Description

Pair trade:  Long HLTH, short 0.1979 WBMD

HLTH has agreed to merge into WBMD.  At closing, each share of HLTH will be exchanged for 0.1979 shares of WBMD plus $6.89 cash subject to a downward adjustment.  The downward adjustment is the difference between the actual proceeds received by HLTH on its $195 million of auction rate securities (ARS) and $194.5 million.  As a condition to the merger HLTH has to liquidate these securities.  These ARS are backed by student loans, 97% of which are guaranteed by FFELP and were AAA when HLTH purchased them.  Depending on your view on the magnitude of the haircut that HLTH will take, the expected trade outcome range is as follows:

Upper limit – no haircut

Invest $5.59: long HLTH ($9.92) - short 0.1979 WBMD @ $21.89 ($4.33)

Receive $6.89

Gross return 23%

Lower boundary – 50% haircut

Invest $5.59: long HLTH ($9.92) - short 0.1979 WBMD @ $21.89 ($4.33)

Receive $6.39

Gross return 14%

While it is difficult for me to estimate the actual magnitude of the haircut, I believe 50% provides a substantial margin of safety.

Currently HLTH has three operating business: WBMD, ViPS, and Porex.  HLTH has committed to divest ViPS and Porex.  It is a condition to the merger that HLTH divests of either of ViPS or Pores prior to closing.  “If either ViPS or Porex has not been sold at the time the HLTH Merger is ready to be consummated, WebMD may issue up to $250 million in redeemable notes to the HLTH shareholders in lieu of a portion of the cash consideration otherwise payable in the HLTH Merger. The notes would bear interest at a rate of 11% per annum, payable in kind annually in arrears. The notes would be subject to mandatory redemption by WebMD from the proceeds of the divestiture of the remaining ViPS or Porex business.”

It is highly likely that the merger will close for the following reasons:

-  HLTH controls 96% of the votes of WBMD through its ownership of 48.1 million Class B shares (84% economic interest)

-  Both companies mention in their respective 10Ks that the merger is expected to close in Q2 or Q3 of this year

-  There is no reason for HLTH to remain independent.  HLTH has committed to divest ViPS and Porex.  It has also expressed that there is “significant interest from potential strategic buyers.”

-  The condition that the amount of cash is sufficient to cover the cash portion of the consideration has already been met.  Specifically, the consolidated cash plus the potential $250 million form the notes has to exceed by $85 million the fully diluted cash portion of the consideration.  As of February 21, HLTH reported a cash balance of $1.45 billion.

In the unlikely event the merger fails to close, in my view the downside is minimal.  Under this scenario, one would have paid $5.59/share for ViPS, Porex, $2.56/share of net cash, 0.049 WBMD/share, and $1.3 billion worth of NOL.  To examine the downside, it is necessary to value each of ViPS and Porex conservatively.  In the interest of brevity, I will say that these are good businesses with high returns on invested capital.  Here are the numbers (in US$ million):

                        2007    2006    2005

ViPS

Rev                  103      99        90

Adj Ebitda        21        20.5     17

Capex              2          2.5       1

Porex

Rev                  92.5     86        79

Adj Ebitda        27        25        22.5

Capex              2.5       3          2.5

In my view a conservative valuation for these business would be $435 million ($2.23/shr) equivalent to 10x ’07 Adj Ebitda-Capex.  (Adj Ebitda excludes non-cash stock compensation and unallocated corporate expenses.)

HLTH owns 48.1 million WBMD shares, or roughly 0.2466 WBMD/share.  Since we shorted 0.1979 shares of WBMD, in the event the merger fails we would own a net 0.049 shares of WBMD per share of HLTH.  At the current price this is worth $1.07/share.

In sum, under a failed merger scenario, we would end up with $5.86/share of value bought for $5.59/share.  Please note that in the interest of being conservative I have assigned no value to the $1.3 billion NOL.

Included in the $1.45 billion of reported cash are $575 million of proceeds from the sale of their 48% stake in EBS.  “The Company expects to recognize a taxable gain on the 2008 EBSCo Sale and expects to utilize a portion of its federal NOL carryforward to offset a portion of the tax liability that would otherwise result from the 2008 EBSCo Sale.”  Without further information, it is difficult to determine the actual cash outflow connected with the tax liability for this transaction.  My guesstimate of the cash tax liability is a range of $50-$100 million.  Partly offsetting this cash outflow is the company’s free cash flow generation at the rate of $70 million per year.

Catalyst