OVERVIEW: With the passing of about a year since my last write-up on MDF and after some disappointing results followed by significant operational & management changes, which give me confidence that my original thesis on the shares remains intact, I thought it was timely to provide a comprehensive update and reiterate my favorable opinion on the stock. I continue to believe that the shares offer investors an opportunity to buy a good business (defined by a high ROIC and FCF dynamics) with improved management at only about two-thirds or less its of intrinsic value with a free call option on future growth from a new value enhancing business, some near-term catalysts to unlock shareholder value and a reasonably healthy margin of safety. The current opportunity in the shares is due to the current losses/difficulties that the company has experienced in opening up a new related and potentially more valuable business. The current poor economics associated with this start-up effort is depressing overall corporate results and clouding the very favorable economics of its core business. Thus, for those investors who are willing to invest the time to dissect the company's operations and look at some of the valuable assets on its balance sheet they will find a company whose sum of the parts is worth significantly more than the current stock price. Given the favorable cash flow dynamics associated with the company's PSN business, its healthy cash rich/no debt balance sheet, the private market value of some of its assets, I believe that MDF would be an excellent candidate for either a private equity firm or other entity to acquire the company.
For those unfamiliar with MDF, the company is a health care provider operating in a number of counties in South Florida with two operating divisions: 1) a slow growth high FCF provider service network (PSN division) that is contracted to provide medical services for Humana Medicare Advantage members, and 2) a growing self-funded "green fields" HMO business (unprofitable currently) that is operating in a number of the surrounding South Florida counties. If you are interested in a more detailed understanding, you can refer back to prior VIC postings on 11/15/06, 3/11/05 and 4/11/04 as well as some detailed Q&A updates.
The following are some of the key statistics for the company: Share price: $2.43 52 Week Range: $3.40 - $1.62 Shares Outstanding: 52.0M Average Monthly Volume: 259,300 Market Capitalization: $126M Enterprise Value: $97M Cash/Per Share: $29.3M / $0.56 Debt: $0 TTM Sales: $254.6M TTM EPS: $0.03 TTM FCF: $6.9M
THE SUM OF THE PIECES MATH SUGGESTS A SIGNIFICANTLY HIGHER VALUATION IS WARRENTED: The simple math to support my belief that the shares are significantly undervalued is as follows. By one measure, valuing the company's +20% ROIC high FCF core provider service network (PSN) at only a modest 10x LTM FCF and adding the $0.56 in cash and an NOL of $0.12, yields a price of about $3.60 per share. Using recent M&A transactions which point to a private market value for the PSN of 8-9x EBITDA, translates into a valuation of about $3.86-$4.26 per share. Thus, this points to the fact that MDF's PSN business alone, coupled with the associated cash and NOL on the company's books, provides upside potential in the shares of about 50%-70% as well as providing a meaningful margin of safety and downside protection for investors.
However, importantly, this valuation accords no value (although one could argue negative valuation) to the company's efforts to launch a more valuable HMO business. Thus, investors are getting this future growth opportunity for free (a free call option). As I stated in previous postings, HMO enrollees are more highly valued in both the public and private markets due to the ownership of the customer and are valued at about $4,000-$5,000 per member, while those business with scale valued closer to $5,000-$7,000 per member (see 11/15/06 posting for more detail on this). Thus for argument sake, assuming for a moment that MDF decides to just close this business and sell off its membership (not my expectations) and using the June quarter numbers (I expect some modest growth in the September quarter and more healthy growth the following two quarters) and the lower $4,000-$5,000 valuation/member, this would add an additional $0.40-$0.50 to the prior analysis.
A summary of the math is a follows:
Metropolitan Health Networks
Sum Of The Parts Analysis
PSN Business using TTM FCF:
TTM FCF: $24.48M pre tax / $15.18M net
Value @ 10x FCF multiple: $151.8M
Shares Outstanding: 52.0M
Value Per Share: $2.92
PSN Business using private market values:
TTM EDITDA: $20.7M
Shares Outstanding: 52.0M
Value Assuming 8x Multiple: $3.18
Value Assuming 9x Multiple: $3.58
HMO Business:
Private Market Value Per Enrollee: $4,500
Current Number Of Enrollees: 5,100
Estimated Value Of Current Enrollees: $22.95M
Shares Outstanding: 52.0M
Value Per Share: $0.44
Net Cash Value:
Net Cash: $29.3M
Shares Outstanding: 52.0M
Value Per Share: $0.56
NOL Value:
NOL: $6.1M
Value Per Share: $0.12
In conclusion, using the most conservative sum of the parts analysis for the PSN business and ascribing NO value to the HMO business leads to a $3.60 value (+50% upside) for the company. On the other hand, a more generous valuation (using a private market value for the PSN & HMO businesses) translates into a value in excess of $4.50 (+80% upside). I will let you pick what metrics is most appropriate. However, by any measure there is significant upside in the share price.
