Description

Thesis:

We believe Examworks is a structurally declining business with substantial legislative “tail risk” that is on the cusp of a downturn in organic revenues in 2016 and going forward versus company guidance for continued mid-single digit organic revenue growth and a stable regulatory environment.  We believe Examworks bulls view EXAM as a “platform company” with strong synergies from acquisitions, mid-single digit organic growth prospects and a secular share gainer in an economically insensitive market.  We believe this disconnect in perception vs. reality is similar to what happened to the company shortly after IPO, when the stock fell from a high of $26 to as low as $6.50 a share.  Currently trading at 11.5x forward guidance (which we think is too high), we see a high likelihood of mid-single digit organic declines in revenues and greater on the ebitda line.  At a more appropriate multiple of 7.5x our estimates of EBITDA, consistent with the multiple they received last time organic growth declined shortly after their IPO, we think the stock would be worth $15 a share, down over 55% from current prices.

 

This is a long write-up.  Examworks has been written up previously.  For those familiar with the thesis or who have researched this in the past, sections 2-4, 7, & 8 will likely be of most interest and we believe are not widely appreciated / new, whereas other sections are probably are more familiar to people who have researched the business in the past.

 

Main points of Thesis:

1. Overview of IME business & Flaws in the roll-up strategy

2. Examworks has a spotty history of acquisitions and due diligence, a big problem in a roll-up (one example of which being Canadian acquisition shortly before adverse regulatory impact).  We believe the latest example of this is their acquisition of Gould & Lamb & Medallocators, which combined were about 15% of LTM EBITDA and are in the midst of imploding amidst recent resignations of two key executives.

3. UK business (25% of LTM EBITDA) faces impending legislation that threaten to substantially reduce 80%+ of their IME volumes.  This risks is not disclosed by company in annual report or discussed by the company that we have been able to find.

4. In large part due to UK business model and associated issues, free cash flow conversion has been poor and is getting worse.  For this reason we think EBITDA valuation overstates true value of the business.  We also believe Examworks also faces meaningful credit risk due to generous receivables terms to struggling UK customers.

5. This would not be the first time management glossed over regulatory issues set to materially impact one of their business units overseas.  Shortly after IPO, the Canadian business experienced adverse regulatory actions which resulted in a substantial decline in operating performance despite management assurances to the contrary in the quarter leading up to this impact.

6. In the US IME business, which we estimate to be about 50% of total EBITDA, the market is in slow structural decline, which has been masked more recently by Examworks share gains in national accounts.

7. We believe there are already signs that organic growth, ex-currency, has turned negative in Examworks core UK & US geographies

8. This is not the first time Examworks has faced organic declines in their business or troubles with acquisitions.  Similar issues in the past shortly after the IPO led to the stock falling from $26 to 6.50 a share.  We believe a repeat of this is possible.

9. We believe further share gains in the US are threatened as Examworks faces multiple new competitive threats from prior owners non-competes rolling off, senior employees fired in October 2013 whose, non-competes recently ended, and large new players entering the space on the back of the success of EXAM stock

 

1. Overview of the business & flaws with the roll-up:

Although management’s focus has shifted in recent years to encompass a collection of different businesses, Examworks at its core is a roll-up of more than 56 independent medical exam (IME) businesses, the majority of which have been acquired in the last 7 years.  The IME industry varies by state and country, but generally is tied to the number of workers comp claims  (particularly in the US) and auto accidents resulting in bodily harm (particularly in the UK).  In both these cases, some party—a workers comp carrier, an auto/disability carrier, or a self-insured corporation—is often on the hook to pay the associated medical costs with someone’s injuries.  The claim is eventually handed to an adjuster who, among other things, in many cases will seek the opinion of an independent doctor to verify the patient's injury claims and the prescribed treatment options.  IME businesses serve insurance carriers, third party administrators, and self-insured employers by handling the logistics of this process – finding the appropriate doctor in the patient’s zip code, setting up the appointment, handling associated paperwork, and ultimately delivering a report of the doctor’s findings top the customer.  Companies choose IMEs based on a combination of price, service (turnaround time, responsiveness, no-show rate, willingness to make the adjuster’s life easier), and quality of the doctor network.   In the UK, this process is driven more by personal injury lawyers, but the basics are similar.

Examworks’ basic premise in rolling up the IME industry is that they would be able to expand their doctor network (improving geographic reach of their network), and allow large carriers to consolidate their vendor network for IMEs to a much smaller group of mostly national carriers.  At the same time, they could acquire these businesses in many cases for 4-5x ebitda, raise pricing in certain areas, and realize other operational synergies.  At this point we believe Examworks has rolled up most of the industry and that the consolidation thesis has largely played out.  For this reason, Examworks has been expanding into other industry (Medicare set-aside, bill review, UK IME, Australia IME, Canada IME) to continue their acquisition-fueled growth.

 

Although there is some merit to carriers wanting to consolidate vendors and the premise behind Examworks roll-up makes some degree of sense, we believe there are a host of issues, both operational and secular, that are resulting in the core US business declining organically in 2016 and the foreseeable future, vs. management guidance of mid-single digits organic growth.  We also think the UK business,  which is about 25% of EBITDA, faces even more substantial risk.  Together, we believe the combination of UK & the US are 85% of EXAM’s EBITDA, and are on potentially on the verge of a years-long decline in revenues and profitability.  

2. Examworks has a spotty history of acquisitions and due diligence, a big problem in a roll-up.  We believe the latest example of this is their acquisition of Gould & Lamb & Medallocators, which combined were about 15% of LTM EBITDA and are in the midst of imploding amidst recent resignations of two key executives.

