EUR 850.00 For Business Accounts Only

Morningstar | Surgery Partners' 2Q Results Suggest Turnaround Is on Track; Maintaining Fair Value Estimate

No-moat Surgery Partners reported quarterly results that we think should begin to grow investors' confidence in management's strategy. While not a perfect quarter by any stretch, we think that the actions taken by CEO Wayne DeVeydt in his first six months on the job bode well for patient and risk-tolerant shareholders. We're planning on maintaining our $19 fair value estimate for the company, which implies roughly 10 times our 2019 adjusted EBITDA estimate, and would highlight that both sizable financial leverage and an acquisition heavy strategy underpin our very high uncertainty rating.

While not necessarily following a unique playbook, we think DeVeydt has made the difficult decisions over the last two quarters required to put Surgery Partners in a position of strength over time. Divestitures of noncore assets and a flattening of the firm's organizational structure should help free up the capital needed to reposition the firm. While much has been completed to-date, portfolio pruning activities will likely be ongoing until at least year-end. Further divestitures are likely, and we wouldn't be surprised to see additional physician practices or the firm's lab and optical services businesses sold off in the near term. These areas have long acted as an anchor on results, and we think the firm would be best served by realigning around its core competency of providing short-stay surgical services.

The rest of 2018 will continue to be a turnaround year, likely with bumps along the way. That said, we're excited about the firm's future prospects as investments in physician recruiting, technology infrastructure, and procurement all begin to bear fruit in the coming years. Management intends to better integrate the firm's string of acquisitions by implementing a common billing organization and consolidating patient accounting systems, which should both improve existing operations and create a more flexible platform to streamline the on-boarding of future facilities.

While absolute performance still has a way to go to reach steady-state strength, the firm's sequential same-facility revenue growth of 3.1%, up from slightly negative performance in the first quarter, suggests to us that management's strategy is on the mark. Organic volumes continue to languish at negative 1.4% year over year (although up from negative 4.1% in the first quarter), but revenue per case growth of 4.5% was driven by improved acuity and payer mix. This shift is likely intentional and sustainable, as management focuses on driving growth in the right procedure areas and utilizes its payer expertise to improve firmwide reimbursement. Additionally, in spite of continued investment in operations, adjusted EBITDA margins were able to show roughly 120 basis points of sequential expansion.

While there was much to like in the firm's results, its balance sheet continues to be the most pressing concern. The business is saddled with a sizable debt load, with total gross leverage levels near 8.5 times our adjusted EBITDA estimate for the full year. Management continues to emphasize using the firm's cash flow to acquire assets rather than reduce debt in the near term, a decision we question given the state of the company's balance sheet. Roughly 60% of its debt outstanding is variable-rate, further increasing the incentive to allocate toward leverage reduction, in our view.

Finally, we'd highlight the favorable preliminary outpatient prospective payment system rule for 2019 issued by the Centers for Medicare and Medicaid Services, or CMS, in July. Overall, the proposed filing should benefit the industry due to improved reimbursement rates and an expansion of cases that CMS will pay for in the ambulatory surgery setting. Not only does the preliminary rule propose increasing total payment rate for ambulatory surgery centers by 2% net of adjustments, but it also favors Surgery Partner's procedure mix through a 4% increase to musculoskeletal cases. Further, we think the expansion of the approved procedures list suggests Surgery Partners is positioned to benefit over the long term from increased utilization as CMS continues to encourage the use of more cost-effective sites of care.