On Friday SHL provided an update on its preliminary 2015 results. The new CEO joined the company earlier this month. The press release contained a number of negative news.
Let’s start with the first part of the announcement:
”Based on unaudited numbers, excluding extraordinary items, SHL’s businesses in Germany and Israel performed as expected.
In Germany, initial external evaluations related to two performance based contracts were just concluded and demonstrated successful outcomes and an economic benefit for the health insurers, however, the economic benefit is lower than previously estimated. The effect of the evaluations on 2015 revenues is limited as revenue for the year grew by approximately 15% on a constant currency basis. Although revenues grew by double digits on a constant currency basis, this is below SHL’s guidance of over 20% revenue growth on a constant currency basis.
Furthermore, due to the said external evaluations, SHL is expected to write-down an accounts receivable, associated with the service years 2013 to 2015, of USD 6 to 6.5 million. Additional evaluations are anticipated over the course of the contracts and are expected to continue and demonstrate positive outcomes and cost savings.”
The statements made are contradictory. SHL clearly performed below expectations in 2015 and missed the guidance. The increase in revenue is solely attributable to the acquisition of GPH which generated USD 9.2 m in 2014 and was acquired in April 2015. Assuming no revenue growth, GPH added USD 6.1 m or roughly 15% to SHL’s 2014 revenues of USD 40.0 on a constant currency basis. Hence, on a constant currency basis, SHL was not able to grow revenues organically although they had announced a large contract win for the German affiliate almeda at the beginning of 2015.
To call the outcome of the contract evaluations “successful” is misleading in light of the large write down. I expect the German business to have generated cumulative revenues of roughly USD 40 m from 2013 to 2015. Therefore, the write down of accounts receivable represents roughly 15% of revenues during that period. That is substantial. It also indicates the usage of aggressive revenue recognition.
Unfortunately, it is still getting worse:
” In addition, as part of the preparation of the financial statements, certain additional assets (mainly a tax receivable), estimated at between USD 4.5 to 5 million are expected to be written off. During the year SHL was involved in a restructuring process in Germany and in a merger process with a Chinese buyer, with SHL incurring significant costs in the process amounting to a total of approximately USD 3 million. SHL filed a claim for breach of contract against the Chinese buyer for an amount of approximately CHF 11 million or equal to 10% of the merger consideration (USD 11 million) the outcome of which cannot be estimated yet.
As a result, based on preliminary unaudited numbers and these extraordinary items, SHL expects to record a Net Loss for 2015 of between USD 16 to 17 million.”
As far as I can see, the tax receivable was related to VAT amounts to be received pending approval from the tax authorities. Expenses for the restructuring in Germany and the failed takeover attempt by the Chinese investor were foreseeable at the time of my investment. However, the total amount of USD 3 m is relatively high for a business of this size.
They are expecting a loss of between USD 16 m to USD 17 m for a business that generated revenues of slightly more than USD 40 m in 2015! Even worse, not only “extraordinary items” summing up to a negative contribution of between USD 13.5 m to USD 14.5 m contributed to a loss in 2015, but also on a consolidated basis the operating business itself seems to be loss making according to the vague information provided in the press release.
The company provides a bleak outlook for 2016:
“For 2016, the effect of the above on revenues is estimated at approximately 10% compared to the entire year 2015, with minimal effect on cash flow. The other one-time extraordinary items are not expected to have a material effect on SHL’s ongoing business and financial performance in 2016.”
So the German business seems to face substantial problems and profitability might remain under pressure due to limited pricing power.
My investment thesis was based on the assumption that the free cash flows coming from the recurring revenue generating and highly profitable business in Israel have been allocated to build a slowly growing and similarly profitable business in Germany. As it turns out, that does not seem to be the case. Doing business with public health funds in Germany might be more difficult than with self-paying patients in Israel. As I have learned from the press release the assumptions made regarding the German contracts were way to optimistic. In addition to that, there is still uncertainty regarding the expansion into the US and Asia. The company spent a lot of capital over the last years without being able to add revenues not to mention profits from these regions.
With a new CEO joining a company, balance sheet adjustments and profit warnings are common. However, from my perspective the procedure in this case is way more than just managing expectations. In combination with the problems the company faced in Germany in the past, I have my doubts now whether SHL will be able to generate sustainable profits in Germany going forward.
With a market cap of USD 61 m and net debt of USD 10 m the company’s valuation is now looking relatively rich, given that two segments (Germany and new markets in US and Asia) are loss making. Israel is contributing at least USD 4 m of very stable operating segment profits per annum. However, this is before overhead costs of roughly USD 3 m on the corporate level.
I started to invest in this company only two months ago. My conversations with representatives at German health funds and the company’s public information gave me comfort that the German business is performing well. However, I did not take into account the large amount of accrued revenue from these contracts and the inherent risks in terms of cash conversion. Next time, I will have to get a better understanding on the terms of the contracts when researching comparable companies.
In conclusion, I have two issues with this investment: First, from the management teams I invest with, I expect a more plausible way of sharing information with shareholders. Second, the outlook for the business has deteriorated substantially. At the same time, the company’s valuation is not providing an adequate margin of safety anymore.
Therefore, I prefer to watch the further development of SHL Telemedicine from the side line. I assume that I started selling my position on Friday. Based on the current share price, I expect this investment to result in a total loss of 10%+.
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