Thesis                                                                                                                                                                        

Conmed Healthcare Management (“CONM” or the “Company”) is a noncyclical, stable cash flow generating business with +60% ROIC that trades at a depressed valuation. This mispricing exists because of a failed buyout attempt last fall and resulting selling pressure from the suitors. I will discuss in more detail, but the deal’s failure had nothing to do with the Company. Since then, CONM has secured several new contracts, yet the stock still trades well below where it did before the proposed buyout was announced. Upside to the equity is +50% over the next year with catalysts and strong downside protection given financial visibility and $1.10 of net cash per share.

Investment Merits

• Appealing Industry Dynamics: CONM provides outsourced health services to 55 jails and detention centers across 9 states, 41 counties and municipalities. The Company does not operate in state and federal prisons. Competition within the jail segment itself is highly fragmented. CONM serves approximately 2.4% of the total local jail population (18k of 749k) and captures an equivalent amount of the ~$2.7B that detention centers spend annually on med services. Of the total correctional healthcare market, including prisons, CONM has an approximately 1% share. None of Conmed’s peers are publicly traded so disclosure regarding inmate population by type of facility is limited (ie. prison vs. jail). Relevant national competitors are Corizon – 400k inmates (formed from Valitas-ASGR merger), Wexford Health Sources – 91k inmates, Correct Care Solutions – 64k inmates and Naphcare – 68k inmates. Based on Bureau of Justice data, this group accounts for less than 18% of the total addressable prison and jail market. The rest of the market is self-managed or handled by smaller outsourced providers, local physician groups, hospitals/ clinics and universities. Municipal contracts are evaluated at the local, typically facility-level by the warden or sheriff. This dynamic prevents a larger competitor from controlling an entire state or region.          
• All detention centers are legally required to provide healthcare to inmate populations under the 8th Amendment. Spending has historically been insulated during recessions due to this Constitutional mandate. The fact that CONM has consistently grown sales and EBITDA through the downturn demonstrates this point. In fact, constrained local budgets have actually been a positive for the industry as local governments turn to lower cost, private healthcare services providers. The Company indicates that it can provide coverage at $9.77/inmate/day versus the estimated national average of $10.31/inmate/day (formerly-public peer ASGR reported $10.65/inmate/day in 2010). The industry does not receive federal healthcare reimbursements and has no exposure to government sponsored services such as Medicare and Medicaid.   
• Financial Visibility: All revenue is under contract agreements, the weighted average life of which is 3.6 years. Initially contracts are typically awarded through a competitive RFP process and are four to five years in length with annual renewals thereafter. Pricing is per inmate and +75% of contracted revenue includes annual healthcare CPI-based price increases. CONM get paid on a monthly basis based on the inmate population. Gross margins are largely variable as the Company can change staffing levels should inmate levels fluctuate. These factors give CONM a high level of revenue visibility. The Company presently has 72 different contracts. Below is a list of those that have been publicly disclosed, representing approximately 90% of LTM revenue.   