 

While Examworks’ has done deals, especially large ones, that have worked out well, there is a history of some very poor deals they have done too.  Shortly after IPO, Examworks acquired several Canadian IMEs shortly before proposed negative legislative changes that sent Canadian revenues down 24% in FY2012.  We have also heard multiple instances of Examworks’ buying mostly smaller IMEs, especially in their early days before they put in place particularly strict non-competes, where an IME would be bought, key employees would soon leave, and quickly take most their old business back in short order.  We have heard Examworks subsequently locked up most owners for 5 years and many key employees / sales people with 2 year non-competes.

 

Although these miscues are generally well known, these diligence problems have persisted and are more pronounced as the company moves into acquiring new business lines, something they have recently ramped up dramatically.  In February 2014, Examwork’s acquired Gould & Lamb, which operates in the medicare-set aside business.  In short, this business provides analytics services to “set aside” portions of lump sum insurance payments to be used only for medical expenses, so people don’t take the money meant to treat medical expenses and splurge on discretionary items, only to later run out of money and utilize medicare or Medicaid to fund the health costs that should have been funded from their settlements.  

 

Examworks paid 75M for a business that generated 27M of revs and 9.5M of EBITDA.  Shortly after closing, we believe Examworks suffered from buyer’s remorse, as multiple industry participants have told us Gould and Lamb lost its largest customer to competitor Medallocaters / Ability Service network shortly after closing.  Based on conversations with people in the industry, it was clear that EXAM bought the wrong company – Gould and Lamb was perceived to be poorly run and was seeing revenues in decline.  Undeterred, shortly thereafter, Examworks bought Medallocators for 80M, which we believe contributed about 32M of revs and 11M of EBITDA, which we believe is Proforma for the account they won from Gould & Lamb, meaning they basically paid twice for the same book of business.  In their press release, they note that Ken Loffredo, the CEO of the acquired business, would run the entire book of business (renamed ECS). We have heard Loffredo has an excellent reputation in the industry, and was the right person to put in charge.

 

Fast forward two years, and we believe these two businesses are performing poorly.  Although not disclosed by Examworks, we believe Ken & his #2 departed in early March, along with about 15% of  the workforce.  Our conversations suggest Ken was instrumental in helping Examworks winning a couple of the big accounts they won in ECS post close of the acquisition, and now that he has departed those same customers and others are likely to sever their relationship with Examworks.  Assuming combined businesses were flat since acquired, this would present headwinds to nearly 15% of overall LTM EBITDA and nearly 25% of US EBITDA.  It also makes one wonder what the company may have missed in its most recent deals.

3. Undisclosed Risks in the UK business are severe and threaten Examwork’s model in the UK

Pending legislation (due to hit April 2017) as well as the continued rollout of the Medco portal (established April 2015) has the potential to “completely destroy the low value personal injury business”, upon which Examworks relies for most of their volumes and revenues.  Management disclosure on the UK business is poor, in our view, and management generally has downplayed potential legislative threats.  We believe investors mistakenly view this business as a stable mid-single digit grower that grew the last couple years at a double digit pace due to substantial market share gains and superior execution.  In reality, we think the underlying driver of this business are questionable whiplash claims by aggressive personal injury lawyers and associated ecosystem that the UK is attacking aggressively and hopes to drive out of business.  Recently passed and further pending legislation could result in substantial declines in the number of medical exams, and potential bankruptcy and/or closure of many of Examworks largest customers.  The UK PI market is very complicated, and we have heard conflicting descriptions.  Below is our best effort to describe the industry as we understand it.

 

1. Historical Overview of Examworks business in the UK

 

Examworks provides IMEs in the UK in a similar way to how they do it in the US, but for a very different purpose.  In the UK, the vast majority of IMEs are conducted on bodily injury accidents sustained in car accidents.  The IME is usually ordered by a lawyer representing a person who claims to be injured in a car accident.  About 4 to 6 weeks after the accident, the lawyer will refer their client to an IME provider like Examwork / Premex, who locates a doctor, schedules and appointment, and produces a medical report that will be used in litigation.  Examworks entered the market by acquiring a small IME provider, UK Independent Medical Services, in 2010, followed by Premex in early 2011.  Although the company has done some smaller acquisitions since then, we believe the vast majority of their business are IME services, specifically IME services for injuries sustained in auto crashes.

 

2. What drives Bodily Injury claims in the UK?

All of this sounds simple enough, but there is more to the story.  While bodily injury claims should be relatively stable over time, in the UK they have been anything but.  Despite road accidents reported to the police falling over 30% from 2005 to 2013, total bodily injury claims have grown 62% over the same period:

 

 

Stated another way, in 2005 there were approximately 2.1 personal injury settlements for every accident reported to the police.  By 2013, there were 4.7 bodily injury claims per accident reported to the police.  This means that in the period of 8 years, the number of bodily injury claims per accident increased by about 125%!

 

This is at odds with logic and trends in just about every major developed country, where bodily injury claims tend to track (and in many cases are declining more) than road accidents as cars become increasingly safer.  Due to this trend, auto insurance costs have increased faster in the UK than in any other European country.  Today auto insurance in the UK is about 2x more expensive than in any other European country:

 

This issue has confounded politicians and auto insurance carriers.  Auto insurance carriers in the UK don’t make money despite rates being so high, because their claims costs are so high.  Aviva hired Frontier Economics in March 2015 to do a report on the issue, which summarizes many of the reasons they see for this issue:  

 

http://www.frontier-economics.com/documents/2015/03/frontier-report_aviva-09-03-15.pdf

 

3. UK is the “Whiplash capital of the World”

 

According to Aviva, the largest UK auto insurer, 80% of bodily injury accidents are whiplash claims.  Based on the government portal data that tracks bodily injury claims, there were 877,000 claims in 2015.  This implies that there are over 700,000 whiplash claims in the UK every year. If this sounds like a lot for a country with 64M people, it is.  According to the Institute and Faculty of Actuaries, approximately 30% of accidents in the UK result in a personal injury claim.  Although data varies by country and it is hard to get precise comparable statistics in other geographies, it is clear that the instance of personal injury claims in the UK in general and whiplash claims in particular are very elevated vs. other European countries.   According to the aforementioned Frontier economics study, there are a few notable differences between the UK and other European countries:

