Greystone Capital - Medical Facilities Corp: Surgical Hospitals Are Licenses To Print Money

The following segment was excerpted from this fund letter.

Medical Facilities Corp. (OTCPK:MFCSF, TSX:DR:CA)

Medical Facilities Corp. found its way into the portfolio this quarter as an under-the-radar microcap that owns minority interests in a group of surgical hospitals in various geographies. The company's four core facilities are located in South Dakota, Oklahoma and Arkansas and provide services ranging from orthopedics to spinal care to various inpatient and outpatient procedures. Medical Facilities partners with physicians for ownership of these hospitals, and operates the facilities from an administrative, billing and back-office standpoint, while generating revenue by collecting a facility fee for their services. This model is a beneficial partnership for both the company and its physician owners, as doctors are free to provide medical care while MFC takes care of management of the facilities.

I wouldn't typically be interested in this business or industry, as there is no shortage of bad examples of private equity surgical hospital rollups where scaled players who took on too much debt collapsed under the weight of a high fixed cost model. MFC is not a rollup, and when run well, surgical hospitals are licenses to print money. Furthermore, there are elements of this story that I believe have allowed us to purchase shares at bargain basement prices. Following years of mismanagement, recent activist involvement led to a management and board change, strategy shift, dividend cut, and operational improvements that were executed with the sole focus of driving shareholder value. The dividend cut and strategy shift caused the stock to sell off, which hasn't quite recovered despite the positive improvements that have taken place.

Furthermore, MFC has some of the best performing hospitals in their geographies, carry less leverage than their peers, and have been in operation between 20-40 years, earning very high-quality scores among patients and staff. MFC will also benefit from favorable trends in the US healthcare market including an aging population and strong demand for orthopedic services moving forward. Despite this being a competitive space, MFC has some aspects of a soft moat, that have allowed the facilities to grow their patient volumes and revenues at mid-single digit rates for the past decade plus.

These include:

• High levels of patient satisfaction are driven by convenience, high standards of care and a less bureaucratic environment than a traditional hospital. This allows for more convenient intake and discharge as well as better scheduling availability
• Physicians practicing at MFC facilities can drive their procedure volumes higher than a traditional hospital setting, thereby increasing earnings potential which leads to surgeon loyalty over time
• The scale of each facility means that MFC can offer a wider range of procedures and patient choice, providing an equal alternative to a traditional hospital
• Given the choices available, MFC can lead with billing transparency and avoid surprise medical bills for hospital visits

I like our chances to do well here as the mandate for management is simple. Manage the hospitals efficiently, sell off non-core assets, and return capital to shareholders. MFC has been executing on all three initiatives, by divesting five of six non-core Ambulatory Surgery Centers, restoring hospital level margins, and returning a significant amount of capital by repurchasing nearly 20% of shares outstanding last year alone. It is likely the business will continue to divest both non-core assets and potentially surgical hospital assets over time.

Selling into strength will benefit MFC. Significant consolidation is taking place across the industry, with the last 12-18 months representing one of the most active periods for M&A in industry history. The rise of physician owned hospitals, outpatient care, the need for market share gains and significant scale mean that MFCs assets are very attractive and could fetch strong valuations in a sale scenario. The closest public company comps, as well as every relevant M&A transaction I could find point to a sale scenario being one path to strong returns. Absent that, mid-single digit top line growth, even on a slightly elevated cost base, means that MFC should be able to generate $1.5 - $2.0 dollars in FCF/share within the next few years. The current share price is $6.75 USD. With the continued divesting of assets, more share buybacks, and potential margin expansion, our upside could approach 100% over time.

Editor's Note: The summary bullets for this article were chosen by Seeking Alpha editors.

Editor's Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks.