As valuation professionals, we actively follow publicly traded companies in the healthcare industry. These companies provide insight into how company management and investors evaluate the opportunities and risks faced by a particular industry. Challenges in the diagnostic imaging business are not unique; nearly all ancillary healthcare service companies are experiencing similar macroeconomic headwinds. However, ancillary healthcare stocks have continued to demonstrate gains.
An ancillary service is defined as an auxiliary or supplemental service, such as diagnostic imaging, used to support the diagnosis and treatment of a patient condition. Ancillary services are generally non-core to acute care hospital operations and involve patients in non-life threatening circumstances. Arguably, ancillary services are elective in nature as patients have control over the frequency, timing and choice of service provider, and may even “opt-out” entirely of recommendations by their physician (i.e. ignore a physician-recommended request to get an MRI).
Although not perfectly comparable, the diagnostic imaging industry can gather insights from the experiences of other publically-traded ancillary companies (collectively referred to as “Ancillary Companies”) which face similar challenges. We will review the stock performance and management commentary of the Ancillary Companies to highlight how these companies have reacted and will continue to address current industry trends. For illustrative purposes, we will focus on the following companies:
Ø RadNet, Inc. (Ticker – RDNT) – Owner and /or operator of approximately 250 outpatient imaging centers primarily in California, Maryland, Delaware, New Jersey, New York, and Rhode Island;
Ø Laboratory Corp. of America Holdings (Ticker – LH) – National operator of clinical laboratory tests including 44 primary laboratories and approximately 1,700 patient service centers;
Ø Quest Diagnostics Inc. (Ticker – DGX) – National and international operator of clinical laboratory tests including routine, gene-based, esoteric and forensic drugs; and
Ø AmSurg Corp. (Ticker – AMSG) – National operator of approximately 235 ambulatory surgery centers of which approximately 151 are focused in gastrointestinal endoscopy while 84 are multi-specialty. AmSurg added physician services to its portfolio with its purchase Sheridan Healthcare during the 3rd Quarter of 2014.
Management Insight
In response to reimbursement, volume and other unique challenges, the Ancillary Companies have unanimously responded by realigning cost structures to maintain profits. To a large extent, these operators continue to reference continued cost reductions as the panacea of industry woes as demonstrated in the following quotes:
RadNet:
“And it’s part of the fact of life in the imaging industry. If you go back several years and look at our EBITDA margins, it’s hung around sort of the 19%, 20% level now for about 4 years running….so we think that, that pattern of being able to continue to make our business more efficient to mitigate pricing pressures in the future will continue. So that we’re….quite confident that we can keep margins relatively stable.” [Mark D. Stolper, CFO during Q4 2011 Earnings Call]
“We are faced with a $20 million to $22 million negative impact to our revenue in 2014 from changes in the Medicare physician fee schedule. We are meeting this challenge with the comprehensive $30 million cost savings plans.” [Mark D. Stolper, during CFO Q4 2013 Earnings Call]
Laboratory Corporate of America Holdings:
“We should be able to, as any company, continue to improve our cost structure, improve the way we do our business, and that should either help mitigate the pressures that we're seeing or, hopefully, help improve our operating margins going forward.” [Glenn A. Eisenberg – CFO & Treasurer during Q2 2014 Earnings Call]
Quest Diagnostics:
”We now expect revenues to be flat to down 2.0% for 2014…we also continue to make progress driving operational excellence…we exited the year with run rate savings of more than $500 million, and this surpasses the original Invigorate goal that was established in 2011, a year earlier than planned. This positions us to exceed our $600 million goal in run rate savings by the end of 2014, and this, again, compares to the run rate of 2011. And we now anticipate run rate savings approaching $700 million, and we also continue to be committed to our longer-term goal of $1 billion in savings beyond 2014.” [Stephen H. Rusckowski, CEO Q4 2013 Earnings Call]
Investor Insight
Given the challenging industry landscape and management cost containment measures, a review of the stock performance of the Ancillary Companies sheds light on the investors overall assessment of the likely-hood that management will be able to achieve results. As shown in Exhibit 1, the S&P 500 returned 9.1% since January 1, 2014, while the median price appreciation for the Ancillary Companies increased approximately 20.0%. Over the prior twelve months, the S&P 500 returned 18.6% compared to the median price of the same universe of Ancillary Companies of approximately 20.0%. Overall, the Ancillary Companies have exhibited positive returns for the prior twelve months and have outperformed the broader S&P 500 index since January 1, 2014.
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Based on the performance metrics illustrated in Exhibit 1, investors continue to support the prices (therefore the valuations) of the Ancillary Companies. The stock market has sent observers a message: valuations for publically traded ancillary services have not deteriorated and there appears to be investor confidence in management responses (e.g. cost cutting and /or rightsizing of business operations). Therefore, a valuation professional should be wary of business forecasts where flat to declining revenue and increased costs squeeze profits into perpetuity. The impact of anticipated management responses should not be underestimated in the valuation of imaging businesses, or other ancillary business.