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Accretive Health (AH) has been in the news lately, its stock plummeting on the Minnesota Attorney General’s pursuit of an investigation that casts AH as an abusive debt collection agency standing as a gate keeper in hospital emergency rooms and seeking to deny care and leverage health needs into an advantageous payment collection process.  After topping out above $28 in February, the stock collapsed below $8 last month before recovering to yesterday’s close of $11.11. 

This has turned the attention away from a great growth story (over 50% year-over-year growth, 86% compounded growth in adjusted EBITDA over the last five years), and brought valuations down to under 1x revenues, with rapidly improving margins now at 10% on adj. EBITDA, a current PEG ratio of 1.0, a next year estimated P/E of 13x to 17x, and looking ahead to 2015, a reasonable case can be made for low single digit EV/EBIT forwards.  The current balance sheet is strong, with the market cap of $1.1 billion supported by over $200 million in cash.

Understandably, this stock has some hair on it, and still requires growth to justify its valuation.  That is a combination that would normally have very little interest to a value investor; however, it bears some scrutiny because if the growth characteristics remain intact, this is as cheap as growth gets.  In addition, some of the margin improvement is hidden because the nature of their business results in very little profit in the initial year of a contract.  As contracts mature, margins improve decisively.

Accretive is one of the most direct beneficiaries of the growth in Health Care IT (HCIT) spending.  In health care, technology and services designed to improve revenue capture and cost management at hospitals and large physician groups currently has only approximately 20% penetration.  As might be expected, the multiples in the HCIT space are fairly lofty.  AH’s multiple has corrected and what was once a premium valuation has fallen to a discount relative to its peers, understandably so given the headlines.  Ascertaining whether or not that is justified in the long run was the original intent of my research.

The Minnesota Attorney General is suing AH for violations of patient privacy and debt collection laws; claiming that patients were pressured for payment before they received care and that AH debt collectors didn’t properly disclose their role.  The investigation was originally pursued due to the theft of a laptop containing confidential patient data.  All of this led to the subsequent loss of the contract for that seven hospital system, which represented about 10% of 2013 earnings forecasts.  This broke AH’s otherwise perfect renewal rate (excluding customers lost due to change in control or reorganization). 

While holding patients at gunpoint before providing healthcare would be an interesting business model for a truly outrageous debt collector, and mirrors some general assumptions about the ethics of debt collectors and the financial strain that uninsured patients put on a hospital, it begins to crumble under closer scrutiny.  Modern hospital systems run at very narrow 2% operating margins.  Accretive Health seeks to significantly increase the percentage of revenues that is contractually owed to their healthcare partners from third-party payers.  AH can find a 400 to 600 basis point improvement in their operating margin before AH’s profit participation, which means tripling the hospitals’ operating margin. 

Here is the important part—95% or more of the revenue collected is received from insurance companies or government payers.  The remaining 5% comes from patients who are typically insured and have the ability to pay their co-pays.  Regarding uninsured patients, AH has helped over 250,000 uninsured patients find a paying solution that they didn’t realize they qualified for—whether it is Medicaid disability, Cobra, a motor-vehicle coverage, or workers compensation.  50% of the bad debt that hospitals experience is not coming from the uninsured patients, but rather from the confusion and errors in seeking payment from the insured patients. 

In addition, I found it incomprehensible that people in healthcare management would not be very aware that they cannot deny service to patients based on ability to pay.  In fact, in Accretive’s response to Senator Franken’s inquiry into the matter, they explain that in their employee training materials and employee scripts that they emphasize in red bolded, capitalized script that: “NOT ONLY ARE PATIENTS NEVER TO BE DENIED SERVICE FOR NON-PAYMENT, THEY ARE NEVER TO BE GIVEN THE IMPRESSION THAT SERVICE WOULD BE DENIED FOR NON-PAYMENT.”

The Minnesota hospital group Fairview was the client in the attorney general’s case.  Accretive institutes the policies of the client, and in their response to Franken, points out many misleading statements and descriptions in the attorney general’s report.  As AH and Fairview expanded their procedures into other departments, such as labor and delivery, as part of a department by department expansion, the AG characterized it as a predatory move to target moms admitted yesterday. 

