Description

OVERVIEW: MDF offers investors the opportunity to buy a good (high ROIC/FCF) and well managed business at about 60% of intrinsic value, a free “call option” on future growth from a new value enhancing business and a near-term catalyst to unlock shareholder value in the near future. Valuing the company’s high ROIC/FCF core PSN business at only 10x FCF and adding the $0.48 in cash and an NOL of $0.12, yields a price of about $3.82 per share. Adding to this a conservative estimate of the value of the company’s asset base of current HMO members, raises the intrinsic value of MDF by about $0.30 to about $4.12 per share. Thus, even considering today’s rise, the current share price of $2.50 represents only about 60% of my estimate of intrinsic value and as such, helps provide a meaningful margin of safety and downside protection for investors. In addition, as it accords little value to the company’s future efforts in launching a more valuable HMO business, investors are getting this future growth opportunity for free. Assuming some reasonable enrollee targets over the next 12 months and using the comparable values accorded this base of HMO members (in both the public markets and in private market transactions), leads to a price target of about $4.70, or upside of over 80% from current levels. With the company beginning to show some favorable traction in its HMO business and a number of growth/profitability catalysts on the horizon, we believe that the value of this asset will be unlocked and investor sentiment on the shares will turn favorable in the near future.

Metropolitan Health Networks (MDF) is a name that has appeared on the VIC new idea board on two prior occasions; once by me (3/11/05) and once by valuearb (5/11/04). Thus, there is enough background information available for anyone new to the story and I will not go into detail at this time. As such, my comments will be more analytical in nature. However, I would say that how I would position the company now, is that after success in phase one of the company’s financial and business re-engineering strategy under the company’s current CEO and management team, they are beginning to show progress on phase two (building a HMO business), which should provide a catalyst for the share price by highlighting unrecognized shareholder value.

SATISFYING RULE #1 OF VALUE INVESTING; THE CORE BUSINESS OFFERS A VERY HEALTHY MARGIN OF SAFETY: In phase one of its restructuring, the company’s then new CEO, Michael Earley, unwound the company from a number of problematic prior acquisitions and refocused itself on its provider service network (PSN business), labeled Metcare, to ride the favorable trends created by the Medicare Modernization Act of 2004 (see prior write-up for more detail on this point). This focus has been successful in creating a very stable and healthy business and the foundation to self fund the launch of its second business initiative. I estimate the PSN business has a +20%ish ROIC with very healthy FCF dynamics that throws off a considerable amount of excess cash. After losing focus on this business in the second half of 2005 as it was launching its HMO business, over the last 12 months the company has returned profitability and cash flow levels back up to a more normalized levels. This was evident in the company’s Q3 results reported earlier today, which has highlighted by a notable improvement in PSN profitability and excellent free cash flow. As a result, even considering the company’s efforts over the last 18 months to self fund its HMO business, the amount of excess cash on MDF’s debt free balance sheet has steadily risen to about $25.1M ($0.48 per share). Based on the Q3 results, the PSN business currently provides annualized pretax profits of $27M and almost $25.8M of EBITDA. Thus, at current prices this business is only being valued at 4.1X on an EV/ EBITDA basis. Moreover, if you value the PSN business at a reasonable 10X its FCF and add in the $0.48 per share in excess cash and the $0.12 NOL, you come up with a value of over $3.82 per share; a significant premium to the current price. Thus, in a worst case scenario, if MDF’s new HMO business initiative fails, management could just shut it down (as most incremental costs tied to it are outsourced and there are little if any tangible assets) and they would have a core business that in my judgment is worth about 50% more than the existing stock price. The importance of this for value investors, consistent with rule #1, is that the combination of the healthy FCF dynamics of the PSN business and the excess cash provides a solid margin of safety and downside protection for investors.

