Description

 Investment Thesis:

• With the divestiture of its HMO operations completed, MDF's cash flow should accelerate in 2009 and profitability will reach record levels.
• With a FCF/EV yield of over 35%, a cash adjusted P/E of only about 3.0X 2009 EPS, a EV/EBITDA multiple of only 2.2x, and a relative valuation of less than half its closest comparable, the shares offer an attractive valuation.
• The combination of current cash on the balance sheet and the predictable near term cash flows, which represent a 25%-30% discount to a worse case scenario valuation, offers value investors a very healthy margin of safety.
• My intrinsic valuation analysis show the company is worth about $3.00-$3.50 per share today (more than double the current stock price) and this figure should grow by an additional $0.25-$0.30 per year based on additional cash flow generation.
• Management's has in place an aggressive program underway to repurchase 19% of the shares outstanding, which I view as a strong vote of confidence and will be accretive to EPS by about 20%.
• The company recently divested its money losing HMO operations which has improved profitability, cash flow and earnings.
• The remaining business operations have delivered healthy returns, with a 20%+ ROIC and strong cash flow dynamics for many years, although masked by the recently divested HMO operations.
• A new expanded partnership with Humana provides MDF with a number of incremental growth opportunities and expansion into new Florida counties.
• The company is buying additional networks of physicians and service providers to help diversify its financial performance away from risks tied to changes in Medicare Advantage.
• A strong balance sheet with about half of its market capitalization in cash and no debt helps support its current share repurchase program and gives management the ability to selectively acquire groups of physicians in its network.

INTRODUCTION: In his 2009 letter to shareholders Warren Buffett stated "pessimism is your friend, euphoria the enemy". With that in mind I note that one of the areas of the market that investors have recently shunned is the sector of the healthcare market tied to Medicare. The combination of the rhetoric from the Obama administration to reduce health care spending and to move to a national health care system coupled with the actions by the government to reduce the growth in Medicare payments beginning in 2010 has pressured most stocks in the sector. One of the stocks that has sold off on these concerns is MDF. Thus, I believe it is timely to update my recommendation on the shares, discuss recent changes that enhance the business model and highlight a valuation that even considering a worse case scenario (i.e. the Medicare business completely goes away sometime in the future) is attractive in that the current price represents a discount to cash and predictable near term cash flows with a free call option on the residual business.  

For any VIC member unfamiliar with the company there are a number of past write-ups that I would refer you to regarding background. In short, the company operates a provider service network (PSN) of doctors, hospitals and related professionals that service Medicare members in a growing number of south and mid-Florida counties primarily through a HMO partnership with Humana. Given the nature of the business and the role that MDF takes on as a risk provider, where it receives a fixed payment per Medicare member per month and provides the necessary medical services that these members require, there is some variability in its profitability, especially on a quarterly basis. Notwithstanding this, the company's PSN operations have consistently shown strong profitability on an annual basis since a new management team was brought on during 2003.

AN IMPROVED BUSINESS MODEL & CASH FLOW DYNAMICS: With the appointment of a new CEO in mid 2003 followed by subsequent restructuring moves and the addition of a new senior level management team, MDF was transformed into an increasingly healthy and very profitable company. As a result of a recent corporate restructuring the company's business model has improved with the divesture (sold to Humana) of its money losing efforts to start-up its own HMO. The elimination of the company's HMO operations removes a major issue that has been clouding the shares, depressing profitability and cash flow, and diverting management's time and attention away from its core business. What is remaining at the company now is a healthy and very profitable PSN business. Noteworthy this core PSN business has historically delivered a 20%+ ROIC and excellent cash flow dynamics since 2004 when the new management team came on board. As a result of the divesture of the HMO and the benefits of a more focused management team, my estimates are that the company's profitability and cash flow will accelerate to record levels in 2009. During the current period of significant economic upheaval this financial performance should stand out and will place MDF in an unique position this year. I am modeling cash flow to accelerate to about $13.5M, which represents a FCF/EV yield of over 35%. In the past these cash flows were used to self fund its green fields HMO start-up efforts and are now free to build up, make small selected acquisitions and repurchase shares under an aggressive buy-back program. Note, the March 09 quarter will mark the first totally clean quarter of financial results without the HMO operations. Thus, going forward MDF's financials will show the true underlying health of the company's core PSN business model.

AN EXPANDED PARTNERSHIP, NEW GROWTH OPPORTUNITIES: Historically, while the company's PSN operations have very profitable and delivered strong cash flow, top line growth has been modest. However, due to the expanded relationship the company has structured with Humana as part of the divesture of its HMO operations, there are multiple opportunities for future growth. While the recent changes by the government to moderate the growth in Medicare Advantage reimbursement rates (discussed below) could have some negative impact on the growth in overall Medicare Advantage members, MDF has new growth opportunities tied to: 1) servicing the 7,400 members it sold to Humana, 2) partnering with Humana to expand into new Florida counties together, and 3) benefiting from Humana's aggressive marketing plans to grow its CarePlus operations.

