Orthodontic Centers of America OCA S W
June 24, 2002 by sunny329
2002 2003
Price: 25.50 EPS
Shares Out. (in M): 0 P/E
Market Cap (in M): 1,305 P/FCF
Net Debt (in M): 0 EBIT 0 0
TEV: 0 TEV/EBIT

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Description

I recommend taking a short position in Orthodontic Centers of America (OCA).  Quite simply, I believe that OCA’s operating and financial results are very suspect.  Moreover, OCA has a dubious business model and is outrageously valued at its current price ($26.40).  Below is an explanation of why the company’s business model is lacking and why I believe that OCA drastically overstates its earnings.  Companies such as OCA with glaring accounting and reporting issues will be severely punished in this market when they are exposed—it is only a matter of time.  OCA’s behavior is pretty much par for the course in the physicians practice management industry, which does not exist anymore because all of the companies have gone bankrupt.  OCA is still standing and to the casual observer seems to be a healthy, growing company that represents the exception in the industry.  Look again.  The following is primarily derived from my examination of the company’s SEC filings.

OCA describes its business model as a provider of integrated business services to orthodontic and pediatric dental practices.  OCA’s true business model is acquiring an ownership stake in (what OCA terms “affiliating” with) orthodontic practices primarily in the U.S. and in a few foreign countries (Japan, Mexico & Spain).  As of March 31, 2002, OCA had 367 affiliated practices, 869 affiliated centers and 617 affiliated practitioners.   Out of this total, 118 practices, with 264 centers and 156 practicioners were acquired in the acquisition of Orthalliance, a struggling competitor, in November of 2001.  A “practice” is your typical plain vanilla orthodontic practice.  After OCA acquires a practice, it generally opens multiple centers, or offices, per practice so that the orthodontist who runs the practice can see patients in various geographic areas within a given city.  Often, there is a practitioner who works within the practice but is not an owner in the affiliated practice (there is typically one orthodontist per practice and the second person in the practice--if there is a second person--is a non-owner dentist that performs orthodontic work).  These practicioners are generally considered associates or employees of the practice.  So, to sum up the above, OCA has 367 practices.  There are on average 2.37 centers or offices per practice and 1.68 practicioners per practice.  

OCA’s strategy, as quoted from their 10-K, is to “focus our recruitment of orthodontists and pediatric dentists with existing practices on those who generate less than $500K of annual patient revenue prior to their affiliation.”  Also, according to OCA’s 10-K, the average U.S. orthodontic practice in 2000 earned revenue of $713K and pre-tax income of $350K in 2001.  Therefore, OCA is targeting significantly below average orthodontists for affiliation.  When OCA “affiliates” with an orthodontic practice, it signs an agreement whereby OCA pays the orthodontist currently running the practice an upfront fee and enters into an arrangement whereby OCA provides a wide range of services to the practice including marketing and advertising, management information systems, staffing, supplies and inventory, scheduling, billing, financial reporting, accounting, and other administrative and business services.  In approximately 95% of OCA’s service agreements, the orthodontist does not have control over the practice's business management, including such matters as advertising, hiring and termination of staff and the purchase of equipment and supplies.  OCA is also generally responsible for billing and collecting patient fees and once the funds are collected, they are generally deposited into a bank account that OCA establishes and maintains.  OCA generally has sole signatory authority over these bank accounts and the exclusive responsibility for any disbursements to the orthodontist.

In exchange for the upfront fee and the services listed above, OCA is entitled to receive 40% of an affiliated practice’s operating profit post-affiliation.  The orthodontist supposedly retains the other 60% of operating profit.  In addition to receiving 40% of the operating profit of a practice, OCA is reimbursed for all direct expenses of the practice.  

Below is an explanation of how OCA calculates the upfront fee that they pay to a practice upon “affiliation”:  

OCA affiliates with a practice by entering into a service agreement with the practice.  A typical practice that OCA affiliates with has less than $500K of revenue pre-acquisition and a 40% operating margin.  Therefore, the operating profit is $200K and OCA is entitled to 40% of that operating profit post-affiliation ($200K * 0.40 = $80K).  OCA pays an upfront fee of between 4x and 5x their pro-forma share of operating profit for the practices, or $320K to $400K.  This fee is paid in a combination of cash and stock (usually 75/25 cash/stock).  The stock vests over a 180 day period.  OCA records this expense under cash flow from investing activities and debits the balance sheet for an intangible asset of the same amount.  That intangible asset is then amortized over 25 years, which is what OCA deems the life of the service agreement with the orthodontist.  

Valuation

What first got me interested in this stock is the valuation, which seemed normal on a P/E basis, but very abnormal on a per practice basis.  OCA has 52.877 fully-diluted shares outstanding and the current price is $26.92 per share for a fully-diluted market cap of $1.423 billion.  Debt is $125 million and cash of $16.5 million gives an enterprise value of $1.531 billion.  Given that there are 367 practices, this works out to a value per practice of $4.17 million.  But OCA is only entitled to 40% of the practice’s operating profit, so the implied value per practice is really $10.43 million ($4.17 / 40%).  This seemed like a huge value for practices that were generating less than $500K of revenue prior to their affiliation with OCA, but the forward P/E of 17.5x certainly seemed reasonable for a high-growth company.  I could not figure out what OCA was doing to take a practice that was being valued at between $0.8 million and $1.0 million at the time of affiliation ($500K * 40% operating margin = $200K * 4x – 5x) with OCA and turning those practices into $10 million businesses in the public markets.  And how could earnings be so substantial?

Business Model

So what is OCA doing to create a value per orthodontic practice of approximately $10.4 million when these practices were earning less than $500,000 of revenue and between $100,000-$200,000 of profits, all of which was essentially paid as a salary to the practice’s key employee, the orthodontist, prior to acquisition?  And what do the orthodontists receive in return for giving up 40% of their business’ profits?  And how does OCA take the worst performing orthodontists in the industry (a good number of them are probably the laziest), pay them with a big upfront check and stock that has virtually no vesting period, and then make them the most productive in the industry?  Here is how the company explains its value-add:

·        OCA stimulates demand for orthodontic services through marketing and advertising through radio, TV, print and internal marketing promotions.  OCA spent an average of $75,250 in 2001 per affiliated orthodontist on advertising and marketing in 2001 (up from an average of $66,439 per affiliated orthodontist in 2000 and $66,426 per affiliated orthodontist in 1999).  This compares to the national average of $4,820 per orthodontist for traditional practices in 2000.  

·        OCA boasts that “our innovative office designs permit an affiliated orthodontist to treat patients without moving from room to room. Our proprietary patient scheduling system groups appointments by the type of procedure and dedicates certain days exclusively to new patients”.   Pretty impressive, huh?

·        OCA provides its practices with “advanced technology” to increase the efficiency of affiliated orthodontic centers and to improve integrated business services.  OCA claims that its operations are supported by computer systems, including patient scheduling, billing and collection, financial and statistical reporting, accounting, inventory control and purchasing.

·        OCA also provides an on-line inventory order system, which allows its affiliated orthodontic centers to order supplies directly from vendors through our private computer network. The order system is designed to reduce supply costs, associated administrative costs, shipping time and storage requirements, and to improve the accuracy of orders placed and the flow of information between vendors and our affiliated orthodontic centers.

While the average orthodontist treats 50 patients per day, OCA affiliated orthodontists treat 76 patients on average.

So why are people so eager to get their braces from OCA affiliated practices?  While almost all orthodontic practices require a 25% down payment from patients at the start of treatment, OCA requires no down payment (although the Orthalliance practices do require a downpayment of 25%).  OCA attracts clients because it is cheaper as well.  The fees charged by OCA per patient treatment averaged $3,197 in 2001 vs. the national average of $4,216.  OCA’s average fee of $3,197 is slightly lower than the average orthodontic fee in 1991 ($3,221) for all U.S. orthodontic practices, so OCA is about ten years behind the rest of the industry in terms of pricing.  In 2001, approximately 13% of the fees paid to OCA practices were paid by a third party payor and the remainder was paid by the patients out-of-pocket.

Accounting Post-Affiliation

Once OCA affiliates with a practice, the accounting is as follows (two hypothetical practices and then how these practices are accounted for at the corporate level—all taken directly from a recent OCA slide given out at an investor presentation).  

1.        OCA is entitled to 40% of an traditional OCA practice’s operating profit
2.        OCA is entitled to approximately 17% of an Orthalliance practice’s revenue

Hypothetical Practice level Financial Results

                                   OCA Practice           Orthalliance Practice
Revenue                             $1,000,000              $1,000,000
Expenses                            ($400,000)             ($500,000)
Operating Profit                     $600,000              $500,000
% OCA’s portion of oper profit        40% of oper. profit        17% of revenue
$ OCA portion of oper profit             $240,000              $170,000
Doctors’ portion of profit             $360,000              $330,000

  
How these Two Practices are Then Accounted for at OCA Corporate

OCA Corporate

Not in OCA’s Income Statement        
Gross Revenue                 $2,000,000
Less: Doctor’s portion        ($690,000)
        
Included in OCA’s Income Statement        
Net Revenue                $1,310,000
Expenses               ($900,000)
Operating Profit        $410,000

Note that OCA only shows net revenue in its income statement.  Nowhere in its filings can you get the gross revenue number.

Earnings Quality?

My next focus was on earnings quality to figure out the disparity between the P/E, which seemed reasonable, and the value per practice, which seemed astronomical.  OCA is projecting $1.54 of EPS for 2002.  Below is a build-up of OCA’s projected earnings and a reconciliation of these earnings on a per practice basis.

Projected 2002 EPS                                 $1.54
Fully-Diluted Share Count (as of Q1)                 51.787 million
Implied Net Income                                 $79.8 million
Effective Tax Rate (as of Q1)                         37.7%
Implied Pre-Tax Income                                 $128.0 million
D&A (Q1 annualized)                                 $21.8 million
Interest (Q1 annualized as a proxy)                 $5.4 million
Estimate of Corporate Overhead (conservative)         $10.0 million
Practice level EBITDA contribution                 $165.2 million
Total practices as of 3/31/02                         367
Per practice EBITDA to OCA                         $450K
OCA’s stake in practice EBITDA                         40%
Implied practice level EBITDA                         $1.125 million

So, in order for OCA to legitimately meet its $1.54 EPS projection, the average practice would have to earn $1.125 million of EBITDA.  At an operating margin of 55% (taken from their website as the average mature practice operating margin), this implies average revenue per practice of $2.05 million.  OCA has successfully avoided giving average practice level operating results for the past few years.  According to OCA’s SEC filings, “newly developed orthodontic centers typically generate operating losses during their initial 12 months of operations”.  I believe that at least 95 practices, or a full 26% of OCA’s total practices as of 3/31/02, were most likely generating operating losses as of 12/31/01, making the earnings projection more difficult to believe.

How Can This Be The Case?

The financials statements indicate that OCA is hiding costs on its balance sheet (capitalizing an inordinate amount of expenses).  OCA has never reported free cash flow (operating activities – investing activities) on an annual basis, despite the wonderful economics that management describes.  Below is a description of the various balance sheet accounts that I believe OCA uses to obfuscate economic reality and keep expenses off of its income statement.

Every year, OCA’s 10K states that “our capital expenditures consist primarily of the costs associated with the development of additional orthodontic centers”.  OCA’s 1999 10-K stated that “the average cost of developing a new Orthodontic Center is approximately $255,000, including the cost of equipment, leasehold improvements, working capital and start-up losses associated with the initial operations of the Orthodontic Center”.  Obviously some of these costs, such as start-up operating expenses, should not be included as capex, but to be ultra-conservative, I am assuming that each practice actually costs $255K to build.  OCA developed 36 new centers in 1999.  This implies total required capex of $9.2 million.  OCA’s total purchases of property, plant & equipment were $22.5 million in 1999.  The average cost of building a new center in 2000 according to OCA’s 2000 10-K was $255K.  In 2000, OCA developed 18 new centers.    Therefore, the total capex for these centers should have been $4.6 million in 2000.  OCA’s total purchases of property, plant & equipment were $20.3 million in 2000.  The average cost of building a new center in 2001 according to OCA’s 2001 10-K was $325K (prices went up a lot since the prior year I guess).  In 2001, the company developed 28 new centers.  Therefore, 28 practices should have required $9.1 million of capex.  On property, plant & equipment alone, OCA spent $22.1 million in 2001.  Cumulatively, from 1999 to 2001, OCA spent approximately $42 million of unidentified capex (how is Orthodontics so capital intensive)?  Where did the rest of the property, plant & equipment go each year?  How can capital expenditures “consist primarily of the costs associated with the development of additional orthodontic centers” when in 1999, 2000, and 2001, the cost of developing new centers only accounts for 41%, 23%, and 41% of total property, plant & equipment purchases, respectively?

One naturally assumes that OCA acquires a practice with an upfront fee then receive an annuity stream of operating profits from the practice.  Not the case.  In OCA’s 2000 10K, the company states that in 2000 it “made payments to orthodontists or orthodontic entities with which we affiliated in earlier periods, with a total acquisition cost of about $34.2 million”.  OCA deems these payments to orthodontists with whom they are already affiliated “amendments” to the service agreement.  In its 8-K filed on 5/9/02, OCA states that “investment in intangibles generally represents consideration paid to our affiliated practices in return for amending or initiating service agreements with us.”  “We currently anticipate that cash flow from investing activities for fiscal year 2002 will be between approximately $(35) million and $(45) million.  We believe that the majority of this investment will be directed toward growing existing centers, extending service agreement terms with our existing affiliated practices and de novo growth internationally.”  Why is OCA making such large payments to orthodontists that they had affiliated with in prior years?  If OCA adds so much value and the doctors are so pleased with the arrangement, why does OCA have to amend the service agreements?   If the service agreement is really for 25 years, why do they have to “extend” it?  Perhaps it is because OCA is stripping all of the profits out of the practices through hourly service fees and other expenses that OCA allocates to the practices so that OCA actually records significantly more than 40% of the practice’s true operating profit.  I believe that instead of having the orthodontists take 60% of the operating profits, it compensates them through the intangible assets account, which gets amortized over 25 years, and therefore barely reduces reported earnings.  The orthodontists would have no idea about the accounting, as OCA collects all receivables anyway.  As long as they are getting paid, what do they care how many fees and costs OCA decides to allocate to their practice or if their practice is even profitable?  Even if the payments are lumpy and in the form of amendments to service agreements, the doctors do not care.

The issue of “amending service agreements” brings up more issues related to the quality of OCA’s earnings.  How can Ernst & Young allow the company to amortize the intangible assets over 25 years when OCA is constantly amending & extending the service agreements, which clearly indicates that the asset has a much shorter life than 25 years?  OCA does not disclose this in its filings, but when it affiliates with an orthodontist through a service agreement, although the service agreement may have an average life of 25 years, the orthodontist’s employment agreement and non-compete is only for seven years.  It is obvious that the only asset of a practice is the orthodontist.  How can OCA claim that the service agreement is for 25 years, then?

The intangible assets account on the balance sheet seems inflated, too.  The intangible assets account represents the excess of the purchase price over the tangible assets of the practice being acquired.   As of 3/31/02, the net amount of intangible assets on the company’s balance sheet was $229.1 million.  Accumulated depreciation was $34.9 million as of 3/31/02.  Therefore, gross intangible assets are $264.0 million.  The company currently has 367 practices, but 118 were acquired in the Orthalliance transaction.  Therefore, net of the practices acquired from Orthalliance, the company developed or acquired 249 practices (the Orthalliance acquisition was booked as goodwill, not intangible assets).  This results in intangible assets per practice of slightly greater than $1.0 million.  However, the intangible assets recorded in a transaction are only supposed to represent the excess of purchase price over the tangible assets acquired, so the actual purchase price would be higher than $1.0 million per practice.  Given that OCA has stated that it acquires the average practice for approximately $320K-$400K (newly developed practices are obviously cheaper), this does not add up unless OCA is continually paying the orthodontics through the intangible assets account.

Perhaps the most dubious balance sheet account is “advances to affiliated practices”.  Every OCA 10-K describes this account as follows:  “advances of about $40,000 to newly-affiliated practices during the first year of an affiliated center’s operations, which advances bear no interest and typically are repaid during the second year of the affiliated center’s operations”.  As of 3/31/02, the total amount of “advances to affiliated practices” on the balance sheet was $33.6 million.  At $40K per practice, this balance sheet account suggests that 840 practices all have full drawn-downs on this advance (none have paid any back even though they are so profitable).  OCA only has 367 practices and even if you go by affiliated centers, OCA only has 869.  In the 2001 10-K, it states that “of the advances at December 31, 2001, approximately $3.8 million was to affiliated practices that generated operating losses during the three months ended 12/31/01.”  At $40K per practice, this implies that 95 practices, or 26% of total practices, were generating operating losses as of 12/31/01.  Another way to look at is that in 2001, the company advanced $7.9 million to affiliated practices.  At $40K per practice, this was sufficient to fund 198 practices.

OK—So When Does OCA Crack?

I can not imagine how any institution can be long this stock in this environment, even if they were not aware of the issues raised above.  OCA has been slapped on the wrist in the past for aggressive revenue recognition and had to restate its 2000 financial results (the cumulative effect of which was to reduce the reported net income by a whopping $50.6 million).  Without this accounting change, OCA would have reported net income of $47.7 million in 2000, so the accounting change represented 106% of net income.  This company obviously has massive accounting issues, so when they are exposed by a source with more authority than myself, the stock is toast.  I can not speculate as to when this will happen, but as with Tyco and Enron, these things take time.  