• The Company signed three new contracts in in the middle of last year and one in January. This represents $9M of annual revenue, only 25% of which has yet to be reflected in its numbers. Even if no new contracts are awarded and organic growth is flat, CONM should be able to generate at least $77M in revenue and $6M in EBITDA in 2012. As the business has grown, EBITDA margins have expanded due to operating leverage (SG&A largely fixed) and increased scale at the facility level. Cost of services is comprised of medical staff wages (57% of sales) and treatment costs such as lab fees, pharmacy and insurance (21%). Almost all of which is variable. In early 2011, the Company initiated a wage increase. This was the first such increase in two years and resulted in 50bps of gross margin compression. The Company believes it can recoup this through price increases and ultimately generate +10% EBITDA margins at the $100M sales level. My estimates above assume flat margins with no price increases. Industry-wide employee costs and supply have been stable. Labor is not organized at CONM.
• Strong Cash Flow Profile: Minimal capital needs, nearly 100% recurring revenue and improving margins generate very high quality earnings and cash flow. Jails provide the facilities and most of the technology and non-labor overhead, so set-up costs and capex are very limited (averaging a one-time $70k per 1k inmate facility). The Company requires very limited incremental overhead to grow. Municipalities also pay promptly (15 days sales). These factors make for a very scalable business. The Company should produce $3.5M of FCF in 2011. In addition to share repurchases (that will commence after the release of Q4 earnings), it can continue to acquire smaller competitors. Based on conversations with management, a dividend seems less likely.
• Competitive Position: When CONM wins a new contract it is typically displacing other outsourced providers, internal staff or local hospital operators. CONM competes on quality and price. The Company can compete on price, but its exceptional record of quality is its strength. This is evidenced by a nearly 100% customer retention rate. Health services account for 10% of a jail’s operating costs. Though jails are clearly cost sensitive, law suits, political risks and fines from a shortfall in quality can be catastrophic for a municipality. To avoid these financial and headline risks, sheriffs, wardens and local politicians must have a quality provider. State and national regulators certify compliance with standards through regular audits. The Company’s 100% audit success rate enables it to be a turn-around solution for troubled facilities. In 2009, the Pima County Jail received federal sanctions for poor quality. CONM replaced the incumbent and rectified the matter within one year and has retained the business since. Another example is the Baltimore County jail system. Prior to 2010, Baltimore’s provider, Corizon, had very low internal performance metrics (30% of services were being fulfilled per terms of contract). As a result, Corizon was paying the jail system $150k per month in penalties and the jail itself was facing regulatory scrutiny. Then in 2010 CONM came in, replaced the larger Corizon and improved the fulfillment rate to nearly 100%. Across all its facilities, CONM pays less than $150k in penalties a year. The Company has only lost a customer once when a competitor underpriced them. However, CONM won the business back within a year when the replacement failed to meet quality standards. The Company also won the recent Galveston contract from a larger competitor that could not match Conmed’s quality and level of management attention. CONM should be able to continue to win contracts for 500-2k inmate facilities that are less relevant and underserved by larger operators. CONM has never been involved in a major malpractice suit and none of the facilities it services have received noteworthy healthcare related fines.
• Growth & Market Opportunity: The Company has nearly tripled its footprint since 2006, increasing its presence from 17 counties to 41. Conmed’s growth and profitability is at an inflection point. Increased scale has enabled it to successfully compete for larger, more profitable contracts to manage +1k inmate facilities. In January, CONM signed its first contract in the state of Texas. This agreement with the 1k inmate, County of Galveston jail will add $3.5M in annual revenue (underway as of February 1). More significantly, the Company now has a foothold in Texas and should be able to capture additional contracts as the industry’s selling season gets underway in July. Potential customers can now visit and evaluate the services CONM offers in Galveston. The Company’s expansion in Virginia serves as precedent for this approach. The Texas contract win was unforeseen and has not yet been appreciated by the market. CONM has agreements with seven of the 149 jails with 1k or more inmates nationally and 11 of the 322 jails with 500k or more. 
• CONM has also been able to increase its revenue per facility by expanding its service offerings. For example, it first entered Oregon with a general staffing contract. Because of the quality of its service it was able to add dental and mental health services post-RFP. According to the company, approximately half its contracts are full service and two-thirds now include mental health services. An initial staffing-only contract that is expanded to full service can result in a doubling of revenue. If CONM were able to convert all its existing contracts to full service, it could add an incremental $4-5M in annual revenue. The Company has historically been able to generate 8-10% top-line growth from price increases, volume increases and additional services. 75% of its existing contracts include price escalators, enabling the Company to continue to grow organic revenue at a +5% rate. In addition to cross-selling and increased penetration within its current footprint, logical new states include North Carolina, South Carolina and Florida. Conmed can also buy competitors and expand the scope of the services to that target’s customers. Such was the case recently when it acquired a small provider that serves Randall County, Texas (announced February 2). The Randall contracts are staffing-only, so CONM could double revenue here. Management’s focus, however, has been on growth through contract wins. The Company has historically been disciplined on the acquisition front (three since going public).           
• Currently 30% of correctional healthcare is state university provided and a similar amount use local hospitals and internal medical groups. These operators have much higher cost structures and cannot compete on price. Services provided by these groups are often twice the cost of that offered by outsourced providers like Conmed. This is an area of opportunity for the Company and its peers, particularly as contracts roll-off and municipalities seek to cut costs.
• Secular Trends: DOJ data indicates that Federal prisons are operating 35% above capacity. The use of local jails has been a mechanism to help alleviate this overcapacity. As a result, local facilities have seen inmate populations increase at 2.4% annually since 2000 while prison populations have increased 1.6%. Facing overcrowding in its prisons, Virginia recently announced that it is increasing the number of convicts that it will send to jails. Now all sentences of less than two years will go to jails rather than the previous one year cut-off.      

