's services are of a non-discretionary nature (unlike some other cyclical health companies we have seen), since even during this recession operating cash flow remains rather stable. As a result, the company has paid down its debt by $17 million in the last four quarters from its operating cash flow, suggesting the situation is well under control.

Sixty-million dollars of that debt, however, is convertible into equity. Surely, this potential dilution is scaring investors off, right? Actually, this too does not appear to be that big a deal. At first glance, the conversion price of the convertibles is $6.37/share, which is below the stock's current price of $7.83. But when the company issued these convertibles, it also purchased call options on its own stock at $6.37 (and sold call options at $8.31), effectively raising the convertible price (from the company's perspective) to $8.31. Should it so choose, the company also has the option of paying cash, rather than shares, to the converters of the debt, to avoid dilution at a poor price.

So the debt, even the convertible debt, seems manageable. So why is the market offering up this company for so cheap? The answer lies in the lower rungs of the income statement, where few investors venture. While the company generates $6 million of earnings per quarter, it pays most of this to the physicians it has partnered with (as per the first line of this post). The "minority interests" are getting a majority of the profits in this situation!

A glance at the cash flow statement further illustrates that the economics of this company are not as neat as they first appear to be. While the company has earned net income of over $57 million over the last three years, it has paid out almost $50 million in "Distributions to minority interests", the doctors that are performing the surgeries.

The top of the income statement (revenues, COGS, SG&A) is its most popular section. But sometimes companies are structured in a way such that it is the bottom of the statement that affects the stock's intrinsic value the most. This company would appear to be a screaming steal to those who do not closely scrutinize the company's statement of earnings from its revenues all the way down to the shareholder's pocket.

Disclosure: None


Paul said...

thanks for posting again saj. you are a great teacher! your site is one of the first i read almost every morning. i hope one day you'll open up your fund and let us invest! :)

Saj Karsan said...

Thanks, Paul! I appreciate it

Frank said...

The bulk of NOVA's assets is Goodwill, which is a big red flag for me. It appears that their strategy is to consolidate these physician-run practices, taking the physicians on as partners. The companies that I have seen that do this sort of thing tend to overpay for the acquisitions, leading to massive goodwill "Assets".

On the plus side, having the physicians as partners ensures that the managers of the individual locations have interests aligned with NOVA. A lot of physicians seem to enjoy the work but not the administrative end, so NOVA provides a valuable service in that regard.

Great assessment Saj

Anonymous said...

I can't really say i agree with you on how most physicians enjoy their work. I think they mainly enjoy their cash, and thats about it. I have met many different doctors since my family moved around abit since i was a kid. Haven't met many sincere doctors, but they sure as hell charge me a lot of money for 10 min face to face time.