A few pieces of evidence suggest to me that judgment day is coming sooner rather than later.  OCA is struggling for growth.  The acquisition of Orthalliance was completely illogical.  The company is being sued by 55 Orthalliance orthodontists and the number of Orthalliance orthodontists that join the suit and choose to turn down a large upfront bribe from OCA increases quarterly.  At 12/31/01, the number of orthodontists from Orthalliance suing OCA only  numbered 38.  These orthodontists do not want to be associated with OCA—I do not blame them.  I can not speculate as to how these suits will turn out, but they challenge the legality of OCA’s business model, so if they are successful, OCA could be in a lot of trouble.

OCA’s growth prospects are dim.  Only 200 accredited orthodontists graduate in the U.S. every year and the number of orthodontists practicing in the U.S. has remained at about the same level since 1989.  OCA has begun to expand internationally, which is essentially a joke in my opinion.  Here is what OCA had to say about international expansion in its 8-K—“We are very excited about what is occurring internationally. At this time, we are not going to provide separate income statement data for our foreign affiliates. We can tell you that our goal is to add between 15 and 20 affiliated orthodontic centers in Mexico and over 10 affiliated orthodontic centers in Japan during 2002.”  There are 20 OCA affiliated orthodontists in Japan, 2 in Mexico, 2 in Spain, and 2 in Puerto Rico for a total of 26 OCA affiliated orthodontists internationally.  According to OCA’s 10-K, as of 12/31/01, these 26 orthodontists had taken down $9.4 million of “advances to affiliated practices” from OCA.  That averages out to $361K per orthodontist—far more than the $40K per practice that OCA describes in its 10-K.  This is in addition to the upfront fee to acquire OCA’s share of the practice that was paid to the orthodontists.  I am not quite sure how OCA management could possibly be excited about this.  Other growth initiatives such as raising patient pricing are likely to severely affect patient volumes (who wants to go to an orthodontic factory if you are paying the same price as a legitimate practice where the orthodontist will spend time with you).  All of the growth initiatives are dubious and with the Orthalliance transaction, the company showed its hand—I believe that they will fold soon.
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    Description

    I recommend taking a short position in Orthodontic Centers of America (OCA).  Quite simply, I believe that OCA’s operating and financial results are very suspect.  Moreover, OCA has a dubious business model and is outrageously valued at its current price ($26.40).  Below is an explanation of why the company’s business model is lacking and why I believe that OCA drastically overstates its earnings.  Companies such as OCA with glaring accounting and reporting issues will be severely punished in this market when they are exposed—it is only a matter of time.  OCA’s behavior is pretty much par for the course in the physicians practice management industry, which does not exist anymore because all of the companies have gone bankrupt.  OCA is still standing and to the casual observer seems to be a healthy, growing company that represents the exception in the industry.  Look again.  The following is primarily derived from my examination of the company’s SEC filings.

    OCA describes its business model as a provider of integrated business services to orthodontic and pediatric dental practices.  OCA’s true business model is acquiring an ownership stake in (what OCA terms “affiliating” with) orthodontic practices primarily in the U.S. and in a few foreign countries (Japan, Mexico & Spain).  As of March 31, 2002, OCA had 367 affiliated practices, 869 affiliated centers and 617 affiliated practitioners.   Out of this total, 118 practices, with 264 centers and 156 practicioners were acquired in the acquisition of Orthalliance, a struggling competitor, in November of 2001.  A “practice” is your typical plain vanilla orthodontic practice.  After OCA acquires a practice, it generally opens multiple centers, or offices, per practice so that the orthodontist who runs the practice can see patients in various geographic areas within a given city.  Often, there is a practitioner who works within the practice but is not an owner in the affiliated practice (there is typically one orthodontist per practice and the second person in the practice--if there is a second person--is a non-owner dentist that performs orthodontic work).  These practicioners are generally considered associates or employees of the practice.  So, to sum up the above, OCA has 367 practices.  There are on average 2.37 centers or offices per practice and 1.68 practicioners per practice.  

    OCA’s strategy, as quoted from their 10-K, is to “focus our recruitment of orthodontists and pediatric dentists with existing practices on those who generate less than $500K of annual patient revenue prior to their affiliation.”  Also, according to OCA’s 10-K, the average U.S. orthodontic practice in 2000 earned revenue of $713K and pre-tax income of $350K in 2001.  Therefore, OCA is targeting significantly below average orthodontists for affiliation.  When OCA “affiliates” with an orthodontic practice, it signs an agreement whereby OCA pays the orthodontist currently running the practice an upfront fee and enters into an arrangement whereby OCA provides a wide range of services to the practice including marketing and advertising, management information systems, staffing, supplies and inventory, scheduling, billing, financial reporting, accounting, and other administrative and business services.  In approximately 95% of OCA’s service agreements, the orthodontist does not have control over the practice's business management, including such matters as advertising, hiring and termination of staff and the purchase of equipment and supplies.  OCA is also generally responsible for billing and collecting patient fees and once the funds are collected, they are generally deposited into a bank account that OCA establishes and maintains.  OCA generally has sole signatory authority over these bank accounts and the exclusive responsibility for any disbursements to the orthodontist.

    In exchange for the upfront fee and the services listed above, OCA is entitled to receive 40% of an affiliated practice’s operating profit post-affiliation.  The orthodontist supposedly retains the other 60% of operating profit.  In addition to receiving 40% of the operating profit of a practice, OCA is reimbursed for all direct expenses of the practice.  

    Below is an explanation of how OCA calculates the upfront fee that they pay to a practice upon “affiliation”:  

    OCA affiliates with a practice by entering into a service agreement with the practice.  A typical practice that OCA affiliates with has less than $500K of revenue pre-acquisition and a 40% operating margin.  Therefore, the operating profit is $200K and OCA is entitled to 40% of that operating profit post-affiliation ($200K * 0.40 = $80K).  OCA pays an upfront fee of between 4x and 5x their pro-forma share of operating profit for the practices, or $320K to $400K.  This fee is paid in a combination of cash and stock (usually 75/25 cash/stock).  The stock vests over a 180 day period.  OCA records this expense under cash flow from investing activities and debits the balance sheet for an intangible asset of the same amount.  That intangible asset is then amortized over 25 years, which is what OCA deems the life of the service agreement with the orthodontist.  

    Valuation

    What first got me interested in this stock is the valuation, which seemed normal on a P/E basis, but very abnormal on a per practice basis.  OCA has 52.877 fully-diluted shares outstanding and the current price is $26.92 per share for a fully-diluted market cap of $1.423 billion.  Debt is $125 million and cash of $16.5 million gives an enterprise value of $1.531 billion.  Given that there are 367 practices, this works out to a value per practice of $4.17 million.  But OCA is only entitled to 40% of the practice’s operating profit, so the implied value per practice is really $10.43 million ($4.17 / 40%).  This seemed like a huge value for practices that were generating less than $500K of revenue prior to their affiliation with OCA, but the forward P/E of 17.5x certainly seemed reasonable for a high-growth company.  I could not figure out what OCA was doing to take a practice that was being valued at between $0.8 million and $1.0 million at the time of affiliation ($500K * 40% operating margin = $200K * 4x – 5x) with OCA and turning those practices into $10 million businesses in the public markets.  And how could earnings be so substantial?

    Business Model

    So what is OCA doing to create a value per orthodontic practice of approximately $10.4 million when these practices were earning less than $500,000 of revenue and between $100,000-$200,000 of profits, all of which was essentially paid as a salary to the practice’s key employee, the orthodontist, prior to acquisition?  And what do the orthodontists receive in return for giving up 40% of their business’ profits?  And how does OCA take the worst performing orthodontists in the industry (a good number of them are probably the laziest), pay them with a big upfront check and stock that has virtually no vesting period, and then make them the most productive in the industry?  Here is how the company explains its value-add:

    ·        OCA stimulates demand for orthodontic services through marketing and advertising through radio, TV, print and internal marketing promotions.  OCA spent an average of $75,250 in 2001 per affiliated orthodontist on advertising and marketing in 2001 (up from an average of $66,439 per affiliated orthodontist in 2000 and $66,426 per affiliated orthodontist in 1999).  This compares to the national average of $4,820 per orthodontist for traditional practices in 2000.  

    ·        OCA boasts that “our innovative office designs permit an affiliated orthodontist to treat patients without moving from room to room. Our proprietary patient scheduling system groups appointments by the type of procedure and dedicates certain days exclusively to new patients”.   Pretty impressive, huh?

    ·        OCA provides its practices with “advanced technology” to increase the efficiency of affiliated orthodontic centers and to improve integrated business services.  OCA claims that its operations are supported by computer systems, including patient scheduling, billing and collection, financial and statistical reporting, accounting, inventory control and purchasing.

    ·        OCA also provides an on-line inventory order system, which allows its affiliated orthodontic centers to order supplies directly from vendors through our private computer network. The order system is designed to reduce supply costs, associated administrative costs, shipping time and storage requirements, and to improve the accuracy of orders placed and the flow of information between vendors and our affiliated orthodontic centers.

    While the average orthodontist treats 50 patients per day, OCA affiliated orthodontists treat 76 patients on average.

    So why are people so eager to get their braces from OCA affiliated practices?  While almost all orthodontic practices require a 25% down payment from patients at the start of treatment, OCA requires no down payment (although the Orthalliance practices do require a downpayment of 25%).  OCA attracts clients because it is cheaper as well.  The fees charged by OCA per patient treatment averaged $3,197 in 2001 vs. the national average of $4,216.  OCA’s average fee of $3,197 is slightly lower than the average orthodontic fee in 1991 ($3,221) for all U.S. orthodontic practices, so OCA is about ten years behind the rest of the industry in terms of pricing.  In 2001, approximately 13% of the fees paid to OCA practices were paid by a third party payor and the remainder was paid by the patients out-of-pocket.

    Accounting Post-Affiliation

    Once OCA affiliates with a practice, the accounting is as follows (two hypothetical practices and then how these practices are accounted for at the corporate level—all taken directly from a recent OCA slide given out at an investor presentation).  

    1.        OCA is entitled to 40% of an traditional OCA practice’s operating profit
    2.        OCA is entitled to approximately 17% of an Orthalliance practice’s revenue

    Hypothetical Practice level Financial Results

                                       OCA Practice           Orthalliance Practice
    Revenue                             $1,000,000              $1,000,000
    Expenses                            ($400,000)             ($500,000)
    Operating Profit                     $600,000              $500,000
    % OCA’s portion of oper profit        40% of oper. profit        17% of revenue
    $ OCA portion of oper profit             $240,000              $170,000
    Doctors’ portion of profit             $360,000              $330,000

      
    How these Two Practices are Then Accounted for at OCA Corporate

    OCA Corporate

    Not in OCA’s Income Statement        
    Gross Revenue                 $2,000,000
    Less: Doctor’s portion        ($690,000)
            
    Included in OCA’s Income Statement        
    Net Revenue                $1,310,000
    Expenses               ($900,000)
    Operating Profit        $410,000

    Note that OCA only shows net revenue in its income statement.  Nowhere in its filings can you get the gross revenue number.

    Earnings Quality?

    My next focus was on earnings quality to figure out the disparity between the P/E, which seemed reasonable, and the value per practice, which seemed astronomical.  OCA is projecting $1.54 of EPS for 2002.  Below is a build-up of OCA’s projected earnings and a reconciliation of these earnings on a per practice basis.

    Projected 2002 EPS                                 $1.54
    Fully-Diluted Share Count (as of Q1)                 51.787 million
    Implied Net Income                                 $79.8 million
    Effective Tax Rate (as of Q1)                         37.7%
    Implied Pre-Tax Income                                 $128.0 million
    D&A (Q1 annualized)                                 $21.8 million
    Interest (Q1 annualized as a proxy)                 $5.4 million
    Estimate of Corporate Overhead (conservative)         $10.0 million
    Practice level EBITDA contribution                 $165.2 million
    Total practices as of 3/31/02                         367
    Per practice EBITDA to OCA                         $450K
    OCA’s stake in practice EBITDA                         40%
    Implied practice level EBITDA                         $1.125 million

    So, in order for OCA to legitimately meet its $1.54 EPS projection, the average practice would have to earn $1.125 million of EBITDA.  At an operating margin of 55% (taken from their website as the average mature practice operating margin), this implies average revenue per practice of $2.05 million.  OCA has successfully avoided giving average practice level operating results for the past few years.  According to OCA’s SEC filings, “newly developed orthodontic centers typically generate operating losses during their initial 12 months of operations”.  I believe that at least 95 practices, or a full 26% of OCA’s total practices as of 3/31/02, were most likely generating operating losses as of 12/31/01, making the earnings projection more difficult to believe.

    How Can This Be The Case?

    The financials statements indicate that OCA is hiding costs on its balance sheet (capitalizing an inordinate amount of expenses).  OCA has never reported free cash flow (operating activities – investing activities) on an annual basis, despite the wonderful economics that management describes.  Below is a description of the various balance sheet accounts that I believe OCA uses to obfuscate economic reality and keep expenses off of its income statement.

    Every year, OCA’s 10K states that “our capital expenditures consist primarily of the costs associated with the development of additional orthodontic centers”.  OCA’s 1999 10-K stated that “the average cost of developing a new Orthodontic Center is approximately $255,000, including the cost of equipment, leasehold improvements, working capital and start-up losses associated with the initial operations of the Orthodontic Center”.  Obviously some of these costs, such as start-up operating expenses, should not be included as capex, but to be ultra-conservative, I am assuming that each practice actually costs $255K to build.  OCA developed 36 new centers in 1999.  This implies total required capex of $9.2 million.  OCA’s total purchases of property, plant & equipment were $22.5 million in 1999.  The average cost of building a new center in 2000 according to OCA’s 2000 10-K was $255K.  In 2000, OCA developed 18 new centers.    Therefore, the total capex for these centers should have been $4.6 million in 2000.  OCA’s total purchases of property, plant & equipment were $20.3 million in 2000.  The average cost of building a new center in 2001 according to OCA’s 2001 10-K was $325K (prices went up a lot since the prior year I guess).  In 2001, the company developed 28 new centers.  Therefore, 28 practices should have required $9.1 million of capex.  On property, plant & equipment alone, OCA spent $22.1 million in 2001.  Cumulatively, from 1999 to 2001, OCA spent approximately $42 million of unidentified capex (how is Orthodontics so capital intensive)?  Where did the rest of the property, plant & equipment go each year?  How can capital expenditures “consist primarily of the costs associated with the development of additional orthodontic centers” when in 1999, 2000, and 2001, the cost of developing new centers only accounts for 41%, 23%, and 41% of total property, plant & equipment purchases, respectively?

    One naturally assumes that OCA acquires a practice with an upfront fee then receive an annuity stream of operating profits from the practice.  Not the case.  In OCA’s 2000 10K, the company states that in 2000 it “made payments to orthodontists or orthodontic entities with which we affiliated in earlier periods, with a total acquisition cost of about $34.2 million”.  OCA deems these payments to orthodontists with whom they are already affiliated “amendments” to the service agreement.  In its 8-K filed on 5/9/02, OCA states that “investment in intangibles generally represents consideration paid to our affiliated practices in return for amending or initiating service agreements with us.”  “We currently anticipate that cash flow from investing activities for fiscal year 2002 will be between approximately $(35) million and $(45) million.  We believe that the majority of this investment will be directed toward growing existing centers, extending service agreement terms with our existing affiliated practices and de novo growth internationally.”  Why is OCA making such large payments to orthodontists that they had affiliated with in prior years?  If OCA adds so much value and the doctors are so pleased with the arrangement, why does OCA have to amend the service agreements?   If the service agreement is really for 25 years, why do they have to “extend” it?  Perhaps it is because OCA is stripping all of the profits out of the practices through hourly service fees and other expenses that OCA allocates to the practices so that OCA actually records significantly more than 40% of the practice’s true operating profit.  I believe that instead of having the orthodontists take 60% of the operating profits, it compensates them through the intangible assets account, which gets amortized over 25 years, and therefore barely reduces reported earnings.  The orthodontists would have no idea about the accounting, as OCA collects all receivables anyway.  As long as they are getting paid, what do they care how many fees and costs OCA decides to allocate to their practice or if their practice is even profitable?  Even if the payments are lumpy and in the form of amendments to service agreements, the doctors do not care.

    The issue of “amending service agreements” brings up more issues related to the quality of OCA’s earnings.  How can Ernst & Young allow the company to amortize the intangible assets over 25 years when OCA is constantly amending & extending the service agreements, which clearly indicates that the asset has a much shorter life than 25 years?  OCA does not disclose this in its filings, but when it affiliates with an orthodontist through a service agreement, although the service agreement may have an average life of 25 years, the orthodontist’s employment agreement and non-compete is only for seven years.  It is obvious that the only asset of a practice is the orthodontist.  How can OCA claim that the service agreement is for 25 years, then?

    The intangible assets account on the balance sheet seems inflated, too.  The intangible assets account represents the excess of the purchase price over the tangible assets of the practice being acquired.   As of 3/31/02, the net amount of intangible assets on the company’s balance sheet was $229.1 million.  Accumulated depreciation was $34.9 million as of 3/31/02.  Therefore, gross intangible assets are $264.0 million.  The company currently has 367 practices, but 118 were acquired in the Orthalliance transaction.  Therefore, net of the practices acquired from Orthalliance, the company developed or acquired 249 practices (the Orthalliance acquisition was booked as goodwill, not intangible assets).  This results in intangible assets per practice of slightly greater than $1.0 million.  However, the intangible assets recorded in a transaction are only supposed to represent the excess of purchase price over the tangible assets acquired, so the actual purchase price would be higher than $1.0 million per practice.  Given that OCA has stated that it acquires the average practice for approximately $320K-$400K (newly developed practices are obviously cheaper), this does not add up unless OCA is continually paying the orthodontics through the intangible assets account.