• In France, whiplash claims as a percentage of total bodily injury claims are only 3%

• In Germany, about 4% of accidents have a personal injury, vs. 30% in the UK

• In Sweden, regulation arising from the Whiplash commission succeeded in reducing whiplash claims about 40%, although whiplash claims remain elevated

• By country, motor insurance in the UK relative to other European countries (in terms of purchasing power parity in 2012), were:

• France – 40% lower

• Germany – 47% lower

• Norway – 35% lower

• Spain – 29% lower

• Sweden – 46% lower

 

4. How Examworks, PI lawyers, and an ecosystem of service providers enable and cause the whiplash epidemic in the UK

The personal injury racket is enabled by a complicated ecosystem of entities who all profit off PI claims in various ways.  A whole essay could (and has) been written on this subject, but we will do our best to summarize to the best of our understanding.  When you get in an auto accident in the UK, the first call you make is typically to your insurer, who sells your information to a CMC or lead generation firm.  After that, you may then call a credit hire company to get a replacement car while yours is in the shop, who also sells your information.  After that, you probably take your car into the garage, where the mechanic sells your information.  Further, you are bombarded with ads on TV by Claims Management Companies (CMCs) who act as lead generators for the law firms.  All of this parties – insurers, garages, credit hire, and CMCs—have historically received referral fees from law firms for passing them business that results in a claim being filed.  In 2013, this practice was outlawed, but all these firms have come up with creative ways to get around these laws and the practice is still prevalent today.  These firms are aggressive in trying to solicit business.  According to one study, 1/3rd of respondents received nuisance calls from accident claim companies.

 

Despite many people who want nothing to do with these claims, the pitch is compelling.  Since the introduction of the claims portal in 2011, typical settlements for pain and suffering from a whiplash case run £1,350.  Additionally, many claimaints often times would get up to a month or more of lost wages from not being able to work – at minimum wage this runs about £1,400.  Further, because it is often cheaper to settle than to take them to court, insurance companies settle in the vast majority of cases.  So, from a claimant perspective, the pitch is compelling – you pay nothing for representation, if you win you give up 25% of your damages on contingency, but you still get a month of work and about £2,000.  In exchange, you have to make an appointment with a doctor (through a company like Premex, owned by Examworks).  Further, you often need to get rehab, which would typically be 5 1 hour appointments for a few weeks. Premex also provides this service.

 

The cost to insurance companies of claims are much greater than the amount the victim is paid.  Here is an illustrative example of the total cost to the insurance company under current rules:

**Cost pain and suffering:  £1,350

**Loss of one month lost wages: £1,400

**Fixed Fee paid to claimaint’s lawyer: £550

**5 Physiotherapy sessions: £500

**Cost of the medical reports: £180+

**Other potential costs include counselling for PTSD (can run £2k+), psych evaluations, credit hire, longer than one month lost wages, and generally administrative costs associated with these claims.

 

Examworks / Premex operates in a key part of this system.  Every whiplash claim needs a medical report (and sometimes more than one), and Examworks gets get paid for that.  We’ve also heard as much as 60% of claimants who file whiplash claims seek rehab (to help bolster their case).  Premex can provide this service as well.  Also, to the degree the law firm or claimant is particularly aggressive, they can order very expensive psychological evaluations and treatment to deal with post-traumatic stress disorder, nightmares, etc.  These can run thousands of pounds.  Not only does this help their case, but this drives substantial business to companies like Premex who will often share a portion of their revenue with referring parties (typically the law firm or a CMC).  Examworks refers to these payments as commissions or referral fees on their calls, even though the practice of paying for referral fees to law firms was made illegal in 2013.

5. Examworks exposure to these issues and how much revenue at risk

 

Examworks doesn’t provide great disclosure on their UK business, but has generally downplayed the threat of whiplash legislation on their business.  Examworks provides a series of services in the UK, but we believe the biggest segments for them are IME reports and rehab services, both of which are directly tied to the magnitude of whiplash claims.  Multiple conversations with industry participants have resulted in guestimates ranging to 70-90% of Examworks’ volumes being driven by whiplash claims.  This is further supported by prior cited statistics, which suggest as much as 80% of personal injury claims in the UK are whiplash related.  There is an even better source, however, for the percentage of Premex’s own claims that are whiplash related, and that is Premex themselves.

 

In response to the government’s investigation into whiplash injuries, Premex submitted a brief to the government outlining their position on whiplash injuries, and sharing their data.  In it’s brief, Premex describes itself as follows:

 

“as the leading provider of medico legal reports, Premex holds a meaningful underlying data set relating to whiplash type injuries and associated prognosis periods. To the best of our knowledge, this is the largest data analysis of its kind involving some 279,148 ‘whiplash’ type injuries”

 

The brief goes on to describe that this data was collected over the past 36 months from their own practice.  Further, they disclose that they completed 124,371 medical reports in 2012.  Assuming modest growth in Premex over the 2009-2012 period, we can back into estimates of what % of medical reports Premex did were for whiplash claims.  We believe the number to be 85%,, and estimate Premex’s total medical report volumes broken out between whiplash and non-whiplash as follows:

Not only is Premex the largest provider of medical claims and whiplash claims in the UK, but we also believe their exposure to this business has continued to grow as total claims and their market share in this market has grown.  Although whiplash claims are the vast majority of their volume, revenue per exam is lower in this area.  Non-whiplash medical reports can sometimes be 2-5x whiplash exam costs.  That said, we believe Examworks’ rehab business, which could be as much as 25% of their total revenues, derives the vast majority of their revenues from whiplash related rehab.  Also, we believe it is likely that Examworks is also providing higher value medical reports like psychological and orthopedic reports in addition to the standard whiplash report, which would .  Because the insurer pays for these reports, and because Examworks typically pays the referring party a cut or commission on the total dollar value of medical exams, there is strong incentive to order as many reports as the defending insurance company will pay for.  To the degree that that personal injury claims per accidents returned to 2.1 claims per reported accident, total personal injury claims – the main driver of Examworks business – would decline over 55%.

