Tuesday, July 10, 2007
Transcribing Profits with Transcend Services
Transcend Services (TRCR-$23.00) provides medical transcription services to the health care industry. After trading in a sideways pattern between $2.00 and $2.50 per share for most of 2006, the stock price exploded in October and has entered a strong uptrend. Driven by a turnaround in profitability and momentum traders scrambling onboard this thinly-traded stock—insiders beneficially own 32% of the outstanding stock—Transcend has gained more than 1,000 percent in the past ten months!
The market for medical transcription services is sizable. The total annual market potential for outsourced medical transcription services is estimated to be approximately $6 billion. While competition is significant, with perhaps 1,500 transcription services companies nationally, and few barriers to entry, Transcend is one of only a handful of companies that operate on a single, Internet-based technology.
HIPAA compliance has saddled healthcare providers with increasingly complex documentation requirements, resulting in an increase in the need for dictation and transcription of medical encounters.
In addition, demand for medical transcription services is growing as the demand for healthcare services increases. Macro-economic trends such as the aging of the baby boomer generation are projected to have a major impact on the demand for healthcare services in general and should lead to a corresponding increase in the demand for medical transcription services, which analysts forecast to grow 16 percent a year.
Transcend provides two primary medical transcription options to the healthcare industry: (i) transcription support services for customers with their own transcription systems and (ii) its BeyondTXT Platform, which leverages advances in speech recognition technology, enabling an end-to-end digital voice-to-text transcription solution using the Internet.
Transcend is planning to gradually increase the percentage of voice files processed through BeyondTXT, from approximately 20% of its total volume of transcriptions at the end of 2006 to approximately 25% by the end of 2007. Longer term, the percentage of volume that is edited using speech recognition technology will depend on such factors as the mix of volume that is processed on Transcend’s proprietary platform vs. customer platforms, the percentage of dictators for which Transcend is able to build high quality voice profiles, and the Company’s ability to hire, train, and retain talented medical language specialists (MLS) and editors.
In our view, management’s success in leveraging demand for BeyondTXT will directly impact gross margins. The rollout of the Company’s speech recognition-enabled BeyondTXT platform will result in additional cost savings as fixed infrastructure costs are spread out among a higher user base.
Management is also looking to contain costs by moving business offshore. Indian contractors transcribe approximately 7% of the transcription volume processed by the Company. Transcend expects this number to increase in 2007. However, significant portions of existing and potential customers do require that transcription services be performed domestically.
We believe that the Company is well positioned to increase market share by taking advantage of uneven service delivery by some of the smaller medical transcription firms, which also lack the requisite technology and capacity to compete on a ‘value proposition.’
Transcend also intends to increase market share through acquisitions.
Transcend reported first-quarter net income of $1.3 million, or 15 cents a share, up from $150,000, or 2 cents a share, in the year-ago period. Revenue rose 30% to $10.4 million from $8.01 million in the comparable period last year.
Impressive share-net gains and investors’ share trading, notwithstanding, the 10Q Detective has some concerns about the ‘quality of earnings’ reported for the three-months ended March 31, 2007.
Management reported that of the $2.41 million increase in revenue, 79 percent, or $1.90 million consisted of sales from new customers. This is misleading, for a more detailed review by the 10Q Detective uncovered that this growth was not organic, but was purchased through recent acquisitions: Medical Dictation, Inc., a Florida-based medical transcription services company, and OTP Technologies, Inc., a Chicago area medical transcription company.
In its 10-Q regulatory filing, management said “no single customer accounted for greater than 10% of total revenue for the quarter ended March 31, 2007.”
However, revenue attributable to one contract with Providence Health System - Washington (for four hospitals) accounted for 9.2% of total revenue for fiscal 2006.
In addition, “the Company provided medical transcription services for the three months ended March 31, 2007, to individual customers that are members of a group of hospitals. Revenue attributable to members of this group comprised 22% of the Company’s total revenue for the three months ended March 31, 2007.” These ‘individual customers’ number approximately 40 customers who are members of Health Management Associates, Inc., a single healthcare enterprise.
At March 31, 2007, the Company had net operating loss carry-forwards of approximately $16.4 million, which is being used to reduce income taxes. As a result, the Company paid no current federal income taxes due for the first quarter.
