...as concerns P/B and P/S with Birner Dental Management Services (BDMS), they trade at a very high valuation to their P/B, and not in line with their average ROE, and that is before taking out leverage. Is there an answer to the discrepancy between their high P/B with only about 18% ROE and how P/S ties into that?
Wow. This is going to be a complicated answer. Actually – yes – there’s an answer to the discrepancy. In fact, there are two answers. Birner has very high amortization charges. And Birner had a different definition of revenue.
This is an accounting article. So here comes the footnote…
“….(Birner Dental Management Services) restated its audited consolidated statements of income for the years ended December 31, 2007 and 2008 and its unaudited consolidated statements of income for each of the quarters of the years ended December 31, 2008 and 2009. The restatements affects (Birner’s) previously reported revenue and expenses for clinical salaries and benefits paid to dentists, dental hygienists and dental assistants. (Birner’s) reported revenue increased by the amounts paid to dentists, dental hygienists and dental assistants. Clinical salaries and benefits increased by the same dollar amounts as the increase in revenue. The restatements have no impact on (Birner’s) contribution from dental offices, operating income, net income, earnings per share, consolidated balance sheets, consolidated statements of shareholders equity and comprehensive income or consolidated statements of cash flows, or the calculation of Adjusted EBITDA.”
Ready to dig into this?
With BDMS, there are several accounting complications you need to understand. Most importantly, there’s an unusually huge and persistent gap between EBITDA per share and earnings per share. Basically, Birner constantly understates its economic earnings. So, any metric that uses net income is going to give you a misleading take on the company.
Before we go any further with BDMS, you probably want to get someone else’s take on the company – not just mine. I’m sure there are some bearish folks out there. And it would be good to Google around and try to find their blogs. Because any explanation I give you of how BDMS’s business works, how its accounting works, and what it means for an investor could be accused of being overly bullish.
Remember: We’re talking about a $33 million market cap stock here. So, the mere fact that I frequently use BDMS as an example should tip you off to the fact that I obviously like the company enough to research a pretty obscure stock. So be warned – I’m not providing the consensus opinion here (if there is one on a $33 million stock). I’m just giving you my take.
Okay. Now let me explain the discrepancy between what I think BDMS’s “owner earnings” are and what kind of net income, ROE, operating margin, etc. you are seeing.
Go to GuruFocus’s 10-year financials page for BDMS. Notice anything odd? Look at EBITDA. That’s earnings before interest, taxes, depreciation, and amortization. Notice how stable EBITDA is. Let’s take EBITDA per share.
Okay. So, it’s a boring, stable company. BDMS has a business predictability ranking of 3 stars according to GuruFocus. Not bad for a company with a $33 million market cap. What’s weird about all this is that the stability of EBITDA is not shared by the stability of other numbers. Most notably, the revenue numbers are all over the map. Especially notice how revenue leaps from $18.26 a share in 2008 to $31.86 a share in 2009. Do you really think BDMS’s sales grew 75% in one year while adding exactly zero EBITDA that same year?
That doesn’t sound likely.
So what does sound likely?
An accounting change. Go to gross margin and operating margin. Notice how they both fall off a cliff – in almost the exact same ratio – at the same time sales spikes while EBITDA stays steady.
You know what’s coming here. If you check EDGAR for that time period, there’s a good chance you’ll find that BDMS changed what counts as revenue. By changing the revenue line they changed their gross margins, operating margins, etc. However, changing revenue recognition doesn’t change EBITDA.
Think of advertising companies. In fact, think of Groupon (GRPN). Remember, Groupon’s revenue controversy? Groupon counted as revenue cash that was paid out to its merchant partners. Is that really revenue? Or is that just handling cash? They aren’t the same thing. Otherwise: banks, brokers, etc. would report trillions of dollars in revenues.
This was a big deal because it was Groupon. People were talking about valuing the stock – which had no earnings – on a price-to-sales ratio. The problem with using price-to-sales is that sales can be a very squishy number. It’s easy for a company to exaggerate its revenue. It’s harder for a company to exaggerate its free cash flow, EBITDA, etc.
Okay. Now remember how Groupon’s revenue numbers suddenly changed by a huge amount? That didn’t mean the business actually changed. The only thing that changed was the way Groupon described its business to shareholders.
Same story here.
In our BDMS example, it’s not like patients paid any more for their visit to the dentist. Nothing that substantial happened. All that happened is BDMS changed what it counted as revenue received from the offices that form its cash conduit. Basically, people pay offices. And then offices pay Birner. By changing what is revenue and expenses for the offices you can change what is revenue and expenses for Birner. This has no real impact on Birner’s economic reality. In fact, Birner had been reporting their own non-GAAP number for years. So, in reality, Birner was – if shareholders read the whole 10-Q, 10-K, etc. rather than just the audited financial statements – always reporting all these numbers.
They always reported what the revenues and expenses of both their offices and the corporation itself were. I think they used terms like “contribution from dental offices” and “contribution margin”. Anyway, I remember reading the 8-K where Birner explained the change they were making – and restated their financial statements. It was utterly inconsequential. However, it does affect any metric that uses sales as either the numerator or the denominator.
This is a good example of why you always need to read a company’s actual 10-K, 10-Q, and 14A. Never invest in a company until you’ve done that.
