Description

Description

Health Fitness (FIT: $2) provides fitness and wellness management services primarily to U.S. corporations.  FIT currently manages 231 corporate fitness centers, 170 corporate health management sites and 97 un-staffed health management programs.  Staffing services and program management in both fitness and wellness mgmt segments are offered through on-site fitness centers, remotely via the web and through telephonic health coaching.  Wellness management programs include risk assessment, education, coaching, physical activity and weight management.  Numerous studies indicate that healthier employees are more productive, experience reduced levels of stress and are absent from work less often due to illness. It works; very important for the self-insured clients who account for a big slug of FIT's customers.  PWC Health Research Institute and others have published many studies on this topic.

The company is profitable ('08E ebit margins: 5% and recovering), growing ('08E revs: $76M, +9%) and has no debt, yet trades at ½ of fair public market value and 1/3 of low end strategic value (yes, to a rational buyer).

Investment Thesis

Following a small strategic acquisition and a two-year period of significant investment in internal capabilities and process improvements, Health Fitness is beginning to show significantly improved profitability as the fast-growing wellness management business begins to scale.  As the contribution from wellness management overtakes that of legacy fitness management, FIT's reported results and strategic value should continue to appreciate.  As these improvements become transparent to even the casual observer, we believe the enormous gap between the public market valuation and the strategic value will compress, either through market appreciation or a sale of the company, or hopefully a combination of both!  Our sense is that large shareholders and management are increasingly frustrated with the current situation.  Fair public market value would be a double, while reasonable strategic value is a triple from current levels.

Valuation

At $2, with 9.7M shares and no debt, FIT has a market cap and EV of just $19M. This represents 3.6X 2008 EBITDA ($5.2M) and a 22% free cash flow yield, defined as (EBITDA-Capex)/EV.  On '09, the EBITDA multiple drops to 2.6X and the free cash flow yield jumps to 30%.  ($7.2M-$1.0M)/ $19M. Capex (including modest capitalized software development) should be about $1M in both years.  The company's staffing services and program management model results in very high ROIC, even with the current depressed margins. Estimated 2008 EBIT of $4.1M was achieved on net tangible assets of less than $10M. Note: Q3-08 revenue/ebitda/eps were $18.5M/$1.8M/$0.09, suggesting our '09E could be conservative, even in the current environment.

With expected '08 and '09 EPS of $0.23 and $0.34, the current $2 price implies P/Es of 8.7X and 5.8X, respectively.

On $76.5M of '08E revs, FIT's EV/revs is only 25%.

FIT trades at 71% of estimated yearend '08 stated book value of $2.80.  About $15M of the stated BV is goodwill, from the 2003 acquisition of JNJ's fitness/wellness business ($10M) and the HealthCalc.Net acquisition in 2005 ($5M),  so tangible book is about $13M or $1.35/share.  Current EBIT/Net Tangible Assets is over 40%, on depressed margins.

Strategic Value

Yet, all these metrics understate just how cheap FIT really is.  We estimate at least $1M of public company costs and $2-3M of readily attainable cost synergies with a host of industry players. The $2-3M of cost synergies is based on conversations with management and other industry sources and represents only 3-4% of FIT's '08 total cost base of $70M.   A strategic buyer could thus realize $10M of current year EBITDA ('09 ebitda: $7M + $3M above) and consummate a highly accretive deal at 6-7X ebitda or $6-7 per FIT share, a multiple of 3-3.5X the current $2 stock price.   NOTE: options related leakage increases as the stock price passes $4 and we've incorporated some of that in our targeted strategic price range.  We believe that management historically targeted an 8-12X ebitda range for strategic value, but they are likely (hopefully?) more realistic in the current environment. We are of course happy to settle for their # if a buyer agrees more with them!

Another way to look at the business is to split Fitness Mgmt and Health Mgmt.  Fitness Mgmt is a profitable, but low/no growth business, which while potentially strategically valuable as a physical presence on the corporate campus, is probably worth 50% of revs, assuming high s.d. ebitda margins. (The company gives gross margin by segment but does not allocate salaries or SG&A to the segments, therefore my segment ebitda #s are estimates.) Health Mgmt on the other hand is growing rapidly, scaling into improved margins and has proven over many years to be strategically valuable to multiple industry players.  With d.d. ebitda margin potential and a solid growth outlook we think Health mgmt could be worth a minimum of 1X revs, even without a strategic event. As the revenue split will be roughly 50/50 in '09 a blended valuation of 75% of revs (at least $80M in '09) suggest an EV of $60M or about $6/share.

Strategic transactions in Health Management would suggest valuations closer to 2X range adding about $40M or $4/share to the "public market" valuation range, however the appetite of the various players has been somewhat volatile so we'll stay with 1X to remain "conservative"/realistic.

Management

FIT's management team has been meaningfully enhanced over the past few years with the additions of President and CEO Gregg Lehman in January 2007 and John Griffin, COO, in Feb 2008.  Gregg and John have led a re-engineering of the company with a focus on cost rationalizations and process improvements to create true scalability. We believe YTD 2008 results are evidence that these investments are beginning to pay off.  This is a much better and more valuable company than the FIT of 2 years ago.  

