EXECUTIVE SUMMARY: I recommend a LONG position in MedAssets (MDAS) with a 1-2 year price target of $30/share (+40% expected return). Consensus appears directionally correct in its assessment that MDAS, as a leading vendor of performance improvement services for healthcare providers, should benefit from providers’ growing urgency to improve revenue collections and reduce costs in the face of growing pressures on healthcare spending along with increasing complexities in medical billing and reimbursement. Although I agree that MDAS is well-positioned to benefit from tailwinds driven by healthcare reform and regulatory changes under PPACA and the transition to ICD-10, I believe the market still underestimates the magnitude of potential upside.

MY BULLISH INVESTMENT THESIS: My variant view is predicated on three key factors that do not appear adequately priced into the stock: [1] MDAS today seems to have mostly realigned its business units and stabilized the management turnover that had hindered the company’s growth from late 2010 through mid-2012; [2] the market is overly concerned with the company’s debt load (~4x LTM EBITDA and 5% blended interest rate), for which MDAS is nowhere near risk of covenant breach and which should be paid down quickly using most of the free cash flow (I estimate FCF of $82mm in 2013 and $122mm in 2014); and [3] the longer-term trend towards consolidation of hospitals in the U.S. should drive earnings upside not currently captured in estimates. I believe the combination of these factors along with the imminence of regulatory changes driven by PPACA and ICD-10 in 2014 and beyond could lead to 1-2 turns of EV/EBITDA multiple expansion, along with 4-9% upside to consensus on EBITDA and EPS for 2014.

VALUATION: Currently trading at 10.4x EV/LTM EBITDA and 9.1x EV/NTM EBITDA on consensus estimates, I believe MDAS shares are significantly undervalued. In my view, the company is in its early innings of improved stewardship and alignment with shareholder value creation, and should continue to benefit from strong market positioning, barriers to entry and favorable industry tailwinds. The company also has high earnings visibility due to 80-85% annual recurring revenues and a publicly-disclosed forward 12-month backlog. The company also has several notable regulatory tailwinds including the phase-in of several important provisions under PPACA in 2014 and beyond, as well as the mandatory transition from the ICD-9 to ICD-10 diagnosis and reimbursement code set by October 1, 2014. All these qualities give me confidence that MDAS will be able to achieve low-teens EPS growth and 10%+ FCF yield through 2015. Nonetheless, the market is prone to undervaluing MDAS, as both buy-side and sell-side analysts typically apply a single point valuation multiple for the entire company – essentially a “conglomerate discount” – instead of using a sum-of-the-parts (SOTP) analysis.

In my view, SOTP is an appropriate valuation approach given that MDA’s two business segments, Spend and Clinical Resource Management (SCM) and Revenue Cycle Management (RCM), are highly disparate with minimal business overlap. I also believe that the RCM business could eventually be divested or spun-out to unlock shareholder value. Although there does not exist a direct comparable today for the SCM business, Premier (a leading GPO and key competitor of MDAS) could go public in 2014 which could drive upward re-rating of MDAS shares. Applying a 11.5x multiple to my 2014 EBITDA estimate of $201mm for the SCM business and a 10x multiple to my 2014 EBITDA estimate of $70mm for the RCM business while backing out net debt, I get an implied valuation of $30/share.

CATALYSTS & EVENT PATH:

(1)     2Q13 earnings call after market close on Wednesday, July 31

(2)     New major contract wins

(3)     Refinancing or faster than expected paydown of debt to lower interest expense

(4)     Phase-in of new provisions under PPACA starting in January 2014 and transition to ICD-10 diagnostic coding system by October 2014, which could accelerate growth in demand for MDAS’s offerings in quarters preceding these events

(5)     Future IPO of Premier Inc. (reportedly sometime in 2014) – Premier is a key competitor to MDAS and the leading GPO player with 25-28% market share (vs. ~20% for MDAS), which could be valued at a low-teens multiple on trailing EBITDA and lead to upward re-rating for MDAS

(6)     Potential divestiture or spin-off of RCM division could remove “conglomerate discount” and unlock significant shareholder value

RISKS & DOWNSIDE CASE: As MDAS has spent much of the last two years going through significant strategic and operational transitions, the greatest risks to a long position would include management turnover, further restructurings, and inability to execute, as well as competition (more so for RCM than for SCM). I believe a downside case could entail 2014 EBITDA being in-line with or slightly below consensus, as well as assumed EV/EBITDA multiple contraction to 8.5x for SCM and 7.0x for RCM. This would lead to an implied downside valuation of $18/share. Nonetheless, I believe current levels represent an attractive entry point for a long position, given the 3:1 upside/downside ratio.