The clinical documentation outsourcing industry is highly fragmented, with less than ten firms in the industry accounting for less than 10% of the total outsourcing market. There are currently two large national transcription competitors, one of which is Spheris and the other of which is MedQuist (MEDQ-$11.15), several mid-sized service providers with annual revenues between $10.0 million and $40.0 million, including Spi Technologies (a wholly owned subsidiary of Philippine Long Distance Telephone Co.), and hundreds of smaller, independent businesses. Ergo, the field is ripe for consolidation.
Historically, the Company has financed acquisitions either through debt or equity or a combination thereof. At present, there is only $1.5 million available on a term loan from Healthcare Finance Group, which management believes is insufficient to complete larger transactions [medical transcription firms with more than $5.0 million in annual sales].
The Company has engaged investment banker, Morgan Keegan, to help locate potential acquisition candidates and financing for these.
In our view, Transcend’s ability to execute its acquisition strategy is less dependent on its ability to secure financing than in the past (when the share price was less than $3 per share). At $23 per share, and with only 8.15 million shares outstanding, the Company can use its common stock as currency.
However, the balance sheet is looking anemic. As of March 31, 2007, Transcend had goodwill and intangible assets at carrying amounts of $4.5 million and $601,000, respectively. The total of $5.1 million represented approximately 41% of total assets, up from 38% of total assets as of December 31, 2006.
The Company has contractual obligations--leases for the rental of office space and operating leases related to the purchase of computer and other equipment-- totaling $849,000 due in 2007—more than the cash and cash equivalents of $653,000 on the balance sheet at the close of the first quarter.
Other Investment Risks & Considerations
Transcend’s reliance on key third party software could affect its ability to operate competitively. MultiModal Technologies, Inc., an enabler and provider of conversational speech solutions, provides integral parts of the BeyondTXT technology under a non-exclusive, third party vendor agreement, renewable for up to four successive one-year periods.
Management’s inability to maintain the relationship with MultiModal, or find a suitable replacement for the technology, would adversely affect the Company’s ability to operate competitively and to meet the workload demands of its existing customer base.
We question management’s commitment to sustaining technological leadership and innovation. Transcend invests only about one-percent of its annual sales in R&D to improve its Internet-based platform/ infrastructure to yield faster turnaround times, better workflow management and increased productivity.
Insiders collectively own approximately 32% of the outstanding common stock. Consequently, together they continue to be able to exert significant influence over the ‘independence’ of directors and the outcome of most corporate actions requiring shareholder approval and business.
Nonetheless, the 10Q Detective is impressed with who sits on the Board, including Joseph P. Clayton, the Chairman and former CEO of Sirius Satellite Radio, and Walter S. Huff, Jr., the founder of HBO & Company (and a personal friend of Transcend’s Chairman and CEO Larry G. Gerdes, who held various executive positions with HBO prior to 1991).
Gerdes and Huff beneficially own 13.55% and 12.13%, respectively, of the outstanding stock of Transcend Services.
On June 4, 2007, Mr.Gerdes entered into a selling plan pursuant to Rule 10b5-1, pursuant to which he may sell up to 200,000 shares of the Company’s common stock on a periodic basis through June 30, 2008.
This is the rare case where a CEO cashing in some stock “to diversify” does not trouble us.
In recent years, more than 40% of Gerde’s annual compensation has been in company stock. For example, on December 15, 2006, Gerdes—and other Named Executives—were each granted 50,000 shares at an option price of $3.40 per share!
In addition, as of December 31, 2006, Gerdes owns (exercisable) options underlying 100,000 shares at an option price of $4.15 per share.
Ralph: “For the last time, Alice, I'm telling you, I'm going for the $99,000 question.”
Alice: “For the last time, Ralph, I'll be very happy if you win the 600 bucks.”
Ralph: “$600? Peanuts, peanuts! What am I gonna do with peanuts?”
Alice: “Eat 'em, like any other elephant.” ~~ [The Honeymooners, 1955]
In our view, bullish sentiment remains intact, and additional momentum buying on the back of a solid second quarter could send the stock price bouncing along to newer highs.
In addition, companies which provide services complementary to medical transcription, such as electronic medical records, coding and billing, may expand the services they provide to include medical transcription, and therefore, may consider Transcend—with an enterprise value of only $178.8 million—an attractive purchase.
Momentum buying in a bull market—even Ralph Kramden might get lucky owning this stock.
“Yessir, this is the time I'm gonna’ get my pot of gold.” ~~ Ralph Kramden.
Editor David J. Phillips does not hold a financial interest in Transcend Services. The 10Q Detective has a Full Disclosure Policy.