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  • Writer's pictureGreystone Capital

Why I’m long CRH Medical Corp.

Healthcare has been a much debated and often disliked sector for investors. Rightfully so, as it appears at times the government has a rooted interest in seeing to it that companies make as little profit as possible. Price regulation is a real risk, and the fact that a solid business can see revenues dip due to factors outside of its control is enough to scare most investors away. However, it’s our aim as investors to find and execute on opportunities where short term fear and uncertainty presents an asymmetric risk/reward proposition by putting a decent business on sale at an unreasonable price.

CRH Medical Corp., of which I own shares, and write about below, can be considered a medical ‘roll-up’, as they use cheap debt to acquire private GI practices across the country in an effort to consolidate the anesthesia services industry. Before you pull out your barf bags, I believe the company, while subject to regulatory risk, is trading at unreasonably low multiples of free cash flow, a discount to it’s closest peers, and believe the market is overlooking the cash generating ability of the company by focusing on GAAP earnings, which may never look like a bargain (current P/E >30) given the company’s high amortization of intangible assets.

While CRH is not exempt from some of the factors discussed above such as including changes in patient payer mix (federal versus commercial), lowered insurance reimbursement rates, and a shift in patients toward higher deductible insurance plans, I believe we’ve seen the worst of any ‘stroke of the pen’ risk, and see the company as well-run, with a proven business model and the ability to continue to generate a free cash flow yield in excess of 10% through 2020.

Description of the Opportunity

CRH represents a compelling risk/reward opportunity in the form of a rapidly growing leader in anesthesiology services for GIs in the US and Canada. I believe the company is undervalued on an absolute and relative basis, currently trading at a dramatically low multiple of current and future estimated free cash flow. Given the company’s niche position in their market, stable business model, long runway for growth, and fears surrounding short-term operational results, I feel I’ve been provided with a solid margin of safety at current price levels, with the chance for 100% upside or more within 12-18 months.

CRH Medical Corporation (CRH) is (the company’s words) a North American company focused on providing gastroenterologists (GI’s) with innovative services and products for the treatment of gastrointestinal (GI) diseases.

The primary reason for the current mispricing dates back to April 2017, when CMS (Center for Medicare and Medicaid Services) proposed rule changes that would affect both the company’s payor mix (Federal versus Commercial) and reimbursement rates as they relate to administering certain endoscopic procedures.

The new billing codes (which I will discuss below) will have the net effect of decreasing the amount CRH will likely bill and collect for anesthesia services provided in conjunction with colonoscopy procedures, starting in Q1 2018.

Following this announcement, as well as management’s guidance of a double-digit decline in adjusted EBITDA (and a 4%-5% decline in EBITDA margins), the company’s share price collapsed from around $9.25 to $2.14, or more than 72% from April of 2017 to last month. Following the company’s below average Q3 results, where anesthesia revenues declined slightly from Q2 due to issues surrounding payor mix (and not rate cuts) that the company believes are non-recurring, shares took yet another hit as of the first few weeks of November of 2017 (where I started building a position) and have bounced around from $2.50 to $3.25 (currently $2.70) for the last few months.

Shares currently trade at around $2.75 today, which is less than 9.2x TTM free cash flow (taking into account distributions to non-controlling interest), and less than 9x EV/EBITDA, providing investors with a significant margin of safety, given our estimates of future growth as well as peer/M&A multiples. We appear to have reached maximum pessimism, and view the extreme mispricing as unwarranted, given 3-year revenue and adjusted EBITDA growth north of 100%, stable and growing free cash flow, experienced long-term management, and the company’s ability to be a first-mover on a large pipeline of strategic acquisitions that will meaningfully add to the company’s bottom line.

Applying a very conservative 9x – 10x multiple to the company’s projected adjusted EBITDA for 2018 of around $36 – 38mm, OR projected FY 2018 free cash flow of around $24-25mm (a multiple I feel is low for a company that has grown free cash flow/share at a 118% CAGR over the last three years), I believe shares should trade in the range of $3.30 – $3.70 by 2018, or a +50%+ premium to current prices.

This valuation doesn’t include future growth prospects, additional acquisitions in the coming years, or recently announced share buybacks. I believe there is significant potential for 100% upside over the next 12-18 months, and given our cost basis of less than $2.00, I believe I have been provided a large margin of safety with little chance of permanent capital loss. I see shares trading in the $6 – $8 range by 2019-2020, with the same 10x multiple applied to our 2019 and 2020 estimates of free cash flow.

