Boring Portfolio

Boring Selling PMSI
January 14, 1998

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Prime Medical Services (Nasdaq: PMSI)
1301 Capital of Texas Hwy, Suite C-300
Austin, TX 78476
(512) 328-2892

Closing price, Jan. 14, 1998: $11 1/4

Trade: Selling 400 shares

Prime Medical Services operates a fleet of 60 lithotripters in 34 states, currently performing over 36,000 procedures annually, through contracts with more than 400 hospitals and 255 managed care companies. The company also operates one mobile thermotherapy device and is currently developing additional mobile routes to provide thermotherapy services to hospitals and surgery centers to treat benign prostatic hyperplasia (BPH).

A Look Back

When the Borefolio added 400 shares of Prime Medical back in March of 1996, the stock stood at $10 a share. Based on earnings estimates for the year, a target price of $14 was established -- and very quickly achieved. In fact, within a few short months Prime's stock had climbed past $19.

Since then the stock has declined substantially, getting as low as $8 3/4. The decline occurred in spite of the company meeting earnings expectations and doubling in size through a series of acquisitions, most notably that of Lithotripter Inc. Part of the decline was a matter of being in the right place at the wrong time: Prime acquired Lithotripter Inc. just as the small-cap market melted in the summer of 1996. A planned stock offering had to be canceled, and the acquisition was financed through debt instead. Sales of stock by partnering physicians and retiring insiders also weighed on the stock.

Since our original purchase, Prime has launched another line of business. It inked a deal with the manufacturer of the Prostatron to set up partnerships using this technology to treat prostatic disease. The Prostatron was the key to Prime's future growth as further expansion of its lithotripsy business approached practical upper limits. The company outlined its plans for the Prostatron in its 1997 second and third quarter conference calls

Up to this time the company has done a good job of meeting our expectations. So, why are we selling?

Stark Reality

There are many possible reasons for selling a stock: reaching fair value, a series of disappointing financial performances, or a fundamental change for the worse in the business or the business environment. It is the last reason that moves us to sell Prime.

Last week, the feds released new regulations that will be used to administer the Stark II legislation. These regulations could very well change the way that Prime Medical does business. The legislation prohibits the type of partnerships that Prime has had with urologists both in the lithotripsy business and in the new Prostatron partnerships.

When we discussed the situation with Cheryl Williams, the CFO of Prime Medical, she offered the opinion that the regulations could be a net plus for the company. She reasoned that buying out the lithotripsy partnerships would bring more of the profits to Prime's bottom line, and she also felt that new lithotripter purchase opportunities could result as physicians looked to get out of prohibited partnerships. On the downside, she said that disbanding the Prostatron partnerships could have an adverse impact on the growth of that new business.

We agree that there may indeed be new opportunities on the lithotripsy side of Prime's business. Any buyouts would require the company to raise additional capital, however. At this time debt stands at 54% of Prime's market capitalization, so additional leveraging could be risky. As for a new stock offering, that might be viewed by investors as potentially dilutive, rocking the stock as happened in 1996. Also, lithotripsy is not a growth industry except through acquisition; the procedure is a mature one, with a modest intrinsic growth rate.

Prostatron Unplugged?

The Prostatron was an important engine for Prime's growth, and the likely unwinding of the newly-established partnerships is something that concerns us. If there are competing methods for managing medical problems and there is no therapeutic or cost advantage to the patient or insurance company, a physician is inclined to choose the procedure he or she is most familiar with or the procedure which provides the maximum reimbursement. An example (and one that is prohibited under Stark regulations) is the doctor who sends a patient to an X-ray facility in which the doc has a financial interest. The patient might well need the X-ray and the cost might be the same, but the doctor makes a bit more money by using that particular facility.

The development of the Prostatron business depends in part on persuading urologists to change from their current methods of treating BPH and trying something relatively new. Prostatron thermotherapy is FDA approved, appears to be cost effective, and may offer significant advantages; but it is also somewhat controversial. Not all urologists are convinced that the Prostatron is as good as the standard surgical procedures. Prime Medical will have a harder time spreading the use of Prostatron technology in the absence of its physician partnerships. The time needed to ramp up this business will probably increase and may require additional marketing expense.

The Big Squeeze

The second factor that leads us to sell our shares of Prime Medical is related to the healthcare industry more generally. The service side of the healthcare industry is undergoing a massive margin squeeze. Purchasers of health insurance want to pay less. Insurance companies are squeezing providers. Hospitals are squeezed, doctors are squeezed. Tighter Medicare and Medicaid reimbursements add their own significant pressure. We are thus increasingly convinced that the service side of the healthcare industry is not where we want to be invested. The risk/reward equation has switched to increasing risk with a more uncertain reward.

Conclusion: We'll Watch from Shore

Prime Medical may ultimately succeed in maintaining their margins; and by conventional valuation measures, the company's stock is by no means overvalued. Those measures are derived from analyst estimates, however, and those estimates are in turn dependent on Prime continuing along its previously outlined course. That course will almost certainly change now, and Prime must swim against a fairly stiff current.

We will continue to monitor the company. If Prime can demonstrate that it's able to negotiate its way through the rough water successfully, we may give the company another shot. But for now, we'll watch from the safety of the shore.

Mark Weaver, MD
Gregory Markus, PhD