Description

DMX presents an interesting opportunity to buy a growth story, which has a major catalyst coming up and yet provides a margin of safety.

What is DMX/I-Trax/CHD Meridian? The main thing that they do is run health centers in companies. OSHA requires manufacturers to have healthcare professionals on-site when they reach a certain number of employees. Traditionally, a company has had to hire the healthcare workers and oversee the operation themselves. Some companies are deciding to outsource the running of these centers and DMX is the leader in this rather nascent category. However, what DMX has found is that a health center can provide other services, like employee wellness programs and disease management services, as well as sick visits and that white-collar workers benefit from this, too. For example, they run a health center for Goldman Sachs in NYC. DMX offers a value proposition by reducing healthcare costs to the employer because employees have immediate access, which results in less employee down time. Further, the medical staff is salaried and can take the time to provide better care to the employee, resulting in half the referrals to costly specialists. The medical staff can also offer other services, where they can follow up with employees with chronic illnesses like diabetes, heart disease, etc. Reimbursement for running the centers is on a cost plus basis. The “plus” part consists of a 20% to 25% management fee.

Here is the scoop on the growth. There are 7,500 company health sites in the US and more companies are expected to outsource that task to DMX, which is the largest operator of these centers. DMX currently manages 213 sites, so they are in the early stages of growing the company. Additionally, they started a pilot program on 1/1/06 with Goodyear that combines all their ancillary products. If they sold all their products just to existing clients, revenues would triple. There is a lot of room to grow with existing clients without even adding new ones. They have seven centers with Toyota in US, including a new center at their San Antonio plant that is their biggest center yet. The San Antonio site alone should generate $4.5 million revenues in 2007, which is significant for a company with $122 million in trailing twelve month revenues. They also hired six new sales people and expect mid-teens revenue growth for 2007 based solely on the contracts that they have signed so far. However, there are two catalysts coming that could change things.

The Catalyst: DMX has promoted the benefits that they provide to employers, including how their combined focus lowers a company’s employee medical costs. However, due to their small size, there are a lot of skeptics about their value-add. They have a number of clients who have taken a wait-and-see approach and have only outsourced one or two sites. Recently, an independent, peer review study was conducted on their operations. The results of the study will be published by a medical journal in the coming weeks. Management has seen previews of the article, but cannot discuss it until publication. All that they have indicated is that the results show a magnitude of difference that exceeded their expectations. The significance to DMX will be profound. They will have positive proof of the benefits and savings that they offer to potential employers from an objective third-party, and they will generate a lot of good publicity. This will provide a significant lift to their growth. They are contemplating seeking patent status on their process. The second catalyst is that they are also near to securing a mega lift-out from a Fortune 50 company.

Margin of Safety: One of the programs that DMX offers is running closed-door pharmacies. Due to a class of trade designation, DMX can buy directly from the pharmaceutical companies at rates cheaper than a PBM and pass the savings onto the client in a very transparent way. However, they are restricted from selling to the public. The pharmacy contracts are run on cost plus basis, so DMX takes no inventory risk. DMX is fairly coy on the profitability of this program. The cost plus accounting requires them to report revenues net of expenses, and they are not required to report it separately. Thus, it is buried in the revenue figures but they do provide a gross revenue figure as a note to the financials. They did $38 million in the last quarter and $113 million YTD. Management has indicated that this is a low-margin business. If you assume 5% net margins and $150 million of gross revenues, that is $7.5 million of net per year that requires almost no capital commitment. At 10X earnings, the pharmacy business is worth about 60% of the market cap.

Competition: Only two other companies compete in the space, privately held Concentra and Matria (MATR), but running on-site health centers are not their main businesses. They concentrate on wellness programs, pharmacy benefit management, etc.

Capital Requirements: One of the beauties of the health center business model is that they assume the business from the client, including hiring the existing staff. This requires minimal investment on the part of DMX. That is why management feels it will be able to internally fund growth. The average cash balance on their credit facility has decreased from about $9 million in January to about $6 million in September.

Valuation: So far, DMX has been a good story stock, but what is it worth? The answer depends upon how they grow. Management has guided revenues to be $138 million to $143 million in 2007 and that gross margins should eventually be in the 24% to 25% range. Below are projections out to 2010 that assume 20% revenue growth from 2008 to 2010 and 10% SGA growth:

Using a forward EBITDA multiple of 12X, the projected 2010 EV is $309.7 million. Assuming $6.5 million in net debt, I get a projected market cap of $303.2 million. I assume shares will grow to 45.9 million outstanding by the end of 2009 due to the preferreds converting and stock options. That implies a 2009 stock price of $6.60, representing a 19% CAGR over four years. If revenues grow 25%, it is a 28% CAGR. 30% growth is a 35% CAGR.

Here's the hair on DMX:

1. Dilution - They have 36.4 mm shares o/s and 5.7 mm shares issuable under a convertible preferred issue (in the cc they referenced that some preferreds had been exercised and converted) and 6.8 mm shares issuable under stock options and warrants that are largely in the money.

2. EBITDA - Their credit facility with BofA that they rely upon to fund working capital requires an escalating level of EBITDA that peaks at $4.45 mm (on a ttm basis) as of 12/31/06. They did $3.9 mm of EBITDA in nine months YTD and have guided to doing $1.4 million of EBITDA in 4^th quarter. The restriction stems from them violating the original credit facility covenants in 2005, which prompted them to restructure operations.

3. Pharmacy Loop Hole - They have "class of trade" designation that allows them to deal directly with pharmaceutical companies and dispense drugs to an employee group. They have been sued by pharmacies seeking to prevent them from being drug dispensers but have so far prevailed in court. Risk is that CVS or Walgreens push new legislation to close that loop hole.

4. Competition - They are facing increased competition from PBM's and managed care operations. However, neither can provide the whole suite of services that DMX offers, and DMX seems to be the only one willing to run on-site clinics/primary care facilities for the employer. Most health insurers offer life style solutions (smoking cessation, diets, etc). Couple that with the influence that PBM's have, and it may be difficult for DMX to break into an employer's current healthcare arrangement.

5. Insurance - Since they employ healthcare professionals, they need professional liability insurance. The policies are "claims" made and they have a gap in prior years because two of the insurers that they bought policies from went bankrupt. In 2004, they created a captive insurance company to provide primary professional liability coverage, and then they are able to reinsure a portion of it.

6. One Large Customer - 11% of revenues come from one client. They also have a concentration of clients in the auto and manufacturing sectors. A slow down in auto sales could impact their revenues.

7. They have a poison pill.

References:

3^rd Quarter conference call replay @ (866) 321-0085; the pin number is 190960#.

Catalyst