University General Health System: Profitability + Expansion = Exponential Growth

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ByStewart Flink:

University General Health System, Inc. (UGHS.OB)

October 2012

1. Business Summary


University General Health System, Inc. ( www.ughs.net ) is a Houston- based public company ( UGHS ). It is a regional, integrated, multi-specialty health care provider in the acute care space, which currently offers physician-centric and patient-oriented services in the state of Texas. UGHS is in the process of 'breaking out' with respect torevenue and net income, asit is a very different animal from both the non-profit competitors (which make up over 85% of the industry) as well as the for profit competition. Management has described UGHS as a "healthcare ecosystem" with diversified revenue sources among a broad platform, including concierge services. There are currently 650+ employees and some 550 doctors in the system.

The company operates through three overall segments:

· The Hospital segment offers various medical and surgical services; inpatient, outpatient, and ancillary services comprising inpatient surgery, outpatient surgery, heart catheterization procedures, physical therapy, diagnostic imaging, and respiratory therapy; and 24-7 emergency services and inpatient services that include critical care and cardiovascular services. It also operates diagnostic imaging, physical therapy, and sleep clinics. This segment is approximately 85% of the total revenue and the bulk of the profitability in 2012.

· The Senior Living segment operates senior living communities offering housing and 24-hour assistance with activities of daily life to mid-acuity frail and elderly residents; and offers memory care services primarily for residents with Alzheimer's disease and progressive dementia. This is about 10% of total historical revenue and margins are low, but it is a referral source to other areas.

· The Support Services segment provides billing, coding, and other revenue cycling management services; and interrelated services, including food, hospitality, and facility services for businesses and healthcare facilities. This segment contributes about 5% toward totalrevenue, and is growing.

After recent analysis of Q2 and management guidance for 2012, I am convinced this company is undervalued based on its competitive advantage within the industry, its strategic plan for increasing top-lin e growth (which involves organic growth, accretive acquisitions, and new construction) and, most important, its proven model of rising cash flow and profitability. It is important to realize that for the last three years, UGHS was a turnaround- a distressed company burdened with debt and struggling to survive. Today, it is a thriving business with significant free cash flow, a balance sheet that is improving every quarter, and enterprise with a deep management team poised for growth.

Management has publicly stated that it expects to earn $25 million in net income in 2012 , and by backing into a few numbers, I estimate that EBITDA for the year comes in at least $40 million . It has restructured its debt (please see press release issued October 2nd), which combined with current cash flow, gives UGHS the flexibility to continue on its acquisition strategy for the remainder of 2012 and beyond.

The compelling part of the story is what could happen in 2013-2014, as this appears to be a repeatable business model that can be advanced into other cities in Texas and nationwide. Management suggested in a press release last year that they intend to expand in dozens of large, urban markets in the future, so the growth from a regional to a national company is an inherent part of management's vision. Due to all these factors and more, I believe the stock is undervalued at current levels.

2. General Industry Description: The competitive advantages of UGHS

The industry is both complex and highly regulated, with three major entities:

1) Physicians (represented by AMA)

2) Hospitals focused on acute care (represented by the American Hospital Association)

3) Insurance companies (including Medicare and Medicaid)

There is immense pressure to reduce costs and increase quality. Most ofUGHS's competitors are non-profit, so many of them are not "motivated" the same way as UGHS. As mentioned previously, approximately 88% of all competitors are non-profit models, and have fewer incentives to focus on reducing expenses and profitable expansion. The focal point here is that this is a companythat is owned by the shareholders, and management owns a significant percentage of the company. Because UGHS is focused on smaller facilities (50-100 beds) as opposed to 500-1000 beds, it has a more efficient model with higher quality of care for less cost. Add in the concept of physician-owned hospitals with entrepreneurial doctors that have incentives to compete with better care and higher profitability, and you get a clearer picture of how and why UGHS excels. Keep in mind that many for-profit facilities are owned by investors as well as physicians.

Although it should be noted that very few competitors embrace the UGHS model,it is succeeding despite mega competition in its own backyard. The Texas Medical Center in Houston has more beds per capita than anywhere in the world with 32 million square feet (and adding 1 million square feet per year). Imagine the possibilities in markets where there is little or no competition ifit is very profitable in a competitive market like Houston. It should be noted that there are competitors who are diversified like UGHS: Mayo Clinic, Cleveland Clinic and Kaiser Permanente, to name a few. However, there is ample room for growth in many areas, even in cities where these competitors already have a presence.