NOT PAYING FOR THE INCREMENTAL GROWTH OPPORTUNITY: While the PSN operations are clearly a good business from a returns and cash flow perspective, it is realistically only a zero to low single digits growth business. With its core business now back on solid footing, management is in the midst of the second phase of its business re-engineering: launching its own HMO business, labeled Advantage Care, in some of the surrounding counties in Florida. This initiative appears to be well targeted at increasing shareholder value from the perspective of not just enhancing growth prospects, but creating a more valuable business franchise. The key here is that unlike the PSN business, where MDF is providing a service for other companies’ customers, the HMO business gives MDF ownership of a very valuable asset base of Medicare customers. Part of the attractiveness of this customer ownership is tied to the fact that MDF will be in control of its own destiny as it removes the unlikely risk that one day Humana may opt not to renew its contract with them. However, for investors the real attractiveness of the move to create its own HMO is tied to the premium valuation that this business is accorded for both publicly traded HMO’s as well as in the private market via acquisitions in this space. I was informed by industry sources that small Medicare focused HMO’s are valued at about $4,000-$5,000 per member, while those with scale advantages are valued at about $5,000-$7,000 per member. This seems to be consistent with a number of data points available. In the public market, regional Medicare focused HMO HealthSpring, is valued at about $5,600 per member. Looking at transactions in the private market, on one end of the scale in December 2004 Humana purchased Care Plus, a Medicare Advantage HMO plan in the Miami-Dade, Broward and Palm Beach counties of Florida for a value of about $8,160 per member. On the other end of the scale, in a deal that was recently abandoned, HealthSpring offered to acquire America’s Health Choice, a Medicare Advantage HMO, operating in seven counties in Florida for a price of about $3,850 per member. The low price being offered for America’s Health Choice represents a number of factors including: its size, the fact that it has been subject to regulatory sanctions by the government administrator; CMS, and what I understand are concerns the buyer has relative to the true size of the revenue base. I believe a conservative valuation for MDF’s HMO business for our discussion (although the value in an acquisition transaction should be meaningfully higher) is in the $4,000-$6,000 per member range. Thus, this asset of rising HMO membership for MDF has growing value to investors. Importantly, in my opinion this asset is not discounted in the share price primarily due to the fact that the HMO business is in investment mode and has not reached scale and is currently unprofitable. Thus, investors are getting a free “call option” and not paying anything for the potential growth and increased valuation associated with the company’s initiative to launch its HMO business.

WITH PROGRESS BEING MADE, THERE IS A NEAR TERM CATALYST ON THE HORIZON TO UNLOCK THE VALUE IN THE COMPANY’S HMO BUSINESS: To date MDF’s progress in building enrollment in its HMO plan has for the most part been good. After a little more than a year of trying to build enrollment, they have signed up about 3,500 members. After beginning in 6 counties in the Treasure Coast & Gulf Coast regions of Florida, the company recently expanded its HMO plan to 5 additional counties in Central Florida. A major opportunity for MDF is the fact that they are targeting the rural counties of Florida where competition is relatively light and Medicare penetration levels are low. Noteworthy, compared with the 22% penetration of Medicare in the state of Florida on average, the penetration levels in the counties that MDF are targeting average only 8%. By comparison, the penetration level in some counties like Miami Dade approximates 40%. Thus, there is an excellent opportunity for MDF to increase its penetration in its selected counties without requiring a significant increase in overall Medicare penetration levels to anywhere the level found in other counties. The company has invested about $12M in marketing and start-up related expenses in launching its HMO business. This has negatively impacted its P&L and profitability and clouded the shares from an investment perspective. The good news is that there is tangible evidence that these efforts are now beginning to bear fruit and, as the company hits some major mileposts, this should begin to be recognized by investors. For example, in the last window of open enrollment, the company’s win rate of all new Medicare enrollees relative to the 4-7 competitors in each county was about 35%. This shows their marketing message is working. Noteworthy, after learning from its initial efforts and making some adjustments in its marketing efforts, the company has notably lowered its cost of acquiring new HMO customers to a level of about $1,300 per additional enrollee. Given that this cost of acquisition of these incremental HMO enrollees is one-half to one-third of their value in private market transactions, this appears to be a very favorable economic equation for shareholders. Perhaps more importantly, the growth in membership in the Treasure Coast region has resulted in that region turning profitable. I believe this shows that MDF has the right formula for running a profitable HMO and that if the company can grow membership in the other counties, they should achieve overall profitability in their HMO business. Entering the new enrollment window beginning today, November 15^th (thru March 31^st), the company has a goal of about doubling its HMO membership by the end of March 2007. This is about consistent with the breakeven level for profitability in the HMO business of about 6,000-7,000 members. Importantly, I believe the losses in the company’s HMO business, which has represented the big cloud overhanging the shares, have peaked and will consistently be reduced over the next few quarters. Thus, should the company achieve its HMO membership targets, profitability will be achieved and serve as a significant near-term catalyst to unlock the value in the company’s HMO business in either the pubic market or as a potential acquisition candidate.

The following are my calculations for the potential upside in the share price in the next 12-18 months using what I believe are a very conservative set of assumptions:

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. I 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.

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