 

 

6. Pending and existing legislation changes that threaten to “completely destroy the low value personal injury” and, by extension, Examworks business in the UK

There have been a series of legislative efforts to curb out of control whiplash costs.  Earlier legislative efforts focused for example on reducing lawyers fees have been unsuccessful, because the business is still very profitable even at lower revenues that they now face.  Efforts to make paying referral fees illegal have also proven unsuccessful, as most parties involved have cleverly devised ways to compensate for referrals in ways that aren’t technically referral fees.

 

In October 2014, the Medco portal was announced.  The goals of Medco were numerous, but at its core the effort was to make sure whiplash claims were more properly medically validated.  This process involved regulating the price for a simple whiplash medical report (down about 20% and called out by Examworks as a headwind to their business).  There are also efforts to better regulate the IME providers on Medco, which we think has largely had a neutral impact on Examworks.  One the bigger changes, scheduled to come into effect in June 2016, is the regular auditing of doctors who participate in Medco.  Prior to Medco, there were stories of certain doctors offices that saw 20 patients an hour, and would diagnose everyone with whiplash symptoms, order 5 physiotherapy sessions, diagnose post traumatic stress disorder and order costly counselling, etc.  In the story of a smaller IME provider, we heard of doctors conducting whiplash consultations via skype.  Elimination of smaller non-compliant IMEs should help EXAM, but elimination of rubber stamp, turnstile doctors offices should hurt the industry at large.

 

Under the new Medco regime, doctors are required to upload their medical report to the portal.  To the degree their medical reports are found to be outliers or their patient load deemed excessive, they will be kicked off the portal.   The hope is that by raising the costs of compliance to doctors, this will help to reduce fraudulent claims.

 

Despite its promise, Medco has done little so far to curb claims.  The launch was rife with trouble from the start, it didn’t work very well, and as of yet has made little dent in claims.  Under mounting pressure of the auto insurance industry, the press, and consumers, the HM Treasury, in its Autumn Statement released in November 2015, saying that it intended to pass legislation by April 2017 that is designed to stamp out fraudulent whiplash claims by attacking the economic incentive claimants have to file false or exaggerated claims.  

 

Under the new proposal, there are a few changes, the most meaningful of which would eliminate cash payments for “minor whiplash injuries”, and only award cash payment for pain, suffering, and other matters in serious crashes.  Although it is unclear what the definition of “minor whiplash injuries” will mean, the current expectation is that this will be based in large part of the duration of the symptoms, with the definition likely ranging somewhere from 6 months to 2 years.  According to Premex’s own data from 2010-2012, 62% of all whiplash symptoms last less than 6 months, and 94% last less than a year:

 

 

Although no cash compensation would be received, the claimant would be offered free treatment.  But with no promise of cash payment in a minor whiplash claim, the theory is that there would be no strong incentive for claimants to make up injuries, and cases would plummet.

7. Others are very nervous about this legislation, but Examworks hasn’t even disclosed it.

The proposed changes in the Autumn statement have spooked the industry.  Conversations with solicitor firms have suggested that many fear they will have to shut their doors if the legislation in the Autumn statement is enacted.  These fears have also rippled through a couple other publicly traded companies with exposure to these changes.  Slater & Gordon, a publicly traded law firm in Australia that owns a collection of personal injury law firms in the UK, saw their stock decline more than 50% on the day of the Autumn statement.  Trade associations like The Law Society as well as Slater & Gordon came out aggressively against the proposed legislation.  The National Accident Hotline, one of the largest CMCs in the UK, saw their stock decline over 25% on the day the autumn statement was released, and subsequently has begun targeting higher value personal injury claims in anticipation of potential impact of the proposed legislation, and traded down as much as 50% as they disclosed potential impact to their business. On the day of the Autumn Statement announcement, Examworks stock was unchanged.  Further, although Examworks references prior legislation impacting the industry, they make no mention of this proposed legislation as a risk factor in their most recent annual report or on conference calls.

 

8. Uncertain future not reflected in valuation

We view the Premex business in the UK as being a fight between the UK government to regulate the main demand driver for IMEs (whiplash claims away), vs. the law firms, CMCs, and IME companies who try to find work-arounds to legislation to keep the gravy train going.  Although it is unclear exactly how this will play out, we think the risks and business quality are not reflected in the valuation being ascribed to the company and this part of their business.

 

4. Potential for receivables write-downs given counterparty risk in UK business.  This dynamic also leads to poor cash flow conversion relative to EBITDA for the business.

Examworks notes on their conference calls that their DSOs in their UK business are in excess of 300 days.  Examworks also has over 60M of receivables that have been outstanding or do not expect to be collected for more than 1 year.  A big part of the Premex business is extending credit to law firms, and we believe this exposes Premex to substantial credit risk, especially to the degree their primary customers are likely to be impacted by pending legislation.  In some cases, Examworks receives payment directly from insurers.  In most cases, however, especially in higher value IME bills, the insurer refuses to pay the bill until the case is settled or won.  Because the claimant doesn’t typically have the resources or desire to pay the IME bill, either the law firm or the IME will carry the credit until the case is settled.  To the degree that the case is settled unfavorably, or to the degree that the law firm that Examworks has extended credit to goes bankrupt, Examworks can face substantial accounts receivable writedowns.  Based on DSO disclosures, there are a variety of reasons to think that Examworks faces meaningful credit risk in their A/R book.  Further, because of this dynamic around poor cash flow conversion, we think EBITDA as a metric is not a fair way to value the UK business.