Business Overview

CRH Medical Corporation (CRH) is (the company’s words) a North American company focused on providing gastroenterologists (GI’s) with innovative services and products for the treatment of gastrointestinal (GI) diseases. In 2014, CRH became a full-service GI anesthesia company that provides anesthesia services for patients undergoing endoscopic procedures in ambulatory surgical centers (ASCs). The company now serves 35 ASCs in seven states, and performs approximately 235,000 patient cases annually. The anesthesia services segment represents approximately 88% of the company’s revenue.

In addition, the company provides hemorrhoid treatment services (their legacy business), via a proprietary product called The O’Regan System, that is sold directly to physicians. O’Regan is a single-use, disposable hemorrhoid banding technology that is safe and highly effective in treating hemorrhoids. This business segment is responsible for 12% of yearly revenue, and continues to grow at 8-10% per year.

Since making their first acquisition in 2014, the company has made 15 additional acquisitions to date, growing sales from $12 million in 2014 to $100 million for the year ended 2017, and EBITDA from $2 million to $34 million (attributable to shareholders) during that same time period. Free cash flow has grown at a 118% CAGR during the last three years, and the company anticipates spending around $30-$35mm per year on acquisitions moving forward.

CRH’s goal is to establish itself as the premier provider of innovative products and essential services to GI’s throughout the US. The company is aiming to consolidate the highly fragmented gastroenterology anesthesia services business.

CRH’s strategy is to use their existing relationships with GI doctors to gain a ‘foot in the door’ with deep sedation, and demonstrate the value-add, while helping doctors monetize an additional area of their practice.

The company takes on cheap debt to acquire anesthesia practices for less than 2.5x revenue and 4x – 5x EBITDA. These practices are highly cash flow accretive, often within a quarter or two, and as mentioned above, require little further investment once up and running. To date, the company has been conservative in allocating capital for acquisitions, paying average acquisition prices of around 2.3x EV/Revenue and 3.9x EV/EBITDA.

Competitive Advantage

What I like about the business strategy is the predictable, recurring revenue nature of the anesthesia practices, and the barriers to entry for smaller players to compete with CRH. Given a few hundred million dollars, it would be tough for competitors to displace the company, given their long-standing relationships with GIs, time it takes to educate and train the doctors, and ability to be a first-mover in a small space with little deal-flow (CRH basically talks doctors into partnership after educating them on the benefits). It would be tough for a competitor to replicate nearly 20 years of relationships.

In addition, it helps that the company has operated in various states and become familiar with specific laws associated with healthcare services. This operational experience has provided the company with a national scope of knowledge that is not easily learned. For competitors, before penetrating any particular market, there is local ‘feet on the ground’ knowledge that must be acquired in terms of legal requirements, medical service reimbursement levels, and healthcare contracting. CRH feels they understand local markets better than most, providing it with the ability to move first, and quickly.

I feel that CRH is different from a typical medical acquisition ‘roll-up’ because of their unique niche in the market they serve, as well as their cautious, conservative capital allocation approach. CRH isn’t a private equity firm looking to buy, grow and exit. They partner with these private practices for the long term, renewing all service contracts year over year and assisting GIs with growing and managing every aspect of their practice.

How can we get hurt?

The business model involves taking on cheap debt to acquire private practices. Although I normally avoid like the plague business models that require the use of large amounts of leverage, CRH has demonstrated the ability to generate plenty of free cash flow, which can be used to pay down debt in the near or long term. In the meantime, the balance remains fairly flexible, with debt levels at less than 2.0x EBITDA to shareholders.

CRH has just under 8% of its market cap in cash through the most recent quarter, with $10.4mm in the bank. Working capital was $13.1mm, and the company is more than able to meet their short-term obligations, having generated nearly $50mm in TTM EBITDA, with around $4 – $6mm in finance/interest expenses per year. Total debt/EBITDA remains at a healthy 1.6x, well below the company’s debt covenant ratios of 2.75 : 1.

The company has a revolving credit facility with the Bank of Nova Scotia (and more recently JP Morgan), having started with $33 million in 2015, increasing to $55 million in 2016, and as of June 2017 the facility was amended to provide $100 million. $64.2mm is outstanding on the facility, and the company pays a much more attractive interest rate at LIBOR plus 2.5% than their previous borrowings provided. Quarterly principal payments come out to around $625,000.

I view the company’s debt as much improved from just a few years ago, when CRH was struggling with a legacy business, and had little in the way of revenue growth or book value. Before making their first acquisition in 2014, the company entered into a subordinated note agreement with Crown Capital Fund III Management to borrow $19.9mm USD at an interest rate of 12% (!). in addition to the debt funding, the company paid Crown a fee of $1.35mm, as well as issued 2,000,000 shares of stock as compensation. In other words, they were robbed.

