|Shares Out. (in M):||325||P/E||0||0|
|Market Cap (in $M):||5,098||P/FCF||0||0|
|Net Debt (in $M):||4,867||EBIT||0||0|
|TEV (in $M):||9,965||TEV/EBIT||0||0|
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We believe Change Healthcare (CHNG) is a collection of misunderstood, defensive, mostly extremely high-quality healthcare software businesses trading at a tremendous discount to public market comps and recent private equity transactions. The opportunity exists due to a) limited float and associated overhang from McKesson and private equity, b) a complex business with limited competition and public peers, c) optically high leverage, and d) skepticism around the ability of the business to grow. We think all these concerns are misplaced and will abate over the next 12-24 months. We believe the road to re-rating started today (February 10th) with the announcement of the split-off of shares held by McKesson (over half of shares outstanding, more than 3x the current float). If we are right, we think the stock could more than double over the next couple years.
CHNG is a merger of McKesson’s technology assets with Change Healthcare, a healthcare software business previously controlled by private equity. McKesson merged its business into Change in exchange for a partial dividend recap and 70% of the equity in the new venture. At the time, McKesson was trading at 13x NTM earnings and 8.5x NTM EBITDA. Select healthcare tech peers traded at an average of 11.5x NTM EBITDA. At the time of the merger, both parties valued the combined business at roughly 12x EBITDA. McKesson put its CHNG equity on the balance sheet at the equivalent of $23 a share. The plan was to take advantage of the valuation arbitrage, do the messy integration in the private markets, and IPO the assets in a couple years once the story was cleaner.
Fast forward to today: healthcare tech peers trade at 15x 2020E EBITDA, and multiple PE transactions of close peers have occurred at similar levels. By comparison, CHNG trades at 10x our 2020E EBITDA. We believe this discount is unwarranted and that this is a good absolute value and excellent relative value for assets of this quality.
Although we do have some differentiated views on the trajectory of the business, we think we can add the most value by simply explaining the basics of what Change does and where it makes its money.
IPO, Split-off, Overhang:
Post deal announcement in June 2016, the company spent nearly 3 years cleaning up the business in preparation for IPO. Unfortunately the company IPOed into a market with elevated concern around nationalized healthcare and other existential threats. Mgmt received options at $19 a share early in 2019. The IPO was originally targeted to price at $16-19 a share, but given the high leverage (~5x EBITDA), massive McKesson overhang, and the political backdrop, shares priced at $13 a share. 5 insiders bought in the IPO, and the CEO and CFO subsequently purchased $1M of stock each at prices above the IPO price. The company also issued some tangible equity units, meaning the actual public float was sub-$1B despite the company having a $10B EV and fully diluted market cap of roughly $5 billion. On February 10th 2020, McKesson finally announced they will be splitting out the CHNG shares they still own. We believe the split-out removes the major overhang both a) kept investors from doing the work and b) hampered the company’s ability to better explain its business due to regulatory restrictions around marketing in certain potential spin / split structures.
What does a great business look like?
Researching large businesses with many segments is hard and time consuming. We are uncertain the degree to which people will ultimately do the work to appreciate the quality of the business (or frankly if possible to get arms around a business of this magnitude). So let’s just look at things at a high level - under the theory that if it looks, walks, and talks like a duck, people will eventually realize it is a duck. This duck measures as follows:
-88% of revenue recurring
-Retention rate in best businesses close to 100%, high switching costs
-31% EBITDA margins, 25% “EBITDA - Capex” margins for the entire business
-56% EBITDA margins, 50% “EBITDA - Capex” margins in growth businesses that compose over 50% of company EBITDA and the bulk of value in the business
-High quality, higher margin businesses in aggregate have been and should continue to grow at mid to high single digits
-Minimal economic sensitivity, modest pricing power and volumes tied to patient visits / claims
-Dominant market share, often 50%+, in many core products
-Lenient capital structure, maturities 4-5yrs out, leverage covenants set at 7.5x leverage
Overview of Change’s Business:
The US healthcare system is a complex web of interactions between thousands of payors, tens of thousands of places of care, hundreds of thousands of practitioners, and millions of patients. There are very complex rules around reimbursement, standards of care, coverage, claims submission and claims processing built up over decades. To add further complication, these rules are always changing.
At its core, Change provides the key plumbing of many of the core processes that ensure a) providers get paid what they are supposed to in a timely manner, b) payers only pay what they have to, while quickly and efficiently disputing and identifying inaccurate claims. Based on many conversations with formers / competitors / customers, we believe the assets that compose the bulk of EBITDA are some of the stickiest and most integral parts of this process.
CHNG breaks out their business into 3 segments: Network Solutions (18% of revs, 30% of EBITDA), Software & Analytics (52% of revs, 55% of EBITDA) and Technology Enabled Solutions (30% of revs, 15% of EBITDA).