(The text above summarizes my pitch. Please read on for my analysis of business overview, why an investment opportunity exists today, expanded investment thesis, management quality and corporate governance, and key risks.)

According to industry reports, over 25% of hospitals in the U.S. reported negative profit margins during the year and many were hovering just slightly above breakeven levels. Through the company’s group purchasing organization and software-based offerings, MDAS helps healthcare providers to better manage their clinical supply costs and optimize revenue collection. Management estimates they can improve operating margins by 1.5-5.0% for their customers, which include over 4,200 acute care hospitals and 122,000 ancillary or non-acute providers. MDAS’s customer base includes about 70% of hospitals in the U.S., and 80-85% of its revenues are recurring due to contracts that are typically 3-5 years in duration. This gives MDAS a level of earnings predictability that is unusual in the healthcare information technology space.

MDAS has grown to its current state through over a dozen acquisitions of companies that have been integrated into one of two business segments. Spend and Clinical Resource Management (SCM) accounts for 62% of company revenues and nearly 75% of total EBITDA, owing to 44% segment EBITDA margins and potential for mid- to high-single digit annual revenue growth going forward. Within SCM, group purchasing organization (GPO) services account for 67% of revenues, followed by consulting (18%), SaaS/analytics (8%), and other services (7%). MDAS has over 3,000 GPO clients and helps achieve best pricing in the sourcing of supplies that can reduce providers’ expenses by 3-10%. MDAS earns money by charging administrative fees from healthcare suppliers; these fees range from 0.50% to 3.00% of the total dollar amount that each member purchases through the GPO. The GPO then returns about one-third of these fees to its members under a revenue share obligation.

Revenue Cycle Management (RCM) accounts for the other 38% of company revenues and 25% of total EBITDA, owing to 24% EBITDA margins. RCM offers over 30 solutions to address the vast majority of revenue cycles for its 2,600+ customers. In contrast, many competitors are focused on specific niches or particular aspects of the revenue cycle. Moreover, through its partnership with Cerner, MDAS’s claims management solutions are embedded within Cerner’s patient accounting platform, so there is really no part of the revenue cycle that MDAS does not touch. MDAS is one of the larger players in the highly fragmented market with mid-single digit share. About two-thirds of revenues are derived from SaaS solutions, which are used by healthcare providers to optimize revenue capture and recovery, accelerate cash collections, reinforce charge integrity, and manage value-based reimbursement. The remaining one-third of segment revenues is derived from services and consulting work.

WHY AN INVESTMENT OPPORTUNITY EXISTS TODAY: Both buy-side and sell-side analysts are mostly neutral on the stock. The 16 sell-side analysts covering MDAS have issued ratings of 10 Buy, 5 Hold, and 1 Sell, and the average $21.65 price target is at parity with current stock price. Although shares have appreciated over 25% since the end of May 2013 due to what I believe has been a combination of large institutional purchases and positive momentum, they are only now in-line with the levels prior to the company’s $850 million acquisition of The Broadlane Group in September 2010.

To understand why this is, I will quickly summarize what has happened with the company and industry during that timeframe. In order to finance the Broadlane acquisition, which was valued at an eye-popping 5x revenues and 17x adjusted EBITDA on an LTM basis, MDAS had to raise $960 million in debt which quadrupled the amount of debt on MDAS’s balance sheet. The initial vision for the Broadlane acquisition was to give MDAS access to 1,100 additional acute care facility customers to whom the company could potentially cross-sell its revenue cycle management (RCM) solutions while also bolstering its own supply chain and GPO business, which was expected to consequently increase its negotiating power vis-à-vis suppliers.