 

Below is an estimate of Examworks’ actual cash flow relative to what their theoretical cash flow should be.  While not perfect, this method should be directional close.  Note the large and widening gap in FCF conversion to EBITDA:

 

 

Some of this poor FCF conversion can be explained by EXAM’s organic growth, especially in 2013 and 2014.  Because the UK business has much higher DSOs, one would expect that working capital would be a drag on FCF generation as long as the UK business is growing rapidly.  However, despite reported slowing organic growth in the business as a whole and in the UK in particular, working capital build increased dramatically at the same time organic revenue growth is falling.  

 

Despite modest organic growth in the UK on a constant currency basis (6%) and negative on an as reported basis (-1.4%), Examworks blames the working capital build on their UK business in their latest 10K:

 

“The increase in working capital in 2015 primarily consisted of increases in accounts receivable in our U.K. business and decreases to accrued interest expense, offset by increased accounts payable and accrued expenses.”

 

Several large law firms in the UK are under duress.  Slater & Gordon, referenced earlier, is being valued as

if it is headed for bankruptcy.   Parabis, a PE backed law firm, recently declared bankruptcy, and sold their

Argent business to Examworks in the bankruptcy process.  Extending long dated credit to an industry

that faces substantial business risk is likely not to be a winning strategy long-term.

5. This would not be the first time the company glossed over regulatory issues set to materially impact one of their business units overseas.  Shortly after IPO the Canadian business experienced adverse regulatory actions which resulted in a substantial decline in operating performance.

 

This would not be the first time investors were blind-sided by downplayed regulatory issues.  One contributing factor to EXAM’s poor stock performance in late 2011 were issues with an IME client in Washington, which Examworks described as follows on their Q2 2011 conference call:

 

“In late June, we received written correspondence from a client in the western region regarding some administrative concerns. We immediately had our vice president of the western region contact the vendor manager to review these issues.  Once the issues were fully understood, we implemented workflow, system and policy changes and enhancements to address the issues and then met with the vendor manager in person to communicate our position and action on each of these points. Feedback from this account indicates that we should be back in full operational mode by the end of this month.”  –Q2 2011 CC

 

In part because this raised concerns of regulatory or other issues, management received a question on potential regulatory threats to the business and assured investors there was nothing to worry about:

 

Q: Just one last one, are you aware of any regulatory changes in any of your markets that might have any material impact on the business?

 

A: Not at all. I think it's important to remind everybody that these regulatory changes are and will continue to be a significant part of our business. They've existed for years, they've occurred for decades and nothing has occurred nor is there anything on the horizon that we believe would disrupt or harm our business in any meaningful way. So, we don't see anything that we're alarmed about at all.

 

One quarter later, after posting double digit declines in organic growth, the company blamed

much of this negative impact on both the Washington & Canadian issues they referencedon the prior call.  The Washington state issue, which they’d previously described as being back to full business by

the end of August, now was expected to not contribute meaningful revenue again until January.

 

“As we discussed on our last call in June, 2011, we were placed on inactive status and we're unable to

perform workers' compensation IMEs in the State of Washington resulting in approximately a 5% decline in

year-over-year revenues. We were reinstated with this important customer on October 27, 2011 to active

status and we expect meaningful revenue contribution to resume in January 2012.”  --Q3 2011 CC

 

One quarter after dismissing any regulatory changes as having a meaningful impact on the

business, the company called out a 300bps headwind to revenues from regulatory changes in

Canada:

 

“As we also previously discussed, there was a legislative change in Ontario, Canada that took effect on September 2010. The changes from this legislation manifested themselves largely in the third quarter as some insurance companies made process changes that are delaying the timing of IME requests. We believe that the causes of delays will begin to get resolved in the second half of 2012. This accounted for 3% of the decline”  --Q3 2011 CC

 

When the company eventually revealed Canadian pro forma revenue growth, it turns out the business had declined over 27% in Q1 2011 and 35% in Q2 2011.  The Canadian segment continued to decline in Q3 and Q4 of 2011, despite lapping what should have been very easy comp and management’s suggestion at the time that business would bounce back by H2 2011.

6. Core of EXAM’s business (est. 50% of EBITDA) focuses on a market facing slow structural decline

 

In the US, the IME industry is a bit more straightforward than it is in the UK.  IMEs are primarily used by workers comp and auto insurance carriers to manage claims.  In the US, workers comp claims compose the majority of the market.  Unlike in the UK, clients are primarily the insurers themselves, or in some cases, third party administrators or self-insured companies.  IMEs are utilized to independently assess the validity of the patient’s claims, as well as to help manage treatment to minimize costs and maximize effectiveness of the treatment.  IME usage is tied directly to workers comp claims and bodily injury claims.  In the US, both of these measures are in slow, structural decline, which Examworks has acknolwedged.  For auto claims, which we estimate to be about 30% of volumes, better safety features on newer cars have resulted in decreasing bodily injury claims.  These claims have declined 11% from 2005 to 2014, or a cagr of -1.2%:

 

 

Workers claims / Disability, which we estimate to be the bulk of the balance, are also in structural decline, as blue collar manufacturing jobs, long a large source of workers’ comp claims, are increasingly being replaced by white collar office jobs, which have a much lower associated risk of issues that would result in workers comp claims.  The national council of Compensation Insurance (NCCI) has accumulated excellent data on claims trends in workers comp in the US.  They stimate that from 1990 through 2009, claim frequency declined at a 4% cagr.  Between 1991 and 2012, claims declined cumulatively by 58%:

 

 

Despite volumes across the industry generally declining a couple percent each year for IMEs, pricing does move a bit positively each year, driven primarily by increasing doctor costs.  Examworks also suggests that they believe the % of cases that use an IME are growing and contributes to market growth.  That said, we have heard from numerous market participants, including competitors, formers, and customers, that all suggest that the market is flat at best, vs. management’s commentary that the market is growing and that they can grow mid single digits over time.