Catalysts

Near-term catalysts include: 1) financial performance from new contracts; 2) appreciation for the quality of the business and alleviation of failed sale stigma/ selling pressure; 3) share repurchases; 4) improved corporate communication; and 5) potential sale. The new contract wins toward the end of 2011 will add $8M to 2012 revenue and +$1M to EBITDA. This growth will become evident in the Q1 numbers. Conmed’s increased scale and new presence in Texas positions it well to win new contracts and expand its existing contracts when the selling season begins in the summer. Even if it does not win any new business in 2012, EBITDA should increase +20% off its existing base. In mid-December, the Company announced a $5M share repurchase program which can commence after the release of Q4 earnings. The Company also recently hired an IR firm to assist with marketing. Management did not actively seek to sell the Company, but as we saw, they are amenable to a deal. In particular, board member and 20% shareholder, John Pappajohn, has indicated he is supportive of a sale.         

Background   

Conmed began providing healthcare services exclusively to Maryland county detention centers in 1984. By 2000, the Company had grown to serve over half the state’s county detention centers. From 2003 to 2006, CONM expanded into Kansas, Virginia and Washington through contract wins. In 2007, the public shell company Pace Health Management acquired Conmed for $23M and concurrently assumed the Conmed name and brought on the existing management team. In 2008, the Company acquired two smaller operators in Oregon and Maryland. It has been able to leverage those contracts to expand service offerings and establish a regional footprint.

In late 2010, Pappajohn proposed a sale of the Company to the board. In December 2010, the Company retained Gleacher and shopped the Company to 86 potential buyers, 62 of whom received a CIM. At a January board meeting 10% shareholder Dr. James Desnick was in attendance as an observer (apparently something that the Company had previously permitted). Upon learning of the sale, Desnick requested a CIM and shortly thereafter submitted a bid at $4.15. Five other parties also submitted offers at $3.80-4.05 per share or 9.6-10.2x LTM EBITDA. Desnick, as part of a group called Ayelet Investments, emerged as the only final offer and reduced the bid to $3.85 or 9.8x EBITDA. The deal was announced on May 13. On November 14, one day before the shareholder meeting, Ayelet announced it could not complete its financing. Ayelet publicly sited a disagreement on sub debt covenant terms with Levine Leichtman Capital. The more likely reason was that the lenders learned of Desnick’s criminal past which included multiple healthcare frauds, revocation of medical licenses and malpractice settlements, two of which were over $15M each. CONM received a $2.3M termination fee ($1.5M after-tax). Neither Desnick nor anyone from Ayelet is a member of the board, so operations have been unaffected by this development.

CONM initially went public because it believed a currency would enable it more effectively buy smaller operators. The Company has not issued stock in any of its acquisitions, does not need capital to grow, yet still has to disclose its financials to competitors and bear the costs of being public. It seems likely that CONM will try to sell itself again in the next year.   

