Metropolitan Health Networks MDF
March 11, 2005 - 3:06pm EST by
2005 2006
Price: 2.55 EPS
Shares Out. (in M): 0 P/E
Market Cap (in $M): 128 P/FCF
Net Debt (in $M): 0 EBIT 0 0

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The recent 20-25% price decline (on no news) creates a buying opportunity for this well managed company with a healthy competitive niche and a +20% ROIC business model with strong cash flow, currently valued at a FCF/EV yield of about 12% and selling at a significant discount to private market value as well as below comparable companies on a GAAP EPS basis. I believe there is a 40-60% appreciation potential in the shares from current levels to the $3.50-$4.00 level.

Metropolitan Health Networks (MDF) was posted on VIC on 5/11/04 by valuearb856 at a price of $0.96. First of all let me complement valuearb856 on what has turned out to be an excellent call on the shares of MDF and that anyone who followed the advice to purchase the shares have clearly been well rewarded. I will not spend a lot of time describing the company’s business in that the original posting included a good description of the company’s and outlined what has been a very impressive financial turnaround engineered by a relatively new management team. What I will add here (and expand upon below) is that since the original posting we have gotten better visibility into a number of key issues, including: the opportunity to see a couple of quarters of improved financial results and tangible evidence of what the new business model looks like, further insights into both the company’s growth plans and the underlying improvements in the industry from the changes in the Medicare Modernization Act of 2004, a strengthening of its relationship with its HMO partner, Humana, and re-listing its shares on the American Stock Exchange. However, where I respectfully differ with the author (and that what makes a market) regards the valuation of the shares. The recent VIC posting on 3/2/05 states that the shares are “no longer cheap” and calls investors to exit the shares at this time. Conversely, I believe that the recent 20-25% decline in the share price (on no real fundamental news that I am aware of) has brought the shares back to a level that makes them attractive for value investors who like well positioned/run companies with excellent ROIC and cash flow dynamics. The reasons why I differ with those who believe the shares are no longer attractive and the logic that supports my position is outlined below.

-- Since the original posting on MDF on VIC on 3/2/05 we have seen tangible evidence that the business transformation and financial turnaround at the company was not short term in nature and is in fact sustainable. From a financial perspective, revenues have shown a modest acceleration (aided by a minor acquisition), operating margins have increased from the 4-5% range to the 9-10% range, quarterly EPS has risen (aided somewhat by favorable seasonality) from the $0.03-$0.04 range to the $0.07-$0.08 range. Maybe most importantly, FCF has turned positive and has been tracking in the $3-4 million range per quarter, which has resulted in cash reserves increasing from about $1.4 million to what I estimate will be about $10 million in the soon to be reported December 2004 year end financial results (scheduled to be released on 3/22/05). In addition, management has renegotiated a favorable new contract with Humana and strengthened its management team and Board of Directors. THUS, THE CONCLUSION I COME TO IS THAT IT IS UNDISPUTABLE IN MY OPINION THAT RELATIVE TO THE ORIGINAL POSTING ON 5/11/04 MDF IS A MUCH STRONGER COMPANY WITH A MORE TANGABLE BUSINESS MODEL AND FAVORABLE INVESTMENT DYNAMICS THAT SHOULD BE ACCORDED A HIGHER VALUATION THAT LAST YEAR DURING ITS TURNAROUND PHASE!

-- Those investors who no longer believe the shares are attractive seem to anchor on fully taxed GAAP EPS as a reason to support their belief. I happen to believe GAAP EPS are not the best way to value a company, but for the time being I will go along with using this metrics. As best I could find, the closest comp to MDF is Continucare Corp (CNU), which also has NOLC’s and currently does not pay taxes. Thus on a relative valuation basis, the TTM P/E for CNU is about 16.2x vs. 11.5x for MDF. Even on a fully taxed GAAP basis, MDF’s P/E fully taxed EPS of $0.20 is currently only about 13x (below the non taxed P/E of CNU). In addition, if you compare MDF with a number of comparable Medicaid service providers like Amerigroup (AGP), Centene (CNC), Molina (MOH) and Wellcare Health (WCG), they all are valued on a TTM GAAP EPS P/E in the 20-30x range and on average about 22x 2005 estimates. Note, valuing the company at a more consistent 17-20x P/E with its peers on fully taxed GAAP EPS of $0.20, leads to a share price of $3.50-$4.00. THUS, THE CONCLUSION I COME TO IS THAT ON A GAAP EPS BASIS THE SHARES OF MDF ARE IN FACT CHEAP ON A RELATIVE BASIS!