Despite its growth and acquisition aspirations, management appears to be disciplined and focused on economic valuation creation not just size or mathematical eps accretion. FIT built an in-house phone coaching capability for about $3M all in vs. acquiring an existing player for an estimated $12-$15M. The in-house route clearly took longer and is not yet fully utilized and thus has penalized ebitda margins and eps but is now beginning to scale and has certainly enhanced FIT's value proposition to clients and strategic value to would-be acquirers.

There are 1.4M shares and options, of which 644k options are currently exercisable ($3.94 avg. exercise price) and 300K shares were granted that vest following the 2009 audit subject to hitting certain performance objectives. [We are trying to get the specific targets]   Also 765k 5-yr warrants @ $4.80 related to a Nov, 2005 PIPE.

Appears to be an active board; during 2007 they held a remarkable 13 formal meetings, and I don't think it was for the extra $1k/meeting director fee.

The board did form a strategy committee in November 2007.

The board represents itself as open to approaches/process when time/price are right. We It appears that discussions were held with multiple industry players at some point in 2007 although the only observable transactions were the I-trax (DMX) purchase of (FIT competitor) ProFitness and I-trax's subsequent sale to Walgreens at a premium valuation. (see below).

Buyback

In Q2 2008, FIT did repurchase 571k shares (5% of outstanding) for $2.35M or about $4.12/share. Even in hindsight the board/management defend this acquisition as "well below full value".

Profitability

Beginning in 2006 FIT invested heavily in people and process to add internal health/wellness management capabilities and later to re-engineer those processes to create true scalability.  This investment can be seen in the combined Salaries and S,G&A lines in the P&L which went from 17.3% in 2005 to 21.3% in 2006 and peaked (we think) at 25.2% in 2007.  During this period, the growth of the higher gross margin Health Mmgt segment allowed overall gross profit and gross margins to improve from 25.1% to 28.1%, thus limiting the ebitda margin decline to 410 bps from 2005 to 2007 (8.1% to 4.0%).  In 2008, overall gross margins appear to have continued climbing (to 30%) as both Fitness (24%) and Health (37%) improved and the mix continued to shift in favor of health. In addition, Salaries and SG&A appear to have crested as a % of revs, pulling back below 25% due to flat absolute SG&A. Thus 2008 EBITDA margins have likely rebounded to 6.5-7%.  Management has indicated further progress in 2009 and beyond. With continued growth and ramping profitability in Health Management, we think overall EBITDA margins could exceed 10% within 2-3 years.  NOTE: D&A currently account for about $1.1M or 1.5% of revs.

Simple Business, Simple Model

Strategic Position

Despite a good lineup of core service offerings, and a budding turnaround achieved by a solid management team, Health Fitness is simply too small to compete long term with the big boys, does not have a full suite of integrated service offerings and can only truly maximize value for shareholders by selling itself to another industry player at what is likely to be a good deal for both buyer and seller.

Organic Health Management growth, albeit impressive to date, will not be sufficient as FIT just can't scale big enough fast enough.  We believe truly accretive acquisitions will be hard to come by and are highly unlikely to create equivalent value versus an organized sale of the company.

Ultimately FIT needs to add or be added to a company with capabilities in care management, higher acuity management and on-site health management. FIT does offer many additional services via tie-ups but RFPs are increasingly targeting fully integrated, turnkey providers.  Few players actually have this capability now, but more/most will eventually.  The organic growth strategy risks falling behind as this market develops.

The health management services industry continues to consolidate. Disease management and managed care companies have acquired health management companies over the past 3 years.

In December 2005, FIT Acq'd HealthCalc.Net, a leading provider of web-based fitness, health management and wellness programs to corporations, healthcare organizations, physicians and athletic/fitness centers.  HealthCalc added about $2M to revs in 2006 but is no longer reported separately. I can't say I am enamored of this acquisition but it was a prior management team, was smallish ($6M incl. earnout) and does appear to have positioned the company for better growth in Health Management.

FIT continues to express interest in expanding its disease management capabilities via acquisition although the acquisition appetite sounds disciplined and relatively modest.

Competitors (and potential acquirors?) include:

Healthways - HWAY - disease management specialist has added wellness management capabilities over the past few years. HWAY acquired Axia Health Mgmt in Dec 2006 for $450M, after entering the wellness mgmt space with the 2005 acquisition of myhealthIQ.

Allere/Matria - Disease mgmt specialist was acquired by Inverness (a serial acquirer) in May 2008.

Big Health Plans - AET, WLP, HNT, UNH - prob most interesting those with national footprint/aspirations, but wellness programs can be applied to any covered population.  Note WLP has a disease mgmt sub called HMC, but also uses FIT for wellness mgmt.

Amedisys - home health and hospice services with some disease mgmt, has expressed desire to diversify.

CVS/Caremark - do something to counter Walgreens? See below.