However, less than five months later, the stock plummeted 35% the day after it reported 4Q10 earnings, which missed consensus expectations across all key financial metrics as did company guidance for 2011. Moreover, the company’s longer-term annual growth goals, which had once been 15% for revenue and 25% for cash EPS, were tempered to just 10-12% and 20% respectively. Cross-selling opportunities through Broadlane were now expected to be much more limited than management had initially anticipated, RCM sales were now projected to be meaningfully lower than consensus as customers had prioritized electronic health record (EHR) installations over RCM bolt-ons in the face of the HITECH Act of 2009, and a greater portion of revenues for spend and clinical resource management (SCM) contracts was being composed of performance-based guarantees, which led to potential revenue recognition being postponed to a later date.

In hindsight, management did the correct thing by providing conservative guidance for which it could later exceed. However, in speaking with past employees of MDAS, the acquisition of Broadlane (along with the dozen or so others that MDAS had rolled up since its inception) created a number of business challenges that would plague the company for the next two years. For example, financial leverage reportedly prevented the company from being as innovative as it would have otherwise intended. Also, a number of customers that had been with Broadlane did not end up migrating to other MDAS solutions following the acquisition, meaning that a number of the initially expected revenue synergies never ended up materializing. Finally, significant turnover at the middle- and upper management ranks between late 2010 and mid-2012 hindered MDAS’s ability to execute and also created significant negative morale (for a taste of how tepid company morale has been, consider looking at some of the 140+ employee reviews on Glassdoor.com).

MY BULLISH INVESTMENT THESIS: I believe that the market undervalues MDAS shares for three key reasons:

First, investors typically apply a single multiple (either P/E or EV/EBITDA) to value the whole company, leading to a “conglomerate discount” notwithstanding the fact that SCM and RCM are very distinct businesses. Moreover, one of these businesses could someday be divested or spun off to unlock shareholder value.

MDAS shares currently trade at 9.1x EV/forward EBITDA, which is a somewhat depressed multiple. Despite the fact that the company appears to have stabilized its key management ranks and have much of the restructuring/layoffs behind them at this point, investors have rightfully been concerned about the company’s ability to execute. Specifically, consensus remains skeptical over whether management’s longer-term goals for 10% revenue growth and 15% EPS growth by 2016 will be achievable. However, 2013 guidance of y/y top-line growth of 3-7% for RCM (versus 15% in 2012) and 5-7% for SCM (versus 8% in 2012) seem realistic and achievable to me, and consensus expectations for EPS of $1.29 are also within guidance range of $1.22-1.32 (+12% y/y at the midpoint).

However, I believe management’s guidance appears plausible given that profitability challenges across healthcare providers will continue to drive demand for MDAS’s solutions. Demand could reinvigorate as key provisions of the Patient Protection and Affordable Care Act (PPACA) are phased in during 2014 and beyond. Moreover, at the beginning of 2012, management transitioned the organizational structure of the RCM segment from matrix-based to one where the segment president had full ownership of the P&L. It also changed the basis of incentive compensation structure for sales managers to be based on revenue targets. Prior to 2012, sales managers earned incentive compensation based on backlog targets, which meant that managers were more motivated on acquiring potential clients upfront and less inclined to maintain client relationships and ensure that clients followed through on their long-term contractual commitments. MDAS ended up losing some key accounts as a result of these misaligned incentives, which caused the RCM segment to underperform relative to expectations in 2010-2011. However, my channel checks with suppliers and customers have suggested that MDAS has finally started to see a more positive impact from superior incentive alignment and organizational structure, which should ultimately improve the amount of MDAS’s backlog that actually gets converted into revenues.

Furthermore, my conversations with other analysts that work at leading institutional shareholders and are close with MDAS’s management team have revealed that management may be gradually warming up to the idea of exploring various means of increasing shareholder value, including a potential divestiture or spin-off of RCM. Although management contends that there are untapped cross-selling opportunities and synergies between the two divisions, there is minimal overlap today as can be seen in clear disparities within internal operations as well as customer call points. The RCM segment does not do business with 60%+ of SCM customers, and although management had historically said that they saw this as an opportunity to cross-sell in the ~40% of customers where there was overlap, I believe the more tenable explanation is that there is simply no reason for overlap between these segments. These segments also handle two very different ends of healthcare providers’ value chain, and therefore communicate with two very different sets of hospital personnel. One former employee with whom I spoke asserts that RCM and SCM could conceivably operate independently and achieve whatever cross-promotions they hope for through a joint venture.

