Surgery Partners, Inc.

Moat: 2/5

Understandability: 3/5

Balance Sheet Health: 3/5

Surgery Partners, Inc. operates a network of surgical facilities and ancillary services, focusing on the outpatient surgical sector.

Investor Relations Previous Earnings Calls

The moat, understandability, and balance sheet health scores reflect a conservative evaluation to ensure a margin of safety in any assessment.

SGRY’s moat is limited, scoring a 2 out of 5. It primarily relies on its operational scale and favorable relationships with physicians to secure a steady stream of cases, which aren’t insurmountable competitive advantages. While SGRY has established an extensive network of surgical facilities, these can be replicated by competitors, and their focus on cost leadership and efficiency, while important, isn’t a barrier to entry by itself.

  • Network of Facilities: SGRY operates a large network of surgical facilities, which can offer convenience for physicians and patients alike. However, these facilities are not based on proprietary technology, are built on long term leases, and do not create a sustainable advantage against competitors which can replicate it.
  • Physician Relationships: Successful and high volumes of surgical procedures are directly related to solid relationships with physicians. SGRY aims to provide an environment where physicians want to perform procedures. Even though this is good for margins and performance, these relations can move with physicians to another facility.
  • Cost Leadership: In the highly competitive healthcare landscape, SGRY aims to provide high quality services at low costs, but these processes are not proprietary and can be replicated by peers.
  • Insurance Payor Relationships: Being a large operator and having an established history, SGRY has favorable negotiations with health insurance payors. This relationship, however, is reciprocal and can change at any point based on negotiations, limiting the power of this factor.

The moat is susceptible to the following key risks:

  1. Operational Risk: SGRY’s reliance on high efficiency in a market where they cannot reduce prices will have a major impact on the business. While the management is doing well to improve efficiency and lower costs, it may not be enough to compete with more efficient and innovative companies.
  2. Physician Loyalty: A substantial portion of the SGRY’s revenue stems from physician relationships. Any deterioration of these relations or movement of key physicians to other facilities can drastically affect the company’s performance and earnings.
  3. Regulatory and Legal risks: changes to healthcare laws and regulations can negatively impact SGRY’s margins and performance. In addition, litigation due to malpractices or accidents can have a serious impact on profitability and shareholder value.
  4. Competition: There are a lot of new players in the market and companies like Tenet are actively increasing their surgical centers which can limit the moat of Surgery Partners.

The resilience of the business lies primarily in its ability to quickly adjust to market changes in pricing and procedures. The healthcare industry has a history of high switching costs due to long-term established relationships between payors, health care facilities, and physicians. As long as SGRY manages its physician relations well, the company can weather market turbulence and come back stronger than its peers.

Recent Earnings Call (October 2023) Highlights * The most recent earnings call showed that even with revenue beat by 6% and improved net income, the company’s margin levels were under pressure. Revenue growth for the last 9 months was 17% y/y but the net income has decreased over time, highlighting the fact that they were not making good profits. * The company acknowledges that they are facing high expense pressures. The company notes that they had to increase the rate at which they are onboarding new physicians and are also seeing higher medical supplies. * The management is taking measures to adjust the cost structure, including implementing new AI processes to reduce labor costs, but it remains to be seen if they can do this fast enough. * The focus on margin improvements was a big point as they are focusing on increasing revenue from ancillary services, and they have begun to centralize contracts and improve relationships with insurers.

Business Explanation:

SGRY is in the business of running ambulatory surgical facilities. They provide outpatient surgery services to patients that are less complex than what hospitals do, and therefore the company focuses on specialization like orthopedic, ophthalmology, and gastroenterology, which are well-suited to the outpatient setting, as opposed to the longer hospital stays that most of the more complex procedures require.

  • Revenues Distribution: SGRY’s revenue is generated from two main segments: surgical services and ancillary services. The former is self-explanatory, being the revenue gained from surgical procedures, but the second is from non-surgical procedures like lab tests, imaging, and physical therapy, that are used to improve their profit margins. In 2023, the payer mix for revenue was around 52% from commercial, 25% from Medicare, and 23% from other payors. They have a high mix of commercial payors which help with better pricing.