    Perhaps the most dubious balance sheet account is “advances to affiliated practices”.  Every OCA 10-K describes this account as follows:  “advances of about $40,000 to newly-affiliated practices during the first year of an affiliated center’s operations, which advances bear no interest and typically are repaid during the second year of the affiliated center’s operations”.  As of 3/31/02, the total amount of “advances to affiliated practices” on the balance sheet was $33.6 million.  At $40K per practice, this balance sheet account suggests that 840 practices all have full drawn-downs on this advance (none have paid any back even though they are so profitable).  OCA only has 367 practices and even if you go by affiliated centers, OCA only has 869.  In the 2001 10-K, it states that “of the advances at December 31, 2001, approximately $3.8 million was to affiliated practices that generated operating losses during the three months ended 12/31/01.”  At $40K per practice, this implies that 95 practices, or 26% of total practices, were generating operating losses as of 12/31/01.  Another way to look at is that in 2001, the company advanced $7.9 million to affiliated practices.  At $40K per practice, this was sufficient to fund 198 practices.

    OK—So When Does OCA Crack?

    I can not imagine how any institution can be long this stock in this environment, even if they were not aware of the issues raised above.  OCA has been slapped on the wrist in the past for aggressive revenue recognition and had to restate its 2000 financial results (the cumulative effect of which was to reduce the reported net income by a whopping $50.6 million).  Without this accounting change, OCA would have reported net income of $47.7 million in 2000, so the accounting change represented 106% of net income.  This company obviously has massive accounting issues, so when they are exposed by a source with more authority than myself, the stock is toast.  I can not speculate as to when this will happen, but as with Tyco and Enron, these things take time.  

    A few pieces of evidence suggest to me that judgment day is coming sooner rather than later.  OCA is struggling for growth.  The acquisition of Orthalliance was completely illogical.  The company is being sued by 55 Orthalliance orthodontists and the number of Orthalliance orthodontists that join the suit and choose to turn down a large upfront bribe from OCA increases quarterly.  At 12/31/01, the number of orthodontists from Orthalliance suing OCA only  numbered 38.  These orthodontists do not want to be associated with OCA—I do not blame them.  I can not speculate as to how these suits will turn out, but they challenge the legality of OCA’s business model, so if they are successful, OCA could be in a lot of trouble.

    OCA’s growth prospects are dim.  Only 200 accredited orthodontists graduate in the U.S. every year and the number of orthodontists practicing in the U.S. has remained at about the same level since 1989.  OCA has begun to expand internationally, which is essentially a joke in my opinion.  Here is what OCA had to say about international expansion in its 8-K—“We are very excited about what is occurring internationally. At this time, we are not going to provide separate income statement data for our foreign affiliates. We can tell you that our goal is to add between 15 and 20 affiliated orthodontic centers in Mexico and over 10 affiliated orthodontic centers in Japan during 2002.”  There are 20 OCA affiliated orthodontists in Japan, 2 in Mexico, 2 in Spain, and 2 in Puerto Rico for a total of 26 OCA affiliated orthodontists internationally.  According to OCA’s 10-K, as of 12/31/01, these 26 orthodontists had taken down $9.4 million of “advances to affiliated practices” from OCA.  That averages out to $361K per orthodontist—far more than the $40K per practice that OCA describes in its 10-K.  This is in addition to the upfront fee to acquire OCA’s share of the practice that was paid to the orthodontists.  I am not quite sure how OCA management could possibly be excited about this.  Other growth initiatives such as raising patient pricing are likely to severely affect patient volumes (who wants to go to an orthodontic factory if you are paying the same price as a legitimate practice where the orthodontist will spend time with you).  All of the growth initiatives are dubious and with the Orthalliance transaction, the company showed its hand—I believe that they will fold soon.
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    Catalyst

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    Messages


    SubjectManagement
    Entry06/24/2002 11:59 AM
    Memberwizard877
    Have you tried to get management to explain their accounting to you? I'd like to know what their take is on these issues.

    SubjectManagement will not speak to a
    Entry06/24/2002 12:08 PM
    Membersunny329
    Management will not speak to anyone with a known short bias. They are reluctant to speak with anyone that is not on their shareholder list. Good luck. I have not discussed these issue with management.

    SubjectManagement will not speak to a
    Entry06/24/2002 12:08 PM
    Membersunny329
    Management will not speak to anyone with a known short bias. They are reluctant to speak with anyone that is not on their shareholder list. Good luck. I have not discussed these issue with management.

    SubjectOCA transaction multiples
    Entry06/24/2002 01:10 PM
    Memberbratton354
    great write-up. hard to argue with your presentation. do you have any idea what the mutliples on both an EBITDA and per practice were in the OrthoAlliance and Apple Orthodontix deals?

    Subjectbratton--i promise to get back
    Entry06/24/2002 05:58 PM
    Membersunny329
    bratton--i promise to get back to you in a bit--i am very busy right now. it is somewhat of a difficult analysis b/c the purchase price includes not only what oca paid the shareholders of orthalliance, but also what they are paying the orthalliance doctors to try to stop the orthalliance practices from leaving. a good portion of these payments are in shares and given the number of orthodontists that have chosen to join the suit against oca and turn down the payment, it is somewhat of a fluid calculation. i will get back to you, though.

    SubjectBratton, Orthalliance 1.
    Entry06/25/2002 12:13 PM
    Membersunny329
    Bratton,

    Orthalliance

    1.3 million shares issued valued at $32.3 million issued to Orthalliance shareholders. $4.2 million of merger related expenses and $119.8 million of liabilities assumed. Plus, in connection with the Orthalliance merger, OCA instituted seven incentive programs under which shares of OCA common stock could be granted to Orthalliance orthodontists and pediatric dentists. Participation in each of the incentive programs was based upon the Orthalliance doctors either entering into a new agreement with OCA or amending their old agreement. The amount to be paid also depends upon the doctors' contribution to OCA post-acquisition relative to their contribution to Orthalliance pre-acquisition, among other things.

    It is very difficult to tell how many shares have been issued or what OCA has done to convince Orthalliance shareholders to stay with the company. However, on the company's cash flow statement, on the bottom of the page, there is a supplementary line item called "Notes Payable and Common Stock Issued to Obtain Service Agreements". This number jumped from $0.8 million for the nine months ended 9/30/01 to $29.1 million for the twelve months ended 12/31/01, implying that $28.3 million of notes and common stock were issued to obtain the agreements in the fourth quarter. Adding this to the above merger consideration gets you to $156.3 million. There will be additional shares issued in the future, though. Also, as more Orthalliance doctors enter the lawsuit, I would be surprised if more shares were not offered as an enticement.

    There were 118 Orthalliance practices as of 12/31/01. This implies $1.3 million per practice, but it is actually higher since shares will be issued in the future. Quick back of the envelope Orthalliance ltm ebitda as of 9/30 is $27 million, but declining and doctors were very unhappy because of Orthalliance share price, and obviously OCA is not getting the full benefit of that b/c so many doctors from Orthalliance have entered suit and are no longer paying OCA under their service agreement. Real issue with the Orthalliance merger is cultures, which are totally different and the reason that many Orthalliance dentists are choosing to join the suit.

    Apple--12 practices, $5.0 million in cash, 57,643 shares.





    Subjectgreat work . . .
    Entry06/25/2002 05:55 PM
    Memberwill579
    looks like you found the Mobile Mini of the dental world

    Subjectmini idea was great and now
    Entry06/25/2002 07:04 PM
    Membersunny329
    mini idea was great

    and now worldcom.

    thanks will.

    Subjectgreat idea sunny
    Entry06/26/2002 01:14 AM
    Membermichael99
    Sunny, thanks for sharing your thorough and original research. Impressive stuff.

    This is another one where the cash flow statements really tell the story. I just recently discovered similar accounting in another entity, but at least in the end the other one produces FCF. Here with OCA, "Where's the free cash flow?" jumps to mind immediately. I think a lot more people are starting to look at the lines just below 'purchases of PPE.' OCA, as I don't think it ultimately earns its cost of capital, is a net destroyer of capital, and will need capital inflows to survive ultimately. Why can't it go to zero?

    In my view, how a zero might come about is when management starts acting stupid with acquisitions (which it may have already done to some extent) and capital allocation in a risky, desperate attempt to keep up appearances and further manipulate earnings. Then the house of cards is revealed, their dentists revolt and sue and it starts to get very messy because no one wants to let them buy in anymore, etc. OCA could easily go that route, I think. Your thoughts?
    Again, thanks.

    Mike

    SubjectMike, I think that you are
    Entry06/26/2002 10:27 AM
    Membersunny329
    Mike,

    I think that you are exactly right. A snowball effect can take place once this company's cost of capital increases significantly. When the stock price begins to reflect the economic reality of this business, more and more orthodontists will request "amendments" to their agreements, which becomes more and more costly. Your only asset becomes very unhappy, and frankly, there is not much you can do about it. Not to mention that the OCA orthodontists are required to purchase OCA stock (they are cumulatively on the hook for 1.83 million shares), which they will be really unhappy about once the stock price reflects the economic reality.

    History shows that this industry does not cover its cost of capital. There have been many "zeroes" in this industry. I would not be surprised if OCA is one of them.

    Subjectservice agreement "amendments"
    Entry06/26/2002 10:50 AM
    Memberquentin720
    I wonder whether there is a more benign interpretation of the "payments to orthodontists . . . with which [OCA] affiliated in earlier periods" than you have in your write-up.

    Check out this page on the OCA web site:
    https://www.orthodon.com/YourFuture/contract.asp

    It describes Target Payments paid to affiliated orthodontists equal to 3 times the annual increase in OCA management fees in the 3rd year after affiliation (with a cap of $250k). I'm not sure that account for the entire $34.2 mm paid in 2000, but it must account for a lot of it. If so, that would not be an amendment/extension, but simply a payment under the original agreement.

    SubjectOCA
    Entry06/26/2002 12:24 PM
    Membermitch395
    1) What do other orthodontists say about OCA?
    2) On the CF statement, of the intangible assets acquired, what % is from new practices acquired and what from amending existing service agreements in past few years?
    3) Where else on the balance sheet are there items where OCA is capitalizing costs that they should be expensing (i.e, are their other balance sheet items OCA uses to pay its orthodontists or is it all on the intangible asset line in your opinion?

    SubjectQuentin, I agree that it co
    Entry06/26/2002 03:13 PM
    Membersunny329
    Quentin,

    I agree that it could account for some of the $34.2 million. Economically, however, having to repay your doctors 3x any growth that you achieve should have a profound effect on valuation. It should also give the doctors a lot of incentive the first three years, which will likely tailor off after the second payment. I think that this structure only encourages the doctors to collabarate with OCA to push as much of the profits as possible to OCA (at least for the third year) rather than retaining them at the practice level (through the overallocation of costs to the practices), since they are paid on a multiple of growth in OCA's earnings from their practice, not as a multiple of total practice profit.

    SubjectBalance sheet
    Entry06/26/2002 03:20 PM
    Memberjohn771
    It looks like they hid $55mm in tangible assets from last year's ORAL acquisition. Plenty of ammo for manipulating this year's earnings. Excluding deferred tax items:

    Current Assets per ORAL (6/30 10Q): $42.8mm
    Acquired ORAL Current Assets per OCA (10-K): $14.2mm

    PP&E per ORAL: $7.8mm
    Acquired ORAL PP&E per OCA: $3.9mm

    Other Tangible Assets per ORAL: $6.6mm
    Acquired ORAL Other Tangible Assets per OCA: $2.8mm

    Liabilities per ORAL: $100.9mm
    Acquired ORAL Liabilities per OCA: $119.8mm

    Net Tangible Assets per ORAL: -$43.7mm
    Acquired ORAL Net Tangible Assets per OCA: $-98.9mm

    If I understand this correctly, then it looks like $55mm disappeared between 6/30 and 11/9.

    Subject1) What do other orthodontists
    Entry06/26/2002 03:26 PM
    Membersunny329
    1) What do other orthodontists say about OCA?
    2) On the CF statement, of the
    intangible assets acquired, what % is from new practices acquired and what from
    amending existing service agreements in past few years?
    3) Where else on the balance
    sheet are there items where OCA is capitalizing costs that they should be expensing
    (i.e, are their other balance sheet items OCA uses to pay its orthodontists or is it
    all on the intangible asset line in your opinion?


    1) Best feedback I can give you is that there is a culture clash between OCA and Orthalliance doctors b/c OCA advertises heavily and runs orthodontic factories and Orthalliance doctors are the type that are averse to advertising medical services b/c it is viewed as dishonorable and focus on quality of care over revenue generation. This is what I have heard.

    2) Can't be sure. No way to tell from filings; all that I could discover is in my write-up.

    3) Can't be sure, but P,P&E seems suspiciously high and advances to affiliated practices seems out of whack with reported profitability and how they represent this account in their filings.

    SubjectWait, are you being fair?
    Entry06/26/2002 03:53 PM
    Memberquentin720
    Sunny - When I read your original report, one of the most compelling arguments you made was that OCA was "renegotiating" its agreements and paying its docs for extensions/amendments/what have you and then capitalizing those payments into intangibles. But if those payments were made (in part, in total, I don't know) pursuant to earn out provisions in the original agreements, it is hard to claim that OCA is cooking the books. You don't appear to like these earn-out provisions (I don't think they are so bad), but it is not fraud.

    SubjectQuentin, I was told by the
    Entry06/26/2002 05:48 PM
    Membersunny329
    Quentin,

    I was told by the company's CFO point-blank that they often have to visit a disgruntled doctor and give him additional cash and/or stock to keep him happy. Moreover, using cash to amend service agreements is specifically noted in the public filings.

    SubjectQuentin, I was recently tol
    Entry06/26/2002 06:58 PM
    Membersunny329
    Quentin,

    I was recently told that in the last few days, when questioned about the intangible assets account being so large relative to the purchase price of the practices, management tells investors that this was due to amendments of service agreements.

    Moreover, you simply can not justify such a large intangible assets account given the acquisition prices of the practices. When you consider that a good number of the practices are greenfield and in those cases you do not make such a large upfront payment to acquire a practice, the intangible assets account seems even less reasonable.

    Hope this helps.

    SubjectSunny
    Entry06/27/2002 10:11 AM
    Memberquentin720
    I agree that the size of the intangible assets is a red flag, but I want to rule out all legitimate explanations before I agree that there is fraud. I will do more work and get back to you.

    BTW, I could never imagine owning the stock. My additional work is only to decide between doing nothing and shorting it.

    Subjectvalue of practices
    Entry06/27/2002 03:49 PM
    Memberarc122
    The accounting here is clearly opaque at best but as Sunny points out you do not really need to sweat the details in some senses.If you go and check with any orthodontists you know they will tell you that the implied value of the practices is miles off the mark .For a comparison one of the most successful practices in westchester count NY recently sold for 1 million and that one was of infinitely higher quality than these ones .What more do you need to know that the implied value of the practices?

    Subjectarc and sonny
    Entry06/27/2002 04:32 PM
    Memberquentin720
    Arc's post highlights an issue that I've been wrestling with. What is the value of 40% of a practice, when the buyer does not have to operate the practice, as compared to the value of 100% of a practice, when the buyer has to operate the practice? As for myself, I think I would pay more for the former than the latter (assuming, for the moment, that I am an orthodontist).

    If I knew that Arc was correct and that orthodontic practices routinely trade for prices in excess of $1mm, that actually gives me some comfort that the prices OCA is paying for its service agreements are not crazy.

    Any thoughts?

    Subjectquentin, i do not understan
    Entry06/27/2002 04:49 PM
    Membersunny329
    quentin,

    i do not understand your question.


    Subjectsunny
    Entry06/28/2002 09:13 AM
    Memberquentin720
    Let me restate it. Let's assume that a contract orthodontist can earn $200k/year. Let's further assume that there is an orthodontry practice that has revenues of $700k/year and profits of $280k/year. If I were an orthodontist and paid $1mm for that practice, then I would actually be paying 12.5x profit for the practice (i.e. the multiple should only be applied to the true profit of the practice after all the salaries are paid). If I were OCA and paid the same multiple, then I would pay $1.4mm for just 40%. Is OCA paying too much? I'm not sure, but I'm not sure that it is a crazy price either.

    SubjectQuentin: According to OCA m
    Entry06/28/2002 10:01 AM
    Membersunny329
    Quentin:

    According to OCA management, OCA pays a multiple of 5x their pro-forma share of a practice's profit. For a practice that was earning profit before doctor's salary of $280K, OCA would pay $560K upfront. The problem is this: OCA's various balance sheet accounts and implied earnings per practice strongly suggest that OCA is taking more than 40% of a practice's profits and in exchange is paying the orthodontist through the intangibles account. OCA amortizes this payment over 25 years, thus it has a minimal effect on their reported earnings. OCA has every incentive in the world to book more of the practice's profits on their income statement and keep the doctors happy through amendments of service agreements. OCA's intangibles account is severely inflated when you consider that the average OCA practice has less than $500K of revenue pre-acquisition, so the maximum OCA should be paying is $400K (assuming a 40% margin)--so how is the intangible account so large? Moreover, a lot of OCA practices are greenfield, so they should cost even less since there is no practice to buy upfront.







