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Allscripts Healthcare Solutions (MDRX)
Current Price: $12.50
Allscripts is a healthcare IT (HCIT) company with significant potential upside resulting from a successful turnaround that began in 2012 but has yet to be appreciated by the market. The Company develops electronic health record (EHR) software that hospitals and physician groups use to run their businesses and keep track of patient records (2/3 of revenue), and also provides ancillary services to its software clients (1/3 of revenue). This is a high quality business with mission-critical products, a diverse / sticky customer base and high switching costs that generates ~80% of its revenue on a recurring basis under long-term contracts with inflation escalators.
With a double-digit, and growing, forward free cash flow yield, the market is significantly undervaluing a predictable, economically insensitive business that is finally starting to return to growth following a five year period of flat revenue. Based on near-term revenue inflection and FCF generation, MDRX should re-rate to at least 15x forward FCF / share or $20 per share over the next 12-18 months, with potential incremental upside from capital deployment. This would equate to ~60% appreciation in the share price. MDRX’s closest public comp, Cerner (CERN), trades at ~39x 2016 FCF.
Projected Summary Financials:
Note: the above analysis conservatively assumes no capital deployment for repurchases, debt paydown or M&A. NetSmart transaction discussed below.
Troubled Merger with Eclipsys
Allscripts stumbled in 2012 after a failed integration of its 2010 transformational merger with Eclipsys. Both companies had gaps in their product portfolios that could have led to competitive disadvantages over time and previous management viewed this deal as more cost effective than each addressing the gaps from scratch. As the deal closed, there was lots of excitement around the merger. But it became clear that the Company did a poor job of integrating the software, leading to deteriorating market perception, some high profile client defections, and a steep decline in bookings (a leading indicator of future revenue growth).
New Management / R&D Ramp
To fix these issues, a completely new management team was brought to the Company at the end of 2012, who took all the right steps to stabilize MDRX, including investing heavily back in the business, which temporarily depressed margins. This new management team, led by Paul Black (the former COO of CERN), improved relationships with existing clients, ramped up R&D and customer support, and gave away free or discounted services in order to stabilize the business. While the Company’s top line and margin profile suffered during this period, these changes are finally starting to pay off as we are beginning to see a material inflection in the business that is not yet reflected in the stock price.
After a steep decline in bookings in 2012, the Company has recently regained momentum, including some high profile new client wins in recent quarters (high profile wins not only instill confidence in the existing customer base, but they also provide credibility for other hospitals to select MDRX). In fact, bookings were up ~20% in 2015, surpassing $1 billion, supporting the notion that Allscripts is able to both upsell existing customers as well as win new business - both of which will lead to continued top line acceleration in the near future.
Bookings, as reported by Allscripts, are defined as the lifetime value of new software / services sold in a given year (under multi-year contracts), but importantly do not include renewals or inflation escalators. Given their definition of bookings, Allscripts will be able to show top-line acceleration even in a flat bookings environment, since this new business would layer onto the existing recurring revenue base. For example, of the $1.1 billion of new bookings in 2015, (chart below), ~30% are short-term and will be earned and recognized in the first year, and the remaining ~70%, or $784 million, will be earned over the course of the contract term (average length ~7.5 years = ~$105 million in 2016 and each year thereafter).
Return to Revenue Growth
Since 2011, MDRX has not grown revenue for several reasons, all of which are starting to inflect and are now turning from headwinds to tailwinds. First, the Company is starting to benefit from improved product quality and client satisfaction following the poor integration with Eclipsys. This is not only leading to accelerated new business wins, but also a material deceleration in client attrition (see table below).
Second, the Company has shifted most of its new contracts from an upfront license model to a subscription model over the last few years, which has been a drag on topline. This has led to a decline in upfront / non-recurring revenue, which has been a drag on the overall topline growth for the Company. However, MDRX is largely done with this transition and recurring revenue currently accounts for ~80% of sales, providing a more stable and predictable revenue base off which to grow from going forward.
These dynamics have already started making their way into the company’s reported financials, as the recurring revenue growth rate accelerated from 3.7% in 2014, to 5.4% in 2015, and expectations are for continued acceleration in 2016. From here, client attrition will diminish and new business wins will continue to accelerate, the net of which will drive continued topline momentum.
In 2011, MDRX’s EBITDA margins were 800 basis points higher than their 2015 levels on a similar revenue base, with most of the decline since then attributable to actions the Company has taken to stabilize the business. This provides a natural tailwind to margins going forward as the cost structure is now built out and set up for operating leverage. As another good proxy, MDRX’s “EBITDA – Capex – Capitalized Software” margin is 800 basis points below CERN’s, despite being structurally similar businesses. While some of the difference can be attributed to scale, MDRX enjoys the benefit of having significantly higher software mix than CERN, giving confidence that there is significant room for operating leverage and margin expansion going forward. The driver of this leverage will be flattish G&A, with topline growth coming in at incremental gross margins of ~30-75%.
Other sources of upside:
In March of 2016, MDRX announced that they were forming a JV with private equity partner GI Partners to buy NetSmart for ~$950 million, or ~14x EBITDA. NetSmart is a leading outpatient vendor that sells software and related services to providers in behavioral health. Rising awareness about the importance of mental health and services needed to deliver effective care is driving double digit growth in the sector. With a 15% market share (23k organizations with 450k providers), NetSmart is the only national player and is 10x the size of its next largest competitor. On top of that, the behavioral health market is only 50% penetrated for EHRs, and given the ongoing legislative efforts, it is likely that the government will require these facilities to adopt EHR technology, providing additional growth optionality going forward. This situation is very similar to the physician market 5-7 years ago, before penetration of EHR systems increased rapidly in hospitals and physician practices.