-- Historically, I have found that valuing a stock on its FCF potential compared with its EV tends to be more meaningful than using a P/E on GAAP EPS in evaluating potential attractiveness of an investment idea. Indeed, the company’s strong FCF dynamics under the direction on the new management team is what has attracted me to the shares. On that basis my work shows that, assuming very little growth, the company should generate about $14M in FCF in 2006. Given the current EV of about $119M translates into a FCF/EV yield of about 12%. In the current environment, I am hard pressed to find companies like MDF, which have a good sustainable business model, a ROIC in excess of 20%, are well run by a management team that has demonstrated by their prior actions that they are doing the right things to enhance shareholder value and which is selling for a FCF/EV yield in the low teens. If other VIC members know of other candidates, please share them with all of us! However, one could argue that when the company’s NOLC’s run out (sometime in 2006, by my estimate), their FCF would be lower and would be correct. However, you need to consider that the FCF generated in the interim period would also lower the company’s EV assuming that management does not blow it on a dumb acquisition (not likely the case with MDF). So redoing the math to factor in a full 40% tax rate, my quick calculations show that in 2006 the FCF/EV yield (assuming some modest revenue growth, consistent profitability and the increased cash on the balance sheet) would approximate a 9.5% level. Note, I have found that most companies with a solid business model and who have a consistent ROIC in excess of 20% tend to trade at higher levels on a FCF basis. THUS, THE CONCLUSION I COME TO IS THAT FOR VALUE INVESTORS WHO FIND COMPANIES WITH GOOD CASH FLOW DYNAMICS AND A HIGH ROIC APPEALING, ESPECIALLY RELATIVE TO A FIRM’S ENTERPRISE VALUE, THE SHARES ARE ATTRACTIVE!

-- A recent acquisition of a somewhat similar (but not even a pure play like MDF) company in this space suggests that the stock is selling significantly below its private market value. In doing some research on the company, I noticed that in December 2004, Humana (the HMO that MDF has partnered with) acquired Care Plus Health Plans of Florida for $408M. Care Plus provides Medicare Advantage HMO plans and benefits to nearly 50,000 Medicare eligible members in Miami-Dade, Broward and Palm Beach. Thus, this is a business very similar to MDF, but in different areas of Florida. Importantly, this acquisition values each Medicare enrollee at about $8,160. If you apply the same value to MDF’s approximately 25,900 members, this works out to about $211M, or $4.20 per share. This represents about an 85% premium to the current stock price! Just to take this logic one step further, also back in December I noticed that MDF appointed Doug Carlisle, who is the SVP of Senior Products at non other than Humana to their Board of Directors. Of note, in listening to some of Humana’s recent investor presentations they have articulated their goal of increasing their Medicare membership in major markets. In that I am not an investment banker looking to broker a transition, I’ll stop short of trying to suggest something here. HOWEVER, THE CONCLUSION I COME TO HERE IS THAT THE RELATIONSHIP BETWEEN MDF AND HUMANA IS STRONG AND, MOREOVER, THE SHARES ARE SELLING WELL BELOW PRIVATE MARKET VALUE!

-- The last point I would make has to do with the possibility of acceleration in future growth, which importantly, is NOT factored into any of my forecasts nor the stock price. The move to set up its own HMO is clearly on opportunity, and one that seems to make sense. It is a little too early to analyze its profit potential as all the details are not yet available. Yes, there may be some initial costs, but one way of looking at them is that MDF’s management is using its NOLC tax benefit savings to fund a potentially new growth area for the company. However, a more interesting potential growth driver for MDF could be an increase in Medicare enrollment. Noteworthy, as a result of the recent changes from the MMA, the multi-year continuous decline in Medicare enrollments in MDF’s territories has stopped and there are some early signs that they could begin to show positive growth in the future. What I found interesting in reviewing some of the publicly available government data on quarterly changes in Medicare enrollment data for MDF’s three major counties in South Florida was a significant change over the last few quarters in the number of Medicare enrollees. Most importantly, after many years of steady and significant declines, the data now shows enrollments have stopped declining and in fact have even now turned positive. For example, the trend for the change in Medicare enrollment for MDF’s three major counties over the last 8 quarters is: -2,015, -1,509, -1,048, -818, -1,113, -282, +171, and +158. Another significant point of interest in this regard are the very bullish forecast that MDF’s HMO partner Humana made saying they believe Medicare enrollment growth will approximate 10-15% in 2005. In order to help make this happen, Humana has put in place a very aggressive advertising campaign to get the word out and grow membership. If Humana is successful with these efforts, MDF would clearly be a major beneficiary. Despite this push by Humana, prudence tells me that one should not believe that enrollments should all of a sudden turn around overnight and begin a period of double digit growth. In fact, I think the 10-15% growth in Medicare enrollments projected by Humana is somewhat aggressive and have for conservative reasons, have not factored this into my forecasts. HOWEVER, THE CONCLUSION I COME TO IS THAT AFTER A MULTI-YEAR PERIOD OF HAVING THE WIND IN ITS FACE RELATIVE TO MEDICARE ENROLLMENTS, MDF IS LIKELY TO NOW HAVE THE WIND AT ITS BACK, WHICH IS LIKELY TO TRANSLATE INTO SOME GROWTH, WHICH TENDS TO ATTRACT A WHOLE NEW GROUP OF GROWTH/GARP INVESTORS!


-- Continued solid quarterly results in both earnings and FCF, beginning with Q4 FY2004, scheduled to be released on March 22nd.

-- Signs of an acceleration in Medicare enrollments in MDF’s major counties.

-- A possible acquisition of the company.
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