    Let me restate it. Let's assume that a contract orthodontist can earn $200k/year.
    Let's further assume that there is an orthodontry practice that has revenues of
    $700k/year and profits of $280k/year. If I were an orthodontist and paid $1mm for that
    practice, then I would actually be paying 12.5x profit for the practice (i.e. the
    multiple should only be applied to the true profit of the practice after all the
    salaries are paid). If I were OCA and paid the same multiple, then I would pay $1.4mm
    for just 40%. Is OCA paying too much? I'm not sure, but I'm not sure that it is a
    crazy price either.



    Subjectsunny
    Entry06/28/2002 10:11 AM
    Memberquentin720
    where does that 5x multiple statement come from? Why would a young orthodontist (with 25 years of work ahead of him) sell 40% of himself for 5x profits? Does that make sense to you? I feel like I am missing something.

    SubjectDirectly from the CFO, Quentin
    Entry06/28/2002 10:19 AM
    Membersunny329
    Directly from the CFO, Quentin. The example of a practice acquisition that I gave in my write-up came directly from him. According to the CFO, OCA rarely pays more than 5x (upfront) their share of a practice's profits. This does not foot with the intangibles account, though.

    SubjectSunny
    Entry06/28/2002 10:35 AM
    Memberquentin720
    Nor does it foot with common sense. If I were a small business lender at 1st National Bank of Hooville and the local orthodontist showed up looking for a $500k loan, I'd make him the loan and the doc can keep 100% and just pay me the interest (and some principal over time). So why would a doc sell 40% so cheaply.

    As a side note, what would you pay for a $500k practice when your business model seems to increase case load dramatically? If you believe the numbers concerning new case starts (569 during 2001), that is a revenue run rate of over $1.8mm/year per practice. To me, that is the most unbelievable part of the story. How does OCA take a $500k practice and turn it into a $1.8mm/practice?

    SubjectLast day before I begin Orthod
    Entry06/28/2002 11:13 AM
    Memberraf698
    Thanks for the insight, Sunny! I am quitting my job to become an orthodontist. If we take another simple model, let's assume that OCA has an average life of four years left on its service agreements, and that based on today's price, that works out to be $2.1M per practitioner. This gives a baffling valuation of 500k/yr for each practioner--to get less than half their profit?!?

    Now, this from salary.com:

    A typical Orthodontist working in the United States is expected to earn a median base salary of $102,172. Half of the people in this job are expected to earn between $83,939 and $123,885 (i.e., between the 25th and 75th percentiles).
    (This data is as of June, 2002.)

    Orthodontist Low Median High
    the United States $83,939 $102,172 $123,885

    Talk about monetizing shareholder ignorance!




    Subjectraf, i find oca's business
    Entry06/28/2002 11:40 AM
    Membersunny329
    raf,

    i find oca's business model and valuation to be glaringly absurd. oca's disclosure is misleading and their accounting completely misrepresents their business' profitability. again--given the history of practice management companies failing--it is simply not a viable business model, i do not know how people think this company is worth what the market is implying. you would think that after enron, tyco, worldcom, etc. people would learn to stay away from those companies that they can not understand. especially with the history of failure in this industry, anyone who owns this stock blindly deserves what is in store for them.

    SubjectJohn, Sorry for the delayed
    Entry06/30/2002 11:27 AM
    Membersunny329
    John,

    Sorry for the delayed response...I missed your post when it was posted this week. Frankly I would be surprised if OCA did not use the Orthalliance merger as an opportunity to manipulate earnings. The disparity in balance sheets, however, could partially arise from the fact that a number of Orthalliance doctors are suing OCA and therefore OCA is not accounting for their service fees. OCA may have also written off assets related to these doctors. That being said, I have seen companies establish large reserves for service contracts that are unprofitable in connection with an acquisition and subsequently amortize the reserves into earnings, which obfuscates true earnings power. This could very well be the case. Nice catch--


    SubjectSunny
    Entry07/02/2002 01:48 PM
    Memberjbk727
    Sunny -- great work, very interesting idea. I'm an analyst at a hedge fund and we're taking a close look at it now, but would love to talk to you about it in more depth, if you have the time.

    SubjectWhen to cover
    Entry07/03/2002 11:29 AM
    Memberpirate681
    Great idea, only wish I shorted more. So when do we cover? Pirate

    SubjectPirate, Very difficult to s
    Entry07/03/2002 01:00 PM
    Membersunny329
    Pirate,

    Very difficult to say. I doubt that this company has very much value at all and the comps are all zeroes, but there is not as much debt on OCA as there is in a typical roll-up.

    If one assumes that the average service agreement has a life of 5 years instead of 25, which is probably giving them too much credit, then total amortization of service agreements would be $52 million in 2002 vs. approximately $10 million (which is what they will likely have as amortization expense in 2002). The difference is $42 million and depending upon the tax deductibility, this results in an annual hit to eps of between $0.48 and $0.80 per share. Let's just say $0.60 for a round number. Now, their 2002 EPS is $0.94 instead of $1.54. Then, you have to wonder about all of the capex. What are they spending so much money on? Also, the advances to affiliated practices account is very curious. Say that this is a business that should have a P/E of 10 maximum because of the accounting issues (which have been proven in the past), industry failures, slowing growth, and inherent risk in orthodontist attrition. Add in the Orthalliance risk, which is substantial, and 10x seems generous. I place the value just under $10 per share. That being said, it could well be a zero depending upon what they have to give their orthodontists in terms of "amendments" and just how bad the advances account smells once you peel back the onion. These businesses quickly unravel.

    Hope this helps. Have a great weekend.

    SubjectThe company's response
    Entry07/05/2002 10:52 AM
    Memberwrt233
    The stock is up strongly today, I assume due in part to the 8-K it released, which addresses some of the issues critics have been raising. I haven't studied it closely enough to comment yet.
    ----------
    ITEM 9. REGULATION FD DISCLOSURE

    The following information was compiled from recent questions received from investors. We are providing these questions and answers in written form to furnish the investment community with more information that we hope will help investors to better understand OCA from a financial point of view. This also reflects our attempt to comply with disclosure guidelines contained in the Securities and Exchange Commission's Regulation FD.

    o When will you conduct your earnings conference call for the second quarter of 2002?

    Thursday, August 8, 2002 at 2:00 p.m. (Eastern Time). The dial-in number for the call will be released soon, or you can listen to the webcast at www.ccbn.com, which will be archived for at least 30 days following the webcast.

    o What is management's earnings expectations for the year and quarter?

    We affirm our prior estimate of net income per share of approximately $1.54 for fiscal year 2002. We are still closing our books for the second quarter, and at this time we do not have any reason to change our previous estimate of $0.39 for the second quarter. We can't assure you that our actual earnings will turn out to be those amounts. There are a number of factors that could affect our ability to achieve these estimates, many of which are beyond our control. Examples of these factors are included in the section of this document captioned "Cautionary Statement About Forward-Looking Statements."

    o What are cash flow expectations?

    As we stated in our last Form 8-K filed on May 9, 2002, we expect cash flow from operating activities for fiscal year 2002 to be at least $60 million. Again, this is only our current estimate of this amount, which could change and might be wrong. The risks described in "Cautionary Statement About Forward-Looking Statements" and other factors could prevent us from achieving this estimate.

    o The company's stock price has been under considerable pressure over the past two weeks. Can you explain why?

    We believe that present investor sentiment in the broader markets is one of caution and that many publicly-traded companies' reported financial statements are receiving greater scrutiny. OCA is no exception. We are sensitive to investors' concerns and we have a history of being responsive to investors' concerns.

    The responses that follow in this document are an attempt to answer many of the questions we've received lately. To be clear, we prepare our financial statements in accordance with generally accepted accounting principles and we stand by the appropriateness of our accounting treatment.

    CONTINUED

    SubjectThe company's response (2)
    Entry07/05/2002 10:53 AM
    Memberwrt233
    CONTINUING

    o What is the nature of the intangible assets on your balance sheet and how are those intangible assets amortized?

    We generally affiliate with an existing practice by acquiring substantially all of the non-professional assets of the practice, either directly or indirectly through a stock purchase, and entering into a service agreement with the practice owner and his or her professional corporation. The terms of the service agreements range from 20 to 40 years, with most ranging from 20 to 25 years. The acquired assets generally consist of equipment, furniture, fixtures, supplies and leasehold interests. We record these acquired tangible assets at their fair value as of the date of acquisition (which typically represents about 5% to 10% of the purchase price), and depreciate or amortize the acquired assets using the straight-line method over their useful lives. The remainder of the purchase price is allocated to an intangible asset, which represents the costs of obtaining the service agreement, pursuant to which we obtain the exclusive right to provide business operations, financial, marketing and administrative services to the practice during the term of the service agreement. We amortize that intangible asset over the useful life of the service agreement (up to 25 years).

    From time to time, we have provided consideration to existing affiliated practices in return for the practices amending their service agreements with us to provide material long-term value to us, with a corresponding increase in the amount of the related intangible asset. For example, on occasion we may agree to amend a given service agreement as part of an affiliated practice's acquisition of another existing practice, center or patient base, which in turn becomes part of the acquiring practice. In cases when one of our affiliated practices acquires another practice and it potentially provides earnings leverage to us, we may therefore be willing to help fund the acquisition by way of incremental consideration to the affiliated practice.

    We view our investment in service agreements, whether it be in a new affiliation or with an existing affiliated practice, as an investment in what we characterize as an ongoing "stream of cash flow" from providing business services to the affiliated practices. Accordingly, impairment tests for such assets dictate that we examine our service agreements relative to possible future cash flows. As a more immediate check of future service fees, we also look to the existing patient contract balances of our affiliated practices, which serve as a form of "litmus" test for the intangible balances recorded on our balance sheet (approximately $229.1 million as of March 31, 2002). As of March 31, 2002, these patient contract balances totaled approximately $743 million. While these patient contract balances of our affiliated practices are not recorded on our balance sheet, we look at a percentage of these patient contract balances as a predictor of service fee revenue that we may realize during the following two year period.

    In accordance with FASB Statement No. 144 ("Accounting for Impairment of Long-Lived Assets and for Long-Lived Assets to Be Disposed Of"), we systematically evaluate on a routine basis whether events and circumstances have occurred that indicate that all or a portion of the carrying amount of these intangible assets may no longer be recoverable, and is therefore impaired. Any future determination that impairment has occurred would require us to write off the impaired portion of unamortized intangible assets, resulting in a charge to our earnings.

    By way of information, during 2001, the composition of our investment in intangibles, excluding the effect of the OrthAlliance merger, was approximately 77% related to new affiliations and 23% related to existing affiliated practices. Of the amount invested in new affiliations during 2001, a portion was related to orthodontists who signed definitive agreements in 2000, but to whom we did not ultimately exchange consideration for the affiliation until 2001. For fiscal year 2000, our total acquisition costs for affiliations was $34.2 million, and we estimate that the proportional investment in new affiliations versus investment in existing affiliates was not materially different than in 2001. Another noteworthy statistic is that the gross intangible investment per practice declined to approximately $711,000 at year end 2001 from $748,000 at year end 1998. On a per-practice basis, our gross investments in intangibles imply that we have not deviated from our consistent investment behavior. While we have long preferred to target our affiliations with practices having gross patient-based revenue of $500,000 or less, we have affiliated with many practices that are larger. Industry statistics will attest that the average size of orthodontic practices has increased substantially over the last decade, and we have been forced to consider affiliating with larger practices in order to expand our pool of prospective affiliations.

    CONTINUED

    SubjectThe company's response (3)
    Entry07/05/2002 10:54 AM
    Memberwrt233
    CONTINUING

    We amortize our investment in service agreements over the terms of our service agreements, with a maximum amortization period of 25 years, in accordance with generally accepted accounting principles. We view the life of the practice as independent of the given practice owner at the time. In the normal course of business, changes in practice ownership are reasonably common within OCA's network of affiliates. In such cases, the practice transfers to a successor practitioner who assumes the transferring practitioner's obligations under the service agreement. In fact, since 1994 we have facilitated over 100 successful practice or center transitions within our system. While approximately 14 of those practice or center successions resulted from non-performance or under-performance by the affiliated practitioner, or because of the death of the practitioner, the vast majority of such transitions have been to facilitate practice growth, transfer individual centers from one affiliated practice to another, or accommodate practitioners who desired to move, purchase another practitioner's office or patient base, or retire, etc. As with many "businesses," existing management may retire or sell to another owner, but the "business" or practice itself continues on. For example, one of our affiliated practices in Florida has had three separate practice owners, and each successive practitioner has grown the practice. In summary, we've proven, time and time again, that while the practitioner may change, the business of the practice, and our stream of service fees, generally remains unchanged.

    A common misconception is that once a practitioner's initial commitment period has expired, the practitioner can simply exit his or her association with OCA and operate the affiliated practice independent of any obligation to us. However, most of our service agreements require that, before a practitioner may retire or exit from the affiliated practice, his or her obligations under the service agreement must be assumed by a successor practitioner, either through the retiring practitioner selling the practice to a successor practitioner or transferring the practice for nominal consideration to a successor practitioner that we designate. In addition, practice owners are generally subject to a covenant not to compete, which limits their ability to practice within a designated area for a specified period of time (generally two years). These provisions help to insure that there is continuity in the practice.

    We work with practice owners who are seeking to retire to find a successor owner-practitioner to operate the practice. In addition to the contractual requirements under most of our service agreements and the potential proceeds from selling the practice to a successor, a practical inducement for a retiring practice owner to locate a successor for their practice is the potentially costly process of winding down a practice (as facilities' leases and other fixed costs continue to be incurred while the patient base diminishes) and ethical and legal limitations on abandonment of patients.

    CONTINUED

    SubjectThe company's response (4)
    Entry07/05/2002 10:55 AM
    Memberwrt233
    CONTINUING

    o What do you believe are the relevant units of economic analysis for your business?

    Our service fees are largely a function of our affiliated practices' patient activity. Therefore, new patient case starts and new patient contract dollars continue to provide the fundamental building blocks and visibility for financial performance going forward.

    As we discussed above, our business has changed a lot over the years since we were founded in 1985. The units that many analysts and shareholders use to analyze and forecast our business are the number of practitioners and centers. During the late 1980's and into the 1990's, the majority of our initial practice affiliations consisted of one doctor and one center, and therefore for many years we described our business using practitioners and centers. However, our affiliated practices, on average, have grown into multi-location businesses and often include multiple practitioners. We are also serving a growing number of pediatric dental practices, which have their own unique financial characteristics.

    As a related matter, the composition of our doctor base is becoming less uniform over time with more associates and general practitioners operating in our centers. These auxiliary practitioners greatly vary in terms of their compensation and their time commitment to our affiliated practices. Some work only a few hours a week while others work a full schedule.

    We suggest that the appropriate lens to view our business is the entity with which we are directly affiliated and the means by which we derive our service fees - the practice. On a relative scale, the economic results among practices are more uniform than the economic results of individual practitioners and the economic results of centers. As a practical matter, we manage our business using the practice as a profit center, rather than using the individual center or practitioner as profit centers. The overriding source of value among our affiliated orthodontic practices is new patient contract volume, and we have learned that new patient contract volume is managed at the practice level, regardless of the method employed to increase patient contract volume. Whether increased patient volume is derived from adding new centers, adopting affordable pricing plans, adding more practitioners, improving operational efficiency, expanding patient intervals or other factors, we focus on facilitating greater patient volume at the practice level.

    We have had several requests for historical practice count data. The following table provides information about the growth in the number of our affiliated practices for the periods shown:

    NUMBER OF AFFILIATED PRACTICES

    December 31, ------------------------------------------------------------------------- 1994 1995 1996 1997 1998 1999 2000 2001 ---- ---- ---- ---- ---- ---- ---- ----Number of Affiliated Practices... 28 60 96 168 210 225 241 364

    CONTINUED

    SubjectThe company's response (5)
    Entry07/05/2002 10:55 AM
    Memberwrt233
    CONTINUING

    o What are the advances to affiliated entities on your balance sheet and how are those advances repaid?

    Newly-developed affiliated orthodontic practices and existing affiliated practices expanding their capacity by adding additional centers or practitioners typically experience cash flow needs until they begin generating sufficient operating profits at the newly-developed or newly-expanded centers. We may advance funds to affiliated practitioners to assist affiliated practitioners with maintaining a reasonable standard of living during the start up or expansion phase of their practices. According to the terms of most of our service agreements, the practitioner retains a percentage of the cash operating profits of the practice (excluding the doctor's compensation). If the practice does not produce a cash operating profit, the doctor does not retain funds to pay himself. Therefore, we may lend the practice as an advance against future service fees some cash to fund the practice owner's compensation. Part of our role is to facilitate growth of our affiliated practices, while reducing the financial stress associated with that growth, so that our affiliated practitioners can focus on patient care. We should also mention that these advances are not to be confused with "startup losses". We fund startup losses separately, and those losses are generated independent of the practitioner's compensation. We do not record fundings for startup losses of centers on our balance sheet because of our revenue recognition policy in accordance with Staff Accounting Bulletin No. 101.

    These advances to affiliated entities are interest free, unsecured loans to the affiliated practices. The affiliated practice generally begins to repay the advances once the practice becomes profitable, generally at the beginning of the second year that the practice is open.