As the company’s anesthesia acquisition model began to work, they were able to raise more favorable debt in the form of the Scotia Facility, and repaid in full the principal from the Crown Note in June of 2017. In conjunction with the amended Scotia Facility as well as the repayment of the Crown Note, the company recorded a finance expense of $2.04mm, which I view as a one-time non-recurring charge. According to the most recent Q3 10Q, the company expects that cash interest payments will be less than costs incurred historically due to the extinguishment of old debt and the amendment of their current credit facility. This expectation was reflected in the Q3 results as the company incurred $270,000 of interest expense in the quarter versus $1.1mm in Q3 2016.

At the current share price of $1.85 and 74.1m shares outstanding, the company has a market cap of $137 million. Assuming management buys back 10% of shares outstanding (7.4m based on recent board approved buyback plan), the market cap would drop to $122m ($1.85 x 66m shares outstanding). The company has $64 million in debt, over $10m in cash for $54 million in net debt, giving us an enterprise value of $176m. Adding in the portion of equity belonging to non-controlling interest of $54.7m (and using the assumed 10% buyback market cap), we arrive at an enterprise value of $233.4m.

Assuming adjusted EBITDA comes in at around $38m for FY 2018 (assuming full 20% decline from reimbursement rate cuts), and then around $45-$50m by 2019, debt levels will be below 1.7x 2018 adjusted EBITDA, and less than 30% of EV. I expect the company to take on additional debt heading into 2018 and 2019, taking full advantage of their cheap credit facility and tapping into another $30-$33m or so for acquisitions per the company’s guidance. Debt levels may rise to above 2.0x EBITDA in the short term, but as reimbursement rate cuts settle, and adjusted EBITDA maintains it’s 20%+ CAGR, those numbers should be reduced heading into 2020.

As mentioned above, the company recently initiated a 10% buyback program (via NCIB) starting 11/20/17, which will be very accretive for shareholders at the current share price.

CRH defines free cash flow as cash from operating activities less finance expense, acquisition expenses and distributions to non-controlling interest. I defined it differently for our valuation purposes.

My free cash flow calculation assumes net income + D&A, minus capex, changes in working capital, and distributions to non-controlling interests. I have NOT added back income tax expense, stock based compensation, or finance expenses, which I leave out of adjustments to net income in our cash from operations calculation. I want to be very conservative, and while it’s possible that I could add back income tax recoveries, I am leaving those out as of now.

CRH generated $0.31/share of free cash flow to shareholders for the trailing twelve months, which includes distributions to non-controlling interest. Given the company’s competitive position, stable cash flows, mid to high teens ROIC, and 20%+ adjusted EBITDA growth rates for anesthesia services, a 10x multiple for the entire business does not seem unreasonable.

Using that multiple, shares should trade around $3.10 today, before factoring in additional acquisitions, incremental returns on invested capital, and my estimates of normalized 2019 and 2020 free cash flow.

Arriving at a 2020 estimate of $0.41/share of free cash flow to shareholders (a number I feel is very conservative), and applying an 8.5x – 10x multiple, shares should trade in the range of $3.50 – $4.10 within 12-18 months.20142015201620172018E2019E2020ERevenue$11,984$46,048$78,355$100,242$83,917$96,504$110,979% Growth56%284%70%28%-10.5%15%15%Patient CasesN/A71,447141,020201,578201,239235,000267,000Revenue per PatientN/A$644.51$555.00$497.28$417.00$410.65$415.00Total Operating Expenses$7,288$22,016$36,864$85,688$47,833$54,042$58,819Adjusted Operating EBITDA (shareholders)$4,696$23,424$32,371$34,335$36,084$42,462$52,160% Margin39%51%41%34%43%44%47%Less: Depreciation and Amortization Expense$458$6,859$14,934$23,805$18,042$21,231$26,080Less: Stock based compensation$362$2,749$1,375$3,454$3,248$3,397$3,651Less: Acquisition expenses$845$361$406$571$600$750$900Less: Impairment of inventory$0$241$0$0$0$0$0Less: Impairment of intangibles$0$390$0$6,653$0$0$0Operating Income$2,977$13,431$24,754$14,553$14,195$17,084$21,529% Margin25%29%32%15%17%18%19%Net Finance (Income) Expense-$1,623$13,084$4,423$9,834$3,313$3,100$3,100Pre-Tax Income$4,600$347$20,331$24,387$10,882$13,984$18,429Tax Rate % (excluding any income tax recoveries)28%28%28%28%28%28%28%Net Income$975$249$14,638$13,668$7,835$10,068$13,269Plus Depreciation and Amortization$458$6,859$14,934$23,805$18,042$21,231$26,080Less: Capex-$950$185-$114-$116$152$162$172Less: Changes in Working Capital-$1,259-$5,647-$8,044-$2,238$5,732$5,732$5,732Unlevered Free Cash Flow-$776$1,213$21,306$35,119$31,761$37,193$45,253Less: Distribution to non-controlling interest$0.00$0.00-$5,685-$12,899.00-$12,704-$14,877-$18,101% Distribution0%0%26%40%40%40%40%Free Cash Flow to Shareholders-$776$1,213$15,621$22,220$19,057$22,316$27,152Diluted Shares Outstanding49.8M70.7M74.2M74.2M66.7M66.7M66.7MFree Cash Flow per Share (available to shareholders)-$0.02$0.017$0.21$0.30$0.29$0.33$0.41

