Mail Bag: CML Healthcare (CLC.UN)

In a blog comment posted in August reader Steve Casked,

“Is CML Healthcare on your watchlist?  The trust hasn’t done much YTD.  It pays a solid 8% and its cash flow is steady and predictable.  I would like to get your opinion on this stock since you are in the healthcare profession.”

CML Healthcare Income Fund (CLC.UN) is a Canadian operated income trust that is involved in the business of diagnostic services (laboratory and medical imaging) in five Canadian provinces (Quebec, Ontario, Manitoba, Alberta & British Columbia) and two states (Delaware & Maryland).  In addition the company is currently closing an acquisition of Quarry Lake which will add to its operations in Maryland and expand their business into Rhode Island.

I am familiar with the company having researched it in the past, but at a quick glance I noticed a few newer items I’d like to highlight for readers:

The trust has come off from the lofty $17.30’s seen in early 2008 to currently trade in the $13-14 range over the past six months with a YTD return of 4.12% (not including distributions).  The company pays out a monthly distribution to unit holders of $0.08927 ($1.071 annually) which yields an even 8% on a closing price of $13.38 (as of October 30^th).

In the most recent quarter, ended June 30^th 2009, the payout of the trust (calculated as total distributions as a percentage of distributable cash) was 92.5% for the first six months of the year versus 85.9% for the entirety of 2008.

The company’s Long-term Debt to Equity (D/E) has risen to 0.56 for 2008/2009 versus 0.40 in 2007.  That’s not bad for a trust that is looking to expand through acquisitions but in this current credit environment I was not able to determine the price for the acquisition (or the financing) of Quarry Lake which when completed will likely impact this ratio further.  Operating expenses were a key concern I had when looking through the company’s numbers this time around.

Operating expenses (operating, general & administrative) have increased 33% YoY in the most recent quarter after a 70% rise from 2007 to 2008.  For a company expanding operations an increase would be expected as operations are added and more costs are incurred, but the concern I have (as I mention in my full SAML analysis of Coca-Cola) is with the pace of revenues for the company.

Operating expenses have risen faster than the pace at which revenues have risen and that trend, in any industry, is not something that is sustainable.  Revenue for CML Healthcare only rose 48% from 2007-2008 versus 70% for expenses and revenue rose 24% YoY in the past quarter of 2009 versus 33% for expenses.  This demonstrates to me initially that the company is having difficulty managing expenses in the face of lower revenues and begins establishing an unsustainable trend where expenses outpace revenues.  The result is a compression on the company’s margins which management discusses in their most recent quarterly analysis.  As frequent readers and readers who had access to the Coca-Cola analysis know margins are paramount in a company’s ability to secure a competitive advantage and at this time CML Healthcare looks to be undisciplined in this area.

The company’s management however does do an excellent job of explaining and outlining their growth strategy for the trust and are currently executing well on growth through accretive acquisitions.

To answer SteveC directly though CML Healthcare does not appear on any of my watchlists though for two important reasons; the first dealing with my Sustainable Demand Model and the other involving their exposure to external political risks.

My Sustainable Demand Model is a tool I developed and use when I analyse healthcare or consumer stocks for my portfolios.  The basic principle of this model is closely tied to my guiding principle of Enduring Value and is best represented by Warren Buffett’s thesis for investing in Coca-Cola (KO).  That thesis follows the basic principle that if Coca-Cola products are consumed 1.5 billion times today, were consumed 1.5 billion times yesterday and were 1.5 billion times the day before what are the odds that they will be consumed 1.5 billion times (or more) tomorrow?  The odds are very good.  Why?

Coca-Cola offers what consumers want or need on a sustainable scale.  Sales may dip +/- 5% from quarter to quarter based on certain economic forces, but demand for their products is strong, growing and enduring.

I, as an investor, have two options for investing; I can choose to invest directly in the company or indirectly through a secondary investment.  For my portfolios I choose to invest directly in companies that fit this Sustainable Demand Model because I wish to participate fully and to the fullest extent of an excellent company over the long term.

CML Healthcare I consider to be a secondary investment in this model because through its operations it uses diagnostic equipment and laboratory supplies manufactured by companies that I can purchase direct investments in.  Companies such as Becton Dickinson (BDX) or General Electric (GE) provide products that CML Healthcare needs to purchase and use to meet client needs that provide sustainable demand.  In this instance I would rather invest directly and diversify into these individual companies that supply the consumer demand for CML Healthcare than directly invest in CLC.UN.

As one example CML Healthcare operates 125 specimen collection centres across North America where BD products are likely used and in Canada as a whole it is estimated that over 35 million diagnostic medical laboratory tests are conducted each year in Canada (source: CLC.UN 2009 Annual Report).  GE is a global leader in the development and sale of CT and MRI equipment for medical imaging.  By investing in BDX I gain exposure to CML Healthcare’s client services, but also to the hundreds of other companies, clinics and laboratory uses of BDX products around the world.

CML Healthcare’s exposure to political risks is another reason why the company does not appear on my watchlist.  When I conduct any Situational Analysis I first look to identify and compare any or all internal strengths, weaknesses, opportunities & threats with external political, economic, social or technological trends.

CML Healthcare operates within an industry that is heavily regulated, subsidized and overseen by various levels of government.  As I wrote about recently in a post on Shoppers Drug Mart (SC) government involvement in spending or cost cutting can have either a direct or indirect impact on the profitability and operations of private companies.  CML Healthcare may currently have a favourable operating environment in partnership with governments but the way they do business today may not be this way forever.  Funding may change in response to difficult economic pressures and governments may be forced to reassess priorities in healthcare by either centralizing or further decentralizing various care centres or services.

Disclosure: I hold common equity positions in Coca-Cola (KO), Shoppers Drug Mart (SC) & Becton Dickinson (BDX) as well as a fixed income position in General Electric (GE)