    From time to time, affiliated practitioners will approach us to request our assistance in the acquisition of additional assets, centers or practices that will have a material benefit to OCA over the long term. We accommodate such investments by our affiliated practices by advancing funds to our affiliated practices if we determine that is in the best interest of our business.

    o What is the nature of your capital expenditures during the past few years?

    As you would expect for a business with over 800 locations and double-digit historical internal growth, we invest a lot of money in our physical infrastructure and our equipment. Generally, we own all the leasehold improvements, furniture and equipment in our affiliated centers.

    Our capital expenditures have historically fallen into four categories:
    (1) expenditures to facilitate growth and development of existing centers, (2) maintenance expenditures to sustain current levels of business activity at existing centers, (3) acquisitions of the fixed assets of newly affiliated practices, and (4) development of de novo centers in the United States and abroad.

    During the stages of rapid growth in the number of our affiliated practices in the 1990's, we expended a disproportionately high amount of our capital investment on de novo centers relative to expenditures on our existing centers. During recent years, however, our investment has increasingly included capital expenditures directed toward remodeling and improving our existing fixed asset base to facilitate internal growth. Given our heavy reliance on computer systems, we also invested heavily during recent years in our computer systems infrastructure. Our extensive network of affiliated centers requires a consistent level of "field" investment in technology, such as advanced digital cameras or DSL data delivery capability. In addition, we continue to invest in the foundational infrastructure of our international operations.

    CONTINUED

    SubjectThe company's response (6)
    Entry07/05/2002 10:56 AM
    Memberwrt233
    CONTINUING

    Therefore, a comprehensive understanding of our overall capital expenditure needs to include amounts which are required to grow both internally and "externally" (de novo growth and acquisitions) as well as the capital investment required to service and maintain the existing practice base of our affiliated practices. Merely multiplying the number of centers added during a given period by our per-center build-out costs to reconcile overall capital-related investment is an incomplete analysis.

    The following table provides information about the estimated composition of our changes in fixed assets for 2001:

    FY 2001 SUMMARY OF CHANGES IN FIXED ASSETS
    ($ in millions)

    Beginning property, equipment and improvements, net ................... $76.7Center additions ........................... 8.4Remodeling of existing centers ............. 6.9Maintenance capital expenditures ........... 4.8International development .................. 1.7OrthAlliance acquisition ................... 3.9Corporate .................................. 0.2 -----Total gross capital expenditures ........... 25.9Less depreciation .......................... 10.8 -----Ending property, equipment and improvements, net ................... $91.8 =====


    o What is the status of OrthAlliance affiliated practitioners who are litigating with OrthAlliance?

    To our knowledge, there are currently 54 of these litigating practitioners. We continue to be confident in the strength of our position with respect to these lawsuits. As we stated last quarter, based on our prior experience and discussions with some of these litigating practitioners or their representatives, we currently believe that some of these practitioners will settle their lawsuits by paying us an amount of cash in exchange for termination or modification of their service, management service or consulting agreements with OrthAlliance, depending upon the parties' ability to reach an agreement as to the amount to be paid. As some indication of value we may receive when a practitioner seeks to exit his agreement with OrthAlliance, we recently received approximately $1.8 million in consideration for terminating one OrthAlliance practitioner's service agreement, which equated to a transaction multiple of nearly 6 times the practice's EBITDA to OrthAlliance during the prior 12 months. We cannot assure you that such an agreement or settlement will be reached in any of these lawsuits. We also cannot, at this time, predict the outcome of these lawsuits or assure you that we will prevail in any of them, nor can we estimate at this time the amount of damages that we might incur or receive in these actions. In summary, we are working on resolving these lawsuits, and are currently involved in settlement discussions with many of these practitioners.

    CONTINUED

    SubjectThe company's response (7)
    Entry07/05/2002 10:56 AM
    Memberwrt233
    FINAL PART

    o What do you plan to do about the future retiring affiliated practitioners? What is the average age of your affiliated practitioners?

    The average age of our affiliated "practice owners" (that is, affiliated practitioners who have an ownership position in their practice) is approximately 51 years of age. Assuming that the average affiliated practitioner treats patients until he or she is 65 years old, we believe that on average our affiliated practitioners have at least fifteen years of active service in their practices before they retire. Of note, the average age of the associate practitioners working in our affiliated practices is substantially less than 51 years of age. In the limited number of cases in which one of our affiliated practice owners has retired, we have worked with the practice owner to facilitate a sale of the doctor's interest in the practice to a successor practitioner, which perpetuated our economic interest.

    As for succession planning, we have placed great emphasis during recent quarters on assisting our affiliated practices in recruiting associate practitioners. An "associate practitioner" is an employee of a practice owner and receives a salary from him. The associate will often eventually succeed the practice owner as one of our affiliated practitioners.

    As a general matter, associates are, on the whole, easier to recruit than an orthodontist who already owns and operates an existing practice. During the fourth quarter of 2001 and the first quarter of 2002, for example, excluding our acquisition of OrthAlliance in November 2001, our affiliated practices added a total of 13 associate practitioners. These associate practitioners are prospective purchasers of affiliated practices as time passes and the practice owners decide to retire. Associate practitioners also provide short-term benefits because they allow our affiliated practices to grow by increasing their capacity to treat patients.

    In their service agreements with us, our affiliated practice owners have generally agreed to notify us in advance of their intent to retire from their practice, and we work together with the affiliated practitioners to find successors for them. The affiliated practitioners have a significant economic interest in their practices, and, based on our prior experience, we believe that before retiring, they will exert considerable effort to identify someone to purchase their interest in the practice.

    We have a very successful track record in assisting practice owner successions during the past decade, and we are confident in our ability to facilitate such successions in the future. We have a doctor relations team of ten individuals whose responsibilities include succession management. We will continue to recruit for the purpose of successions. Given our large network of affiliated practitioners, our financial and recruiting resources and our suite of services, we believe our affiliated practitioners are in a position of strength relative to their industry peers with respect to attracting buyers of their practices upon retirement.

    Subjectthanks--will read it today.
    Entry07/08/2002 10:47 AM
    Membersunny329
    thanks--will read it today.

    Subjectdid anything in the company's
    Entry07/11/2002 05:55 PM
    Memberotto695
    did anything in the company's response change your thesis?

    Subjectcompany's response
    Entry07/12/2002 07:24 PM
    Membersunny329
    Otto,

    Thanks for asking. Nothing they said changed my thesis and I maintain that this company's earnings are significantly overstated.

    I think that it is good that the company disclosed what percentage of the intangible assets were paid to existing practices. I maintain that the amortization period for these agreements is way too long and results in significantly overstated earnings and therefore misrepresents the true economics. The fact that OCA never writes off any of the intangible assets and never reports any turnover of orthodontists in their filings and instead "merges" a practice with another practices to avoid any write-off is highly suspicious. They are trying to say that even though they acquire the lowest rung of orthodontists, no one ever leaves the system without a smooth transition to another practice and therefore there is never a need for a write-off of the initial purchase price (even though it is in cash and non-vesting stock). I don't buy it. Remember this is a mgmt. team that has shown in the past that they are very creative with accounting.

    The explanation for the advances account is completely lacking. They say in their filings that 40K is advanced per practice, so how do they account for $30 million + of advances? If the practices are so profitable, why don't they pay these advances back? The practice growth has slowed considerably in the last few years, so the number of start up practices taking a 40K draw should be declining sharply. I think that they are using this account the same way they are using the intangibles. They pay or "loan" the doctors money, then deduct the payback from the profits that the doctor can take from the practice, thereby inflating their own EPS while the balance sheet account remains idle.

    The capex breakout is meaningless to me. I have heard that a number of orthodontists are telling investors that OCA has invested approximately $5K-$10K in the last few years in all of their centers combined. That makes sense for a doctor's office. Go ask your local doctor how much capex he spends per year. Then do the math. I guarantee that there are almost no doctors in the U.S. that have spent $150K+ in capex on their practice in the last few years. It does not make economic sense. Orthodontics is not a capital intensive business.

    Hope this helps. I am happy to answer any other questions.


    SubjectOtto, One more thing. The
    Entry07/13/2002 10:59 AM
    Membersunny329
    Otto,

    One more thing. The intangibles account on the balance sheet is still way too big. I was told by the CFO that they rarely acquire any bigger practices and rarely pay more than 4-5x for a practice. This is what they state in their 8-K: "For fiscal year 2000, our total acquisition costs for affiliations was $34.2 million, and we estimate that the proportional investment in new affiliations versus investment in existing affiliates was not materially different than in 2001." So, according to OCA, they invested approximately $8 million in existing practices through this line item (which should not happen--this payment should hit the income statement all at once). That leaves $26 million invested in new practices, right?

    Also in their 8-K, OCA lists the number of practices per year. The number jumps from 225 to 241 from end of year 1999 to end of year 2000. 16 practices therefore cost $26 million? That is $1.6 million per practice. Simply unbelievable. Similarly, in 1999, they paid a total of $21.7 million through the intangibles account to their practices. The number of practices increased by 15 in 1999 for a price per practice of $1.45 million. When you take into account the fact that they are also acquiring some tangible assets (10% of purchase price), the implied price per practice is even higher.

    Either they are paying orthodontists through the intangibles account or paying way too much for practices. Either way, the business model is doomed.

    From everything that I hear, no orthodontists want to sign up with OCA, and they are fighting tooth and nail with the orthodontists. It would make sense that the upfront acquisition prices are going up so much in a desperate attempt to keep the "growth" going. I think this stock is a zero.

    Sunny

    SubjectThoughts on Q2?
    Entry08/15/2002 06:28 PM
    Memberwrt233
    Sunny,

    Any thoughts on OCA's Q2 earnings release and 10Q?

    WRT

    SubjectQ2 Questions
    Entry09/20/2002 11:43 AM
    Membermax685
    Did anyone else notice these issues and, if so, do you have any explanations?

    1. OCA took a $12.8 million pretax charge for the settlement of a lawsuit with an ex-employee. The March 10-Q had said that settlement of the suit "did not have a material adverse effect on our financial condition or results of operations." How could that be?

    2. The advances to affiliates have obviously been a topic of concern. At 12/31/01, advances totaled $31.7 million. Adding the $8.2 million of net advances reported in the June 10-Q should result in a balance of $39.9 million, which is a heck of a lot of advances. However, the 10-Q reported a balance of only $26.4 million. Part of the explanation is that the company restated the 12/31/01 balance and netted $6.5 million of payables against the advances. I can't figure out the explanation for the other $7 million variance, though. Anyone???

    SubjectOCA slam in this weekend's Bar
    Entry10/26/2002 04:22 PM
    Memberwrt233
    From Alan Abelson's column:

    Barron's, 10/28/02
    Alan Abelson

    Oscar Schafer is no stranger to either this column or Barron's. A member of the Roundtable, Oscar is a top-drawer stock picker, and we don't know anyone who, when in the mood, is better at tearing apart balance sheets and income statements. But more to the point, besides possessing both Street and real-world smarts, Oscar is the perfect match for these treacherous markets: He's as comfortable selling short as buying stocks, and he brings the same practiced eye and disciplined approach to both.

    Which is why, we imagine, he has been able to handsomely buck the trend this year and rack up a gain in the low teens, when all of the averages and the vast majority of money managers are under water.

    It doesn't hurt that Oscar has a wealth of investment experience under his belt as analyst and portfolio pro. He put in a lot of time and turned up more than his share of winners as one of the managing partners of Cumberland, legendary investor Walter Mintz's old outfit. But he decided, after all these years, that he finally knew what he wanted to do when he grew up -- namely, launch his very own hedge fund. And that's exactly what he did at the start of this year and, after no little rumination, he named it Oscar S. Schafer & Partners.

    As noted, the fund is off to a splendid start, and last time he counted, he had $115 million under management. The interesting thing is that he has done so well, even though he has been roughly 47% long and 32% short (although his shorts were up high teens, while his longs have suffered a modest loss). All told, the fund's portfolio comprises fewer than 30 stocks, about evenly split between longs and shorts. Among the latter, it's worth noting, was EDS, which skidded a mere 60% after warning that third-quarter earnings would come in considerably shy of Street estimates, prompting Oscar to cover (no hog, he).

    Two other things. Oscar has a sharp sense of humor and an inexhaustible supply of jokes; the latter comes in especially handy in soothing unhappy investors. And he's something of a worrier, which is just what you want of somebody who's handling your precious nest egg.

    This is kind of a windy preface to relating the essence of a recent chat with Oscar on his current favorite short and long. The stock he likes best is called Gen-Probe. The stock he likes least is called Orthodontic Centers of America. Why don't we start with that one.

    What especially caught our eye about Orthodontic Centers (which, because our lips get tired when we keep reading that extended monicker on our word processor, we'll henceforth call by its initials and stock symbol, OCA) is that the stock is down from a high of 32 in January to 9.50; and that more than one brokerage firm has a "sell" on it (which is, in case you're wondering, despite Mr. Spitzer and peers, still extremely rare).

    Even though the stock has already fallen so steeply and its presumed woes are hardly a secret, Oscar's convinced there remains plenty of room on the downside. The company, which was launched in 1985, went public in '94 and made it to the Big Board four years later.

    What OCA does, in a nutshell, is manage the practices of a slew of dentists and, most particularly, orthodontists, providing them with, among other things, accounting, billing, personnel and advertising in return for a cut of the 30% to 40% of the gross. The company has been an aggressive acquisitor -- accompanied by or in response to a slowdown in internal growth -- and boasts a straight-up record of gains that's supposed to be extended this year.

    One of these acquisitions, about year ago, of its major rival, OrthAlliance, if not a total disaster, has been a palpable one, by Oscar's description. It has bred scores of defections and a number of lawsuits, both of which, Oscar says, have the potential to do significant damage to OCA. Those aforementioned brokerage firms issuing sell recommendations seem more than a little concerned that the chief financial officer has quit and done so with third-quarter earnings on tap.

    The bottom line on OCA's stock: Oscar wouldn't be shocked if the shares were cut in half.

    SubjectNew CFO
    Entry10/28/2002 10:33 PM
    Membermax685
    Did anyone check out the background of the new CFO? His latest posts were at Wall Street Deli, Inc. and Cucos. Both are trading for pennies. What a recommendation!

    Subjectoca
    Entry11/08/2002 09:15 PM
    Membersunny329
    sorry i have not had a chance to reply to any of your questions--i took a new job in the last few months and have not spent any time on the site--

    SubjectFollow up
    Entry12/18/2002 07:57 PM
    Memberround291
    Any follow up thoughts on this stock. I like it in the teens and appreciate the opportunity offered up by the shorts. Thanks!

    Subjectthis is a company that i would
    Entry12/20/2002 08:43 PM
    Membersunny329
    this is a company that i would never consider buying. a weak management team with a flawed business model. surely there are more attractive companies to buy. i have not followed it very closely the last few months, however.

    SubjectStumped
    Entry12/21/2002 04:45 PM
    Memberround291
    I'm stumped on your "flawed business model" and "weak management" comments.

    Dentists/orthodontists have among the lowest failure rates among small businesses in the US. Check an analysis available at a website called www.bizstatz.com. There is available a table on failure rates over time and dentists have the third or fourth lowest incidence of failure. OCA has interests in cash flows generated by these businesses.

    Additionally, I don't see much wrong with the accounting. The intangible asset results from the fact that these businesses possess few assets but generate decent cash flow. Whether the company purchases its interest directly or forwards cash to an existing affiliate for the purchase of another practice isn't particularly relevant. The nature of the businesses acquired and current purchase accounting rules dictate this accounting. And, given the low failure rates and long term contracts, the asset is likely to have substantial value. I'd encourage a closer look at OCA operating cash flows than its earnings anyway, but feel free to look at any metric you choose.

    With regard to the "weak management", how do you explain away OCA's historical financial performance? Is it all a mirage?

    There are issues with the litigation, but OCA is not headed for a TKO. It trades at under 10x, generates operating cash flow, has little debt, has few competitors...what about this story am I missing.

    I took a look earlier at the ownership and Ruane Cuniff is on board, having upped their ownership in the last quarter. These are smart folks. Also, in an environment where most insiders are selling, OCA insiders have purchased what looks like about $12 million in stock since September of this year.

    I encourage others here to reread the pros and cons. I don't think I'm crazy but I'm always interested to hear the reasoning of those who think otherwise.


    SubjectI think this continues to dete
    Entry12/22/2002 05:20 PM
    Memberlar179
    I think OCA has a doubtful future. I know the litigation has gotten worse, not better. Two new suits were filed in November with multiple plaintiffs in each suit (KY, TX). Moreover, I know that more OCA docs, as opposed to just Orthalliance docs, are moving down the litigation path. And quite frankly, I think that the book earnings to date has been just a mirage. Consider that the business model, by management's own admission, has reached maturity, yet the company, but for not paying taxes this year, generated no free cash. Also, I know that the public financials contain various mistakes (at least the last two 10-Qs) which have erroneous, to the point of misleading, info in them. There are thousands of other companies out there, many of which don't have the hair of this one. I would just say, don't get fooled by a "book" earnings number. The other metrics point in a very different direction.

    SubjectLitigation & Free Cash
    Entry12/23/2002 11:38 AM
    Memberround291
    The litigation issue is the one true negative that hangs over this stock. But these suits are intended to get certain orthodontists out of their contracts with the company...this is not an asbestos or tobacco type situation. The potential liabilities, if any, are limited and may be offset by amounts the company may receive from orthodontists for allowing a contract to be abbrogated.

