In this series, I (Jin Choi) talk about my goal of reaching $1 million in my TFSA account by 2033. If you want to know what a TFSA is, I recommend you read my free book. In this article, I’ll also talk about events that are raising suspicion among investors regarding a small Canadian company named Assure Holdings.
February Results: Down 6.1%
At the end of February, I had $46,269 in my TFSA account, which was down by 6.1% since the start of the month. By comparison, the Canadian stock market went down by 3.0% while the U.S. stock market went up by 0.5% in Canadian dollar terms. Therefore, my portfolio underperformed.
The majority of my portfolio consists of oil and gas stocks. In February, oil prices dropped from $64.73/bbl $61.43 (in US dollars), and my oil stocks went down. However, oil prices are still above levels they were at since the start of the year, yet oil stock prices are significantly below where they were at that time.
Let me further illustrate my point about how cheap oil stocks are today. In my last month’s TFSA update, I mentioned how Baytex’s (Ticker: BTE) stock was trading at the same price it was at when oil was below $33/barrel. Since then, the company reported a profit of $0.32/share during the last 3 months of 2017 when oil prices had averaged $55/barrel. Now, I think the official profit number is a bit misleading, and I think the real profit is somewhere closer to $0.07/share. But it’s also true that with oil above $60/barrel today, we should expect the company to record significantly more than $0.07/share in the future.
But even assuming consistent profits of $0.07/share every 3 months, it would be easy to see that Baytex is cheap. A profit of $0.07/share every 3 months equates to a profit of $0.28/share per year, and since each Baytex share is worth $3.72/share as of the time of this writing, the price to earnings ratio would come out to $3.72/0.28 = 13.3. This ratio of 13.3 is significantly below the price to earnings ratio for the average Canadian stock of around 20, which means the stock is cheap. Of course, the price to earnings ratio is just one metric, and it has its flaws, but other metrics would tell a similar story.
That’s all I have to say on the topic of oil this month. For the rest of this article, I’ll talk about a small Canadian company called Assure Holdings, which has had some drama of late.
Assure Holdings Red Flags
Assure Holdings provides staffing for “Intraoperative Neuromonitoring” (IONM). Essentially, IONM is a technical system that monitors a patient during surgery. Assure trains and provides technicians who perform the monitoring service.
What makes Assure different from a normal staffing company, however, is the way in which Assure generates revenue. Normal staffing companies bill whomever they provide staff to, period. By contrast, Assure not only bills the hospitals, but it also bills health insurers. This is an important distinction, as we’ll see later on.
At first glance, Assure’s financials look extremely good. As of the latest available financial report, Assure generated nearly $12 million in revenue over the first nine months of 2017, and booked more than $6 million in net income, meaning the company achieved a net profit margin (i.e. net profit divided by revenue) of more than 50%. Generally speaking, a net income margin of 10% or more is considered high.
Source: Company’s Nov 30 Management Discussion and Analysis
But if anything looks too good to be true, it often is. In Assure’s case, I could spot a red flag pretty quickly by reading the official financial statement. Normally, a company that generates a lot of net income will also generate lots of cash from operating the business. But as the following statement of cash flows shows, Assure actually lost cash from "operating activities”.
Source: Company’s Nov 30 Interim Financial Statements
The biggest culprit for this discrepancy between net income and operating cash flows is the increase in ‘Accounts receivable’. Let me explain how this discrepancy arises.
Essentially, this is a case of a company counting its chickens before they hatch. Let’s say a company performs a service for a customer, and bills them $1 million. When a company does that, it can choose to record that $1 million as revenue even before it collects the cash, as long as the company believes it will be collected. The $8 million that I’ve circled in the image above represents this billed-but-unpaid amount.
Of course, the company’s real revenues may end up being very different if customers dispute the bills. Unfortunately for Assure, they are especially vulnerable to such customer disputes.
Assure generates over 95% of its revenue from “out of network” fees. This generally involves billing insurance companies for services performed, even though the services fall outside of the patient’s insurance coverage. Concerning the likelihood of getting paid by the insurers, the company had this to say:
Source: Company’s Nov 30 Interim Financial Statements
To paraphrase the underlined sentence, insurance companies have loose obligations to pay the amount owed, so Assure uses educated guesses to estimate how much they will actually recover from the insurance companies.
Given this situation, it comes as no surprise that insurance companies often refuse to pay out the sums “owed”. Now, when it becomes clear that insurance companies won’t pay, Assure has to make adjustments to its financial statements. But this would end up significantly decreasing their reported revenues and profits, and would most likely cause stock prices to crater as well.
If a company wanted to avoid adjusting its financials, it could insist that customers will eventually pay, even if there’s no basis for such insistence. In this case, the amount billed but uncollected (i.e. Accounts receivable) would balloon compared to the actual cash collected, which is the situation Assure finds itself in today.
It’s in the midst of this situation that an event occurred that freaked out investors. On March 12, the auditors of Assure, as well as the company’s president, abruptly resigned. Concurrently, the company’s audit committee launched a special investigation into the reason the auditors resigned. Assure’s stock price roughly halved from $3.80/share to $1.70/share in reaction to this news.
Now, I should caution that the resignation of the auditors and the president, and the red flags that I see with Assure’s accounting, don’t prove that anyone is guilty of any impropriety. But at the same time, I would be rather surprised if everyone came out unscathed from this investigation.
IF Assure had in fact been inflating its revenue and profits, I believe investors would value the company at a much lower price even than where it’s trading today. Given the negative operating cash flow, the company may be generating little, if any profits in reality. The accounting scandal may further alienate customers, driving the company towards deeper losses. If the company can’t recover from that, it may eventually go bankrupt, making its shares worthless.
So what can we learn from this ongoing saga? I think the big lesson here is to really do your research if you’re going to invest in an individual stock. At minimum, each investor should know how to read financial statements, and be able to spot red flags.