3. Business Model

Clearly, as an entrepreneurial, private acute care business, management is both driven and has the right incentives to keep a watchful eye on the expense side while maximizing profitability. One of the keys to the kingdom for UGHS is its business model vis-à-vis accretive acquisitions. When UGHS acquires a free-standing, ancillary department that is now under the umbrella of a hospital outpatient facility, there is a step-up inrevenue which goes straight to the bottom line. 3rd party payers have been reducing reimbursements to non-hospital owned facilities, whereas when the acquired facility comes under the UGHS license, they become integrated into their system, and 3rd party reimbursements may actually increase. In addition, they now operate under an acute care facility where they can get referrals from their existing network as well as the acquired network. Two things are accretive: the hospital gets more revenue and UGHS picks up physicians who owned the diagnostic center, and subsequently these physicians become a referral source to the hospital.

Let's examine a hypothetical case. Assume the company makes an acquisition of a free-standing diagnostic center in a strip mall. The entity has current revenue $10 million, the current profit is $2.5 million, and therefore there is $7.5 million of expenses. Embedded in the model is a profit allocation between physicians and the new owners. Assuming the acquisition has no organic growth in the first year, revenue could double to $20 million in Year 1. Why? As UGHS 'bestows' its license on the acquired facility, it becomes hospital outpatient department, which means it has upgraded the services and care and can charge $750 or higher for an MRI vs. $500 that it charged before. While insurance companies have reduced reimbursements to independent medical facilities, they continue stable and higher reimbursement rates for patients in licensed medical care facilities.

The bottom line is that costs haven't changed, and it becomes a classic WIN-WIN-WIN scenario. The doctors win because they get an increase in pay based on higherrevenue, UGHS wins with higher profits, and the shareholders win due to higher cash flow and net income (with little or no dilution). While I have no idea what the profit-sharing percentage is, the acquisition will have a meaningful impact on both the top and bottom line for UGHS. I should add that this does not even account for economies of scale in terms of eliminating duplicative costs of accounting, legal, billing and reimbursement, and even software integration.

With respect to acquisition structure and terms, it gets even more interesting. Given the size and profitability of UGHS, I imagine that in most situations, a relative small percentage in cash serves as the down payment, and there could be seller financing involved. Assuming no equity is used in the acquisition, there is little or no dilution- UGHS can make larger acquisitions, using the enhanced profitability of the new company to pay for part of the acquisition. In terms of price, UGHS will pay the seller a certain multiple of EBITDA, and let's assume it is 2-4 times. If the public company has average multiple of 6-7 times EBITDA, UGHS wins again with multiple expansion from private to public.

The company has other ways to expand. UGHS has announced that it will build as many as four hospitals in the Houston area, and management has suggested in certain cases, particularly where there is little or no competition, it is cheaper to build than to acquire. In a town that has 80,000-100,000 people with the closest ER an hour away, they can capture a huge share of the market and add doctors to their network. Again, these may be 50-75 bed facilities, and competitors typically build much larger facilities, leaving the question how profitable large hospitals can be. UGHS has a niche that is proven, and will stay focused on its business model.

4. Financials- Balance Sheet and Income Statement

It appears the company has finally turned the corner in terms of its balance sheet. The debt, which was put in place 4-6 years ago and somewhat of an impediment to growth, was restructured (announced publicly on October 2nd). MidCap Financial provided an asset based lending structure (i.e., accounts receivable) in the form of a $19 million financing agreement. From this new facility, UGHS repaid outstanding debt to Amegy Bank, its past IRS obligations, and others. It has drawn on $12.3 million of the $15 million outstanding (which can expand to $25 million based on certain covenants). In addition, there is a $4 million term note with 1.5 years remaining, which is being paid monthly out of cash flow. In the press release, the company stated that they "estimate that the cumulative impact of the MidCap and Amegy Bank agreements will result in an improvement in working capital of approximately $15 million over a three-year period, along with interest and other expense savings of approximately $3.1 million in the first year and approximately $0.8 in annual savings thereafter. In addition, the Company's balance sheet will reflect an improvement in its current ratio from 0.32 to 0.68 as a result of the transactions and agreements." There are also mortgages outstanding (June 30th balance sheet) on certain facilities as well. The good news is that the average interest rate is in the 6-7% range, and I believe with larger credit facility, those rates come down.