Lately there has been evidence that competitive conditions in the HMO market in Florida, following a period of increased competition by a number of aggressive small and less capitalized players, are starting to reverse and that a significant consolidation is beginning. Noteworthy, a few weaker plans have either shut down, been closed by the government regulators or forced to sell themselves off in the last 18-24 months. In fact these same issues were one reason why the management of MDF made the decision to sell their own HMO to and partner with Humana last year. Given some of the new changes to the Medicare Advantage program (discussed below) which will make it more challenging to grow membership to critical mass for a number of smaller players and the likelihood of some pressures on profitability, some observers believe the pace of consolidation will accelerate. The plans facing the most challenges are those without scale, with weak financial resources and substandard management teams. On the other hand, the winners are likely to be the larger, well managed plans (like Humana) with skilled marketing and financial management teams able to operate more efficiently and wring out every dollar of profit under less plentiful reimbursement programs. Thus, not only did MDF sell off its HMO at the right time, but they appear to have aligned themselves properly with one of the winners during the upcoming consolidation phase.

DIVERSIFICATION EFFORTS REDUCE MAJOR RISK: In an effort to somewhat diversify the company's business and have better control over its network of service providers, MDF has been slowly acquiring various networks of doctors and related health care providers. This physician's network business (PNB) currently accounts for about 24% of revenues and while the company does not break out the profitability of these operations except to say these networks tend to be more profitable than those they contract with, I would suspect that they comprise about 25%-30% of operating profits. I would expect to see the company take advantage of the current environment to use some of its cash to continue acquire additional physician's networks at accretive prices. In addition to the enhanced profitability from these operations, the ownership of a network of doctors and other service providers helps insulate the company from any significant structural changes to the private Medicare Advantage program as the company's costs can be directly reimbursed either directly or through traditional government sponsored Medicare programs..

THE IMPACT OF CHANGES TO MEDICARE: Recently the shares of most HMO's with significant Medicare exposure have come under pressure following news from the government overseeing body CMS (Centers for Medicare & Medicare Services) that the all in Medicare Advantage payment rate per member in 2010 would be less than expected. A preliminary announcement in February, followed by the news of the final rate on April 6^th showed a increase of only 0.8% (versus a increase of about 3.6% in 2009) and when combined with certain coding adjustments, results in a net decline of about 5% in Medicare Advantage payments to private HMO's. The government's motivation is to reduce what it believes is a premium paid to insure seniors in private plans (Medicare Advantage) versus public Medicare. An advisory panel to Congress reported that Medicare pays the private plans 13% more on average than the cost of care for a traditional Medicare patient. The one thing that is sometimes left out of the political discussion on this subject is that the reason why the private plans receive a higher reimbursement is that on balance they offer greater medical benefits for seniors and by many accounts have a higher success rate in taking care of their members.

What will be the impact of this on MDF? The likelihood is that the reimbursement reductions for 2010 will result in some changes to private Medicare Advantage plans. Most of the HMO's are crunching the numbers now and will file their plans for 2010 by the mid-June deadline. The likelihood is that all of the parties - the HMO's, medical service providers (like MDF) and enrollees - will have to make some sacrifices. Most plan operators will likely scale back the services that they offer commensurate with the payments received. The most likely areas that will be affected will be such auxiliary services as dental, eye and hearing plans. Also, drug plans will likely be more restrictive to cover only a limited set of essential generic drugs. I suspect the HMO's will be careful not to make the cuts too severe as that could make them less attractive relative to direct pay government Medicare and slow the growth in members. Even considering offering slimmer benefits, some independent observers believe Medicare Advantage plans will still provide a better value proposition to seniors than they would receive under traditional Medicare. Thus, membership may still expand during the period when these changes are implemented, albeit it at a slower rate. In addition, as discussed previously industry consolidation will likely create an opportunity for the stronger players (like Humana) to take market share and increase membership. Members in these plans will likely also see an increase in their monthly premiums or co-pays. Medical service providers like MDF will also have to share in some way with the fact that there will be less profit in the equation to be shared under existing agreements. Thus, their revenue share per member will likely be negatively affected which will impact revenue and profits. However, in the case of MDF this could be somewhat offset by the combination of incremental growth opportunities and better financial management (i.e. improved risk scoring). As a result, my model forecasts these factors will net out to a reduction in MDF's profitability and cash flow in 2010 of about 10%-15% from the record profitability that I expect in 2009.