The main pushback to my view is that in the absence of a catalyst for a divestiture/spin-off, MDAS shares could continue trading at a conglomerate discount. Unsurprisingly, management has made no specific public commentary on this subject; naturally, MDAS will likely contend that they own two businesses for strategic reasons, and might do so at least until the day they divest one of the two business segments. Because of the uncertainty about if or when this catalyst could materialize, MDAS currently trades near the low-end of its sum-of-the-parts valuation based on my sensitivity estimates. However, this also creates sizable margin of safety for potential investors. In my view, one can now invest in MDAS at near-bottom multiples with favorable industry tailwinds and potential for a number of company-specific catalysts to drive upside (please refer to the “Catalysts” section of this report for additional details).

Moreover, looking at the institutional shareholder base, the vast majority of top 25 shareholders have long-term investment horizons (2+ years). Among the top 10 shareholders, only two pared back their position as of 3/31/13 13-F filings while most others increased their stakes significantly. The current shareholder base seems unlikely to turnover which gives me confidence in the potential upside, and greater “soft activism” from influential stakeholders could facilitate an eventual spin-off. The top 25 institutional stakeholders in MDAS through 3/31/13 are as follows:

Business Segment Analysis and Valuation: My SOTP analysis is provided in the forthcoming chart. My upside scenario implies a valuation of $30/share for MDAS, while downside scenario based on multiples near historical troughs implies a valuation of $18/share.

I believe that the SCM business should be valued at 11.5x EV/NTM EBITDA multiple. I think this is an appropriate multiple as several precedent transactions in the healthcare space – despite not doing one-for-one what MDAS’s SCM does – have been completed around a similar valuation range and that possessed meaningful recurring revenues and earnings visibility, formidable barriers to entry, leading market positions, attractive pricing power, and mid-single digit top-line growth rate and low-double digit EPS growth rate. Notable comparable transactions have included Allscripts’ $1.3 billion acquisition of its rival Eclipsys in June 2010 (13.5x EV/EBITDA), Blackstone’s $3 billion acquisition of Emdeon in August 2011 (12x EV/EBITDA), Apax Partners’ $6 billion acquisition of Kinetic Concepts in July 2011 (10x EV/EBITDA), and TPG’s $4 billion acquisition of IMS Health in November 2009 (10x EV/EBITDA).

I think the SCM business should be valued at least at in-line with this group on a forward basis, given that it stands to benefit from even more favorable industry and regulatory tailwinds than did the prior acquisitions at the time that they were completed. Moreover, the SCM business is highly scalable (the more providers they have in their network, the more sources of fee revenue MDAS can access, and the more bargaining power it will hold vis-à-vis suppliers), holds ~20% GPO market share and trails only Novation and Premier (each of whom hold 25-28% share), has 80-85% recurring revenue streams, and has significant earnings visibility owing to the fact that its customers are typically locked into contracts of 3-5 years.

A case could also be made that SCM should be valued at an even higher multiple, especially after Premier Inc. goes public. Premier is tied with Novation as the leading GPO player with 28% market share (vs. ~20% for MDAS), and the IPO could lead to upward re-rating of MDAS shares. According to a recent Reuters article (http://www.reuters.com/article/2013/02/04/newstory-idUSL1N0B44PN20130204), the IPO could happen sometime in 2014 and is being jointly led by BAML and JPMorgan. Reportedly, it is targeting a $5 billion valuation. According to the company’s website, Premier generated F2012 (fiscal year ending 6/30/12) revenues of $919.2mm (+12.8% Y/Y) and operating income of $322.1mm (35% operating margin, +5.6% Y/Y). A $5 billion IPO valuation would imply a 15.5x multiple on F2012 operating income. Assuming that this Y/Y growth compounds over the next two fiscal years would yield a F2014 operating income of $355.1mm, which would imply a 14.1x multiple on that figure.

I believe that the RCM business should be valued at a slight discount for 10x EV/NTM EBITDA multiple. It is expected to be a faster-growing business than SCM with high-single digit annual revenue growth potential, but offers considerably lower margins as revenue streams are not quite as recurring and there has been a growing mix shift towards consulting and advisory work. Given the rising complexities associated with billing and reimbursement processes, management believes that hospitals will have a higher need for customized consulting, which should help top-line growth but will limit the rate at which RCM can expand margins.