Also, you need to read the notes to the financial statements. The same kinds of notes are often important at different companies. For example, you always read what the definition of “revenue” is. You always read the inventory note. It tells you whether inventory is finished and waiting to be sold or just raw materials waiting for an order to come in. Together, notes like these often give insight into how a company works. Inventory is a particularly important note.
You also have to read notes that have a big impact on reported earnings. So, the key note in Birner’s SEC reports is the note about amortization. Actually, Birner has a whole big section about how the business is structured financially. So you need to read and understand the part about “management agreements”. I’ll give you a quick taste – this is not the full explanation – from part of Birner’s 10-K:
“With each Office acquisition, the Company enters into a contractual arrangement, including a Management Agreement, which has a term of 40 years. Pursuant to these contractual arrangements, the Company provides all business and marketing services at the Offices, other than the provision of dental services, and it has long-term and unilateral control over the assets and business operations of each Office. Accordingly, acquisitions are considered business combinations and are accounted as such.”
Often, one accounting note will lead you to another. This is why you always read a 10-K – or any SEC report – with a pen in hand. For example, once you know that Birner’s management agreements last 40 years, a bell should ring in your head to go check the length of time over which the agreement is amortized.
That trail would lead you to this note:
“The Company's dental practice acquisitions involve the purchase of tangible and intangible assets and the assumption of certain liabilities of the acquired Offices. As part of the purchase price allocation, the Company allocates the purchase price to the tangible and identifiable intangible assets acquired and liabilities assumed, based on estimated fair market values. Identifiable intangible assets include the Management Agreement. The Management Agreement represents the Company's right to manage the Offices during the 40-year term of the agreement. The assigned value of the Management Agreement is amortized using the straight-line method over a period of 25 years.”
Okay. So, what those two notes together tell you is that BDMS writes off 4% of the purchase price – in excess of tangible assets acquired – each year. Finally, I included the bit about the inability of the acquired offices to terminate the agreement except under extreme circumstances because that is such a critical issue with a company like this. If the agreements were easy to terminate, then these acquisitions would really be more like management agreements. In reality, these so-called management agreements are actual acquisitions in all but name.
This reinforces the most important idea in reading SEC reports. When you research a company you aren’t looking for some mystical “right” number in terms of earnings, sales, book value, etc. The economic reality of sales, earnings, assets, etc. is always squishy. It’s always inexact.
How much is your house worth?
I’m sure you can give me a number right now. But I’m also sure it’s probably not the exact price you would sell it at if you put up a for sale sign today. It’s the same thing with business. And that means it’s the same thing with accounting. You don’t read SEC reports looking for little things. You look for big things. You look for an understanding of the economic reality.
In the case of BDMS, I believe – and I’m sure other folks might not agree with me – that the economic reality of the company is that their “owner earnings” are some form of the cash flow generated from operations less their capital expenditures on existing offices. And the management agreements are really outright purchases of dentist offices. Therefore, when I think of BDMS I don’t see the GAAP statements shown in the SEC reports. I see something more like a company that simply buys dentist offices and produces EBITDA.
Now, of course, EBITDA is not earnings. What shareholders get is really just the free cash flow. But when I look at BDMS, what I care about is the overall revenue of the offices – not necessarily what BDMS recognizes as their own corporate revenue – and the amount of EBITDA, free cash flow etc., that leads to on a per share basis. That – plus capital allocation – is what matters most at BDMS.
As far as the idea that BDMS has a low return on equity, I just checked the latest 10-Q. They had $5.72 a share in tangible assets at the end of last quarter. Let’s pretend that’s usually what they have. EBITDA has been in the $2.50 to $3.50 a share range in the last couple years. Free cash flow has been in the $1 to $2 per share range. You can run those numbers yourself and see that the economic reality of BDMS for the last few years has been that the 18% ROE number you cite is pretty much the bottom end of their owner earnings divided by their invested tangible assets. In other words, even without leverage BDMS’s returns on tangible invested assets are good. You’re obviously including intangibles. Which is fine. But it’s not something I would do. There’s no way that Birner’s reported return on equity – including intangibles – is a meaningful figure in any economic sense. Dentist offices don’t produce earnings in line with their book value. And those amortization charges really affect reported earnings. Just look at Birner Dental’s 10-year Financial Summary and compare earnings per share with free cash flow per share.
So, I’d look at the price-to-sales ratio and some form of a margin – maybe the free cash flow margin – for a company like BDMS. However, in this case, you need to go back to past years and make sure you adjust for the new definition of sales. Like I said, this is actually pretty easy. All you have to do is read some of Birner’s old 10-Ks. They provided this data. Just not as part of the audited financial statements.
Finally, I want to talk a bit about how noticeable all this is. It’s not like you have to go to EDGAR to figure all this out. Just by looking at Birner Dental’s 10-year Financial Summary you can see that free cash flow per share has been higher than earnings per share every year for the last decade.
You have to keep your eyes open. And whenever possible you need to look at a company’s financial data in context. Ideally, over a 10 year period. And you always want to look at more than just one metric at a time. Return on equity is important, free cash flow is important, operating margin is important.
But more important than any one number is the overall picture that emerges when you step back and look at the relationship between all these metrics over a full decade. That’s when you start to really understand a company.
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