Valuation

CONM should trade up 40-50% in the near-term and if acquired would command a 100% premium to its current stock price. The Company currently trades at 6.0x 2011E EBITDA and 5.0x 2012E (base case, assuming no new contracts) with a 15% FCF yield. On an absolute basis this is clearly cheap given the quality of the business and its growth prospects. The average historical multiple prior to the buyout attempt was 8.0x EBITDA, implying an equity value 40% above the current stock price. The closest trading comps are CXW, GEO and MD. Though much larger, they have very similar financial profiles and trade at a median multiple of 9.1x LTM EBITDA. The failed buyout attempt by the Ayelet group valued the enterprise at 9.8x EBITDA. This price was considered low as Gleacher and CONM were accused of not adequately shopping the Company. While it is unclear what the end result could have been, a close peer to CONM was recently sold. In March 2011, Valitas Health Services acquired America Service Group (formerly public, NAS: ASGR) for 9.3x EBITDA, 11.0x EBIT. At this valuation, the implied upside to the current share price is 90%. These valuations assume no new contract wins, price increases or margin improvements. They also do not include the fact that Conmed’s financial picture has become clearer with the January extension of its largest contract. All of which will likely generate more interest in the asset. If a strategic were to acquire CONM, they could cut most of SG&A, making a higher transaction multiple economical. In an optimistic scenario of $7.5M EBITDA, the implied upside is 120%. The Company’s cash flow profile would also make it very appealing as a platform company for private equity. Shareholders get downside protection from $1.10 of net cash per share and financial visibility.    

Investment Considerations & Risks 

• Management: Insiders own 28% of the shares (inclusive of 1.2M options). Holdings among management are primarily through options. CEO Dick Turner, only owns 10k shares, but has been granted 1M options. It would obviously be preferable to see more direct share ownership by management, but it should be noted that if the Company were to sell for $5 per share, Turner’s options would be worth $3M pre-tax, 7x his current annual compensation.     
• Risks:
• Constrained budgets have put pressure on correctional facilities at all levels. This has led to legislative proposals to lower minimum sentences for non-violent crimes and to liberalize early release policies. In 2010, for the first time in several decades, the average daily inmate population nationally declined (down 1.1%). Nearly half this decline was from six California jails. CONM does not have a presence in California. Reduced incarceration rates would obviously reduce the demand for Conmed’s services. Though such reforms have been explored, none have gained significant traction. Immigration reform or legalization of certain drugs could also reduce inmate populations. While these are potential industry changes, one should also consider the fact that the elevated unemployment and declining high school graduation rates that we are experiencing now are highly correlated with increases in crime rates. On this basis, a protracted recession may actually be a net positive for CONM.                   
• Conmed’s largest operational risk is a malpractice suit. While suits are somewhat of an ongoing part of any healthcare business, the Company has never had a case costing over $200k. CONM’s insurance policy expense actually went down in 2012 due to the effective management of claims. The Company has never had a riot or epidemic affect a facility in which it services. Jails have much lower incidents of riots than prisons since the average inmate stay is one month. Excessive costs can come from having to send an inmate to an external hospital. Out-of-facility care has historically been well-contained, typically accounting for 2-3% of total of revenue. Currently all of its revenue is earned under contracts that have caps limiting exposure. The average cap is $25k per inmate with the remainder billed back to the facility.     
• As part of its IPO, warrants were issued and convertible into 15% of the shares outstanding. These warrants have subsequently been converted on a cashless basis and should alleviate this overhang on the stock. The conversation will be reflected in the next earnings release. All share count numbers assume full dilution.
• Services contracts typically can be cancelled on three months’ notice. This risk is mitigated by CONM’s near perfect retention rate and the fact that these services are mandated by the US Constitution. The two largest contracts account for 23% of sales (Pima and Baltimore). Pima was recently renewed through June 2013 and Baltimore extends through 2013. After these two, no single contract accounts for greater than $5M in annual revenue.