ExamWorks’ latest financials were published last week. After taking a quick look, and reflecting back on a couple conversations with folks who know their business, I’m a bit puzzled.
For those unfamiliar with the company, ExamWorks is a relatively new publicly traded company that provides Independent Medical Exams and related services throughout the US. Their strategy is acquisition-driven; they are ‘rolling up’ other IME companies and seeking to reduce costs, thereby driving increased profits.
Their management profile is intriguing. Executives have similar backgrounds – looks like they all worked together in the past at companies such as PracticeWorks (a dental practice software company) and TurboChef. Doesn’t seem to be much workers comp or auto IME experience among the senior folks.
So here’s what’s got me puzzled.
First, ExamWorks reports something called ‘adjusted EBITDA’, a non GAAP (generally accepted accounting principle) measure. For we non-accountants, adjusted EBITDA is one of those nebulous reporting categories used by companies (often those growing thru acquisition) trying to show financial results when using GAAP numbers would produce numbers that, according to the companies using them, would not be representative of their real financial status. In terms of actual expenditures, it’s hard to figure out what exactly is included, and not included in ‘adjusted EBITDA’.
Here’s how ExamWorks defines the term – “Adjusted EBITDA [is] earnings before interest, taxes, depreciation, amortization, acquisition-related transaction costs, share-based compensation expenses, and other non-recurring costs.” Two terms stand out – “acquisition-related transaction costs” and “other non-recurring costs.”
Fortunately, as a publicly traded company, ExamWorks is required to use GAAP standards; when these are used the numbers become a bit more clear – for 2010, their actual net was a loss of $5.4 million. That’s not necessarily a problem, after all this is a high-growth company expanding thru acquisition, a strategy that necessarily results in higher costs early on, costs that hopefully disappear and are overtaken by the fruits of the acquisitions.
That is, if the growth-by-acquisition strategy actually works.
ExamWorks (EW) embarked on a massive acquisition spree a while back, with the biggest recent deal involving MES, which was acquired for $170 million in cash and more in stock. That deal, and the many others EW has consummated over the last year plus, is an attempt to own the market, to become the dominant national provider of IME and related services.
The problem with the strategy, and more to the point the future of the company, lies in two areas – revenue cannibalization and scale.
Revenue cannibalization – or, the whole is less than the sum of the parts.
Most workers comp payers like to spread their IME business among at least two, if not several vendors. Now that EW has bought up many of its competitors, these payers don’t look at EW and MES or BME Gateway or any of their other acquired companies as different; the payers, quite logically, consider them to be one and the same. As a result, business that was going to, say MES because it was a competitor of EW is now going to go somewhere else. Not all of the business, and perhaps not even much of it – but certainly some.
The implication is clear – the companies EW is buying may well see declining revenues as a result of the acquisition. And, it follows, the revenues produced by EW may well be less than the sum of the revenues generated by all the companies they acquired.
In the most recent earnings call, EW execs stated words to the effect that they were going to maintain the MES sales force as a separate and distinct entity, perhaps as a way to address this issue. While we in the work comp business may be slow, most of us will eventually figure out it’s the same company, and payers will shift business around to ensure they spread it amongst different vendors.
Which leads us to the next issue, scale.
We’ll leave aside the question of how expenses can be reduced if the company is paying for two competing sales forces, and focus on the Cost of Goods Sold.
The IME and peer-review services business has a cost structure that is based to a large degree on variable costs – primarily, what they have to pay the physicians who deliver the expert opinions. As a ‘craft business’, this doesn’t lend itself to scale-driven profit increases – the more IMEs they sell, the higher their variable costs are. Sure, there are some benefits to scale, such as smaller sales forces, consolidated IT and corporate administrative functions and the like, but these are small potatoes compared to the physician expense.
I suppose EW could try to negotiate better deals with their physician experts, but that isn’t likely to meet with much success. IME docs are a) in short supply; b) can offer their services through a rival IME company; c) payers like opinions from ‘good docs’ and will go to the IME provider who has those good docs on their list; and on a related note, d) quality is really important to most payers, who won’t like it if their IMEs are done by docs who don’t ‘get’ workers comp/auto.
EW’s investment proposition is to a large extent focused on generating outsize margins from a pretty labor-intensive business. Their forecasts call for EBITDA numbers approaching, and eventually surpassing, the 20% of revenue mark. I don’t see how this is possible. People in the business today who run companies in the same space, and do it quite well, can’t come near this figure. Most are pretty darn pleased with an EBITDA in the low teens, and a ten percent figure is pretty much industry standard.
If this was a high-fixed-cost/low-variable-cost business like the PPO industry or software, or relatively new (MSAs), we could reasonably expect a very well run, large player could deliver outsize margins. The IME business is neither. It is a mature industry, with companies operating in a highly competitive market with high variable costs.
In fact, as claims frequency continues its structural decline, the underlying driver of their business – the number of work comp claims – will continue to shrink year after year. Add that to the very real issue of regulatory risk, and you get an investment picture that’s rather risky.
I don’t doubt the management of EW has successfully built companies in dental practice management software and commercial and residential cooking. I’m not so sure they’re going to have much success in the IME business.
Finally, I’m completely befuddled by Wall Street’s apparent inability to understand these issues. For example, Goldman raised their six month share price target by a buck after the numbers came out. I would note that Goldman was a lead underwriter of their IPO…
Thanks to WorkCompWire for the heads’ up.