  • Industry Trends: The surgery market is shifting towards outpatient centers as many surgical procedures can be performed outside of hospitals. This trend is mostly driven by patient convenience and lower costs for patients. In addition, technological advancements are reducing the complexity of surgery, allowing most procedures to be performed at these centers. The healthcare sector is getting a lot more competitive, as many small players with only a few centers try to operate on scale. The threat of disruption through AI and new medical technologies is ever present.

  • Margins: SGRY’s margins are dependent on case mix, payer mix, and physician relations. The company has managed to sustain an EBITDA margin between 10-15%, but this is under pressure with recent inflation and increasing input prices.

  • Competitive Landscape: SGRY operates in a highly competitive landscape and faces competition from multiple players- hospitals, physician practices, and independent ambulatory surgery centers. The company also faces pressure from health insurance companies, which are becoming larger and are consolidating.

  • What Makes SGRY Different: Surgery Partners distinguishes itself by forming long lasting relationships with physicians, through partnering arrangements and joint-ventures. This allows them to attract high-quality professionals to conduct operations within their facilities, which, in turn, allows them to achieve a good market share and gain repeat business from clients. This also allows them to scale faster, and have a larger reach, giving them access to more and more patients and hospitals. They have a high focus on increasing efficiency to lower costs, but the competitors may catch up fast.

Financials Analysis:

  • Revenue: SGRY’s revenues have shown considerable growth over the last few years, from $1.4 billion in 2018 to almost $2.6 billion in 2022, and over $1.7 billion in the last 9 months. However, their growth hasn’t translated into profitability.

  • Profitability: Despite growth, profitability has remained quite inconsistent and under pressure. The company has made a loss in the recent quarters, which is mostly related to high input and operating costs, and the high debt burden.

  • Balance Sheet: The company has a considerable amount of debt, primarily because of acquisitions and expansion. SGRY’s debt-to-equity ratio is around 3. The debt is mainly long-term, and thus is manageable, but interest costs are a pressure point on future profitability.

    • Debt: SGRY faces risks from its high debt, including interest rate risk. While interest coverage is satisfactory and the company’s cash flows can meet the debt obligations, there are inherent risks of leverage. This implies that higher interest rates and any economic down turn, may lead to lower profitability and higher risk of bankruptcies. A large portion of their debt is tied to variable interest rates, which makes the company more susceptible to changes in the macro environment.

    • Equity: SGRY has been using equity to fund operations and growth, which is why the equity portion is low as compared to the assets, and debt of the company. If the company can improve its profitability and cash flows to have a better balance between equity and assets, this would improve the overall profile of the company.

  • Cash Flows: The company has a history of negative free cash flow and this has resulted in a high reliance on debt. As they are expanding fast to capture the market share, their capital expenditure needs and financing costs are high which reduces free cash flow.

Understandability:

SGRY is moderately complicated to understand because while the business model is simple (operating surgical facilities) the value creation framework, the impact of regulations and competition, and the role of insurance payors makes it hard to follow. Therefore, this business has a understandability score of 3 out of 5, as it is not simple like a grocery business, but is not overly complex like a software business.

  1. Business Model Simplicity: Running surgical facilities are relatively easy to comprehend but the impact on costs and the relation between reimbursements and pricing is not simple to understand.
  2. Regulations and Macro Factors: This business is affected by regulations in the health sector and general economic conditions and also faces various external factors, such as increase in competition, inflation, and increasing interest rates, all of which make it hard to forecast and accurately value the business.
  3. Complex Financial Statements: As it has a high leverage and intangible assets, the accounting statements are complex and requires in-depth understanding of different financial terminologies, which are not very common with non-financial people.

Balance Sheet Health:

The balance sheet of SGRY is moderately healthy, and is rated 3/5. While SGRY has considerable assets and its debt is mostly long-term which makes it manageable, it still does not have a balance between debt and equity. In addition, the company has low cash flows and relies heavily on borrowing to fund capital requirements.

  1. Debt Burden: SGRY has a high amount of debt which creates added risks, especially in an environment where interest rates are high and are on an increasing trend.
  2. Cash Flows: The company has negative free cash flows and are heavily dependent on external financing for their operations.
  3. Asset Composition: The company has a low amount of tangible assets which are essential to the business, as compared to intangible assets like goodwill, which may not directly help in generating cash flows, but will still provide value for SGRY, as long as their returns remain high.
  4. Equity Portion: The Equity portion is lower as compared to other companies in the similar sectors, and with increasing debt burden the equity portion will not improve that much in the near term.