Written 25 April 2008. Consult 'Investment Approach' tab for outline of what criteria gets a firm on the research list).

Quantitative score 70/100 on year-over-year accounting data. Qualitatively something similar. While US Physical Therapy (USPH) is in the health sector and a potential defensive, it has historically badly under performed peers in the Nasdaq Healthcare Index. In this it appears to have been a victim of its own financial conservatism. But several decisions since key management changes in 2004 suggest a cultural change. Indications are that the firm has embarked on a revised strategy that places more emphasis on using its strong cash productivity to acquire as well as grow in its usual organic way. In a fragmented market place there is scope for this method to flourish. The firm's website is here; and its latest 10K here.

US Physical Therapy with its 349 clinics is a distant number 3 in its marketplace behind Select Medical (1000+ clinics) and Physical Therapy Associates (825 clinics). It has a long share price under performance history versus peers which has seen its price/earnings rating drop steadily from the high 20s in 2003 to a shade above 20 today. This, perversely, has been the price paid for conservative management - USPH has not taken many risks despite its muscular financial profile.

There are conclusive indications that has begun to change in the last 2 years since the appointments of Messers Reading (CEO), McAffe (CFO) and McDowell (COO) in late 2004. Now settled in, they oversaw a wide ranging closure programme of marginal clinics in 2006 which shocked investors – the shares were marked down nearly 15% overnight floowing the announcement; they have made four acquisitions since 2005 the largest of which last year secured the privately held, 52 clinic STAR Physical Therapy (and, notably, which required a new $30m, expandable to $50m, revolving credit facility); and there has been over $550,000 of insider buying of its stock in March, likely a sign of renewed internal confidence given they were the first such transactions in over a year and a half.

Still, there are obstacles. Gross margins have been taking a methodical beating year over year since 2003; and the quarterly trend into Q4 2007 is especially uncomfortable because, most likely, of the STAR acquisition. The 10K on page 22 has a neat table summarising per visit revenue and cost breakdowns - both of which are going the wrong way.

This speaks to competition and regulation: health may be a defensive sector but it is also political. And in that context there is the concern that, with 207 differently branded clinics, the decentralised financial control style of USPH will not be able to make enduring improvements to its financial ratios despite its widespread use of profit share and ownership schemes with its clinic directors. It is an issue that will worsen in acquisition mode; and initiatives attacking what may now seem like financial minutiae will later look prescient investments.

The Big Picture, then, is that USPH has the balance sheet, free operating cash flow and desire to expand more aggressively than in the past. It clearly has the finances to close low margin sites in favour of acquiring higher – or potentially higher as would seem to be the case with STAR - margin ones. But some tough and detailed financial grind is required to make that game work: a successful change of company strategy depends, in this case, on an implementation of greater focus on internal financial method, measurement and culture.

Exhibit: US Physical Therapy tear sheet