Bandera – Microcap Activism Is A Hard Road To Travel by Jeff Gramm, MicroCapClub
Some people know me by my book, Dear Chairman, but what they don’t know is I’m an avid microcap investor. Along with teaching value investing at Columbia Business School, I co-manage a fund called Bandera Partners and we are active in the microcap space. I sent Ian one of my quarterly letters from a few years ago describing a long and arduous story with a microcap company, and he thought it was interesting enough to share with the world.
In 2003, I found a company called UCI Medical Affiliates with a market capitalization of about $3 million. I was in my twenties, working as an analyst at a distressed debt hedge fund in New York City. UCI, which ran urgent care clinics in South Carolina, had recently emerged from a rare bankruptcy that preserved the equity. Several large blocks of stock were available, but I failed to convince my superiors to buy them. I then bought some shares in my PA and embarked on an intense, eight-year, hard knocks education in microcap investing. I’ve been hooked on microcaps ever since, for better and for worse.
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In early 2011, Bandera Partners (which I run with my partner Greg Bylinsky) negotiated UCI’s sale for $65 million. It felt like a minor miracle. A mere two years earlier, UCI’s valuation had fallen all the way back to the $3 million it garnered when I first found it. I ended up writing 6,000 words about the investment in our next quarterly letter. I also attached some of our correspondence with UCI’s majority owner, Blue Cross Blue Shield of South Carolina, as an exhibit. The letter was so well-received by our investors, that it gave me confidence to write “Dear Chairman.” The book takes its structure from this quarterly letter—a fun narrative followed by an original letter from shareholder to company.
I’m excited to share the UCI saga here, for investors that have learned the hard lessons that microcap investing offers. It is a lurid tale with all the hallmarks of value investing: drug addiction, suicide, prison, and, worst of all, accounting restatements. When I waltzed into this investment, I was incredibly naïve about public companies, boards of directors, and corporate governance. In fact, with UCI I committed the cardinal microcap investing sin: I bought into a company controlled by a majority shareholder. Don’t worry, as you’ll see, it got much worse.
You can read the full story in my Bandera Partners Q1 2011 Letter below.
Bandera 1st Quarter 2011 Review
Your investment in Bandera Value Fund LLC generated the following returns for the first quarter of 2011:
In the first quarter of 2010 Bandera Value Fund returned 4.9% net of management fees and performance allocations. The S&P 500 gained 5.9% for the quarter.
One of our biggest winners this quarter was UCI Medical Affiliates, which was Bandera’s very first purchase at the inception of the fund in 2006. The company operates Doctors Care, a large network of urgent care medical clinics in South Carolina. In March, after a year of negotiations with Bandera, health insurer Blue Cross Blue Shield of South Carolina (“Blue Cross”), UCI’s largest shareholder, announced a tender offer for all of the outstanding shares of UCI at $6.50 per share, a 141% premium to the share price before the announcement. We were UCI’s second-largest holder and sold all of our shares in the tender offer.
The following account of our involvement with UCI Medical Affiliates is very detailed, but for those of you with the time and stamina, we think you will enjoy the history of our first and most challenging investment. Buying small capitalization stocks can be a hazardous activity, but it can be very profitable if you maneuver carefully. UCI in particular was loaded with troubles as well as potential. An investor who bought shares of UCI ten years ago would have endured a bankruptcy filing, the resignation of a CEO with a history of drug abuse, an embezzling CFO who was sent to prison, several periods lasting over a year with no audited financial statements or stockholder meetings, various accounting restatements, the dismissal of its auditor, a controlling shareholder with clear conflicts of interest, and a board of directors that alternated between unresponsive and hostile to shareholders. The same investor who bought shares ten years ago would have witnessed remarkable growth in UCI’s business and a 2,000% return on his or her investment.
If you don’t have time to read 6,000 words about doctors’ clinics in South Carolina, let us refer you to our correspondence with Blue Cross about UCI’s value, attached as an exhibit to the end of this letter. It will help you understand why we liked UCI and how we approached valuing the business. While it is an informative and relatively concise document, it lacks the scandal, intrigue and drama of the complete history outlined below.
