-          Commoditized Services:  HWAY has a rather weak business position as there is nothing truly proprietary about its business [e.g., algorithms, websites, alliance with ~15K gyms through their “Silver Sneakers” senior fitness program, etc.].  I believe that HWAY’s services have become heavily commoditized over the years as barriers to entry have fallen which is evident by their customer insourcing (they lost their largest customer – CI at 17% of revenue – in late 2011), increased competition from larger competitors (UNH/Optum, CI, AET) and smaller start-ups, and lack of pricing power as evidenced by their declining margins due to high-margin legacy contracts either leaving or renewing at lower rates.  They have guided to accelerating revenue growth but a further decline in margins, and have given little clarity as to why margins are deteriorating so greatly.

-          Little/No ROI:  If you speak with HWAY management it is very clear that they do not want you to know what they do, which is essentially contracting with small, regional health plans to identify the sickest patients – though biometric screening, health risk assessment questionnaires, etc. – and provide telephonic coaching and online web tools to manage their chronic conditions (i.e. diabetes, congestive heart failure, smoking cessation, etc.).  In addition, ~1/3 of the business is offering gym memberships to Medicare Advantage members through their Silver Sneakers program.  Despite HWAY’s assertion to the contrary, I believe that there is no ROI to their products which is supported by numerous channel checks with current and former customers and industry consultants.  Some health plans simply use their services as a marketing tool to employers, though my customer checks reveal pushback on pricing due to their inability to adequately prove an ROI.

-          Increased Competition:  Historically, HWAY dominated the disease management landscape before the tide turned against disease management’s ROI and demand dissipated.  HWAY has consistently reinvented itself – this time as a “population health management” company; however this time they have been met with more competition as large players (UNH/Optum, CI and AET) have added these ancillary services to their offerings as a means for working with Accountable Care Organizations (“ACOs” – i.e. coordinated hospitals and/or health systems).  HWAY has been slow to add customers here while their large competitors are continuing to build out their ACO infrastructure.  The bottom line is this is a low-barrier-to-entry, low-value-add business.

MANAGEMENT

This is without a doubt a management team that you want to bet against.  Capital deployment has been poor as HWAY bought back 2M shares in April 2008 for ~$36/share and bought back 1.2M shares in 3Q11 for ~$12.40/share just before losing the CI contract and watching the stock get cut in half.  On the M&A front, they made a large acquisition (Axia) in 2006 for $467 at ~3x revenue which created $385M of goodwill.  They built 255K sq ft of office space in early 2009 for ~$35M which is in the shape of a large “H”.  From a transparency perspective, HWAY gives very few financial metrics and provides only minor details on contract wins, losses and renewals.  The CEO, Ben Leedle, consistently uses what one former customer called, “consultant babble” and the former customer told me it is “crazy that he is still there.”  He also said that “HWAY acquired a lot of things but has no talent to put it together” and they “have destroyed a lot of good companies by acquiring them and sucking the life out of them.”  Mgmt also consistently overpromised and under delivered by setting aggressive LT goals (15-20% EBITDA margins), frequently reducing guidance, and losing large contracts which were previously considered highly unlikely.  I met with the CEO in 2010 when they were reaching 38M lives and their goal was to reach 150M lives (half of US population), but today they have grown their reach to a whopping 40M (i.e., +2M in three years)

BALANCE SHEET

HWAY has a very weak balance sheet as they are highly levered at 3.2x debt / EBITDA and had to raise their debt covenants twice over the past year to avoid breaching them.  Even after the large GW write down in 4Q11 of $183M ($5.35/share), GW + intangibles is still 59% of assets and 77% of their gross PP&E is computer equipment and software.  HWAY also holds very little cash ($2.3M as of 2Q13) and net debt / LTM EBITDA is expected to reach ~3.8x in 3Q13.  While the company has generated $19M of FCF in 1H13, most of that is seasonal as they had taken down working capital from lost contracts which resulted in a non-recurring $13M working capital inflow.

VALUATION

Revenue has been roughly flat from 2010 through 2013, with some dip from the loss of Cigna in late 2011.  HWAY likes to talk about revenue growth excluding contract losses, which doesn't make much sense to me. Nonetheless, my model conservatively assumes continued market growth (with no major contract losses) and natural margin expansion from G&A leverage. I think the picture could be quite a bit less rosy given the aforementioned insourcing/commoditization/pricing risks.

-          Historical Trading:  5-year average: NTM EV/EBITDA of 6x (low of 3x, high of 11x)

• 2.0% ROE and 2.5% ROIC

-          1-Year Price Target (Base Case / Downside):  $11 / $23

• Base:  7x EBITDA / Downside:  12x EBITDA