Beacon Update on CRH CRH Medical Corporation
(CRH-T)
Compelling Valuation with Huge
Growth Opportunity
May 23, 2017
Doug Cooper, MBA
(416) 643-3863
dcooper@beaconsecurities.ca
Despite continued strong quarterly results and great
management execution, recent erroneous short reports
have caused share price volatility with stock down 35%
from late April highs.
Underlying investment thesis still very much intact. Aging
demographics driving endoscopic procedure growth
with deep sedation now accounting for ~50% share.
CRH’s growth strategy driven by GI relationship from
O’Regan hemorrhoid segment. For example, the clinical
practices served by CRH is 963, +32% over the past 2
years while the number of trained physicians on the
O’Regan device has reached 2,490, +26% over the same
period.
These clinicshave become the prime hunting grounds for
its anesthesia acquisition strategy as GI’s look to reduce
potential regulatory risk of owning both a GI clinic and
the anesthesia practice. We point to the fact that 7 of
the last 8 acquisitions have been less than 100%, ranging
from 51% to 65%.
On a run-rate basis, CRH is performing ~180,000
anesthesia procedures. Assuming 20 million annual
endoscopic procedures with 50% utilizing deep sedation,
that would imply that CRH’s “market share” is a mere
1.8%. Consequently, we believe there remains
SIGNIFICANT room to continue its acquisition strategy.
Finally, we remain comfortable that CRH can maintain its
margin profile.
After the sell-off, CRH now trades under 11x our FY18
EBITDA forecast – a material discount to other
demographically driven health care service companies.
We maintain our Buy recommendation and C$11.50
target price.
Lots of Room To Grow
Recent reports have cast doubts on both CRH’s ability to continue its growth through acquisition strategy as well as its ability to maintain its current margin profile. In reaction to these assertions, the stock has dropped ~35%. In the following paragraphs, we will attempt to show why we believe such a theory is misplaced and as such, why the shares at current levels represent an excellent entry point.
Significant Acquisition Opportunities Remain
To fully understand the opportunity within the anesthesia market, one must first be cognizant of the relationships that CRH has developed within the GI community through its O’Regan hemorrhoid sales group. Over the past several years, the company has continuously added clinics and hence physicians who are using the device. At the end of Q1/FY17, CRH counted 2,490 physicians at 963 GI clinics as clients. This is up 26% and 32% respectively just over the past 2 years. These clinics have become basis for CRH’s foray into the anesthesia market.
After its initial 100% purchase of Atlanta-based GAA in December 2014, CRH has looked to “partner” with GI practitioners who may want to reduce their potential regulatory risk of both owing a clinic and the anesthesia practice. Such conversations start through the relationships CRH has already through its O’Regan business. Consequently, of the subsequent 10 acquisitions the company has executed since GAA, 7 have been for less than 100%, with the GI partners retaining between 35%-49%. (Note the 3 acquisitions for which CRH bought 100% were at the smaller end of the revenue spectrum).
One doesn’t need to be a calculus major to see that with 10 acquisitions complete but relationships with 963 clinics, there remains fertile ground to execute on others.
Looking at it another way (in terms of market share), it also leads one to the same conclusion, ie. that significant consolidation opportunities remain:
There are approximately 20 million endoscopic procedures performed annually in the United States. This is growing at above GDP rates as an aging population undergoes cancer screening;
Deep sedation is being increased utilized as part of the procedure. We believe it is now approaching 50%;
CRH is on a run-rate of ~180,000 annual procedures. Based on the 10+ million endoscopic procedures using deep sedation, CRH would have a market share of ~1.8%. Clearly there is additional consolidation that could be done.
From the company being able to fund such acquisitions, one must consider a few factors:
CRH has strong operating margins. Its gross margin on product sales (O’Regan) at ~62% is even stronger than the margin on its anesthesia service (~56%). This, combined with limited cap-ex,results in excellent free cash flow generation, which is currently running at ~$8 million per quarter. Assuming a 4-5x EBITDA acquisition multiple, CRH could buy $1.8 million of EBITDA per quarter without any additional debt or share dilution. Put another way, the company ended Q1/FY17 with $39 million of net debt. If it did nothing, it would be debt free within a year. The bottom line is that CRH’s strong FCF implies that the company is under-levered at this point. It can use both its FCF and additional debt to finance future acquisitions in a non-dilutive manner.
Margins Should be Sustainable
As noted above, CRH enjoys strong operating margins. There is seemingly a chorus of doubters who say that such margins are unsustainable. Again, some understanding is necessary:
a) CRH’s O’Regan business (for which we have heard no concerns about re-imbursement risk given it is sold to the GI’s) covers the entire overhead (and then some) of the company. As a point of reference, the operating profit of its product segment in Q1 was $1.73 million while the entire corporate overhead was $0.9 million. Thus the company generated EBITDA of $0.8 million before the accretion of the anesthesia business, whose profit drops fully to EBITDA (and cash flow);
b) In terms of its anesthesia business, one must understand certain billing aspects of the industry. Endoscopic procedures can take place in hospitals, ASC’s or GI clinics. Such different locations will be captured in the facilities fee, which is part of the bill. As we know, some of these locations (read hospitals) will be less efficient than others. CRH’s facilities are very efficient with significant capacity utilization and hence operating leverage. It is also important to note that anesthesia itself represents only ~20% of the entire cost of the procedure (lab tests, preparation materials, facility fee, physician fee, and anesthesia fee). We can imagine that at some (perhaps most) clinics, the margins being realized are far lower than for CRH (given its efficiency). Yet re-imbursement would have to be the same for all participants. Recall that CRH has less than a 2% market share. Is the tail really going to wag the dog and leave many participants in an unprofitable situation? Remember that the purpose of colonoscopies is primarily as a cancer screening tool (whose treatment costs would be many multiples of the endoscopic procedure). This is also why CRNA’s (ie. nurses) are re-imbursed at the same level as doctors – to make the screening more prevalent. If re-imbursement were to be materially changed and the service was not as widely offered, cancer rates could increase, thus costing payors significantly more.
Maintain Buy and C$11.50 Target Price
We remain bullish on companies that are positively impacted by the aging demographic profile. CRH fulfills our “wish list” of such companies and also generates strong free cash flow, has a very high RoE and has the ability to consolidate a high margin, fragmented industry. Furthermore, over the past 10 quarters, the company has done an excellent job of execution against its business plan. These points all argue for a higher multiple. Yet the recent noise around the company has resulted in a dramatic drop in the share price. From a recent April high of C$12.35, the stock dropped to a recent low below C$7.00. We believe this misunderstanding of its growth prospects and margin sustainability has created a great entry point, especially for those who feel they “missed” the opportunity before. With the stock now trading below 11x our FY18 EBITDA forecast versus some other aging demographically-focused health care service companies at ~17x, we feel the valuation of CRH is now very compelling.
We maintain our Buy rating and C$11.50 target price.