UCI Medical Affiliates – Our first investment
Our investment in UCI was a grueling endeavor that found your faithful portfolio managers racing across South Carolina in a quixotic attempt to free the company from the control of the multi-billion dollar South Carolina Blue Cross Blue Shield affiliate. We knew we faced a challenge – our first conversation with a UCI board member (and former Blue Cross President) ended with him telling us we were “crazy to buy the stock” and that UCI was “ a captive subsidiary” with “worthless” shares that we should stay away from. Undeterred, we proceeded to buy 13% of the company and fight for board representation. We outlasted two counterparties at Blue Cross as well as one CFO of UCI, who now resides in a federal penitentiary. At the darkest moment, UCI’s stock was so far down from our cost basis that we needed it to appreciate to ten times its market value for us to break even (it ultimately went up eighteen times).
Behind the hostile board member, the crooked CFO and the unresponsive majority shareholder was a twice-bankrupt company in a maligned industry that was itself riddled with bankruptcies. So why were we attracted to UCI Medical Affiliates? And why was UCI controlled by Blue Cross, its largest customer? Why buy stock in a company when the ultimate success of the investment depends upon fighting with its largest customer? Most importantly, why did we see potential in UCI’s business and why did the rest of the market disagree with us? This is a complicated story that begins, like the story of many good investment opportunities, with a Wall Street bubble.
The Physician Practice Management (PPM) Bubble
In 1997, the country’s two largest physician practice management companies, PhyCor and MedPartners, announced plans to merge. The deal to create an $8.5 billion company with a network of 35,000 doctors was never consummated, but for a brief moment the announcement validated the PPM industry and legitimized its meteoric growth. Healthsouth’s Richard Scrushy, who served on MedPartners’ board of directors, proclaimed at the time, “This is the model that works.”
PhyCor, founded in the 1980s by four hospital executives, was the pioneer of the physician practice management business model. The company rolled up small medical practices by entering into management services agreements wherein it purchased all the assets of the practice (usually at a valuation of $50,000 per physician), employed the nonphysician staff, and provided various support functions. PhyCor would participate in the income of the firm before doctor compensation (typically 11% to 15% in the early days of the company), but would never directly hire physicians, thus allowing the company to sidestep laws governing the corporate practice of medicine.
For a small clinic, a management services agreement with PhyCor could provide many benefits beyond a needed capital infusion. The clinic could leverage PhyCor’s relationships with health plans and its experience negotiating managed care contracts. PhyCor also had marketing capabilities, group purchasing contracts with vendors (for everything from medical supplies to malpractice insurance), and operational expertise that helped small practices cope with the growing administrative burden on healthcare providers. A successful alliance with PhyCor would allow doctors to focus on providing medical care while simplifying the business side of running a practice.
Initially, the PPM model did work. PhyCor focused on primary care clinics in the South and grew rapidly. Many of its early partnerships thrived as clinics saw sharp improvements in profit margins and used proceeds from the asset purchase as growth capital. The rest of the industry took notice of the company’s rapid growth and the success of its partner clinics. By the early 1990s, some health insurers were even lobbying PhyCor to build physician networks in their regions!
PhyCor went public in 1992 and accelerated its growth with a slew of acquisitions in the mid-1990s. The company’s success was destined to breed imitators, and competitors soon popped up all over the country, many of them funded by public stock offerings. The market’s enthusiasm for PPM companies and their growth prospects led to high valuations across the industry. A natural arbitrage resulted – companies could raise money from investors at 25x to 30x earnings and use it to acquire clinics for significantly lower multiples.
PPMs raised $1.7 billion on Wall Street in 1996 and by year-end over 30 were publicly traded. The influx of well-capitalized companies with a strong incentive to show revenue growth to Wall Street analysts led to a large number of deals with clinics, and a general loss of discipline in the industry:
- Deal pricing – Medical practice valuations rose sharply from about $50,000 per doctor to over $350,000 per doctor.
- Regional and specialty diversity – PPMs lost their focus on creating economies of scale and diversified into new markets and various types of medical practices.
- Unsustainable contracts – Management services agreement structures veered toward larger upfront payments to doctors in return for greater revenue participation of up to 20%. Sometimes the upfront payments were made in stock rather than cash.