USING VERY CONSERVATIVE ASSUMPTIONS, THE SHARES OFFER A HEALTHY MARGIN OF SAFETY: A prerequisite that any good value investor wants, and the shares of MDF offer, is a reasonable margin of safety. The margin of safety is found in MDF's +20% ROIC healthy FCF PSN business, coupled with the cash and NOL assets on its balance sheet. Assuming for a moment that the HMO effort is a failure and MDF needs to exit the business. Given that the company has been self funding this operation and it have very little fixed assets, it could close it down relatively easy and with little costs. They could then sell off the members to one of the many competitors trying to increase the ranks of enrollees in their own plan. This would help MDF grow their cash position by some amount (as discussed previously) and, removing a business that is losing money, leave MDF with a more profitable overall business. However, if I don't consider any gain from selling off its HMO members, I submit the shares of MDF still have a healthy margin of safety. Noteworthy, this is even true during a seasonal weak period in the basic business. In order to be conservative, I looked back at MDF's PSN business over the last few years to find the TTM period when these operations recorded the weakest operating results (i.e. bad cough & flu season and/or poor operations). I then assumed a FCF multiple of only 8x this stream of earnings and added back only the cash; ascribing no value to the NOL. Given all of these conservative factors (a FCF multiple on the PSN business of only 8x's and no value to the HMO members or the NOL), I get a value of $2.10 per share. While I would never use the words worse case, I think you would agree that my assumptions are very conservative. While I would not say that the stock would not trade under this level for a short period due to supply demand imbalances (which it has), I would submit that this is a reasonable downside. As $2.10 per share only represents about 14% downside, I would submit that at current levels there is a reasonable healthy margin of safety in the shares.
Metropolitan Health Networks
Margin of Safety Analysis
PSN Business using TTM FCF:
Trough TTM FCF: $16.1M pre tax / $9.99M net
Value @ 8x FCF multiple: $79.9M
Shares Outstanding: 52.0M
Value Per Share: $1.54
Net Cash Value:
Net Cash: $29.3M
Shares Outstanding: 52.0M
Value Per Share: $0.56
TOTAL VALUE PER SHARE: $2.10
Note: Assumes no value for HMO members or NOL.
KEY POINTS & CATALYSTS: The following are some update comments that underlie my confidence in the story at this time and/or should provide a near-term future catalyst:
-- NEW MANAGEMENT DRIVES MEANINGFUL OPERATIONAL IMPROVEMENTS: In the last few quarters there have been a couple of changes to senior management that in my opinion has improved the company's operating capabilities. Notable in this regard are the additions of: Bob Sabo, who joined the company at the end of 2006 as the new CFO, the appointment of Joe Guethon to run the PSN business and the addition of Dan McCarthy to oversea the problem plagued HMO operations. In my opinion the addition of each individual has helped upgrade the management and operational capabilities of the organization and brought meaningful change to how the company is managed. Management has used the disappointment experienced in the December quarter as a catalyst for change by reviewing all areas of operations with an eye towards improving costs. A number of actions are already in place focused on reducing overall costs in both the PSN and HMO operations, more efficiently growing membership and improving the company's all important medical expense ratio (MER) in each division. Some of the changes are focused on such things as proper coding, improved risk scoring and putting in place procedures to discourage "needless" referrals. As a portion of these change rolled in we saw some improvement in the March and June quarters, with further progress likely in the September period. Any improvement in profitability in the PSN operations and a reduction in the loss and breakeven point in the HMO business would likely be a catalyst to the share price.