Longer term the concern among investors appears to be that the current Obama administration will enact legislation centering on some type of national health care plan that would in effect end private Medicare. While this topic is debatable, most independent observers suggest that such an extreme move would be tantamount to political suicide and would likely take many years at best to enact. Noteworthy, Medicare Advantage plans now provide health benefits to about 10.7 million seniors or about 24% of the 44 million participants in the government health insurance program for the elderly and disabled. Given the inertia and acceptance of these plans from private providers (like Humana) any move to do away with them would likely be met with significant voter outrage. Thus, while changes enacted on the margin by elected officials may slow the growth and/or reduce the profitability of these plans, it is highly unlikely that they will be shut down (i.e. the worst case scenario).

AN ATTRACTIVE VALUATION WITH A NICE MARGIN OF SAFETY: The current market price suggests that investors have already adopted a dire view for the outlook for both Medicare Advantage in general and MDF in particular. I would submit that at current prices the market is already discounting a worst case scenario for MDF and has not properly valued the company based upon the current cash on its balance sheet and the predictable future cash flows in the PSN (excluding the money losing HMO operations) and physician's network businesses. As illustrated below, taking the company's cash position and adjusting for cash flow variables in the current year, as well as the next two years (the earliest time any dire changes in Medicare Advantage could be enacted) shows a cash value above the current stock price. In addition, investors are receiving a free call option on the value of the company's physician's network businesses, which if valued at 8-10x cash flow yields an additional $0.50-$0.75 per share in value. Thus, adding all the pieces of my analysis together looking 24 months out yields worse case value of about $2.09-$2.34 per share, or a 35%-50% premium to the current share price. This value is illustrated below:

On the other hand, valuing the company's cash flow at a 8-10x multiple and adding back in the current cash and temporary account receivable due from Humana, shows the intrinsic value of the company to be about $3.00-$3.50 per share today. This represents significant upside potential in the share price and will grow by about $0.24-$0.27 on an annual basis from future operating cash flows. Note, my analysis does not assume any future growth associated with the company's joint initiatives with Humana. This analysis is as follows:

Finding comparable public companies to look at relative valuations is not easy. The traditional HMO's are much larger in size and have a somewhat different business model. However one publicly traded company, Continucare (CNU), is similar in nature in that it provides health services in the South Florida market to a number of HMO's and is about similar in size to MDF. However, relative to valuations, the similarities end right there. For example, based on consensus estimates, the shares of CNU sell at a cash adjusted P/E of about 8.6x fiscal 2009 earnings versus a cash adjusted P/E for MDF of only 3.0x my estimate of $0.24 per share. Moreover, looking at a relative comparison of trailing twelve month EV/EBITDA multiples, CNU sells at a valuation of about 4.5x, while MDF's PSN operations (excluding the divested HMO operations) is valued at only a EV/EBITDA multiple of only 2.2x. I submit that what is responsible for this difference and the low relative valuation accorded the shares in general is the past operating losses from the HMO. I believe that as investors begin to see the real underlying earnings and cash flow of the new company (excluding the HMO operations) this relative valuation disparity will begin to narrow in the near future, which will begin to be evident with the March quarter results.

 SHARE BUY-BACK IS A STRONG VOTE OF CONFIDENCE: In October of last year the company announced a 10 million share repurchase program, which represented a healthy 19% of the outstanding stock. I view this move as a strong vote of confidence by management regarding both the future fundamental outlook as well as a comment on the valuation of the shares. Noteworthy, management announced this plan when the share price was about $2.00 per share. At current prices, I believe that management has every intention of repurchasing all the shares allocated under the plan. At the end of the December quarter the company had bought back almost 4.1 million shares under the program at an average price of about $1.82 per share. My calculations show that at current prices, repurchasing the remaining shares would be accretive to EPS by about 20% on an annual basis.

 Risks:

• Given the nature of the company's business where it receives a fixed reimbursement for each member and provides the required medical services, its quarterly profitability can be impacted by periods of heavy medical utilization, especially during the winter cough & cold season. Given the data suggesting that the cough & cold season in Q1 in Florida was higher than normal this could negatively impact results, but I expect management's commentary on its business to be very upbeat.
• Annual changes by the government (via CMS) to the Medicare reimbursements require adjustments to the services offered under individual plans (i.e. by Humana), which could impact membership levels and profit margins.
• An increase in competitive conditions or a move to fee based Medicare plans could impact membership levels and profitability.
• Given the partnership the company has with Humana, an inability of MDF to provide adequate services to its members could negatively impact its future relationship.

Catalyst

• Beginning with the Q1 (March) results the real underlying earnings and cash flow strength of the company (excluding the recently divested HMO) will be evident.
• A further build up in the company's cash position through the year.
• FY 09 should be a record year from an earning and cash flow perspective.
• Further moves by the company to diversify its business and acquire more physician's networks.