Transcend Services: A Physician's Best Friend

By Will Ashworth | February 07, 2012 AAA
Every once in a while, a company comes along whose product or service makes total sense. While looking through the holdings of the Wilshire Micro-Cap ETF (ARCA:WMCR), I came across a tiny Atlanta company that provides speech recognition technology and services to more than 320 hospitals and health systems across the United States. With a market cap of around $225 million, Transcend Services (Nasdaq:TRCR) has plenty of room to grow. Read on and I'll explain why now is the time to own its stock. (For related reading, see How To Evaluate A Micro-Cap Company.)

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Competition

Transcend Services has two main competitors: MModal (Nasdaq:MODL) and Nuance Communications (Nasdaq:NUAN). In August 2011, MedQuist Holdings, a provider of transcription services for the healthcare industry, merged with MModal, a leader in speech recognition technology. Transcend Services competes with MModal for both transcription services and speech recognition software. Nuance competes with the company on the technology front with its Dragon Medical speech recognition software. As a writer who suffers from a mild case of carpal tunnel syndrome, I personally use Nuance's Dragon Dictate speech recognition software for my Mac. For the most part it's done what it's supposed to do, and that's reduce the amount of keystrokes. So why not write glowingly about Nuance Communications? It is the more established business after all. Successful investing is all about buying good-to-great companies at reasonable prices. Nuance's stock price is anything but reasonable.

The Road Ahead

Transcend Services' fourth quarter was solid, if not spectacular. Revenues increased 22% to almost $32.9 million. Excluding $7.4 million in revenue from three acquisitions, organic revenues were up about 10%. More importantly, despite several cost issues plaguing the company, it still managed to generate almost $4.9 million in non-generally accepted accounting principles operating income in the fourth quarter compared to nearly $5.1 million in the same quarter in 2010. The two biggest expenses being roughly $1.3 million in transaction costs from the three acquisitions referenced above as well as $662,000 in restructuring costs for its customer service centers in India. Also key to fourth quarter expenses, was almost a 100% increase in its research and development and IT costs to just under $1.5 million. On the whole, 2011 has to be considered a success despite gross margins falling below 40% of revenue. CEO Larry Gerdes rightfully points out in its fourth quarter earnings release, that the company faced a similar problem in early 2010 after several acquisitions temporarily reduced profitability. Get used to this happening in the future because there are many small firms in the medical transcription business, and Transcend Services is a major buyer. Consolidation continues to be a major story in 2012. (To learn more, read Mergers And Acquisitions: Understanding Takeovers.)

Likes and Dislikes

I definitely like the fact that 98% of its revenue is recurring in nature. It's also reassuring to know that it retained 95% of its customers in 2011. This means it needs approximately 7% in new revenue every year to maintain overall revenues. Considering it made six acquisitions in the last three years adding $59 million in revenue, at a cost of $52.5 million, I think it will be just fine. I also like the fact it's done a reasonable job integrating its acquisitions. As long as they remain disciplined buyers of assets, profits will continue to flow. Lastly, over the summer, it introduced Encore, its software as a service transcription platform for hospitals. The new platform provides hospitals with a cost efficient solution for maintaining an in-house transcription department while also being able to utilize speech recognition software. Think of software as a service (SaaS) as just another piece of cloud computing, probably the biggest topic in the computer industry these days. Amazon.com (Nasdaq:AMZN), Salesforce.com (NYSE:CRM) and Google (Nasdaq:GOOG) are just three examples of companies using SaaS as part of their cloud computing initiatives.

My dislikes come down to one simple thing: Its relationship with MModal. In August, Transcend Services amended its 2006 agreement with the company that allows it to continue using MModal's speech understanding technology through Dec. 31, 2016. In its third quarter report, Transcend Services readily admits the relationship poses challenges in the future. While it's in the best interests of both companies to continue working together, it's important investors realize that the risk associated with a breakdown in the relationship is real. In this instance, buyer beware is a meaningful concept.

The Bottom Line

At this point, you might be wondering why I'm recommending Transcend Services and not MModal, who actually provide the software. It's simple, really. Transcend Services has zero debt and almost $100 million in shareholder equity. MModal, on the other hand, has $296 million in debt and just $98 million in shareholder equity. Financially, Transcend Services is the better risk. (For more information, read Breaking Down The Balance Sheet.)

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At the time of writing, Will Ashworth did not own shares in any of the companies mentioned in this article.

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