By Mak Yuen Teen
Following my earlier article on HC Surgical Specialists dated April 14 and my comments which are in today’s Straits Times, I share some further thoughts here about the second transaction, which involved the company buying an additional 19% in Julian Ong Endoscopy & Surgery Pte Ltd (JOES). This transaction was announced on September 3, 2019. It was completed on October 11, 2019.
To recap, the complaint by Ms Serene Tiong to the SMC was made in June 2018. I would expect that company would be aware of this complaint and the defamation suit that Dr Julian Ong filed against Ms Tiong in July 2018. If the company did not know, I would expect that Dr Ong would have disclosed this to the company in the course of the transaction because the outcome of the SMC hearing and the defamation suit, and publicity surrounding it, could have a material impact on JOES. This would in turn affect HC Surgical which would now own 70% of JOES.
In the announcement of the second transaction, it was disclosed in note (2) under the table in section 8, “Relative Figures”, that 19% of the net profit attributable to JOES for 12M2019 was approximately $357,000.
Since HC Surgical paid a total of $3,795,000 in cash and shares, it paid a P/E of 10.6 times for the additional 19%. By itself, that may not be high (I have not looked at multiples paid in this industry so I cannot say it is too high or low).
However, there are a few other issues to consider.
First, the profits for JOES could fall drastically, perhaps even to zero, in the event of an adverse finding by the SMC. In any case, the negative publicity from the defamation suit would likely harm its profitability. It is even possible that there may be legal exposure if there are claims from other patients of Dr Ong.
Second, HC Surgical already owned 51% and has control of JOES. There may be a case for buying an additional 19% and eventually the remaining 30% if JOES is performing well. Paying proportionately more to buy an additional stake may be justified because JOES was newly incorporated when HC Surgical bought the first 51%.
However, after the first transaction in February 2017, the SMA stated that profit guarantees are incompatible with the profession’s ethical guidelines. In fact, the profit guarantees used by HC Surgical were cited as an example.
When HC Surgical entered the second transaction, the profit guarantees under the first transaction were cancelled and there were no profit guarantees at all. In its place were what appears to be to be rather loosely-worded put options (based on what was disclosed) and it is unclear that HC Surgical will be able to enforce them.
Third, the company gave a rather convoluted rationale for buying the additional 19% stake, which I reproduced almost in full in my first article. In a nutshell, I think what the company was trying to say is that by buying an additional stake, Dr Ong would be incentivised to work harder for the benefit of the entire group, not just his own practice. His direct stake in JOES will fall to 30% (and eventually to zero) so his incentive alignment to JOES actually falls when HC Surgical buys more of it.
However, it is unclear to me how Dr Ong would be incentivised to work harder for the benefit of the whole group. If HC Surgical wants to do that, two possible ways are: (a) give him a share of the group profits through a bonus arrangement (in place of some of the cash consideration, for example), or (b) issue him more HC Surgical shares in the transaction and require him to continue to hold a substantial amount of shares.
There is no mention of a share of group profits through a bonus. HC paid him only 25% of the total consideration in HC shares, with the rest in cash. For the first transaction, it was 28% in shares and 72% in cash, so not that much different. Like for the first transaction, there is a moratorium, but after the first year, Dr Ong can sell a quarter of the shares every year and for the shares in the first transaction, he has indeed been selling down HC Surgical shares in line with the moratorium.
Overall, it is not clear to me that the intended rationale of buying the additional 19% will be realised.
I think the board should disclose more information about what it knew when it bought the second 19%, and its thought process in buying this 19% stake and how the transaction was structured, including the terms of the put options and whether they are enforceable. The advice provided by the financial advisor for this transaction, now the sponsor, Novus Corporate Finance, is also relevant in understanding the transaction.