    As to your concerns with free cash flow...yes, the company does invest cash generated from operations in its growth plan. This is a business model that is in the early stages of its life and there are opportunities to invest at rates above cost of capital. OCA has a very small portion of orthodontists/dentists under its umbrella. There is room for growth, here in the US and overseas, and I believe the company can continue to compound earnings at high rates for the next several years.

    Should the company decide to slow growth and return capital to shareholders, that would be just fine with me as well. For what I've paid for the shares, growth is an added benefit but not a requirement to get a good return.

    SubjectInsider Activity
    Entry01/05/2003 10:51 AM
    Memberround291
    Since the stock has cratered insiders have been loading up, as I mentioned in an earlier post. Here's the round-up. These numbers don't include another 10,000 or so shares purchased and reported in this weekend's Barrons.


    12/04/02 TRYFOROS THOMAS 20,000 $10.45 $209,000
    12/04/02 SMITH THOMAS 121,000 $10.38 $1 Mil
    11/01/02 SMITH THOMAS 25,200 $9.61 $242,172
    11/01/02 TRYFOROS THOMAS 25,200 $9.61 $242,172
    10/31/02 TRYFOROS THOMAS 40,300 $9.55 $384,865
    10/31/02 SMITH THOMAS 40,300 $9.55 $384,865
    10/30/02 SMITH THOMAS 113,800 $9.44 $1 Mil
    10/30/02 TRYFOROS THOMAS 113,800 $9.44 $1 Mil
    10/28/02 TRYFOROS THOMAS 200,000 $9.41 $2 Mil
    10/28/02 SMITH THOMAS 210,000 $9.42 $2 Mil
    10/22/02 SMITH THOMAS 114,000 $9.48 $1 Mil
    10/15/02 SMITH THOMAS 300,000 $8.17 $2 Mil
    10/14/02 TRYFOROS THOMAS 200,000 $8.13 $2 Mil
    09/04/02 PALMISANO BARTHOLOMEW 50,000 $13.73 $686,500

    SubjectNot Insiders
    Entry01/05/2003 08:47 PM
    Memberlar179
    Just to clarify, Tryforos and Smith are not "insiders", just unfortunate large holders of OCA. They are part of Prescott Advisors, which I know little about, except that one of their other large holdings is PrePaid Legal, which is one of the biggest short stories on the Street, and just blew up. Don't kid yourself into thinking that they have more information than anyone else on OCA, just like they didn't on PrePaid Legal. Obviously Bart Palmisano is an insider, but I'd point out he sold over 1 million shares of the stock over a year ago, so for him to buy back 50,000 is no big deal. He has been the only one willing to step up to the plate despite the stock price decline. Other than a low p/e on "book" earnings, I really can't find one appealing thing about this stock.

    SubjectPrescott Advisors
    Entry01/06/2003 09:56 AM
    Memberround291
    I don't know much about Prescott other than that it owns over 7% of OCA. Who cares about their investment in PPD?

    It should be pointed out, however, that PPD trippled off it's $10 price hit during the SEC investigation and recharacterization of commission advances. Did Prescott own the shares back then?

    SubjectRuane Cuniff & Co.
    Entry01/06/2003 09:59 AM
    Memberround291
    By the way, did you happen to notice that Ruane Cuniff also owns both PPD and OCA. Would you care to disparage their investment capabilities?

    Hey...bottom line is that I didn't invest in this name because someone else did. I'm simply pointing out that there is significant buying of the shares...by insiders and, I guess, funds.

    Subjecti have no reason to disparage
    Entry01/17/2003 06:36 AM
    Membersunny329
    i have no reason to disparage either of those firms. their heavy ownership was not a consideration when i initially posted this idea and it is not a consideration now. if i relied on other people's opinions then i might as well go into another profession and invest in their funds.

    there are plenty of very smart people on the other side (short) of this trade also. similarly, this has no influence on my opinion of OCA. quite frankly i find that citing these firms' ownership is a very weak argument for owning the stock on your part.

    SubjectConfusion
    Entry01/19/2003 10:22 PM
    Memberround291
    Sunny-

    I unintentionally responded to you as opposed to, I believe, lar. Didn't mean to draw you into this, but agree that investing isn't a game of "follow the leader"...on the long or the short side.


    SubjectQ4 results
    Entry03/18/2003 08:22 PM
    Membermax685
    Sunny and others: anyone have thoughts on the Q4 numbers? A big miss, obviously, but which skeletons aren't out of the closet yet?

    SubjectOutstanding!
    Entry03/19/2003 10:44 AM
    Memberwill579
    great work, great call, great results! congratulations and thanks!

    Subjectthanks will. i appreciate it.
    Entry03/19/2003 08:43 PM
    Membersunny329
    thanks will. i appreciate it. unfortunately i cover financials exclusively now so i have not focused very much on this lately. it is always gratifying to watch companies that deceive and defraud investors get what they deserve. do you cover anything in financials?

    Subjectfor those interested in anothe
    Entry03/19/2003 08:51 PM
    Membersunny329
    for those interested in another company with highly questionable capitalization of expenses, take a look at Commerce Bancorp (CBH). Interestingly, you will note a list of top holders that is very similar to OCA (not to single out any firms in particular).

    SubjectDiscounted Future Cash Flows
    Entry04/30/2003 08:25 PM
    Memberround291
    Dear Sunny -

    I've gotta tell you...I've read and re-read your initial post at least 10 times. Your key argument was so straight forward and rested on a beautifully attractive, straight-forward and provocative question, namely:

    "I could not figure out what OCA was doing to take a practice that was being valued at between $0.8 million and $1.0 million at the time of affiliation ($500K * 40% operating margin = $200K * 4x – 5x) with OCA and turning those practices into $10 million businesses in the public markets. And how could earnings be so substantial?"

    I think you were right in pointing out that the stock got ahead of itself, particularly considering the looming legal issues surrounding OrthoAlliance. This uncertainty was not factored into the share price at the time. I also think your assertion that the accounting is fradulent is off base as I mentioned in an earlier post.

    I'd like to dig a bit deeper though on the central issue you raised which is highlighted above.

    A YOUNG ORTHODONTIST
    As you know, orthodontists must complete an undergraduate degree, graduate dental school, and take post-dental school coursework to qualify to be an orthodontist. When a young orthodontist completes his degree program the holes in his pockets are deep and he is only qualified to do one thing: stick appliances in the mouths of children that only he can remove.

    With little of his own money with which to start a practice and begin making a living, these young, hungry, business inexperienced orthodontists turn to folks like OCA who gladly provide business management in exchange for a share of future cash flow.

    Perhaps the lower than industry average annual practice revenues of ortho practices at the time of affiliation with OCA indicates that these practices are in the early stages of their life-cycle and not, as you suggest, that these affiliates are run by slovenly pigs. If so, one might expect that these young turks will grow their practices initially at rates well above industry average...particularly considering that OCA handles all of the business matters.

    You also refer to the lower prices charged for service by OCA affiliates relative to industry averages. Well, with 6.3% of orthodontists affiliated with practice management outfits like OCA, industry billing growth rates that have averaged 10% for quite some time, consistent advertising expense to leverage, and a bunch of young turks out to conquer the world, does't penetration pricing make sense as as a strategy to grow market share?

    THE ACHEMICAL IMPACT OF DISCOUNTING
    Dental/orthodontic practices rarely fail. The demand for braces grows in volumes and unit prices. Metal appliances must be implanted and removed by a qualifying orthodontists (little potential for competitive service providers to enter). And OCA signs multy year contracts that earns it a portion of business cash flow for a long period of time.

    The certainty of cash flows is there...now let's discount 'em.

    Initial practice revenue $500,000
    Operating Margins 40%
    OCA Share of Cash Flow 40%
    Growth Rate 9%
    Corporate Tax Rate 35%
    Discount Rate 10%
    Present Value (perpetuity) $8,000,000

    Assuming that OCA succeeds in improving operating margins to 50%, the present value is $10,000,000.

    Now, OCA has also succeeded in enhancing enterprise portability, which should also increase enterprise value. It's systems enable a young turk to buyout and easily integrate the practice of a retiring competitor.

    Finally, although I'm a little too lazy to do the math, assume that growth in the early years is significantly greater that 9%, as is likely to be the case. The PV is meaninfully greater.

    So Sunny...does any of this make sense?

    SubjectRe: Discounted Future Cash Flo
    Entry05/02/2003 07:38 PM
    Memberdoggy835
    DCF is overkill. If OCA's practices really average $2m/year the stock is a bargain. If they're lying about the top line then the stock is worthless. There is no middle ground.

    I disagree with most of the original write-up. Why would OCA need to hide expenses in intangibles? There's no way a 2m practice is anything but wildly profitable for all parties. But if those practices only average 1m......

    SubjectWorthless?
    Entry05/02/2003 08:31 PM
    Memberround291
    Doggy -

    I appreciate your comments. Let's think about this for a moment though...under what possible scenario is this company worthless? It has about $95mm in net debt, generated $138mm in EBITDA, and threw off over $20mm in free cash. How in the world does this company go bankrupt? Legal claims involve breaking a contract for which some compensation is likely to be received by the company. On a normalized basis, maintenance CAPEX is negligible. Where is the cash sink hole that will send this company to bankruptcy court?

    Just look at the increasing numbers of people getting braces. OCA gets a portion of each affiliates billing. It also controls nearly all of the cash generated by its affiliates.

    If there was massive fraud wouldn't we know? This is straight-forward business with a clear audit trail and has hundreds of partners (orthodontists) who can afford to hire quailty accounting help.

    Even if the company wrote off the entire intangible asset contracts with orthodontists would remain intact and the company would continue to collect management fees.

    How does this company go bankrupt? Can you dream up just one scenario? And consider this...91.8% of all dentists earned a profit last year...and orthodontists are better trained ad offer a higher value service than dentists.

    SubjectRe: Worthless
    Entry05/03/2003 02:16 AM
    Memberdoggy835
    "under what possible scenario is this company worthless?"

    The scenario where management inflates revenues.

    "..... and threw off over $20mm in free cash."

    Negative 27m if you adjust for the one-time income tax benefit.

    "Where is the cash sink hole that will send this company to bankruptcy court?"

    If management is overstating revenues there's no cash to sink.

    "If there was massive fraud wouldn't we know?"

    Did we know about HealthSouth? Adelphia? Enron? Worldcom?

    If OCA really does 2m per practice then the stock is worth $20/share. If they're lying about revenues and the practices only average 1.2m the stock is worthless. OCA generates no operating profit at that level and the fraud would give the Orthos cause to walk anyway.

    SubjectWierd Syllogisms
    Entry05/03/2003 11:35 AM
    Memberround291
    Doggy -

    First the accusation was that the company stuffed periodic costs in asset accounts and thereby inflated earnings. Now you're setting up a ridiculous litmus test and insinuating that the company may have totally fabricated revenues. Give me a break!

    Your insinuation creates false uncertainty. If you have some basis for believing that this company is fradulently inflating revenue then post it. Otherwise the suggestion is a bit slanderous and thoroughly manipulative.

    Your logic invites further comic relief:

    "If IBM generated $83 billion in revenue, then the stock is worth something, else it's worthless"

    "If GE generated $130 billion in revenue, then the stock is worth something, else it's worthless"

    SubjectDiscounted Cash Flows
    Entry05/04/2003 02:21 PM
    Memberjim77
    Hi round,

    I don't short stocks, so I rarely spend any time on the club's short ideas. It appears you think this one is now a very good long candidate, so I'm a little more interested in the stock and its valuation.

    I haven't looked at this company at all (except for your last few posts) and admit to never officially using DCF models in my assessment of potential investments. I kinda imprecisely do that stuff in my head because I'm usually relying far more on a company's balance sheet.

    I'm afraid I didn't understand your DCF analysis at all, though...and I'm sure I must be missing something.



    You stated, "The certainty of cash
    flows is there...now let's discount 'em.

    Initial practice revenue $500,000

    Operating Margins 40%

    OCA Share of Cash Flow 40%

    Growth Rate 9%

    Corporate Tax Rate 35%

    Discount Rate 10%

    Present Value (perpetuity) $8,000,000

    Assuming that OCA succeeds in improving operating margins to 50%, the present value is $10,000,000.


    If I'm doing the math correctly here, OCA's ebit is $80K ($500k x .4 x .4)...and after tax, it is $52,000. You are then assuming a perpetual growth of 9% on these numbers, discounting the income stream by 10%, and coming up with an $8,000,000 present value? Who would pay anywhere near $8M for this?

    Thanks,
    Jim

    SubjectMea Culpa
    Entry05/04/2003 08:28 PM
    Memberround291
    Jim -

    My math was screwed as I forgot to deduct tax from operating cash flow and discount the resulting number. So $52,000/(.10-.09)= $5,200,000 and $65,000/(.10-.09)=$6,500,000. Furthermore, I assume that there is no incremental investment (working capital or net new fixed asset) required to support that growth.

    The point of this all is to suggest that a stream of growing future cash flows (to which OCA has contractual claims) has significant value. More importantly, there is reason to believe that those future cash flows might actually be realized. The perpetuity assumption is a simplifying one, though contracts do have 20 plus year duration. And the equity market cap of the company has been cut from $1.4 billion at the time the initial write up was pinned to $305mm today. The implied value per practice has similarly been reduced dramatically...from the $10mm number referred to in the write up to about $2.5mm.

    OCA, of course, only pays 4-5x its share of current operating cash flow. But these practices are going concerns with strong market positions (supported by huge advertising spending) that operate in a market that has grown at a 10% CAGR (4% in price and 6% in volume if my memory serves me well) over an extended period of time.

    Now, if a typical practice can only handle $500,000 of incremental capital free business annually due to physical, talent, or other limitations then my example holds no water.

    The company's growth has been capital intensive to date as it has sought to grow through acquiring new affiliations. The growth strategy is shifting to de novo practice development and intangible asset growth will slow.

    OCA is an odd bird. I see it as an industry focused BDC/investment company that adds value through implementing a standardized business system in every practice with which it affiliates. Furthermore, the industry in which it operates is a darn good one.


    SubjectCash Flow Values
    Entry05/04/2003 11:03 PM
    Memberjim77
    round,

    I know you're trying to make the point that a stream of growing future cash flows has significant value. We're getting closer as we're now down from $8M to $5.2M....but I'm still scratching my head how $52K growing at 9%, discounted at 10%, is worth $5.2M in present value.


    I've had a few beers with my pizza tonight...so maybe I'm just misinterpreting what you're trying to express.

    Jim

    Subjectoca is a joke....surely there
    Entry05/05/2003 06:53 PM
    Membersunny329
    oca is a joke....surely there are better longs. i think it is a zero long-term. your model works in an ideal world where oca actually receives this stream of cash flows. in reality, it doesn't work like that b/c you constantly have to keep repaying the doctor or rebuying the practice as he grows and feels that you are adding less and less value to him. check out the receivables. generally, you don't want to bet on a business where the customer doesn't feel that he is getting sufficient value for teh services provided, hence the various court cases. i would add to the short here but for liquidity. i am not very close to the numbers anymore, but from a quick glance, this pig is getting worse every quarter.

    SubjectOCA is a joke
    Entry05/06/2003 03:32 PM
    Memberdoggy835
    A bit harsh, but hard to argue.

    OCA explains receivables with a chart in their 10-K that shows how AR increases over the life of a contract. They explain the average patient age went from 12.3 months to 13.8 months during 2002, and if you do the math it matches the receivables increase. But the 13.8 months doesn't make sense. The typical course of treatment is 26 months and due to growth they've got a lot more patients in months 0-13 than in months 14-26. Average patient age should be about 11 months. Stuff like this crops up all the time when you analyze OCA.

    Accounting for this operation should be the essence of simplicity. Recognize revenue when billed. Recognize expenses when incurred. Forget the straightlining BS and goofy balance sheet line items like "Unreimbursed expense portion of service fees receivable". In Saturday's annual meeting Warren Buffett said "If I don't understand it [an annual report], it's probably because the management doesn't want me to understand it. And if that's the case, usually there's something wrong." OCA's reporting is needlessly complex. OCA should be gushing free cash flow but they're not. These are huge red flags.

    SubjectGrowing Perpetuity
    Entry05/06/2003 06:13 PM
    Memberround291
    Jim -

    I don't have a bunch of time to do a primer on the value of a growing perpetuity, but there are a number of good books that cover the math that I can refer you to:

    Rappaport, Creating Shareholder Value

    McKinsey Team (?), Valuation


    SubjectWe're Not Gonna Agree
    Entry05/06/2003 06:20 PM
    Memberround291
    Sunny/Doggy -

    I guess we'll see where this all shakes out. No point in continuing to talk past each other.

    Just don't see how this business, with its claims on cash flows generated by good businesses and purchased at reasonable prices, goes to zero any time soon. The accounting and, to a lesser extent, litigation issues raised seem to me to be a smoke screne.

    I wonder what the market would pay for this company were it organized as a BDC?

    SubjectReceivables
    Entry05/06/2003 08:14 PM
    Memberround291
    In the broader scheme of things, BIG DEAL! So receivables increased...someone has to take that metal appliance out of the patients mouth and will receive payment before doing so.

    I still have not heard a coherent reason for this stock sinking to zero. Doesn't the company have affiliatiations with 370+ practices? Isn't the practice of orthodontics relatively light with regard to capital requirements? Doesn't the company have less than $100mm in net debt? Didn't the company generate $20mm in FCF? Isn't the number of orthodontic procedures performed annually increasing along with OCA's patient starts?