- Poor allocation of capital at practices – Many doctors made deals with PPMs to pay themselves rather than acquire growth capital to invest in their clinics. By the late 1990s, 10% of the doctors in the country worked under a practice management agreement with a PPM company. Many of these PPMs had grown into bloated organizations managing a jumbled assortment of clinics with different specialties. Whereas the industry had once focused on adding value to partner clinics, it was quickly devolving into a race to aggregate clinics at any cost, with little regard for how they were strategically aligned.
Meanwhile . . . in South Carolina
In 1996, PhyCor entered the South Carolina market by acquiring Carolina Primary Care, a practice with 29 primary care physicians. It was a shot across the bow of UCI Medical Affiliates, which operated 30 “Doctors Care” branded clinics. Over the previous 15 years, UCI had painstakingly carved itself a niche operating small clinics with extended hours that catered to walk-in customers with non-life-threatening health emergencies. Just as UCI’s operations were finally stabilizing (after years of paying off obligations from a 1989 bankruptcy), the company’s cross-town rival, flush with PhyCor’s capital, expanded to 52 doctors and 325 total employees in just over a year. This was yet another tough break for a promising, but perpetually challenged, company. UCI Medical Affiliates was founded by Herb Zlotnick and Ted Schwartz, two entrepreneurs who, in a sense, anticipated both the PPM movement and the popularity of convenient “doc in a box” emergency care clinics. The company went public in 1984 as a multi-state urgent care company, headquartered in New Jersey, with 5 clinics in South Carolina, 4 in Ohio and 3 in Texas.
The Ohio network was a late addition, run by a colorful man named Phillip Naples, who wrote for M*A*S*H and even won an Emmy for a Good Times script. Within a year of the IPO, UCI began to falter as the Ohio clinics bled money at an alarming rate. Zlotnick suspected that Naples, who continued to run the Ohio clinics while he served on UCI’s board, had overstated his clinics’ accounts receivable. When UCI terminated its agreement with Naples and his partners, the two parties became mired in litigation as each side tried to gain control of the Ohio clinics. When Naples hanged himself in 1985, a host of stockholder suits followed and UCI’s stock price fell 80%. The assets of UCI’s Ohio subsidiary were seized by lenders in mid-1986 and the company finally reached a settlement with Phillip Naples’ estate and his partners in September. That same month, the Texas clinics were accused by state regulators of dispensing prescription drugs without pharmacy licenses. UCI’s Texas subsidiary would ultimately file for bankruptcy after being sued by its landlords and vendors for delinquent payments.
Despite the troubles at UCI Medical Affiliates, the clinics in South Carolina were performing well and generating positive cash flow that subsidized the rest of the company. The South Carolina subsidiary was run by Dr. Marion McFarland, a former ER doctor who by 1987 was the last man standing at UCI. As the company crumbled around him, Dr. McFarland shut down the corporate headquarters in New Jersey and exited all the remaining operations in Texas and Ohio. He put the company into bankruptcy to reorganize its debts in 1989. When UCI emerged from bankruptcy the following year, the company’s operations were focused on Dr. McFarland’s Doctors Care clinics in South Carolina. UCI’s headquarters was moved to the original Doctors Care clinic in Columbia, where Dr. McFarland served as CEO, Chairman of a one-person board, and, of course, head physician.
UCI Medical Affiliates expanded gradually over the seven years following its emergence from bankruptcy. By 1997, the company operated 34 clinics and had grown to 480 employees. Unfortunately this period of stability and measured growth did not last. Despite UCI’s early lessons about the challenges of acquiring clinics in different regions, the company responded to the PPM bubble’s expansion into South Carolina in a regrettable way: To protect the competitive position UCI had built for 15 years, the company decided that it too needed to raise capital and rapidly expand.
In 1998, UCI signed a $5.3 million deal to purchase a group of family practice clinics in Georgia and Tennessee from a private equity fund. UCI committed to spend an additional $3 million to convert the clinics into urgent care facilities. The PPM bubble burst shortly after the deal closed, and UCI was unable to raise money to pay for the conversions. The Georgia centers were burning cash and would push UCI back into bankruptcy in a few short years.