 

Despite a flat market, Examworks, to their credit, has grown their US business nicely over the past three years (especially in FY13 & FY14) on an organic basis:

 

*From EXAM press releases.  FY11 is for Examworks brand only

**Assumes 3 percent price increase annually on average, based on industry diligence

***Assumes market growth is 70% Workers comp claim growth and 30% auto.  

We think this growth relative to the market has been driven by several key factors:

1. Reversal of some significant share losses in 2011 that artificially inflated subsequent growth

2. Increased penetration of national accounts, and drive of large insurance companies to reduce vendors largely at the expense of smaller mom & pops

3. Rapid growth in certain customers, like Sedgewick, which we believe uses EXAM & their sub-brand MES on an exclusive basis and has grown themselves through acquisition.

4. Lack of new competition due to former owners and employees sitting out non-compete agreements.

7. There are already signs that organic growth, ex-currency, has turned negative in Examworks core geographies and on a proforma basis.  The company dismisses these concerns noting certain legislative and business pressures have abated.

 

There is a lot of reason to qualitatively believe that organic growth is challenged and that those challenges will worsen, and much of that can be found in detail later in this write-up, but let's start with the numbers.  We believe the business has already started to see organic growth slow dramatically, and even turn negative in the UK.  Despite this trend, the company has guided to improve organic growth sequentially throughout the year, largely on national account wins and roll-outs in the UK and the US.  While it remains unclear if those will pan out, the recent weakness in the business is clear.  We have focused on the US and UK, the focus our analysis and representing over 85% of LTM EBITDA:

 

 

Organic growth in both the UK and US has slowed considerably, turning negative in the UK in Q4 2015 and declining below 1% in Q4 2015.  Overall organic growth declined as well, especially in Q4, driven by the sequential weakness in US & UK results. The numbers are even worse on a proforma basis.  Organic growth remains positive driven by gains in Canada and Australia.

 

As a quick refresher, the company reports proforma results for all operations (including acquired businesses) to allow for a comparison on an apples to apples basis.  The difference between this number and the organic growth number is that it takes into account the growth rate (or lack thereof) of acquisitions that have been acquired in the last 12 months but are excluded from the organic growth estimates.  Further, because organic growth numbers are not audited, it also serves as a check against aggressive management teams.  Interestingly, proforma revenue growth and actual organic growth (ex currency), have diverged recently, suggesting that either recently acquired businesses are shrinking, or that the company is overstating its true organic growth:

*The company does not disclose PF Q4 revenues, only full year.  Q4 numbers are backed into based on mgmt disclosures for Q4 completed acquisitions, Argent & First Choice, which we estimate added 51M of revs to Proforma ebitda in 2015 and 12.5M in the quarter.  We assumed the businesses were flat year over year.  To the degree the businesses were growing when acquired, our PF revenue growth is overstated (e.g. declines would have been worse).  To the degree that the businesses were shrinking, it would be understated, but if the case that means they acquired declining businesses.

 

Bulls are comforted by management’s guidance to big national account wins/rollouts that will begin to add to revenues in 2016.  Examworks track record the last couple years delivering on their guidance has been pretty good, but a fuller picture of the past at Examworks suggests reason for caution in taking management guidance at face value.

 

8. This is not the first time Examworks has faced organic declines in their business or troubles with acquisitions and tried to dismiss the concerns as temporary.  Similar issues in the past shortly after the IPO led to the stock falling from 25 to 7 a share.  We believe a repeat of this is likely in 2016.

 

Examworks IPOed October 28th at $16 a share.  The pitch was not too dissimilar to what it is today, except with more white space – they saw an opportunity to roll-up a very fragmented industry and take share over time as they built out a national footprint and took share from smaller mom & pops.  At the same time, the company suggested they could buy many businesses for 5x EBITDA, which they did.  They targeted mid to high single digits organic growth long-term.  But only a couple quarters into being a public company, Examwork’s began to face some organic growth challenges.  We believe that the company was not forthright to admit organic declines they were seeing in their business.  This eventually resulted in the stock declining from a peak of $26 to a low of under $7 a share in July 2011 to under $6.50 a share in November 2011. We believe this is important in the context of a bull case that rests mostly on guidance.

 

Out of the gate, the company reported Q4 organic growth of 11% and full year organic growth of 12%.  Management was upbeat on 2011, suggesting they were being conservative and guiding to 5-10% organic growth in the core Exam business:

 

“Additionally, we took our numbers where we’ve grown double-digit and said that we feel comfortable in the 5% to 10% range this year. So we think, we built a contingency into that and hopefully we’re being overly conservative on that. “  --Q4 2010 earnings call

 

Despite what they suggested would be a strong year, they noted weakness in Q1 driven by weather:

 

“Notwithstanding what we believe to be a fantastic year for ExamWorks as reflected by our guidance, we feel it is important to share what we believe will be lower than expected Q1 results due primarily to the severe weather conditions that impacted many of our geographical markets.”  --Q4 2010 CC

 

In Q1 2011, the company noted that they were down organically in Q1 on core examworks business (ex-MES), but did not provide any estimate of exactly how much they had declined.  Proforma revenues were up less than 1% YoY, largely blamed again on bad weather.

 

Q: Hi, thank you. I guess first question would be on the organic growth rate, revenue growth rate. I apologize if I missed that. Did you give that out?

 

A: Well, Shelley, I mean, we talked about and forecast on the last call that we actually would be down for the quarter based on these weather conditions we discussed on the ExamWorks side. –Q1 2011 CC

 

The company suggested that appointments delayed by weather would help them bounce back in Q2:

 

Q: Okay. Thanks. And then all of those Exam’s that were impacted by the severe weather, is it fair to assume that they got rescheduled during the quarter? Or is there any expected impact in the second quarter?