-- COMPETITIVE CHANGES OPEN UP NEW GROWTH OPPORTUNITIES: In the last few quarters there have been some changes in the competitive environment that in my opinion should open up some new doors for growth in membership and improvement in profitability. Two things are most notable in this regard. Recently one of the company's HMO competitors, America's Health Choice, was dissolved and its members assigned to another plan. While MDF was not the assigned plan, all other HMO plans have a time where they could compete for these members. My understanding is that MDF has been successful in its efforts in winning over a small portion for its plan. This coming at a time when the open enrollment window was closed has helped it grow its membership modestly during a traditional slow enrollment period (and during a time it has been focused on reducing its HMO cost structure), will be viewed as good news when the September results are released and should translate into a further reduction in the losses from this division. Any improvement in the financial operations of the HMO division should be another catalyst for the stock. Second, another of the company's competitors is in major trouble. Back in the early part of the year the state of Florida moved to close down on of MDF's largest HMO competitive plans. This plan (labeled Any, Any Any) from Universal Health Care has about 70,000 members and its growth was one of the reasons that MDF missed its enrollment goals in the last October-March open enrollment window. While Universal is attempting to fight the state in court, it is losing doctors and members and most importantly, is restricted from signing up new members in the current open enrollment window that began October 1st. If the state is successful in closing this plan down this would create a potential jump ball opportunity for its competitors, including MDF, to win over these members.
-- SUCCESS IN GROWING HMO MEMBERSHIP DURING THE CURRECT OPEN ENROLLMENT WINDOW COULD BE A MAJOR CATALYST FOR THE SHARES: As stated previously, the new open enrollment window for signing up new HMO enrollees began October 1st, and lasts through March. Success in increasing the number of HMO members over the next two quarters could be a major catalyst to move the share price higher. My expectation is that the company will be successful in driving the number of HMO customers from the 5,100 level at the end of the June quarter at least to the 6,000-7,000 level that management had hoped for during the last open enrollment window last year. With managements focus during this time on reducing the cost structure and the breakeven point for this business, I believe that it is highly possible that the company will exit this open enrollment window at or very close to profitability. Achieving profitability in the HOM business would likely be a major catalyst to the shares. Why should I have optimism that management will reach this milestone when it was unsuccessful last year? A combination of factors that are different from a year earlier leads me to this belief, including: new management, a more seasoned marketing approach (i.e. they have learned from last years mistakes and what worked well), a focus on cost cutting and the inability of the company's most aggressive competitor last year to sign up new members while another competitor was dissolved by the state authorities.
-- RECENT M&A ACTIVITY SUPPORTS MY VALUATION ASSUMPTIONS: Recently there have been a couple of acquisitions that reinforce the private market assumptions that I have outlined above. In August, in somewhat of an eye opening announcement in the industry, publicly held Healthspring acquired Miami based Leon Medical Centers, an HMO with about 25,700 members in a cash and stock transaction that values each enrollee at more that $15,000. While there is a premium accorded HMO organizations with scale, this price is well above the range that most industry observers had expected for these types of acquisitions. Clearly, this supports the $4,000-$5,000 per member estimate I have used in my previous sum of the parts valuation analysis and may in fact show that there is significant upside to my estimate if MDF is successful in growing this business to larger scale. Second, recently publicly traded Continucare Corp. announced the acquisition of Miami Dade Health Centers, a health care service provider similar to MDF's PSN division, but smaller in scale. Notable is that management said the acquisition price was at about a 9x EBITDA multiple. This supports my 8-9x EBITDA multiple assumption for MDF's PSN division in my preceding sum of the parts analysis, and may be conservative given MDF's greater scale.
Disclosure: The comments on this stock, and any other I discuss with VIC members on this site, represent my own opinion on the stock which are based on my own analysis and independent research from multiple sources that I believe are reliable. In keeping with the spirit of the club, I suggest others should do their own research before making any investment decisions and welcome any feedback or opinions from other VIC members. Consistent with my investment opinion, my firm has had and may continue to have a long position in the shares of MDF.
Catalyst
1)An increase in HMO enrollment in the seasonally slow September quarter from market share gains associated with the closing of a major competitor.
2)Success in driving a meaningful increase in HMO enrollment during the current open enrollment window over next two quarters.
3)Cost reduction and operational improvements resulting in a lower medical expense ratio (MER) in both divisions.
4)Reducing the losses from the HMO division over the next two quarters and moving this business closer to profitability.
5)The State of Florida completing its efforts to shut down competitor Universal Health Care, and the possibility that its 70,000 HMO members could be up for grabs.
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