Based in Vancouver, Canada, CRH Medical Corp. (CRHM, Financial)(TSX:CRH) operates almost entirely in the U.S., providing products and services to gastroenterology clinics.
CRH's legacy product line is a fully disposable rubber band ligation system for treating hemorrhoids (called the O’Regan system), which it sells to gastrointestinal doctors. Sales in 2018 were $10.9 million, down 5% from last year. The product business is small but complementary to the services business.
The company's main business is providing anesthesia services to patients undergoing endoscopic procedures performed by GIs in ambulatory surgery centers. CRH enterted this business with its acquisition of Gastroenterology Anesthesia Associates in 2014 and has ramped up rapidly from there, having completed 21 acquisitions to date. The revenue generated by this business in 2018 was $101.8 million (up 22% from $83.5 million in 2017).
These practices are structured as subsidiaries which rollup into CRH. Many of the newer acquisitions have large minority ownership (former owners of the anesthesia practices). The rapid pace of acquisitions, along with the resulting acquisition-related expenses and amortization as well as the large minority ownership, has complicated accounting. Minority interest on the balance sheet at the end of 2018 stood at approximately 44% of total equity. This was up from around 38% in 2017.
Source: Chart by author with data from Gurufocus.com
The company has a $100 million revolving line of credit, from which it has drawn $70.5 million. As of year-end 2018, it was incurring interest at a LIBOR rate of 2.5%. The facility matures in June 2020 and is conditional on maintaining covenants. I would imagine that as the company matures, it will seek to establish additional, more stable sources of debt financing, such as issuing bonds or preferred equity. Given the copious cash flow, it should not have too much trouble and hopefully management will act before a recession hits.
Valuation
As an investor, it’s better to be approximately right (with a good margin of safety) than precisely wrong. To simplify, I will assume that 50% of the current and future cash flow belongs to the common shareholders and other 50% belongs to the minority owners.
Therefore, looking at just the income statement can be misleading. The trailing price-earnings ratio is 45. A simpler way to cut through the complexity is to look at the cash being generated from operations and allocating the free cash flow to shareholders versus minority owners.
The following diagram lays out the cash flow from operations over the last five years.
Source: Chart by author with data from Gurufocus.com
Free cash flow, after netting out changes to working capital (orange line – labeled Buffet- Bernhard FCF), has grown rapidly over the last five years, from $3 million to almost $49 million. Remember, half the free cash flow belongs to minority owners, so we are left with $24.5 million for 2018. There are 73.4 million shares outstanding, including executives' stock options. Therefore, it works out to 33 cents of free cash per share for 2018.
Assuming this free cash flow grows at an average rate of 15% per year for the next 10 years and using a cost of equity (discount rate) of 12% and terminal growth rate of 4%, the GuruFocus Discounted Cash Flow Calculator arrives at the following valuation.
Alternatively, we can apply a 20 times multiple to free cash flow to arrive at approximately $6.7 per share. Since the current share price is $2.70, based on the above assumptions, the company appears to have a decent margin of safety.
Conclusion
Revenues have grown rapidly over the last five years (at an annualized rate of 70%) as has cash flow. The business model is straightforward and has a long execution runway. Demographics are very favorable. The accounting, however, is complicated and the model is heavily dependent on a continuous stream of acquisitions with minority stakes, some of which could turn sour due to contractual disputes. The company remains somewhat at the mercy of U.S. Medicare and Medicaid reimbursement and regulatory changes to guidelines since 40% of revenues are derived from government-backed health care.
In 2017, Medicare reimbursement was cut by 9%, which resulted in a steep decline in the stock price. Since much of the business is based on anesthetic services for colonoscopys, which is an elective procedure, it remains dependent on the robust U.S. economy and high employment with medical benefits. Debt financing via a medium-term bank loan with restrictive covenants is inherently risky, especially in an economic downturn.
An aging population, requiring more cancer prevention, is a powerful secular tailwind. The stock is generating a 12% free cash flow yield, which is growing at a 20% per annum clip. It should be attractive to a private equity outfit as well as an acquisition candidate. CRH is a speculative buy. It may well pay for next year’s summer vacation, but I am not betting my house on it.
Disclosure: I am long CRH Medical
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