    What's wrong with this picture?

    SubjectGrowing Perpetuity
    Entry05/06/2003 09:35 PM
    Memberjim77
    round,

    I don't deny there are perpetual formulas to get any numbers anybody wants. I'm just using common sense and I would never pay $5,200,000 for a $52K income stream...especially if my discount rate is lower than the growth rate.

    Jim

    SubjectI meant to say discount rate h
    Entry05/06/2003 09:45 PM
    Memberjim77
    I meant to say discount rate higher than growth rate...but in this case, I wouldn't pay anything close to the 5 million in either case. Actually it doesn't make any sense to me. I have a hard enough time estimating what the next year looks like never mind the next century. I think I'll pass on the book.

    Jim

    SubjectStalemate
    Entry05/07/2003 10:35 AM
    Memberraf698
    The crazy thing about this whole thing is that the thread has degenerated into a long/short battleground. To me, there are a few issues—first, how much are these orthodontist practices worth per office—the real substance behind the valuation argument (when I mentioned early in the thread that I was ready to go to ortho school just so I could sell my practice at this valuation, the poster replied that it was just the valuation—it was the accounting shenanigans). So, I figured that on an office basis, $5 was about right, but once I agreed that the books stunk, I figured that I should just stay away.

    When the OCA board revived recently, I revisited my thoughts briefly, and then decided that I’d wait to see if someone could make a strong case for why the books were not cooked. As it is, the value is probably in the ballpark of worth a glance, if one could be convinced that the mess was overblown. I’m not smart enough to figure all that out, and the longs on the board are not articulate/convincing enough to make it.

    Besides, I want a situation that I will like more as it goes against me, and there are too many headline risks with that outfit. Still, I can see that at this price, one would be more inclined to look for the merit. I’ll remain open-minded, but these medical roll-ups have a bad history. However, if they were clean, with the short interest that they have – over 16 million shorts, it could easily double—although I remain convinced by my original argument that the current price is the neighborhood of value for OCA. Intriguing situation. That’s what makes a market.

    Still, as the original post says, "OCA's behavior is pretty much par for the course in the physicians practice management industry, which does not exist anymore because all of the companies have gone bankrupt."

    I'm neutral, but mostly what was very knowable--the original outrageous valuation, has become the unknowable--how lacking is the business model and what context should the reporting issues be placed.

    At the current price, this one goes into the "too difficult" box. It was easier as a short above $20--still one of the best ideas ever posted on VIC, and no matter how it goes from here, a great case study. This thread will probably never die!



    SubjectRound: Perpetuity Values
    Entry05/07/2003 10:50 AM
    Memberquentin720
    I (and I'm sure Jim77 as well) understand perpetuity values, but your belief that an orthodontry practice is "worth" 100x net income is simply silly. Let's put it into perspective. Using your numbers (i.e. 10% discount rate and 9% growth), the net present value of the first 75 years (yes, SEVENTY FIVE YEARS) of cash flows from an orthodontry practice is worth slightly less than $2.6 million. Doesn't it seem silly to claim that such a practice is really worth $5.2 million?

    SubjectDow 36,000
    Entry05/07/2003 12:03 PM
    Memberroark304
    Play with the perpetuity formula enough, and you could justify the bonds North Korea is trying to issue. Take the discount rate down only 50 basis points and increase the perpetual growth rate just 40 basis points and your practice earning $52K a year is now worth $52 million. Give 'em a 9.5% WACC on 9.4999% growth and you're at $52b per practice. I think you'd have to look long and hard to find someone willing to pay 100X trailing net for an ortho practice on the assumption it will still be growing by 9% in 2103.

    SubjectPerpetual motion
    Entry05/07/2003 02:40 PM
    Memberdoggy835
    OCA's 371 practices did about 720m of revenue last year. If they grow perpetually at 9% and US GDP grows at 4% by the year 2198 our entire GDP will come from these 371 practices! (Everything else we'll import from China, I guess, but at least our teeth will be straight).

    SubjectQ1 - where's the cash?
    Entry05/15/2003 06:13 PM
    Memberdoggy835
    OCA reported 14.9m net income. Cash increased 4.6m, but they got 3.7m by borrowing plus another 0.4m from paid in capital. So net cash was basically flat. 11.7m of the "earnings" went into receivables, the rest mostly went into Other Assets.

    Net cash actually should have increased by 24m since they didn't really pay the 9m of recognized income tax expense. 7m went to pay down current liabilities and notes payable to affiliates, though some of these may have been non-cash transactions.

    No reason for service fees receivable to increase, the business isn't growing. On the bright side, at least they didn't burn cash.

    SubjectWell?
    Entry05/15/2003 07:19 PM
    Memberround291
    Not bad for a company trading at single digit multiples of earnings, with moderate levels of debt, limited market penetration, a portfolio of partnerships with inherently strong/attractive businesses, and operating in an industry that is experiencing double digit billing growth. If this is what extinction looks like, give me more of it!

    Also, I noticed yesterday that Tweedy Browne has become a significant investor (for what it's worth).

    I don't expect anyone's mind to be changed by tonight's earning report...and frankly hope that the uncertainty around this company persists a few weeks longer.

    I also hope to hear more from Sunny, The Big Dog, Jimbo and others on why this earnings report proves nothing.
    __________________________________________________________
    Orthodontic Centers of America Announces First Quarter 2003 Results
    May 15, 2003 5:11:00 PM ET


    METAIRIE, La.--(BUSINESS WIRE)--May 15, 2003--Orthodontic Centers of America, Inc. OCA today announced its financial results for the quarter ended March 31, 2003.

    Bart Palmisano, Sr., Chief Executive Officer, said, "We are pleased with our results for the first quarter, which reflect strong operational performance and the ongoing integration of affiliated practices from the OrthAlliance merger. Our results now exclude the temporary benefit we received in the first quarter of 2002 from OrthAlliance practices that have departed, and we believe we now have a more stable and visible base of affiliated practices to build upon. Operationally, it's 'business as usual' here at OCA as we continue to serve and help to expand our existing affiliated practices and recruit new growth-oriented affiliates."

    For the first quarter of 2003, fee revenue was $100.6 million, generating net income of $14.9 million and earnings per diluted share of $0.30. During the first quarter of 2003, the Company recorded $0.7 million in non-cash asset impairment charges, primarily associated with the closing of centers, and $0.5 million in net losses on the disposition of assets.

    Mr. Palmisano commented, "With all of the changes and dramatic growth that we have gone through in the last two years, the Company is the strongest that it has ever been. Now that our changes are for the most part complete, we have reached a point where we look forward to continuing growing our business in the future. The market for orthodontic and pediatric dental patients is very strong, and we are focused on taking advantage of this market."

    As of March 31, 2003, the Company was affiliated with 371 practices. Comparable center fee revenue growth was 11.4% for the first quarter of 2003, reflecting the inclusion of OrthAlliance affiliated practices, which are typically more mature practices, for the first time in the comparable center fee revenue growth calculation. Included in the comparable center fee revenue growth calculation were 713 affiliated centers for the quarter ended March 31, 2003, as compared with 565 affiliated centers for the quarter ended March 31, 2002.

    In closing, Mr. Palmisano added, "In comparison to the fourth quarter of 2002, which was an unusual quarter in terms of lost revenue and higher expenses, we view the first quarter of 2003 financial results as more reflective of our normal operations, excluding the charges and losses on the disposition of the assets. Also, I am pleased to report that new affiliations and associate recruiting have been positive. From an operational perspective, the Company is quite healthy, and we are looking forward to expanding the market for our business services in the future."


    SubjectMy Last OCA Post
    Entry05/15/2003 09:10 PM
    Memberjim77
    "I also hope to hear more from Sunny, The Big Dog, Jimbo and others on why this earnings report proves nothing."

    round, you seem a tad defensive...probably the gang tackling you've had to endure in your defense of the company. Just to set the record straight, I have no position or interest in the stock. I moseyed on over here after I saw the stock get crushed and was hoping for a good reason to look into it further. After you explained to me how $50K is worth $5M, I just kept moving.

    Good Luck,
    Jimbo

    SubjectGoal
    Entry05/16/2003 09:52 AM
    Memberround291
    Jim -

    I don't recall my knee touching the turf...I've still got the ball and I'm running with it.

    Let's do this again in six months.

    Subjecthave not had a chance
    Entry05/16/2003 10:19 PM
    Membersunny329
    to look at earnings report. but given all of the chatter, I am going to look it over. perhaps it is worth riding this one to zero.

    SubjectOne Level Deeper
    Entry05/17/2003 11:23 PM
    Memberround291
    OK, I'll admit it...I'm obsessed with OCA. I'll also admit that I intended in my "perperuity growth" comments to be as provocative as Sunny was with an equally simplistic counter theory indicating what the value of a practice might be...and assuming away a number of things.

    OCA is, at its core, a finance company. It finances both orthodontists by carrying their cash losses, buying their fixed assets, and forwarding them cash in order to affiliate with them and to facilitate opening of new offices. It finances patients as well by offering them installment payment plans and by allowing them, after a service is provided, to pay OCA only after OCA sends them a bill (with the exception being the advance/concurrent payment required to get the braces off).

    OCA looks ultimately to patient contracts to recoup these cash outlays. But contract cash payments are received over time. So...cash goes out and is recouped, with some excess return, over the course of a couple of years. In the instance of cash expended for fixed assets and operating losses, the cash returns over a five year period. In the meantime a part of the contract receivable (and future potential practice income derived from future patient contracts...ie intangible assets/goodwill) sits on the company's balance sheet and income accrues, at least in part on a straight line basis...sounds like a finance operation to me.

    Now, this knowledge raises a couple of questions for me. How certain can OCA be about receiving sufficient cash to recoup its investment and a return? What levers does the company have to insure that these investments are recouped and a sufficient return on that capital is received? How does the company manage/limit the expenses of a practice? And what is the magnitude of the return on its investment?

    The later question in particular would help in bracketing the kind of multiple to book the company deserves. But even the current book value is understated since only a portion of the contract balance actually is recorded on the company's balance sheet.

    If growth in new, and particularly money loosing practices is constrained, the value of this business would be more apparent as cash flow would presumably gush. This, however, would not stop the growth in receivable investment as existing practices would presumably initiate new patient contracts.

    For me it all gets back to a couple of things : 1) the recoverability of current receivables 2) the ability of patients to pay on their contract (a significant portion of which is nowhere on the company's balance sheet) 3) the ability of the company to manage the expenses incurred by practices, and 4) the ongoing growth in demand for orthodontic services.

    Hey...just because the accounting is complex doesn't mean that it is fradulent.


    PS I propose that a truce be declared between myself, Jimbo, Big Dog, and Sunny and that we each dig a bit deeper.

    Drunkeness notwithstanding (I downed three Checkvar's before authoring this thread), I am...

    Truely,

    Round

    SubjectEarnings
    Entry08/15/2003 05:54 PM
    Memberround291
    Reported in line with revised guidance. Further efforts taken to reduce capital intensive, new affiliations. Business showing the impact of the weak economy.

    Debt reduced slightly. A few more doctors join in litigation and/or stop paying. More aggressive efforts to settle with those disgruntled as announced on the conference call.

    More attention being paid to collectibility of patient contract receivables.

    Palmisano signals more attention to growth through partnering new orthodontists with experienced ones, international initiatives, and a "no capital" affiliation program with other practicing doctors/dentists etc.

    All in all, not to shabby and certainly not much (though I haven't read the 10-Q) to get the shorts stoked.
    ____________________________________________________________
    Orthodontic Centers of America Meets Earnings Guidance for the Second Quarter of 2003
    August 14, 2003 4:24:00 PM ET


    METAIRIE, La.--(BUSINESS WIRE)--Aug. 14, 2003--Orthodontic Centers of America, Inc. OCA today announced its financial results for the second quarter and six months ended June 30, 2003.

    Bart Palmisano, Sr., Chief Executive Officer, said, "We are pleased with our progress in the second quarter. Solid financial results were generated by our affiliated practices in terms of improved cash flow and same-center growth. We continued to report favorable comparable center fee revenue growth of 9.8% for the second quarter of 2003. As the year unfolds, we expect our financial performance to be even better."

    For the second quarter of 2003, fee revenue was $100.2 million. Net income was $13.4 million and earnings per diluted share were $0.27, compared with earnings per diluted share of $0.23 for the second quarter of 2002. Included in the second quarter of 2003 results was $1.0 million (net of $0.6 million income tax benefit), or $0.02 per diluted share, in long-term asset impairments. The results for the prior year period included a non-recurring recruiting related charge in the amount of $8.0 million (net of $4.8 million income tax benefit), or $0.16 per diluted share.

    For the six months ended June 30, 2003, the Company reported fee revenue of $200.9 million. Net income for the first half of 2003 totaled $28.3 million, or earnings per diluted share of $0.56, compared with $0.59 per diluted share, including the non-recurring recruiting related expense of $0.16 earnings per diluted share (net of income tax benefit), for the same period in 2002. Free cash flow, which the Company defines as net cash provided by operating activities minus net cash used in investing activities, was $15.0 million for the first half of 2003, as compared with $10.3 million for the first six months of 2002.

    Mr. Palmisano commented, "Our success during the first half of the year gives me a high comfort level for the remainder of the year and the foreseeable future. We are focused on growth of existing affiliated practices, and that emphasis is paying off. In addition, we continue to make progress on our initiatives to expand the market for our business services, both in the United States and abroad. We have significant opportunities for growth, and we are committed to achieving our full potential."

    SubjectObsession
    Entry08/16/2003 11:05 PM
    Memberround291
    Here are a few numbers that kept me up on a home bound Saturday night:

    Patient Contract Revenue = $1
    Operating Margin % = 40%
    Operating Margin $ = $0.40
    OCA Share of Operating Margin = 40% * $0.40 = $0.16
    Affiliation Multiple = 4x
    Affiliation Cost = $0.64
    Pre-Tax ROI on Affiliation Cost = $0.16/$0.64 = 25%

    Therefore, every dollar invested in affiliation receives $0.25 per annum pre tax.

    How much would you be willing to pay for that stream of cash? Considering that long term rates are around 6%, you'd pay approximately $4 and receive a comparable return.

    Applying a multiple of 4x to OCA's current book value of about $9.35 gets you a $37.40 stock.

    Of course, none of the above considers the fact that patient contract revenue will grow over time.

    Something to consider.

    SubjectCash flow
    Entry08/19/2003 12:39 AM
    Memberdoggy835
    OCA did pay down a little debt and increase their cash balance during Q2. While cash generation is still woeful compared to reported income, the fact that there IS cash generation is both new and encouraging. If this trend can accelerate OCA is a bargain.

    SubjectOdd OCA numbers
    Entry10/16/2003 07:25 PM
    Membermax685
    Has anyone noticed that the OCA "comparable center" results don't seem to make sense? At least not so far as I can tell. I'd appreciate it if anyone can confirm this analysis or straighten me out.

    Looking at the last two 10-Q's and the related press releases, OCA says that "comparable center fee revenue" grew $10.7 million in the first quarter and $6.2 million in the second quarter. These amounts reportedly represented growth of 11.4% and 9.8% over the prior year figures.

    Doing a little simple math, it appears that comparable center, non-comparable center, and total revenues were as follows:

    First Quarter 2002:
    Comp center revenue $93.9 million (10.7/0.114)
    Non-comp center revenue $17.4 million
    Total revenue $111.3 million (as reported)

    First Quarter 2003:
    Comp center revenue $104.6 million (11.4% growth)
    Non-comp center revenue -$4.0 million
    Total revenue $100.6 million (as reported)

    Second Quarter 2002:
    Comp center revenue $63.3 million (6.2/0.098)
    Non-comp center revenue $50.1 million
    Total revenue $113.4 million (as reported)

    Second Quarter 2003:
    Comp center revenue $69.5 million (9.8% growth)
    Non-comp center revenue $30.7 million
    Total revenue $100.2 million (as reported)

    Assuming these calculations are correct, the first odd result is that non-comp center revenues in the first quarter of 2003 appear to be negative. Is that possible/plausible? And, if it did happen, then why didn't the company report a reversal of revenue?

    The second quarter results aren't quite as strange, though they suggest that there was massive turnover in the centers from 2002 to 2003. It makes sense that some centers have dropped out and a few have been added, but it's hard for me to see how so little of the total revenue could have been in the comp center base in the second quarter of 2002 and also why there was so much change in the base from the first quarter of 2002 to the second quarter.

    SubjectRe: Odd OCA numbers
    Entry10/17/2003 06:04 PM
    Memberdoggy835
    Whenever I look inside OCA's numbers I get odd results. I've mentioned the average patient age issue before - they claim a 26 month treatment plan and an average patient age >14 months. With the patient growth they've shown in recent years average age should be well below the halfway point, more like 11 months. I've had similar problems with per practice revenue - for published data and conference call remarks to both be correct the distribution has to be quite unusual (definitely not the Bell curve you'd expect).


    SubjectNew OCA figures
    Entry11/12/2003 07:48 PM
    Membermax685
    There are plenty of interesting figures in the Q3 results, including falling revenues and cash flows. But the things that jump out at me are the 21% year-over-year decline in new patient contract balances and the 50% increase in current service fees receivable since December 31. Revenues are sliding but receivables are burgeoning. How does that happen?

    SubjectSeasonality
    Entry11/12/2003 08:52 PM
    Memberround291
    Max -

    Before you get going on this, take a look at 9/30/02 10-Q.