The Bubble Bursts
PhyCor terminated its merger agreement with MedPartners in January 1998 after its due diligence revealed rapidly deteriorating profits at many of MedPartners’ clinics. By September, Wall Street’s valuation of the 15 largest PPM firms had fallen by 64%. Physicians who had traded a large percentage of their future income for rapidly depreciating shares of stock sued PPM companies to get out of their management services agreements. MedPartners ultimately exited the business altogether. By the end of 1998, another large PPM, FPA Medical Management, filed for bankruptcy.
As often happens in speculative bubbles, even older, experienced companies got caught up in the mania. PhyCor suffered from the same problems that plagued its competitors – economies of scale did not materialize as expected and corporate overhead negated cost savings. PhyCor struggled for a few more years, selling as many clinics as it could back to its physicians, but the company filed for bankruptcy in 2002, just a few months after UCI Medical Affiliates filed for bankruptcy for the second time.
In a flash, the PPM industry went from being a darling of Wall Street to being totally discredited. Because the industry relied on cheap capital to grow – and because many PPM companies were never profitable to begin with – there was a large number of failures when the Wall Street funding machine shut down. But was the business model fundamentally flawed? We did not think so. While many concluded that the PPM model was a Wall Street creation that never made sense to begin with, we thought it was a viable business model for a single-specialty company with the right regional focus.
Our Journey Begins
In 2003 we picked through the wreckage of the PPM industry and found UCI Medical Affiliates. The company’s expansion plans had failed miserably, and the 2002 bankruptcy served two incongruous purposes – first, to organize the debts and obligations associated with acquiring the Georgia clinics, and second, to exit the Georgia clinics. But despite UCI’s financial distress, the company’s South Carolina clinics continued to perform well and generate positive cash flows just as they had during the previous UCI bankruptcy.
As we learned more about UCI Medical Affiliates, it became clear that it was not a typical PPM blowup. The bankruptcy left UCI with about $10 million in debt, but management and large holders had succeeded in preserving the publicly-traded equity completely. Not a single doctor had left the company during the bankruptcy, and revenues and profits were growing rapidly. UCI had 469,000 patient encounters in 2003 and generated cash flow from operations of $3.6 million.
To us, UCI Medical Affiliates exemplified the goals of the PPM business model. The company simplified life for its practicing physicians and allowed them to focus on providing quality care. UCI was concentrated regionally in the larger markets of South Carolina – there were 18 clinics in and around Columbia, for instance – and was clearly benefitting from economies of scale as small increases in advertising yielded strong growth in traffic. Whereas many PPMs were cobbled together in a matter of months, UCI’s South Carolina network expanded slowly, with many new clinics being de novo openings rather than acquisitions of existing practices. After 22 years in business, the “Doctors Care” brand name was known and respected in South Carolina. We believed we had found a gem of a business.
Blue Cross Blue Shield of South Carolina Takes Control
When we first began looking at UCI Medical Affiliates in 2003, Blue Cross Blue Shield of South Carolina owned 27% of the company. As South Carolina’s largest insurer, Blue Cross benefitted when patients went to a low-cost urgent care clinic rather than a hospital’s emergency room. In 2003, a Blue Cross spokesman explained why the company invested in UCI in the early and mid-1990s:
Blue Cross Blue Shield invested in UCI to ensure patients had options for medical services. In some counties, hospitals own most or all of the physician practices, giving them a lock on their local community and a strong position when negotiating with insurers. Doctors Care is everywhere we have customers. We feel like they’re important to have in our network as an alternative.
By 2003, UCI was even more important to Blue Cross than it was in the mid-1990s. It had grown to 41 clinics and was the largest primary care company in South Carolina, with 603 employees and 111 medical providers. UCI was a critical member of Blue Cross’ provider network and delivered healthcare services at a fraction of the cost of those provided at nearby hospitals. The company was also suffering from a governance vacuum that could threaten its independence, a distressing thought for Blue Cross, which did not want UCI to fall into the hands of a local hospital group or another healthcare company.
See the full letter below.