 

A: They are. So as we are working through that backlog, I mean we’ll see those cases come back over the next several quarters like we assessed in the previous earnings call.

 

Despite weakness in the core business, the stock continued to move higher as Examworks successfully acquired much more than they guided to.  Because the company kept acquiring businesses, they were able to raise their guidance in Q1 despite weakness in organic growth in their core business.

 

In Q2 something funny happened – despite weather issues abating, pro forma revenues grew only 2% which the company claimed was in line with their expectations.  

 

“Pro forma revenues for the second quarter of 2011 were $115.7 million compared to $113.9 million for the prior year quarter growing at 2% and in line with our 2011 revenue growth expectations.” –Q2 2010 CC

 

The company did note some operational issues, but noted that they believed these issues were behind them:

 

As expected, these transactions resulted in market disruption, customer concerns, competition misrepresenting facts, as well as employee unease about a changing organizational structure. The results through June and guidance for the year, as well as our customers' increased satisfaction are reflective of our success in overcoming these issues. We believe these issues are increasingly behind us, and as we enter 2012, ExamWorks will resume its level of high single to low double digit revenue growth over the coming years.

 

The company once again did not provide organic revenue growth numbers, when pressed on the call management refused to answer organic growth questions and pressed people to take their questions “offline”:

 

Q: Okay. And then I was just trying to reconcile some numbers here, maybe I misunderstood something, but your pro forma revenue grew 2% year-over-year but then when you disaggregated the acquisitions, you said MES grew 13%, Premex grew 9% and I calculated then the remainder of ExamWorks grew 5%, so everything grew faster than 2%. Did I miss something there?”

 

A:  I think so.  But again Miguel is happy to go through that with you offline after the call”

 

After not getting a satisfactory answer, another analyst chimed in, as excerpted below:

Thanks, good afternoon. I do want to go back to that last question, just to be clear, based on sort of the numbers you gave, the organic growth rate you saw in your business is 5%, is that fair?

Ralph, it's Miguel. Again I'm not – I think we should probably go offline and calculate the numbers out of that.

I mean just to go back...

Dalton said it; we didn't say it and we're confused by it.

I just thought you had said $56 million versus $53.4 million.

Yeah, okay, yes, sequentially, yes, so Q2 versus Q1.

Q2 versus Q1, can you do that year ago or no?

Yeah, again I mean, I think we would have to go over the numbers offline – I don't have those with me.

Given that management had guided to organic growth in the Examworks business as one of their key metrics, and also knew the sequential numbers, it’s hard to believe that they didn’t have this information available to them on the conference call when it was likely a question that was going to be asked.  People eventually did the math and came to the right conclusion that organic growth was sharply negative, and the stock fell from a high of 26 a month earlier to under $14 a share.

 

The company eventually disclosed organic growth for each of the business units in their Q4 release, after their stock had declined nearly 75% from its peak.  

 

 

In Q3, the results got even worse, and the stock subsequently bottomed at under $7 a share as the true magnitude of the issues at the company became clear to investors.  Although the business is bigger today and more diversified, we think a similar outcome here is possible taking into account the numerous challenges the company faces in many of their biggest businesses.

9. Further share gains in the US are unlikely due to multiple new competitive threats

 

We believe that many of the drivers that have led to EXAM’s outperformance in the US are in the process of reversing.  

 

1. Non-competes of many former owners are expiring.  Many of these same people are getting back into the business

 

As mentioned earlier, Examworks typically has 2 year non-competes with key employees from acquisition and 5yr non-competes with owners, although the duration can vary.  One of the big flaws in the Examworks model is that this is a relationship business with the adjuster, and although you can have some success at corporate winning national accounts and mandating compliance on downward to the adjuster level, the adjuster at most companies has lots of latitude in terms of working with whoever they want to.  For many of the small IMEs that Examworks has rolled up, these relationships were held at the owner level.  Based on disclosures of the timing of acquisitions and assuming a 5yr non-compete period, we think a substantial portion of the prior owners of Examworks’ business are exiting their non-competes and restarting their businesses.  

 

In total, we estimate that 50% of Examworks revenues and 29 of their 56 acquisitions to date hit the 5yr anniversary sometime in 2015 and 2016.  Because it takes time for people to restart their businesses, win back trust, penetrate new accounts, etc., we expect there is often a few month lag between non-competes rolling off and new start-ups having an impact on the business.  This means most the impact should hit in late 2015 and into 2016.

 

Based on numerous conversations with industry participants and former owners, we think it is common for a start-up IME to typically get to about 1M of revenues within the first 12 months of launching, and to be able to reach 3-5M of revenues in 3 year period.  Most of the clients, especially early on, are clients they would have worked with at Examworks who are unhappy with service or with whom they have strong relationships who shift business from Examworks to their new company.   If half of the 29 owners who sold to Examworks restart their businesses, and each one siphons off $1M of sales in the first year from Examworks, that would be a 3% decrease to US revenues from owners re-entering the market alone.

Interesting, Examworks has called out pressure from mom & pops as driving a slowing of organic growth in Q3 and into Q4:

 

“Our competitors have been impacted by our success, as the competition lost business from 1 or all of our 6 national accounts. They replaced some or all of this business with local and/or regional work. These changing dynamics at the local level are the primary reason for the temporary pause in our U.S. growth rate. We have sales and operational initiatives underway to address this. We generally see that competitors are very slow to react and adjust fixed expenses to address the shift and the result is either subpar margins or for smaller companies, negative margins. We have seen this a number of times in the past during our 7-year tenure at ExamWorks and it is not a sustainable long-term strategy for our competitors.” – EXAM Q3 2015 CC

 

On their Q4 call, after posting organic growth of just .7% in the US, Examworks declared this problem over:

 