Secondly, the market underappreciates the longer-term earnings upside that the consolidation of hospitals could drive. Neither the sell-side nor buy-side focuses on the eventuality that the number of U.S. hospitals will decline, as smaller standalone hospitals will either need to shut down due to profitability issues or will more likely get consolidated by larger hospital chains. My conversations with physicians and investors that are knowledgeable about the company suggest this could be a source of both earnings and multiple expansion in the mid- to long-term.

On one hand, the Street generally understands that in 2014 and beyond, the Patient Protection and Affordable Care Act (PPACA) will introduce health insurance exchanges and new complexities to the reimbursement process that will increase the cost of compliance for providers. PPACA will also increase the coverage of uninsured individuals and expand Medicaid eligibility, wherein the effect of reducing unpaid hospital bills will be more than offset by costs of care that will exceed Medicare/Medicaid reimbursement rates by an even greater amount. Cuts to Medicare rates were already significant in 2012, and with the aging of the population, the mix shift towards more costly elderly patients will create even more downward pressure on reimbursement rates. According to industry reports, the average hospital operating margin was around 3% in 2012, and over 25% of hospitals had negative profit margins during the year.

On the other hand, what is less often discussed is that the hospital consolidation effect could be much more profound than current consensus expectations, as evidenced by the relative dearth of sell-side commentary on this topic. As smaller hospitals get rolled up by larger ones, significant operational inefficiencies and redundancies will arise that could create an even greater need for MDAS’s solutions. Although the Street appears to be directionally correct in its top- and bottom-line expectations for MDAS, I believe it has underestimated the magnitude of potential upside. While it is difficult to quantify the exact impact of hospital consolidation given that we are still in the very early innings of a potential sea change, current investor sentiment and management guidance suggest that little of this impact, if any, is priced into the stock.

Thirdly, investors often see MDAS’s debt levels as an investment risk, but I actually think it is an investment merit given the company’s commitment to pay down debt and current leeway with respect to covenants. With net debt of ~4xx LTM adjusted EBITDA as of 1Q13, MDAS is nowhere near violating its maximum leverage ratio covenant of 5.75x in 2013, or even 5.25x in 2014 or 4.75x in 2015 for that matter. There is also a minimum interest coverage covenant of 2.5x, where risk of breach is essentially inconsequential. Management expects to generate $80-90mm in FCF for 2013, which it will use primarily to prepay debt and reduce interest expense. FCF generation continues to be in-line with historical conversion rate of ~40% of EBITDA.

Therefore, leverage does not appear to be a risk for MDAS, and actually reduces MDAS’s weighted average cost of capital and provides the necessary financing to continue innovating organic solutions to further bolster MDAS’s competitive advantage. One also shouldn’t count out the prospect of future M&A activity, though management has indicated that its foremost goal is to develop internally before pursuing acquisitions (which should be a breath of fresh air for investors, given that the realization of synergies associated with the Broadlane acquisition with November 2010 took substantially longer than expected). Healthcare performance improvement companies such as MDAS use their scale to raise industry barriers to entry as well as their bargaining power vis-à-vis both customers (e.g. hospitals and other healthcare providers) and suppliers (e.g. government health programs, private health insurers, medical device manufacturers, and supply companies).

Presently, MDAS has $246.9mm in Term Loan A at LIBOR+225-250 maturing in 2017, $284.3mm in Term Loan B at LIBOR+275 maturing in 2019, and $325mm in 8% fixed senior unsecured maturing in 2018. This debt capital structure exists after MDAS refinanced ~$550mm in bank debt in December 2012. The company also has access to a $200mm revolver with a 2017 maturity. Consensus estimates the blended interest rate at ~5.4%, but I believe management will eventually be able to refinance debt to a blended interest rate of less than 5% in 2014 due to a more favorable regulatory environment under PPACA as well as lender-friendly characteristics such as its recurring revenue streams and robust cash flow generation.