Rather than use the company’s segment breakout (which we reconcile below in the valuation section), we find it more fruitful to break out the businesses by our perception of quality and value:
-Great Assets: 35% of revs, 55% of EBITDA, 62% of value
-Good Assets: 25% of revs, 27% of EBITDA, 26% of value
-The Rest of the Business: 40% of revs, 18% of EBITDA, 12% of value
The Great Assets (35% of revs | 55% of EBITDA | 62% of value)
We believe CHNG’s “great” assets, composing over 55% of EBITDA and 35% of revenue, are growing in aggregate mid-to-high single digits with average EBITDA margins of 50%. For each section we include a basic description of the asset as well as competitors and valuation comps. We can answer more detailed questions in Q&A.
Network Solutions (18% of revs, 29% of EBITDA):
This business manages the complex process of getting accurate claims to the right payer such that they get paid in full and quickly. There are several thousand payers in the United States that each require a claim form electronically so the claim can be processed in an efficient manner. These claim forms average 200 fields in length, change yearly, and are different for every payor. CHNG, through its Emdeon business, provides the automated network that allows practitioners to electronically fill out claims to be sent for reimbursement. There are a few pieces of value that CHNG adds in this process:
1) Claims need to be submitted securely to protect patient privacy. It can be an onerous process to set up connections for payers with multiple clearinghouses (let alone thousands of practitioners). The major payers often integrate with a handful of clearinghouses and, in some cases, exclusively with CHNG in particular. We believe CHNG is the largest player in this market and more than double the size of its closest competitors.
2) Claims are typically processed by someone who sits at the front desk and has many other responsibilities. Even if there is a dedicated person, the margin for error when dealing with potential typos (or bad handwriting) from patients or practitioners is very high. A big part of the value is the “claims scrubbing” process, which is a set of rules that checks for likely errors in the claims before they are submitted to the payer and in some cases can fix them automatically. The payers have their own software on their end (also provided by CHNG) to evaluate the accuracy of the claims - those that are accurate are typically paid within 2 weeks. Those that aren’t get kicked back to the provider, who then needs to figure out what’s wrong and resubmit the claim. Needless to say the time involved in dealing with rejected claims is very expensive both in personnel cost and longer-dated receivables.
3) In addition to actually transmitting the claims, CHNG keeps the forms updated on a yearly basis on behalf of the practitioners so they don’t have to constantly change their systems each time a change is made. All but the largest practitioners would be capable of making changes like this themselves.
4) Because CHNG is so large and still has many exclusive connections with payers, competitors will often need to route their claims over CHNG’s network to reach certain players that are exclusive with CHNG. CHNG is able to charge a “toll” on these transactions.
5) CHNG also owns the de-identified data associated with all its claims (including competitors claims that must be routed across their network), which it can resell to data providers. We estimate that this business is roughly 2% of revenues but 5% of EBITDA, and growing teens plus.
Valuation comps: Most are owned by private equity. Recent transactions include:
-Waystar (20x+ EBITDA buyout by Bain, direct comp, but growing teens instead of mid single digits)
-Trizetto (14x EBITDA, acquired by Cognizant, inferior asset in our view)
-Nthrive (11x+ EBITDA - acquired as part of Medassets which included lower multiple GPO asset, multiple likely higher for standalone Nthrive)
Payment Accuracy (10% of revenues, 17% of EBITDA)
Payment accuracy is the “other side” of the claims clearinghouse network. When claims are submitted to a payer, the payer tries to filter out as many incorrect / false claims as possible. This process is critical to a health insurer paying the right amount and processing claims efficiently.
Most states have rules requiring payment in 2 weeks or less, meaning a) payers have to pay out those false claims in cash unless it is caught in those two weeks and b) it is impossible to process those claims manually before payment. This makes the process exceptionally difficult. Therefore, payors use 3 types of payment accuracy defense:
1) First-line prepay defense: software based and paid on a small amount on a per claims basis and scrubs substantially all claims. This line generates the vast majority of savings for the payer but not a proportionate amount of the price paid. The software performs basic verification of the claim for accuracy of basic personal information & insurance information provided. It more importantly does more complex logic work around diagnosis and billing codes, e.g. verifying a procedure is covered, that the procedure was appropriate, that the billing codes were appropriate for the diagnosis, etc.
2) 2nd / 3rd line of defense: software which aims to find bad claims that the first line missed in a more targeted way. This business generates higher revenue per claim (in many cases more aggregate revenue than the first line provider), but by merit of being behind the first line, finds far less claims to correct / deny.
3) Postpay defense: review of claims in the 90 days where the claim has already been paid, led by human labor with some technology tools. There are a host of reviews including upcoding, fraud, adjustments for dual coverage, etc to catch the rest. Providers prefer to catch as much as possible before payment, however, for obvious cash flow reasons.