For its 51% interest in the JV, MDRX paid $66 million in cash and contributed its behavioral health asset (which generated ~$15-20 million of EBITDA). GI Partners funded ~$340 million for its 49% interest, and the JV took on $535 million of debt that is non-recourse to MDRX. Based on this math, the implied value that MDRX got for contributing its stagnant behavioral health business was $275 million, or ~16x EBITDA. Given its controlling stake in the JV, MDRX will fully consolidate the NetSmart financials, which will not only improve the Company’s organic growth profile, but will become increasingly accretive in 2017 and beyond.
In addition to being accretive to revenue, earnings and FCF going forward, the NetSmart investment has the potential to create significant value for MDRX shareholders, either by becoming a stand-alone public Company in the future, or by being bought-in by MDRX.
2. NantHealth Optionality
In 2015, MDRX made a $200 million investment in, and now owns ~12% of a company called NantHealth that has since gone public (NASDAQ: NH). At current levels, this investment is worth the approximate cost of the investment, which is $210 million. The total addressable market for NH’s patent-protected cancer diagnostic product in the US is 1-2 million new cancer patients per year x $10-15k per test, or $20 billion. NH will earn 30%+ operating margins on any revenue it can generate from this test. The total annual EBIT potential of this test, which is considered by some to be revolutionary, is $6 billion in the US alone. NH already has self-insured employers such as Bank of America as well as large payors such as Independence Blue Cross of Pennsylvania signed up to cover the test. Should it start winning coverage from other respected payors, the market value of MDRX’s NH stake will increase significantly.
3. Capital Deployment
Over the next 4 years, MDRX should generate >$700 million of free cash flow, or >1/3 of its market value. In addition to that, at ~2x net leverage, MDRX has significant balance sheet capacity that it can use to deploy in a shareholder friendly manner. A majority of this cash will likely be used for accretive M&A and buybacks.
4. Industry Consolidation
The HCIT industry is still extremely fragmented, with many players that are too small that will eventually go away. The top two players control ~40% of the market, while MDRX is behind them with a high-single digit share. Big names such as Siemens, GE, McKesson all have a large installed base of hospital clients, but they have been unable to generate good returns on their R&D forcing them to either sunset or sell part or all of their HCIT businesses. In addition to those large names, there are hundreds of other vendors that lack the scale to keep up with customer needs and regulatory requirements.
With annual R&D spend of >$230 million per year, MDRX has the required scale and budget to be a long term winner in the space. There are very few other players in the industry that have a budget of this size (Meditech, Cerner, Epic may be the only three – even ATHN spends <$200 million). Over the last few years, a large portion of the MDRX budget was directed towards fixing legacy platforms, but now more is being directed to new products which should drive even more revenue momentum going forward.
Given MDRX’s smaller footprint in the industry, small market share gains relative to the overall market are much more meaningful to the Company’s top/bottom line than they are to its peers.
It is also highly possible now that MDRX has returned to top line growth this year, it will increasingly become an attractive takeout candidate, both to financial buyers (underwriting margin improvement and top line acceleration) as well as strategic buyers looking to bolster their presence in the healthcare space.
While Allscripts reports adjusted EPS, free cash flow per share is a better proxy for the cash earnings power of the business and is the most appropriate metric for valuing the Company. In 2015, FCF of $144 million was $56 million was higher than adjusted net income of $88 million, a $0.30 per share difference. This difference was driven by:
Capex of $18 million was lower than depreciation of $42 million, accounting for $24 million or $0.13 per share difference. This will continue, as Allscripts is spending the appropriate amount on capex but is depreciating some assets such as a recently implemented ERP system and other legacy acquired assets that are no longer a meaningful draw on capital.
Cash interest expense of $16 million was lower than adjusted GAAP interest expense of $24 million, accounting for $8 million or $0.04 per share difference. The difference is sustainable as the higher expense is largely driven by an outsized amortization of discounts and debt issuance costs on the Company’s convert (effective conversion price of $23.135 per share).
Cash taxes of $5 million were lower than adjusted GAAP tax expense of $32 million, accounting for $27 million or $0.15 per share difference. The Company has started to benefit from its NOL and will continue to until the Company becomes a full cash tax payer in 2019, which is reflected in the financial model.
Allscripts also had some non-recurring expenses that were partially offset by a working capital benefit, resulting in a -$3 million or -$0.02 per share difference. The combination of these two should be a tailwind to FCF going forward.
MDRX is a Company with a greater than 10% forward FCF yield, that is growing, and that will rapidly de-rate to only 5x EBITDA if the equity value doesn’t appreciate meaningfully from here. Furthermore, Allscripts will likely use all of its FCF for M&A and buybacks. For the sake of simplicity, if one assumes all of the FCF is devoted to repurchasing shares from 2016-2018 then the Company would trade at a mid-teens forward FCF yield in 2018.
With a double-digit and growing forward free cash flow yield, the market is significantly undervaluing a successful turnaround in a predictable, high quality, economically insensitive business. The opportunity exists because the market is missing the material revenue inflection underway due to accelerating net bookings that is being driven by improved management, product quality and customer satisfaction. Based on near-term revenue inflection and FCF generation, MDRX should re-rate to at least 15x forward FCF / share or $20 per share over the next 12-18 months, which would equate to ~60% appreciation in the share price (with potential incremental upside from capital deployment and various sources of optionality as described herein).
(i) Continued new bookings success and revenue inflection, (ii) increased earnings + operating leverage + prints FCF proves turnaround complete, (iii) FCF usage for buybacks and/or accretive M&A, (iv) event at either NetSmart or NantHealth, (v) whole company is sold
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