MANAGEMENT QUALITY & CORPORATE GOVERNANCE: I strongly believe that a company’s corporate governance and incentive structure can be a powerful explanatory factor of how companies will perform, and as such, proxy filings and insider transactions always warrant thoughtful review. Although the Street seems to have mixed impressions of MDAS’s management quality and corporate governance, I have a more favorable opinion after reviewing key SEC filings and speaking with people that have known CEO/Chairman John Bardis for several years.

Mr. Bardis has been with MDAS since its inception in June 1999, and holds a 1.8% diluted stake in the company. Other named executive officers (NEO’s) and directors hold a 2.7% diluted stake. These insider ownership levels have remained consistent across the years, and there do not appear to be any questionable insider transactions given the relatively low level of insider selling and high composition of dispositions under Rule 10b5-1.

The average tenure for board members is about seven years, and most have significant professional experience in healthcare services or IT. The company’s board consists of 10 directors, organized into three staggered classes of three, three, and four directors each. Although the classified board (as compared with a non-staggered board) makes MDAS a less attractive activist target, I want to reiterate that my conversations with several prominent institutional shareholders have painted a positive picture of MDAS’s management and their willingness to engage with investors. Moreover, a potential spin-off of the RCM segment would not trigger any change-in-control provisions.

Incentive compensation also appears strongly aligned with shareholder interests. For example, NEO’s did not earn any bonuses under the incentive program in 2010 due to the company’s weak execution. Also, according to the 2013 DEF14A proxy filing (submitted on 4/29/13), the board had also changed the formula for NEO’s incentive compensation to be based on EPS targets beginning in 2012. Prior to 2012, they were compensated based on adjusted EBITDA, and I believe that the current incentive program is a much more aligned gauge of shareholder value creation since EPS, unlike EBITDA, takes into account interest expense (a real consideration given the company’s leverage).

INVESTMENT RISKS:

(1)     Operational missteps and restructurings/layoffs could boost earnings growth in the short-term, but could negatively impact sustainability of growth in the long-term – MDAS had grown its operating income respectably over the past few years, but this has primarily the result of cost-containment than revenue growth. While the margin improvement as a positive indicator of management’s ability to identify cost saving opportunities and run a leaner organization, it could also be a concern since MDAS can only cut so much from operating expenses before hindering its ability to innovate. Revitalization of revenue growth is the key issue that bears are concerned about, since this will need to happen in order for multiple expansion to occur.

(2)     Failure to execute and management turnover – MDAS had developed somewhat of a reputation for overpromising and under-delivering especially in its early days of working through the Broadlane integration. Moreover, between 2010 and 2012, there was meaningful turnover at more senior ranks, not to mention significantly layoffs at lower levels. Organizational staffing seems to have stabilized recently, but further shake-up could disrupt the company again

(3)     Increased competition – this is less of a concern for SCM where MDAS is already a leading player with many of its customers signed up for long-term contracts, and where it is not particularly common to switch from one GPO to another for a particular set of solutions. However, competition is clearly of a concern for RCM. This would be especially true if key healthcare IT players such as Epic or Cerner decide to enhance their own revenue cycle management capabilities internally. I am not too concerned about the competitive risk from Cerner since it is currently a partner with MDAS, but if it did decide to develop its capabilities internally, it could become a formidable competitor given its substantially larger install base. Moreover, while I acknowledge that Epic presents a more meaningful competitive threat, my research suggests that bolt-on software (such as that offered by MDAS) may be more readily adopted than mainframe and enterprise-scale solutions given its easier implementation and agile reporting capabilities.

CATALYSTS & EVENT PATH:

(1)     2Q13 earnings call after market close on Wednesday, July 31

(2)     New major contract wins

(3)     Refinancing or faster than expected paydown of debt to lower interest expense

(4)     Phase-in of new provisions under PPACA starting in January 2014 and transition to ICD-10 diagnostic coding system by October 2014, which could accelerate growth in demand for MDAS’s offerings in quarters preceding these events

(5)     Future IPO of Premier Inc. (reportedly sometime in 2014) – Premier is a key competitor to MDAS and the leading GPO player with 25-28% market share (vs. ~20% for MDAS), which could be valued at a low-teens multiple on trailing EBITDA and lead to upward re-rating for MDAS

(6)     Potential divestiture or spin-off of RCM division could remove “conglomerate discount” and unlock significant shareholder value