The vast majority of Change’s payment accuracy business comes from the first-line prepay software space. Change’s product ClaimsXten was called the “800lb gorilla in prepay” by most people we talked to in the industry. Change enjoys the winning end of a duopoly with Optum -- whom many payers refuse to use, given they would be handing claims data to a UnitedHealth subsidiary. Given the algorithmic complexities developed over 20+ years combined with the high-complexity coding system, it is nearly impossible for any entrant’s product to compete in a real way. Change also historically had a near 100% retention rate on customers -- customers are extremely averse to switching a software layer that can lose an insurer obscenely large dollars in event of any downtime or malfunction. These factors lend itself to a 50%+ EBITDA margin.
We believe this business has the potential to easily grow HSD (if not LDD) with its incumbent position as the first-line prepay software, as it captures more of the value caught by the aforementioned 2nd and 3rd types of defense. It also has the call option of massive synergy potential with the network business, as this functionality can be sold to run on the network as a differentiator for payors. (This was not possible previously as Network was legacy Change and ClaimsXten was legacy McKesson.)
Valuation comps: Two competitors have been acquired in the last couple of years:
-Publicly traded Cotiviti was acquired for 16x EBITDA by another private equity owned competitor in June 2018 (plays in secondary prepay and postpay)
-UnitedHealth (Optum) acquired Equian for 18x EBITDA in June 2019 (plays predominantly in postpay)
Clinical Decision Support (6% of Revs, 9% of EBITDA)
This is Change’s Interqual product, a set of clinical best-practices that payors force on their covered providers to ensure medical necessity of treatments. Think of Interqual as an incredibly complex decision tree for doctors which governs everything from length of stay, types of meds that can be prescribed, treatments that can be administered given a number of different variables (diagnosis, blood pressure, past meds, etc). This is critical to the payer’s business -- when wildly cost ineffective treatments are requested by doctors, this allows payors to point to a set of rules to say “we won’t reimburse that.” Interqual is sold as a software application to both payors (per member per month) and providers (per bed per year).
The space continues to be an equal duopoly between Interqual and MCG (owned by Hearst), with high margins and basically insurmountable barriers to entry. Both sets of guidelines were developed over decades by specialists spanning every field of medicine, from general care to specialities e.g. gastro, neuro, etc. It would cost an exorbitant amount of time and money for a new entrant or payer to redevelop this on their own. Meanwhile, Interqual and MCG pay minimal ongoing cost to keep their content updated for new studies / treatments each year, yielding a ~50% EBITDA margin business.
Core Interqual should drive mid-single digit growth over time due to healthcare industry volume and 3-6% rate increases upon each renewal cycle. There is further growth opportunity from a newly released automated preauthorization tool, which automates payor pre-authorizations on simple treatments and procedures cases. While the multiple for MCG by Hearst in 2012 was undisclosed, we believe this modest secular grower with extremely high quality business fundamentals and 50% margins merits a premium multiple.
The Good Assets (25% of revs | 27% of EBITDA | 26% of value)
RCM Technology (10% of revs, 9% of EBITDA): A host of software products for healthcare providers and their service providers to maximize reimbursement rates. The bulk of this business is a) automated eligibility detection / checks when the patient walks in the door (competes with Experian) and b) the workflow solution interface for providers to submit and track insurance claims, both of which are leaders in the market. Note these are sticky, pure software offerings which should command a distinct class of multiple far above labor-intensive RCM services businesses (e.g. R1 RCM).
Risk Adjustment and Quality (6% of revs, 7% of EBITDA): Acquired in the 2015 Altegra acquisition, Risk Adjustment and Quality consists mostly of analytics software + services to help Medicare Advantage and managed Medicaid programs prove the maximum level of patient population risk to the gov’t, to maximize reimbursement. This constitutes part automated analytics packages (to determine highest risk patients groups worth coding up) and part tech-enabled labor (to retrieve and code those patients’ charts for submission to the gov’t). Inovalon and Change dominate this market, with Optum’s solution in third then a long tail of smaller vendors who offer a slice of what Inovalon and Change do.
While we are somewhat skeptical of the labor-aspect of this business and some other fundamentals, this business has maintained healthy margins (~40% EBITDA ex-corp allocation) and has historically been valued highly in the market -- Change acquired Altegra at 15x+ EBITDA and its close comp Inovalon trades today at 17x+ 2020 EBITDA.
Consumer Engagement (3% of revs, 3% of EBITDA): Includes a hodge-podge of technology services centered on improving patient experience, including online scheduling software for doctors, patient reminders, automated customer service, transparent pricing software, and a variety of other solutions. See: https://www.changehealthcare.com/solutions/digital-patient-experience-manager
Chamberlin Edmonds (3% of revs, 3% of EBITDA): Acquired in 2012, hospitals hire Chamberlin Edmonds staff on-site who find & enroll patients who are dual eligible for (but not yet enrolled in) both medicare and medicaid. Our checks specifically called out this service as loved by hospitals, commanding ~35% EBITDA margins despite an inherently human-labor intensive process. A close comp Medassist was acquired by Firstsource in 2013 for 14x EBITDA.