On August 17th, the company reported $5.1 million of net income last quarter . Net patient revenue increased 48% to $26.5 million vs. $17.9 million in the same quarter for 2011. Average daily inpatient census increased over 12% vs. prior year levels. Senior living revenue was $2.3 million, including support services. Overall occupancy rates were 93% in Q2. Totalrevenue rose 63% to $29.1 million. Net patient revenue from commercial and managed care providers was 66.6% and 32.9% from Medicare and Medicaid. Self-pay revenue increased to 11% from 5.3% in the June quarter of 2011. Total equity improved to $14.1 million from a negative shareholders' equity of -$0.6 million at the end of December 2011. The company had $127 million in assets on 6/30.

However, the real story is in Q3 and beyond. Management has publicly indicated $25 million of net income for the year on revenue of approximately $120 million, which puts them at a minimum earnings run rate of $2 million per month. EBITDA should exceed $40 million for 2012, and there are about 326 million shares outstanding fully diluted ( management and affiliates own 40%). With a stock price at $0.40 (the bid price), it puts the market cap at $130 million.

While UGHS is a smaller company, the comps with other public companies paint a picture that is yet another signal that company is undervalued. Typical multiples for the industry are 15-17x earnings and 6-7X EBITDA. The average EBITDA margin is 8.5%, whereas UGHS has an EBITDA margin of 32-40%, which will expand in the next 3-6 months. The industry average for ROA is 4%, and given the projections for the next two quarters, the ROA for UGHS could approach 15-18% range. The one area where UGHS looks risky is the debt/equity ratio- the industry average is about 60%. Excluding capitalized leases (buildings and facilities), the debt/equity ratio is about 3. However, given the earnings projections for just the next two quarters, I expect this number to drop below 1.4 by year end. Looking out to the 2nd half of 2013, my hunch is that the ratio will be in line with the industry.

In 2013 it is anyone's guess, but given the company's stated intention of acquisitions as well as new construction, I can imagine a scenario where the company is doing north of $250 million revenue run rate prior to year-end 2013. Assuming net margins remain at 20% , UGHS has the potential to be at a $50 million net income run rate within 12 months, which would make the company severely undervalued today. Based on current margins and the accretive nature of acquisitions, there is a scenario where the stock could be at $1.25 or higher in a year's time. This would be a multiple of 8x earnings, or about half the industry standard, with significantly higher margins and growth rates.

As the company acquires additional facilities, it will be interesting to see if they use cash or stock. My sense is that they will use cash as a sign that the stock is undervalued and stock-based acquisitions will be too dilutive. Given the current cash flow and additional lines of credit, it would appear that UGHS will go the cash route for the foreseeable future so as not to dilute themselves and other shareholders.

5. Management Team

Dr. Hassan Chahadeh, CEO & Chairman of Board

Dr. Chahadeh received his medical degree at Damascus University in Syria. He studied general surgery and anesthesiology at Baylor College of Medicine in Houston. In addition to the general residencies, Dr. Chahadeh also achieved certifications in advanced microsurgery and cardiovascular anesthesia. Upon completion of his residencies, he pursued a fellowship in Pain Management at the University of Texas MD Anderson Cancer Center in Houston. He is Board Certified in Anesthesiology, General Surgery, Advanced Microsurgery and Cardiovascular Anesthesiology. As an experienced businessman, Dr. Chahadeh has a diverse background in the development and management of healthcare entities including ambulatory surgery, imaging and wound care centers and their associated real estate ventures. As Managing General Partner & Founder of University General Hospital, he has been intimately involved in the initial design, development and operational restructuring of the hospital.

Donald Sapaugh, President & Director

Mr. Sapaugh has in excess of 30 years of healthcare experience, and recently was the Founder, President and Chief Executive Officer of TrinityCare Senior Living, established in January 2000. Prior to TrinityCare, Mr. Sapaugh, from 1978 until 1986 served in various financial management positions and as a Chief Financial Officer in five different general acute care and psychiatric hospitals. Mr. Sapaugh has an extensive background in development, acquisitions, and mergers. He also has public company experience where he served as Chairman and Chief Executive Officer, as well as a board member to many public companies. He has a degree from University of Houston in Accounting and Management.

Michael Griffin, CFO

Mr. Griffin arrived at the company in August of 2009, and he has more than twenty-five years of experience in the healthcare industry. Griffin brings a diverse background in healthcare finance, capital markets, operations and development. His experience as auditor with Peat Marwick to CFO for Multiple Hospital Systems has provided him with a unique understanding of the healthcare industry. In addition as chief financial officer for Simmons Healthcare, his role led him to such places as Australia to oversee development of medical facilities. Mike is responsible for Financial Reporting, Capital Financing, Budgeting, Patient Revenue Cycle & Billing, Facility Construction and Development & Forecasting for New Ancillary Services.