Much of the billing work for hospitals is done via pre-registration confirmation of health insurance, procedures, etc.  While patients wait in an E.R. for non-emergency treatment, it is routine to collect similar registration information.  Many times, in the case of an outstanding payment, it is up to the patient to contact their insurer to clarify that a procedure had been done on a previous visit.  We have all dealt with the complexity and bureaucracy of health care reimbursement, and I don’t believe that it is all adversarial.  It’s often just a crazy sequence of miscommunications and passive aggressive avoidance of resolving these claims.  No need for anecdotal evidence, just ask anyone who is over forty and has health insurance.

Admittedly, there were some troublesome aspects, such as the payments processing center having information regarding the care codes.  Thus, someone calling about the billing would have information about what procedures were done—perfectly understandable at the initial levels, but in the case of dealing with extremely delinquent accounts, are hospitals giving debt collectors information on someone’s treatment for bipolar disorder or other information that is extremely sensitive to the patient?  Part of the spend in health care IT is to fix these legacy systems that lead to dicey situations like this.  Up until I read Franken’s questions, I thought that AH would be a beneficiary as it cleaned up these systems—but given their business model of taking over management of existing processes for a hospital, it appears that they can get caught in the middle.

Fairview Hospital group already had a settlement with the attorney general to fix some practices.  According to Accretive, the AG put pressure on Fairview to cancel the contract.  Given Fairview’s probationary status, it’s difficult to believe that they had a choice.  Accretive points their finger at Fairview for some of the issues raised by the AG.  The Fairview CEO has since resigned.  There seem to be a lot of dynamics at work.  The mayor of Chicago, Rahm Emanuel, has even weighed in, chastising the Minnesota AG.  Even the Illinois AG, who while stating that she is receptive to cooperating with the Minnesota AG, as they would in all matters, made clear to mention that they have received absolutely no complaints about Accretive. 

I have to admit, I liked AH’s business model when I first heard of it, when the stock was more than double its current price.  If they get through this period, I’d think that they be even more attractive, given that they will put procedures and practices in place to insulate themselves from these accusations and policies.  Two years can be a long time for a story like this to dissipate away, but the growth opportunity probably exists for at least the rest of the decade.  Is there a disconnect here?   

To simplify, AH’s business model is to invest upfront and consult and collaborate on the revenue cycle management for the hospital system.  With such thin operating margins, hospital systems don’t have the ability to invest a lot in technology or consulting systems.  AH collaborates with their customer and derives their payment from the improved operating margins. 

While revenue cycle management is their primary focus, they also have programs for quality and total cost of care.  However, revenue cycle management (RCM) represents the bulk of their anticipated one billion dollars of current annual revenue, and AH’s market share is just 2% penetration of the estimated $50 billion market.

AH has admitted that the Minnesota situation has resulted in requests by clients to reconfirm that AH is following the policies and procedures that are laid out by the clients.  These policies and procedures are HFMA (Healthcare Financial Management Association) best practices, and AH has been part of industry wide initiatives to establish standards and policies. 

AH’s target market is hospitals, and it provides a fully outsourced RCM solution.  They are unique in that they require no incremental up-front cost from the client, basically, no investment beyond the hospital’s current revenue cycle spend.  This is a consulting model particularly well-adapted for such a low margin business, as seen in these industry metrics:

• The revenue collection process in the US healthcare system is greater than $300 billion annually.
• Operating margins for not-for-profit hospitals has ranged between 1.7%-5.5% over the past  two decades, averaging 3.85% over the last ten years.
• 28% of community hospitals had negative operating margins in 2010 (source: American Hospital Association Trendwatch Chartbook 2012).
• To operate the revenue cycle for most hospitals today, there’s about a 4.3% cost to collect.
• 30% of CPT (current procedural terminology) codes entered by physicians for reimbursement are denied by the payor on the first pass (JP Morgan, HFMA).
• Accretive Health’s target customers are hospitals and hospital chains with greater than $250 million in annual patient revenue, and large physician groups that are often affiliated with hospitals.  They charge hospitals 4% and physicians 6%.  Typically, hospitals collect 87% of net patient revenues (physicians collect 90%), and Accretive can improve collection levels to 95%.