Walgreens - acquired I-trax Inc (tkr: DMX) the parent of CHD Meridian, which operated on-site pharmacies, health clinics and fitness centers, in April 2008 for $278M. The $5.40/share price represented nearly a 100% premium vs. pre-deal discussion prices and about 2X TTM revenue.  I-trax had reported ebitda margins below 5% at the time so the 40X ebitda multiple is not particularly meaningful. Even assuming meaningful cost savings, we figure WAG paid more than 15X ebitda for I-trax.  Interestingly I-trax itself has just acquired Pro-fitness, a much smaller version of FIT's fitness mgmt segment for about 70% of revs and 10X reported ebitda (prob less than 6X after synergies).

Walgreens also acquired Whole Health Management a private worksite health management company; terms were not disclosed. 

JNJ - Oct, 2008 acquired Healthmedia, a web-based health coaching provider as "an initial step in the creation of a wellness and prevention business platform".  This would be the ultimate irony as FIT acquired JNJ's Health & Fitness Services division back in 2003!

Businesses

Fitness Management Services (55% of '08 revs, 61%/66% in '07/'06)

This segment manages fitness centers that have been built and equipped by corporations and other organizations for their employees.  Most new contracts are obtained via an RFP process. FIT appears to be the largest provider of corporate fitness management services in the U.S.  Over 90% of Fitness Mgmt revenues are derived from Staffing Services in which FIT receives a management fee and full cost reimbursement for agreed upon staffing levels. The remaining Fitness Mgmt revenues come from Program and Consulting Services which are generally fee-for-service such as personal training, weight loss, seminars, special classes and massage therapy.  FIT staff members earn a commission for selling and delivering these programs.  FIT also generates a modest revenue stream from design and sourcing activities for clients.

Fitness Mgmt is a mature market and the client base is price sensitive. FIT's size and capabilities continue to allow it to win RFPs against primarily local or regional competitors, albeit mostly to replace some modest level of client churn. Realistic expectations are for this business to show little, if any, growth but continued solid cash flow.  The physical location on the corporate campus can be a significant advantage in selling Health Management services, however the company has only recently begun a focused cross-selling program with penetration to-date only 3%.

See '07 MD&A re: net gains/losses.

Health Management Services (45% of '08 revs, 39%/34% in '07/'06)

This segment provides health risk assessment and education.  About 55-60% of Health Management revenues are derived from Staffing Services for health promotion programs, lifestyle coaching services and injury prevention and treatment, in which FIT receives a management fee and full cost reimbursement for agreed upon staffing levels. The remaining 40-45% of Health Mgmt revenues come from Program and Consulting Services which are participant fee based, generally paid by the corporation, and include an e-health platform, paper and web-based health risk assessments, biometric screenings to assess blood profiles and body composition, and face-to-face web-based and telephonic coaching.  FIT also generates revenue from data collection and reporting services, especially as it relates to program effectiveness and ROI demonstration.  Other occupational health consulting services fall in the Health Management segment.

Staffing Services contracts generally average 3 years, while Program & Consulting contracts range from month-to-month up to 3 years. 

Health Management is experiencing rapid industry growth and periodic waves of consolidation.  FIT has capitalized on both avenues of growth with internally developed capabilities driving solid organic growth and the December 2005 acquisition of HealthCalc.Net.

According to FIT's 1/22 press release, in 2008 the company screened 121,868 workers (+60% from 2007), 236,024 participants completed its INSIGHT health risk assessment (+29%) and health advising reached 93,204 employees (+162%)  EMPOWERED health coaching grew enrollment by 280% to 18,442 employees.  Given the various fee arrangements and contracts structures, revenue for health management programs and consulting probably grew by about 40% in 2008 with total health management segment revenue growth (including staffing service) of 25%.  Management believes they can grow

Health Management revenue at 20-25% rates for an extended period given industry growth dynamics and continued RFP pipeline developments.

YTD (Sept) 2008, FIT added new contracts and service expansions with annualized revenue of $6.1M, offset by cancellations of $1.7M. Q4 appears to have been another quarter of solid net adds.

Risks

Fitness Mgmt - clearly sensitive to economic conditions as corporate gym is hardly a necessity but relatively modest cost vs. large employee satisfaction/benefit appears to offer some cover.  Have held ground well on renewals but did take estimated $2.5M hit on mostly UAW/Auto renewals in 2007.  Do expect the add-ons ( Programs & services) to slow, hence the no growth outlook despite continued Fitness RFPs.

RFP Process - continue to come in but decision process has clearly slowed, as discussed by management n the last 2 earnings calls.

Ignored - it's cheap, it's a micro-cap, will anyone care? (Note: I care!)

Catalysts

Continued strong results driven by health management rev growth and margin recovery.

Mix shift towards higher growth, higher margin, higher multiple Health Management revenue.

Strategic process initiated by mgmt, shareholders or strategic players.

Catalyst

Continued strong results driven by health management rev growth and margin recovery.

Mix shift towards higher growth, higher margin, higher multiple Health Management revenue.

Strategic process initiated by mgmt, shareholders or strategic players.