    This is a seasonal business with the summer months typically representing a seasonal peak in new patient starts. This quarter isn't much different than the same quarter last year in this balance sheet line.

    SubjectRe: seasonality
    Entry11/13/2003 01:42 AM
    Membermax685
    It looks like current receivables are at 94 days at Sept. 30 this year vs. 76 days last year, and that's not even factoring in the long term receivables.

    Also, in Q3 last year, the 69,000 patient starts was higher than the average of 60,000 per quarter in the first half. This year, though, Q3 starts of 56,000 only slightly exceeded the first half average of 53,000. I don't see how that indicates a lot of seasonality.

    SubjectRe: Seasonality
    Entry11/13/2003 07:23 PM
    Memberdoggy835
    New patient starts are mildly seasonal, but the way OCA straightlines patient billing and revenue recognition smooths seasonality out to almost nil in the financials.

    Service fees receivable don't seem to exhibit any seasonality - they only go up. Total this quarter was 145m vs. 94m in the year ago quarter. They increased 14.5m this quarter alone. On a flat-to-declining business!

    OCA can split receivables into as many categories as they want and fill the 10-Q full of pretty graphs, but these numbers stink. On the other hand they did repay a little debt and buyback a few shares. There's obviously some money coming in the door. Of course there wouldn't be if they were actually paying taxes.

    Speaking of taxes, they recorded a 7m tax expense which they didn't pay. But instead of decreasing their deferred tax asset from 20m to 13m, they actually increased it to 30m. Offsetting that was a 17m increase in deferred tax liability. Odd. At the rate they were going the deferred tax asset would have been exhausted in another couple of quarters.

    SubjectAll Good Points
    Entry11/14/2003 10:04 AM
    Memberround291
    Doggy/Max -

    This was not a good showing, as you point out. Hoping that the litigation situation stabilizes and that monies forwarded those litigating doctors is recoverable.

    Do you guys think OCA is a good short for new money at this point? Or do you think the bottom is zero?

    SubjectShort?
    Entry11/14/2003 02:53 PM
    Memberdoggy835
    "Do you guys think OCA is a good short for new money at
    this point? Or do you think the bottom is zero?"

    OCA's existing contracts are worth something. They may even have an ongoing business that's worth something. But is it worth more than the debt? They eked out a few million of free cash this Q and last, but with numbers flying every which way on the financials it's hard to tell where it comes from.

    My gut says the enterprise is worth a few hundred million. That's less than the current valuation, but not enough to short it.

    SubjectAgreed!
    Entry11/14/2003 04:46 PM
    Memberround291
    Doggy -

    I generally agree with your comments...this business has value, but its being obscured by the litigation situation and, to a lesser extent, strategic flip flops that raise more questions than they settle. Additionally, orthodontic service (a postponable expenditure) appear to be more cyclical (tied to disposable incomes) that one might think just looking at industry spending growth over the last ten years. There was a big secular element in there...namely older people were geting their teeth straightened.

    I'm getting burned (but not to badly), but I don't think this thing is going down the tube.

    SubjectValue, crazy #'s, etc.
    Entry11/15/2003 02:40 PM
    Membermax685
    First off, they did it again with the comp center figures. They said comp center revenues increased $10.8M or 8.3% which means comp center revenue should have increased from $130.1M to $140.9M. Since total revenue actually decreased from $112.7M to $92.7M, however, there doesn't seem to be any way that this comp center revenue calculation could be correct.

    As for value and shorting, I agree that there's value in the practices, though I doubt that it's nearly as much as the $450M or so of current enterprise value. Given how crazy the numbers are, I find it hard to come up with a reasonable estimate of value. Just what exactly is going on with the advances to affilates, for example, and do the international practices have negative or positive value?

    A possibility that would throw all calculations out the window would be fraud. Data such as that in the first paragraph above are sufficient to raise the question in my mind, though of course there's no way to reach a definitive conclusion. I think lots of caution is merited here.

    Round, I don't recall if you have spoken with management. If so, can you try to get a straight answer on the comp center data?

    SubjectEncouragement
    Entry11/15/2003 06:19 PM
    Memberround291
    Max -

    I encourage you to satisfy your curiosity and call the CFO yourself. I don't share your confusion on comps and, while I wasn't happy with the quarter's results, I'm not alledging fraud on the part of the company or in the accounting.

    Also, and just a nit...in discussing the value (or lact thereof as you clearly believe) in this business the referents are contracts OCA has with practices and orthodontists and not the practices themselves.

    Best wishes,

    Round


    SubjectClarifications
    Entry11/15/2003 07:01 PM
    Membermax685
    Round, you're right that I should have said "contracts," not "practices." Re: contacting the company, I haven't had much luck getting phone calls returned in the past, but maybe I'll try again. I thought perhaps you had better access. Meantime, since you don't think the comp center data are confusing, can you please explain the calculations to me? I'd appreciate it!

    SubjectEarnings delay
    Entry03/10/2004 08:29 PM
    Membermax685
    After confirming that earnings would be released post-market today, OCA did a quick about-face and postponed until Monday. Hard to know whether it's just overly cautious auditors or a sign of trouble.

    Subjecti would guess a sign of troubl
    Entry03/10/2004 10:14 PM
    Membersunny329
    i would guess a sign of trouble. i got back into this short a few weeks ago and think it is going to zero in teh near future.

    SubjectGreetings, Sunny!
    Entry03/11/2004 11:26 AM
    Membermax685
    It's nice to have you back on this message board. You're certainly Da Man on this stock! Unless, of course, you're Da Woman, which would be just fine too. In any case, VIC members including me owe you a lot for your insights on OCA.

    Subjectfunny thanks. you had it righ
    Entry03/11/2004 01:27 PM
    Membersunny329
    funny thanks. you had it right the first time--not a woman. appreciate it....win some you lose some.


    SubjectSEC nosing around?
    Entry03/12/2004 05:33 PM
    Membermax685
    Herb Greenberg reported today that SEC Insight was denied information under a Freedom of Information Act request because there's an active investigation pertaining to OCA.

    Subjectthanks appreciate it-i hadn't
    Entry03/12/2004 07:19 PM
    Membersunny329
    thanks appreciate it-i hadn't seen that.

    Subjectdebt covenants and amortizatio
    Entry03/14/2004 04:11 PM
    Memberscrooge833
    hi,
    i was trying to find more details of their debt covenants. does anyone in this group know? Also, I read that they amortize their contracts up to 25 years. That sounds like a very long time, overstating the earnings numbers. Does anyone think the timeline they use for amortization is fair or conservative?

    i am neutral on this idea and have an open mind.

    Subject10-K filed
    Entry03/15/2004 06:25 PM
    Memberdoggy835
    They got the auditors to sign off. Obviously not a robust growth company but they ARE generating some free cash flow. Not as much as EPS, of course, as the various AR line items continue to balloon. But FCF is hard to fake. Doesn't look like a zero to me. Should rally tomorrow.

    It's kind of weird how all these practices can simply stop furnishing OCA with financial info and cash flow. In theory OCA employees are the ones running the office and handling the cash. Might be different at the OrthAlliance offices, but not all non-performing practices are OrthAlliance.

    SubjectFree cash flow
    Entry03/16/2004 01:19 AM
    Membermax685
    Don't get too excited, Doggy. FCF was a whopping $101,000 in the fourth quarter, though it was $18.6 million for the year. Revenue is down, bookings are down, more practices are gone, and "comparable practices" (changed from comparable centers) grew only 5% year-over-year. But I agree, investors will probably focus most on the reported earnings tomorrow. OCA appears "cheap" at 8 times annualized fourth quarter earnings, though it doesn't look nearly as attractive at about 20 times trailing FCF.

    SubjectExcited? Moi?
    Entry03/16/2004 05:30 PM
    Memberdoggy835
    I think you've got the wrong dog. OCA avoided disaster, which surprised me, but I'm hardly bullish. All I'm saying is the contracts they bought have residual value that exceeds the debt balance. Properly managed the company could return cash to shareholders. Of course they won't, instead they'll "reinvest" the cash on dubious foreign and outsourcing ventures. OCA may become a zero eventually, but it's not one now.

    I sure wonder how they got some of this crap past the auditors, though.

    SubjectWoof!
    Entry03/16/2004 06:04 PM
    Memberround291
    As I've been the mildly bullish dog romping around this Sunni Triangle (Sunny-Max-Doggy), I thought I'd emerge from behind the bushes with my usually unpopular opinion of things.

    The performance this year, all things considered, was not that bad. The top line suffered from the defection of OrthAlliance teeth straighteners (for whom the company has discontinued recognizing revenue), but profitability, despite mounting legal bills, has weathered the storm...as you might imagine it would. The receivables situation, which has been an area of focus around these parts, continues to be a minor sore point. This is despite the added and beneficial disclosures in the 10-K, particularly with regard to the Final Payment Accrued Amount. The growth in Billed Receivables requires some work on the part of OCA management to fix.

    Some debt was repaid, shares were purchased, and investments were made in additional centers/practices.

    In my opinion, earning $1.00 per share this year is entirely possible. With the shares trading at $7, OCA looks cheap to me, particularly considering that all revenues are recurring revenues.

    This is the last comment I intend to make on OCA as it appears that reason with regard to assessing this company doesn't hold. The vested interests are so significant on both sides that people only hear what they want to hear.

    Well, such is life...

    SubjectMore OCA
    Entry03/17/2004 04:37 PM
    Memberdoggy835
    "The top line suffered from the defection of OrthAlliance teeth straighteners"

    There's more to it than that. Revenue for 3Q01, the quarter prior to the OrthAlliance acquisition, was 86m. Since then they've reported robust comp center growth, they added 50+ OrthAlliance practices that didn't defect, plus they added other practices and opened de novo centers. Yet 4Q03 revenue was 82m, a 4m drop from 3Q01! The problems clearly extend beyond OA defectors.

    I feel the receivable disclosure has gotten worse. They changed the famous "single patient contract" graph for no apparent reason. They stopped reporting average contract age (which I estimate at an unrealistic 15.6 months) and they no longer disclose the patient count info you need to try and cross check the receivable numbers. Billed DSOs are up to 57 days vs. 34 days a year ago and 23 days two years ago. The 23 day number makes sense as patients pay when they show up for treatment every 46 days. The 57 day number is just goofy.

    It's good they generated FCF and paid down debt in 2003. But there are still a lot of bugs under this rock.

    Subjecti don't think OCA ever actuall
    Entry03/17/2004 09:58 PM
    Membersunny329
    i don't think OCA ever actually created any value for shareholders in its history. saying that their financial results are suspect is being complimentary. businesses such as this will go away. it is just a matter of patience. just as businesses that generate strong returns and reinvest capital in high yielding projects create value, businesses that obfuscate economic reality with dubious accounting and invest all of their capital into receivables because their revenue is suspect (i am running out of euphemisms for frau-----) will fade into the sunset. think of OCA at this price as a gift.

    SubjectExcited?
    Entry03/19/2004 01:18 PM
    Membermax685
    Thanks for the comments, everyone. Dog, I thought you did a great job summarizing some of the key issues from this latest release. The comparison with the pre-OrthoAlliance numbers should give anyone pause. As for Round's EPS forecast, it's possible they will report $1.00 or thereabouts. But given the long amortization schedule on the intangibles and the continued give-backs to docs in lower fees, advances, supplementary payments, etc., there's a huge question, as Sunny notes, whether those are real economic earnings. The market is clearly skeptical.

    SubjectSeeing the Light
    Entry06/24/2004 02:52 PM
    Memberround291
    Months ago I came to the conclusion that OCA is enaged in a scheme to help affiliated orthodontists reduce income reported in their professional corporations and taxed at ordinary income rates and recycle it into gains on OCA stock taxed to orthodontists as capital gains. What did it for me was the incessant sloshing of funds in innumerable forms back to orthodontists from OCA. As a result of OCA not being to turn these spigots off, little wealth is being created for shareholders of OCA stock.

    I lost less that 2% on my investment on this and should have read more into Bart's background as a lawyer and accountant.

    I hereby apologize for bashing the shorts on this one and begin making my way down the long road to rehabilitation in the eyes of the Sunni Triumverate (Sunny, Max and Doggy).

    SubjectRe: the light
    Entry06/25/2004 10:31 AM
    Membermax685
    I appreciate your comments, Round. And I hope that your new perspective is, indeed, the correct one!

    SubjectAll Hail the Great Sunny329!
    Entry06/08/2005 03:29 PM
    Memberdoggy835
    -Delays 10-K and 10-Q
    -Receivables and revenues overstated
    -Prior financials not to be relied upon
    -Negotiating additional waivers from lenders
    -Stock at 1.90

    Sunny nailed this one from the start and stayed with it all the way down. Superb work!

    SubjectSunny--any FCF?
    Entry10/28/2005 12:58 PM
    Membermax318
    Putting aside the fraud and the shareholder and ortho lawsuits (a stretch to being with) what do you make of this company doing $20M in CFFO - Investing Items for 2003 and 2002?

    If you assume that there are 270 practices remaining and they all get the worst case $500k in rev a year and OCA gets 40% of a 40% operating margin, you get $21.6M in operating income if they don't grow the business.

    However, maybe the 40% practice margins are not accurate--I heard that ADPI gets 15% dental practice margins (but that is a different size practice and doctor). I guess your report argues that after the costs run through the balance sheet, the 40% operating margin is not correct because they have to keep making payments to doctors.

    Another way to look at it is that each practice has 500 patients, and they get $129/month from the patients, and the 40% of 40% shares would imply $33M of op income. Without the 2004 filing, we don't know what they did for cash flow in 2004, obviously, but it looks like they were able to cut back on the investing items and produce FCF in the years prior. The question is--did this cause all the orthodontists to leave? They still have 280 or so practices on the website--maybe 220 doctors. The revenue grew also while they were cutting back on the "investment" kickbacks to doctors. The ortho's I talk to do not sound happy with OCA, but it sounds like these guys might be able to generate $20M or so FCF, as long as they can convince the banks to keep them alive long enough to try to collect their receivables and amounts owed to them by departing ortho's.

    Just wondering what your thoughts were. They don't look like they will meet the filing deadline they had set for the end of October.

    SubjectQuestion clarfication
    Entry10/28/2005 02:19 PM
    Membermax318
    Just wanted to clear up the last post. Revenues were growing in the last reported filings (although we know Ortho Alliance is now all gone)--but they roughly maintained revs and cut the "other investment" in the investing cash flows to generate FCF. So can they gut the kickbacks (and growth) and maintain $20M in FCF?

    SubjectRe: max318
    Entry10/28/2005 09:02 PM
    Membertbzeej825
    It's very difficult to determine what real cash earnings of the business are. I think I finally understand what OCA was doing all along. At first OCA wanted to hire guys out of school who didn't have the capital to start up a practice (because of school loans, etc.), which allowed them to pay them the least amount possible relative to an established orthodontist. This in turn would give them the best shot at a good ROIC IF they could help the guy build a decent practice AND retain him down the road. So if OCA signs up this young guy out of school to a 5-7 year contract, by the time he has built up a practice, the guy can just go down the street and set up a new practice (taking his existing relationships with him) or can demand a much higher payment from OCA. Thus the accounting always had these intangible payments under the investing section of the cash flows statement to reflect that, which is why EPS was always higher than FCF. If the guy walked, OCA was still amortizing the "XYZ Ortho" over the 25-year "useful life" even though the doc walked, which is border-line fraudulent IMHO. If the doc is no longer with OCA, the odds of the practice being worth what it once was are very low. Yet, OCA basically never took write-downs on these intangible assets when these docs left.

    The supply-demand imbalance for ortho services has gotten perpetually worse over the years. Less people graduate ortho schools (only about 200/year currently) over time while the demand for ortho services continues to increase. Also, about 600 orthodontists retire/year. Thus the price of ortho services rise (less docs in practice serving increasing demand), which makes the opportunity cost to teach instead of practice that much higher, which results in less people graduating from ortho schools.

    This leads me to my last conclusion, which is that OCA ran out of young guys to recruit and/or had to pay them more from the beginning. OCA was increasingly competing with guys about to retire who were willing to sell their practice for a "cheap" price relative to its cash earnings because there are not enough natural buyers. Every year 600 ortho docs retire while only 200 graduate. That's where OCA came in. They were artificially creating demand for that net 400 practice loss differential. So then you saw OCA go increasingly into the business of buying out practices of guys who were close to retiring. It was a no-brainer for these docs because in essence they were doing a forward sale of their business and getting 5-7 years worth of cash flows up front. When the guy was ready to retire OCA would try to convince these guys to stay another few years. But if you pay a guy 5-7x FCF of his business and then he leaves 5-7 years later, OCA has not made much money if anything unless it is able to improve the business immensely and/or it can recruit a guy out of school and pay him as little as possible to take over. That may have worked in the past, but the returns definitely went down (maybe to zero) as the years went on because there were more sellers of good practices at cheaper prices.

    The only way I'm convinced OCA can make real money is by buying out a doc's business of a guy in his mid-30s to mid-40s who is going through a divorce and basically needs to make a deal (i.e. forced selling) with the devil (OCA) to maintain his current lifestyle. If you buy him out at this age you have a decent shot at getting him to stay for at least 5 years and maybe upwards of 20 if you're lucky.

    I hope this helps anyone who's still involved or looking at the stock either as a long or short. I think at this point OCA is a total crap shoot. It very could be a bk and it could be a decent spec that works out. If I was one looking for a decent spec, I would much rather put my money in PNCL- the write-up was very good IMHO. Just food for thought.
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