Accretive takes over the client’s complete revenue cycle operations for a base fee that is equivalent to the client’s current internal cost of doing the work in house.  In practice, this means that AH might add dozens of employees to manage and augment the roles of hundreds of in house employees.  AH then seeks to enhance efficiency through technology and operational improvements, improve collections including finding alternative payment sources for admitted patients who identify themselves as uninsured (at an 85% success rate), and improve the accuracy of claims filings and resolution of claims disputes.

AH typically enters into a four to five year contract, so that much of its revenue is recurring.  The base fees account for 85% of total revenue, but the relative contribution will decline as incentive payments grow.  The first year of a client contract is essentially breakeven due to overlapping costs during the transition period.  Adjusted EBITDA margin has grown from 2.8% in 2007, 6.5% in 2009, to 9.9% in 2011.  The company’s steady-state adjusted EBITDA margin will probably grow to the mid-to-upper teens. 

Improving adjusted-EBITDA margins—still room to grow:

Accretive Health (AH)   

2008                                       3.1%                                                     
2009                                       6.5%                                                     
2010                                      
2011                                       9.9%
2012e                                    9.1% (JPM)                         11.0% (Goldman Sachs)
2013e                                    12.2% (JPM)                       13.0% (GS)
2014e                                                                               15.0% (GS)
2015e                                                                               16.6% (GS)

Concentration risk:

Ascension health, which was Accretive’s founding customer in 2004, and in return owns 7% of the company, accounted for 89% of revenues in 2006, 60% of revenues in 2009, 41% in 2011, and 38% in 2012 (estimated).  Also for this year, Intermountain accounts for 16% and Henry Ford has 7%.  This is a chunky business, and as AH adds customers, this will improve. 

Another thing to keep in mind is that there is a natural tendency for hospitals with improving operating margins to take over or merge with less efficient hospitals, and then implement best practices and other operational improvements.  Beyond the growth in new customers, there can be significant organic growth as existing customers expand their footprint.

Now for a few numbers, but this is always a bit nutty with growth situations.  My skepticism on growth numbers includes all growth projections that are greater than GDP growth.  However, in health care IT, the dynamics seem clear for continued growth, in large part because of the operational efficiencies that have been gained by using shared solutions and automating many administrative tasks. 

There are two scenarios that jump to mind in valuing AH—the current steady state valuation, and a return to growth, where can this be in three or four years valuation.  Let’s consider the first.  Accretive will do approximately one billion dollars of revenues.  Adjusted EBITDA margins were 9.9% last year, so let’s say roughly $100 million EBITDA is the current run rate.  The market cap as I write this (vs. $11.48 stock price) is $1.140 billion.  Adjusting for over $200 million in net cash, the EV is closer to $900 million or roughly 9x EV/EBITDA on anticipated current revenues.

But that isn’t quite steady state, since EBITDA margins on contracts will grow above 15% as the contract matures.  At 15% margins, this same back-of-the-envelope calculation falls to a 6x multiple.  At 18% margins, this falls to a 5x multiple.  Given the length of the contracts involved, and the stickiness of their major customer, this begins to be a compelling multiple.

There are enough sell side reports that you can slice out the various valuation metrics and return scenarios and DCF models, but I’m not interested in projections, I’m just trying to understand what the current price represents.

However, I will cheat with some sell side calculations for looking three or four years ahead.  Some of these reports have the company growing revenues at 20%, then 18%, then 15% over the next several years.   If these assumptions are in the ballpark, and I can make the case for much higher and much lower numbers (although for the lower numbers, I assume a delay as the Minnesota situation resolves itself, and then some decent subsequent growth), then revenues will hit $2 billion in about four years.  At 15% EBITDA margins, that translates to $300 million versus a current $900ish million EV.  It’s worth looking into and forming your own opinion.

I will close with the usual disclaimer, but I’ll add that since this company is based in my hometown, my initial curiosity about the company was due to conversations about how they evolved from and became a success and the high quality of some of the people who worked there.  I think we all tend to listen when we hear something about a new business model which includes a positive reference about the people who work there.  Then, of course, we look at the numbers.  But I did want to further disclaim that I initiated this analysis with a positive bias given that association.

DISCLAIMER:

This is not meant to be a buy or sell recommendation, and my firm frequently has both long and short positions in many of the securities mentioned. 

Catalyst