Ed Laborde, Secretary/Treasurer & Director

Mr. Laborde is a corporate, securities and finance attorney with experience in a range of industries, including the development of health care facilities. He joined UGHS in January 2011 after 18 years of private practice in Houston-based law firms. From 2004 to 2011, Mr. Laborde was a Shareholder in the Corporate Securities and Finance Practice Group of the Houston office of Winstead PC. From 1993 to 2004, he was a lawyer in the Corporate Securities Practice Group of Houston based Chamberlain Hrdlicka. Mr. Laborde received his law degree from Tulane Law School and his undergraduate degree from Georgetown University.

This is a deep, experienced management team that can take UGHS to north of $500 million inrevenue, and they are motivated to do just that-approximately 40% of the shares outstanding are held by management or affiliates.

6. Risks

a) Potential Overhang: It should be noted that the company did a private placement in April of 2012. The company raised $3.4 million in the form of a convertible preferred, convertible at $0.22 with warrants at a strike price of $0.26. In addition, $5 million was raised in the form of common stock with no warrants at $0.14. While this represents a significant amount of potential overhang on the market (more than 20% of the shares outstanding), my sense is that most of the money was raised from long-term investors. In addition, UGHS purchased a revenue cycle management company for 9 million shares, a hospitality service provider and facilities management company for 5 million shares. Both of these acquisitions for stock are future overhang on the company's shares.

b) Execution Risk: Management may be unable to execute on its acquisition strategy, which is a key component of its future growth and profitability. In addition, expanding into other markets and regions besides Houston may prove to be less profitable, although given the current competitive landscape, it appears this risk is less likely to occur.

c) Macro Health Care Policy Change: Industry risk is always a possibility, but UGHS is has diversified its revenue stream, and is on a path to grow from a regional to a national acute care provider.

d) Going Concern: UGHS was issued a going concern letter at the end of Q2 from its auditors. However, this is akin to looking in the rear view mirror, and given guidance for the year and the debt restructuring that took place, this should be a non-event going forward.

e) Shares Outstanding: Given the amount of shares outstanding, there exists the potential for a reverse stock split in the future. In addition, an additional equity raise cannot be dismissed, as there is $25 million of principal payment obligations from notes outstanding due in 2013. Both of these potential events could have material adverse effects on the stock price if not done properly.

f) Obamacare/post-election issues: There are certainly sweeping changes coming in 2014 (if not before), yet the company believes it can thrive in any environment, and is prepared for a variety of outcomes, including the elections next month.

Conclusion

The model, which is both diversified and vertically integrated, includes operating efficiencies as well as acquisitions of acute care "host" hospitals and the development of "regional" health networks in a defined radius, but with an experienced management team, that can expand to other cities and regions. UGHS has competitive advantages:

· It is physician-ow ned, and therefore exempt under whole hospital exemption via Stark law (grandfathered in prior to 12/31/10)

· General acute care model is more resistant to healthcare reform. Medicare increased reimbursement for General Acute Care Hospitals by 2.1%, while reducing reimbursement to Skilled Nursing Facilities by 3.3%.

· UGHS has a diversified revenue stream with high margins, and has the ability to continue on its growth trajectory

· Stronger balance sheet and profitability in terms of EBITDA, net income and asset growth with positive net equity. The company has the ability to both pay down debt and make acquisitions out of existing excess cash flow.

·Five main areas of acquisition focus: acute care hospitals (already own a main hospital system with 72 beds); ambulatory surgical centers; physical therapy; imaging diagnostic treatment facilities, and senior living.

· Strong, experienced management team, including history of operating or working with both private and public companies, making acquisitions, and managing software and billing systems as it pertains to expansion.

· Stock is trading at $130 million market cap. Based on management guidance, UGHS is trading at approximately 5.5x 2012 earnings , 3x 2012 EBITDA and 1x revenue for this fiscal year. The company is undervalued relative to its peer group based on almost every metric.

Disclosure: I am long [[UGHS.OB]]. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

See also If You Like Google, You Should Love Baidu on seekingalpha.com



The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of The NASDAQ OMX Group, Inc.



This article appears in: Investing , Stocks

Referenced Stocks: UGHS

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