Pharmacy Benefit Management (2% of revs, 2% of EBITDA): One of the leading pharmacy benefits management businesses, small but high margin and has grown organically HSD for many years.
eRX (3% of EBITDA): eRX is 1 of only 2 major eprescribing platforms, and was temporarily separated from CHNG for anticompetitive reasons until McK divests its holdings in CHNG. Eprescribe is the process whereby a clinical electronically submits a prescription for medication, and is today the dominant form of prescriptions (in some cases mandated by law). ErX is a fraction of the size of Surescripts, which is currently being sued by the FTC for anti-competitive practices (mostly against eRX). As of mid-January the case was moving forward, with the FTC seeking an injunction against Surescripts, which we presume would be potentially very positive for eRX.
The Remainder of the Business (40% of revs | 18% of EBITDA | 12% of value)
We believe investors are wrongly fixated on several smaller, lower value businesses that do not compose a meaningful portion of value in the business.
Imaging (11% of revs, 8% of EBITDA): The imaging software business is a mature, low to no growth software business with relatively low switching costs and margins. We value it as such.
RCM Services (17% of revs, 6% of EBITDA): This business provides revenue cycle management services to providers to help them maximize reimbursement. It’s a people intensive process with decent margins, but that we consider lower value. It’s been shrinking a little recently. The company claims it should grow a little bit. We are inclined to believe the company but don’t think this is a meaningful value driver.
Comms & Payor Services (9% of revs, 3% of EBITDA): Mostly entails sending paper or digital patient statements. Declining but a tiny part of EBITDA and an even tinier part of the overall value.
Connected Analytics (3% of revs, 1% of EBITDA): This is a hodge podge of declining legacy assets that the company is in the process of selling. It is small and well below average margins.
Ultimately, we expect people to value the business all on one multiple or on a SOTP basis using the 3 segments the company provides. That said, we have gone through the exercise of valuing the 13 different business groupings we identified to support our valuation assumptions.
Below we reconcile our the above business line breakouts with Change’s reported segments. We apply conservative EBITDA (corporate-burdened) multiples below of:
-15.0x for what we deem “great assets,” anchored by the high-teens transaction multiples of some debatably inferior-quality businesses, as detailed above
-12.5x for “good assets,” still at a discount to general healthcare-tech peers today
-9.0x for the small remainder of value
We arrive at a 13.3x blended multiple using the above methodology, which we apply below to a conservative base case scenario. In this scenario we could easily realize 70% upside at the end of the event path. With a multiple of 14.5x (nearer to healthcare tech peers today) on a slightly more bullish estimates, we could see the stock more than double to 124% upside from today’s levels.
A few other opportunities worth pointing out that we didn’t focus on in the write-up but can elaborate on in Q&A
1) Change’s business has largely come together through a series of acquisitions since BX and H&F assumed ownership in 2011. The businesses have historically operated in silos with little-to-no product or sales collaboration. However, Change has a huge data advantage by dominating claims and patient data in many business lines (Network, Payment Accuracy, Risk Adjustment, etc) that can create irreplicable product differentiation when leveraged across products. Management has messaged that they have begun developing these functionalities in the last couple years, once the CHNG / McK integration was complete. While our investment case does not rely on this whatsoever, success developing these products could drive wholeco mid-to-long term growth back into double digits
2) The CFO of CHNG was previously CFO of CSX, where he helped to implement pricing initiatives. Despite having exceptionally sticky, mission critical software with limited competition, CHNG historically has not raised prices upon renewal. The CFO feels strongly (and we believe) that could be a substantial pricing opportunity here over time.
3) The company is early in its adoption of robotic process automation software, which we believe has the potential to substantially reduce cost and increase margins over time. The company seems confident they can expand margins by another 200-300bp over time.
4) Several businesses have recently performed weakly, hampering top-line growth. We believe that RCM Services is in the process of being turned around and should begin to grow. With Imaging, we expect it to be flat at worst, and we expect the imminent divestiture of connected analytics. Although we place minimal value on all these businesses, we recognize that muted overall top-line growth has likely hurt valuation and expect this pressure to abate in the next several quarters.
5) As mentioned in the business description, eRX’s main competitor surescripts is being sued by the FTC for acting as a monopoly. As the #2 player in the market (and the victim of many of the anticompetitive practices of Surescripts), eRX could benefit, potentially substantially.
McKesson split-off, building track record of top and bottom-line growth as a public company, deleveraging over time, clearer investor communication post split-off
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