“Actual results of 0.7% U.S. organic growth were slightly ahead of our expectations. And we believe that this represents the nadir in our U.S. growth rate. We also discussed the initiatives that we had put in place to carry the tactics of small mom-and-pop competitors. As we indicated, we thought this would be a short-lived phenomenon. And based on our anticipated Q1 results, we expect our U.S. organic growth rate to be at least 3%.” – EXAM Q4 2015 CC

 

We believe management is downplaying the threat posed to them by mom & pops, especially those that are starting up new businesses in the space.  Although Examworks’ national footprint is a big positive, especially to larger carriers, there is much more than that that matters.  Turnaround time, service level to the adjuster, quality of IME, rate of no-shows, and relationships all matter a great deal.  Mom & Pops have and continue to successful compete in national accounts as well as smaller accounts on this basis.  We believe the pressure Examworks faces, rather than abate here, is only growing.  We also believe that several key sales people that were let go in late 2013 recently had their 2 year non-competes end and are coming back into the market, including several taking key roles at large competitors or customers.  Although tough to quantify, this should also pressure results in the US.

 

2. New Larger competitors are getting into the IME business

 

Examworks is far and away the largest player in the IME industry.  We believe Examworks is about 10x the size of their nearest competitor and that the market for IMEs in the US is about half what Examworks says it is.  Examworks success as a stock has attracted the attention of many other players in tangential parts of the market that service the same customers Examworks does and are expanding into IMEs the same way Examworks is trying to expand from IMEs into other service areas.  We think these competitors are getting increasingly aggressive and pose risk to Examworks.

 

Two major players making a push into IMEs are Coventry & Genex.  Genex is a large provider of medicare set-aside, peer review, and medical cost containment solutions to insurance carriers and third party administrators.  In January 2016, Genex hired a former senior regional VP of Examworks to run their IME business.  Coventry is also a substantial national player, naming one of the largest TPAs as it’s customer.

 

We have also heard suggestions from former employees whose non-competes are ending that several TPAs are looking to do IMEs themselves rather than outsourcing them to company’s like EXAM.  Although it remains to be seen to what degree this happens, it poses another threat to the market opportunity for Examworks to go after.

3. Examworks national reach is an asset, but there are several large disadvantages and issues with their service offering that management glosses over and which matters to customers.

 

We have done substantial industry checks on examworks with customers, competitors, and former employees.  While clearly subjective, the tenor of these calls tends to be very negative.  Although nearly everyone acknowledges that Examworks national reach relative to peers is impressive, there are a host of issues that we have heard with regards to Examworks that offsets and in some cases overwhelms the positives associated with their national reach.

 

1. Although Examworks is very strong in certain regions, they are weak in others.   Customers can sometimes struggle with the national account approach given different levels of service and coverage by state.  When customers are forced to use EXAM nationally, certain branches tend to complain, and in many cases get exceptions or a local provider added to the preferred provider list.

2. General feedback on Examworks sales staff is negative at the branch level, with a general disdain reported in many instances for adjusters at the local level.  EXAM’s general philosophy is to win at corporate and push compliance down through corporate down to the adjusters.  Mom & Pops and smaller regional guys tend to win at the adjuster level.  Adjusters often feel like they are forced to work with Examworks, and Examworks reps have been known to display a level of arrogance and feeling of entitlement that the customer “has to use them”.  This is often not the case, however, as Examworks has minimal exclusive relationships.  This strategy typically backfires at some point as a groundswell of adjusters complain in a branch or region and that eventually filters back up to corporate.

3. We have also generally heard that Examworks has unusually high “no show rates” in certain areas.  This means that the patient didn’t show up to a scheduled appointment.  This is problematic because it elongates turnaround time, which is of importance to customers.  It is also a problem because Examworks typically charges for the no-show (which they can do in many states).  We have heard suggestions from competitors that Examworks may intentionally not follow up with patients in the hopes they don’t show, so they can charge for the service but not have to pay the medical provider.

4. Mom & Pops excel at local service and making the adjusters life easier.  This is not a strength of examworks.  If you have service issues with a mom & pop, you can usually call them up and get the person handling your case on the phone to help you resolve the issue.  With examworks, you are often routed to a 1800 number

4. Running out of room to grow:

Examworks already has national accounts at most the largest utilizers of IME services, so it is unclear how much upside remains from national account penetration.  We believe the largest national accounts (of which there are only 2 we have been able to identify) do 80-100M of total IME business a year.  Examworks already has substantial business at both these accounts.  There are then a handful that do 30-35M a year of business, and Examworks already has many of these on contract as a national provider.  Ultimately we just don’t’ see much room for them to continue to grow via share gains, and as aforementioned service issues and increased competitive pressures catch up with them, think it is more likely share declines vs. grows in the future.

Risks:

 

1. Accretive acquisitions:  Management can try to buy their way out of organic or pro forma revenue declines by buying growing businesses.  To the degree they do this, we think they have to pay 8x+, but at the current multiple this would still be accretive to valuation.  Also to the degree the UK industry has substantial issues, management can potential do acquisitions here at much lower multiples which would be more accretive.

2. Hard to diligence and lots of levers to pull to prop up organic growth: We have done over 20 calls with people in industry in the course of our diligence.  Although we feel good about our conclusions, if we missed one large customer who is happy with EXAM and giving them more business, it’s possible that those share gains can offset some if not all of the headwinds we have outlined here.  We also think management has some shady ways they can prop op organic revenue growth, both in the US & UK, if they are so inclined, which could harm the thesis here.

3. UK risk uncertain: UK legislation is pending and still a moving target.  It is possible this gets delayed, watered down, or never gets implemented.  It is also possible that EXAM and other industry participants offset lost business through shifting attention to other areas of personal injury claims or by finding effective workarounds for pending legislation.

Catalyst

**continued softening in organic and pro forma revenue growth vs. expectations

**Hit to management credibility as organic growth falls short of guidance

**Risk from UK legislation that could materially harm the business