CRH Medical - Don't Be Seduced by the Free Cash Flow

This is a case where just looking at cash flow can result in an incorrect assessment

Author's Avatar
Dec 28, 2020
Article's Main Image

CRH Medical Corp. (AMEX:CRHM, Financial) is a Canadian healthcare professional services company whose primary business is rolling up the gastroenterology anesthesia space in the United States.

I wrote about the company last year, deeming it to be a speculative buy at the time. It focuses on gastroenterology centers and helps them outsource their anesthesia requirements. Using this roll-up strategy, CRH Medical has grown revenues from ~$8 million in 2014 to ~$120 million in 2019 and free cash flow from ~$2 million to ~$40 million over the same time.

This growth appears to have faded in recent quarters, however, as has the stock price. Let's take a look at the reasons behind the rapid growth and decline.

1ab333a4566f69c45cc7052b3856a451.png

Reasons behind the decline

The company's main business is providing anesthesia services to patients undergoing endoscopic procedures, such as a colonoscopy, which are performed by gastroenterologists in ambulatory surgery centers in the U.S. CRH entered this business with its acquisition of Gastroenterology Anesthesia Associates in Atlanta in 2014 and has ramped up rapidly from there. The company has made 29 acquisitions through Aug. 8, 2020.

These anesthesia practices are structured as subsidiaries that rollup into CRH. Many of the newer acquisitions have large minority ownership (by 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. The acquisitions are financed through debt (via bank loans) as well as preferred equity (which is recorded on the balance sheet as minority interest).

Minority interest on the balance sheet at the end of Q3 2020 stood at approximately 42% of total equity. A proportionate share of the pre-tax income is owed to the minority interest before the company can retain any net income. There is no dividend as of yet.

884136333.jpg

Chart 2 - Author - (Click here for larger image)

The company's business model is to buy anesthesia practices from gastroenterologists. The company then enters into a "Professional Service Agreement" with the same for a period of time where it then provides anesthesia services to the practice. The agreements are then amortized over the time period of the contract.

So essentially, these agreements are being bought with debt, and then debt keeps on building on the balance sheet as more acquisitions take place. Everything is great as long as the roll-ups proceed, but when growth begins to stall, it's time to watch out. Unfortunately, that is what happened in 2019, and the stock price has since stalled. The Covid-19 crisis also resulted in a steep fall in colonoscopies, which is the bread and butter of CRH.

A warning flag

Recently, CRH's largest customer, United Digestive, gave notice that they will not be renewing the agreement when it expires in 2021. This has contributed to the stock falling. United Digestive represents 20% of CRH's adjusted Ebitda, so this is a significant blow. This non-renewal illustrates a big red flag for shareholders regarding these agreements - how will they be replaced, and on what terms? While the company is trying to grow organically (i.e., without buying Professional Service Agreements), this effort is still at an early stage.

772329317.jpg

Chart 3 - Click here for a larger image.

Conclusion

In my opinion, the company needs to reduce reliance on its agreement-driven treadmill and move towards organic growth. While the company's free cash flow appears to be very strong, it is mostly fictitious as this cash flow is being bought in advance via debt financing. Once you take out the depreciation and amortization and the payments to the minority interests, there is not much left for the common shareholders.

The current acquisition-driven roll-up business model is not attractive. As agreements signed following acquisition begin to expire, it's likely they will not be renewed, or will only be renewed on less profitable terms for CRH. It's also not clear to me if these acquisitions are accretive to the common shareholders given net profits have declined since peaking in 2017. Unless the company can build a sustainable organic growth engine, I do not plan to add to my small position.

Disclosure: The author owns shares of CRH Medical Corporation.

Read more here:

Not a Premium Member of GuruFocus? Sign up for a free 7-day trial here.