Management to date has not provided earnings or free cash flow guidance, or assistance in determining future patient volume, revenue per patient, or EBITDA numbers. There are significant estimates required in calculating many of those numbers given the fact that patient volumes fluctuate, and the nature and timing of acquisitions can cause many of the key numbers to differ quarter over quarter.

I like the capex light nature of the business (once practices are acquired, little additional capital investment is needed), and the ability for CRH to earn mid-to-high teens return on invested capital (excluding goodwill). Factoring in goodwill as a part of invested capital – a practice I believe to be the way to go here – ROIC levels should hover around the 8%-10% range moving forward.Invested Capital (thousands)201420152016201720182019Short Term Debt$6,613$3,818$5,791$3,007$8,293$8,293Plus: Long Term Debt$39,509$26,920$38,138$60,734$93,734$126,734Plus: Leases$0$0$0$0$0$0Total Debt and Leases$46,122$30,738$43,929$63,741$102,027$135,027Plus: Shareholders Equity$18,787$47,725$60,515$66,426$72,869$79,937Invested Capital$64,909$78,463$104,444$130,167$174,896$214,964Plus: PP&E$130$285$324$380$400$420Plus: Intangibles$65,604$87,307$133,667$176,915$209,000$239,000Total Invested Capital$130,643$166,055$238,435$307,462$384,296$454,384Net Income$975$249$14,638$6,558$7,835$10,068Unlevered Free Cash Flow-$776$1,213$21,306$21,728$31,761$37,193Operating Income$2,977$13,431$24,754$14,554$14,195$17,084ROIC0.68%0.14%6.14%2.13%2.04%2.22%CFROIC-0.54%0.73%8.94%7.07%8.26%8.19%ROCE2.28%8.09%10.38%4.73%3.69%3.76%ROIC (Excluding Goodwill)1.24%0.26%14.0%16.69%18.2%17.3%

Further illustrating the margin of safety from a take-private value/EBITDA multiple standpoint, I feel that in a recession or bear market scenario, EBITDA multiples should hold above 6x, given additional acquisitions, increases in patient volumes (colonoscopies and endoscopic procedures are still necessary, and shouldn’t be put off) and revenue growth rates. Applying the 6x multiple to our estimate of 2019 EBITDA attributable to shareholders of $40.5mm gets us to an EV of $243mm. Subtracting projected net debt of $120,000 ($33 million additional over the next two years, less $10m assumed cash balance) gets us to a total EV of $123mm. Dividing enterprise value by 66.6m shares outstanding (after the 10% buyback) gets us to a bear case per share value of $1.85, or right around my average cost basis.(in thousands)2019Bear CaseBase CaseBull CaseEBITDAMultipleEVEBITDAMultipleEVEBITDAMultipleEVAdjusted EBITDA (attributable to shareholders)$40,5006x$243,000$42,4008.5x$360,400$48,10010x$481,000Net Debt$120,000$120,000$120,000Equity Value$123,000$240,400$361,000Shares Outstanding66.6m66.6m66.6mTarget Share Price$1.85$3.61$5.42

My 2020 estimates look similar, with the bear case scenario still producing an estimated share price of above $2.49. Once again, I feel like I have a tremendous margin of safety at current price levels with little chance for permanent capital loss.(in thousands)2020Bear CaseBase CaseBull CaseEBITDAMultipleEVEBITDAMultipleEVEBITDAMultipleEVAdjusted EBITDA (attributable to shareholders)$44,0006x$264,000$52,1008.5x$442,850$58,30010x$583,000Net Debt$95,000$95,000$95,000Equity Value$169,000$347,850$488,000Shares Outstanding67.9m67.9m67.9mTarget Share Price$2.49$5.12$7.19

Although there is going to be some short term pain, starting after the company reports Q1 2018 results, I believe there are multiple ways to win here, and have confidence in management’s ability to execute their strategy moving forward.

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