Description

In the first week of January 2004, Magellan Health (MGLN) emerged from bankruptcy. At today’s price of $27.40, the valuation is reasonable at approx. 7x EBITDA and 14x cash EPS.

Typically this type of valuation would typically not impel me to submit a report to fellow VIC members. However, we are in an environment with a sub-10% VIC bargain meter and some of my fellow members may be looking for an attractive event-driven situation to add to their portfolios. More importantly, I believe there is still quite a bit of upside (likely exceeding 50%) in this situation and there is a clear short-term catalyst. Also, in my view, at current prices the downside is very limited. So, here goes.

Company overview:
MGLN operates the nation’s largest managed behavioral healthcare network which covers about 70MM lives and includes 48,000 behavioral healthcare providers (think clinical social workers, psychologists, etc.). The company is the largest independent behavioral healthcare provider with 33% market share, relative to the #2 Value Options (privately held) with 13% market share. MGLN is an independent third-party provider of psychiatric care services for health insurance plans, large companies, and the public sector (55%, 20% & 25% respective of top-line). The company provides services mostly thru risk-based products but also through administrative services only (ASO) or non-risk products. With risk-based products the company charges $3-7 per member per month (PMPM) and assumes the cost and risk of the utilization of mental health services. With ASO products, there is a smaller PMPM fee for claims processing, utilization review and provider credentialing. The company provides services under 1-3 year contracts and has a 95% retention rate.

Magellan Health was written up by another VIC member in June 2001 and this write up is a good one. (As an aside, at the time of the 2001 writeup, MGLN had an enterprise valuation of $1.6 billion, of which $500 million was debt. Today, the enterprise value is a little over $1.3 billion. If MGLN received the same valuation as it had in 2001, well within the realm of possibilities, we would see a $35 stock price or a 28% gain from Friday’s closing price.)

Based on my channel checks, I believe the 95% retention rate to be legitimate. (It is all the more impressive given that Magellan has been in bankruptcy since March 2003. Not one major client left. In fact, TennCare recently renewed their contract with Magellan Health.) The reason for the high retention rate is that it is very difficult for clients to switch away from Magellan Health as there are few other national providers of behavioral healthcare services. Moreover, most HMOs do not want to provide this service in-house as it represents a small portion (<5%) of the PMPM dollar and has little upside in terms of cost-containment. The business of providing behavioral healthcare to clients is complex. People needing mental healthcare are “a difficult and noisy bunch” (in the words of a clinical social worker), and the management of behavioral healthcare services is quite different from that of a traditional healthcare services. It is easier for an HMO to manage the cost of fixing a broken leg than fixing behavior. According to one psychiatrist I spoke to, “Psychiatry is a different ball game. A broken bone you can see. With psychology it is much more abstract and you have to have someone who talks the language and knows psychology to be able to handle behavioral healthcare managed care.” This is indeed a different animal, and one which the HMOs and Medicaid providers generally do not want to do in-house. We can go into this more in the Q&A.

The company filed Chapter 11 in March 2003 as a result of having over $1 billion of debt. Onex (a public buyout firm in Canada) purchased a significant stake in the distressed bonds of the company and emerged with a 24% controlling stake in MGLN common. There is a terrific article on how Onex got involved with Magellan on the website of The Globe and Mail, a Canadian newspaper. The link follows. (http://www.globeandmail.com/servlet/ArticleNews/TPPrint/LAC/20031128/RO12GERRY/TPBusiness/) The deal manager for Magellan at Onex is Robert LeBlanc. Mr. LeBlanc spent a year unsuccessfully trying to purchase privately-held ValueOptions so he is intimately familiar with the business of behavioral healthcare. Also, VIC members will find Mr. LeBlanc’s career history intriguing. From the Onex website: “Prior to joining Onex in 1999, Bobby was with Berkshire Hathaway for seven years…” I think Mr. LeBlanc might know something about insurance…but that’s just a hunch.

There is a tremendous growth opportunity right beneath our noses which almost every analyst overlooks. 25% of Magellan’s business is in the public sector. According to industry experts, there are billions of dollars of social services contracts (representing 100-200MM of EBITDA) up for bid each year. There is a large growth opportunity for Magellan in managing psychotropic medication, disease management, disability and workers comp disability plans, and other state employee assistance plans. The business of Medicaid outsourcing is a nascent one that was recently featured in a 100+ page report by Lehman Bros. As states outsource more of their social services business to third party providers, Magellan is very well positioned. Texas Pacific Group which got involved with MGLN pre-bankruptcy expected this outsourcing program to drive earnings for years to come. Leverage killed the company’s chances in its prior incarnation but the opportunity remains and today the balance sheet is lean.

The numbers
The company emerged from bankruptcy with 35.3 million shares of common stock and under $200 million of debt. (According to the company, on a fully diluted basis, including options which are struck at current prices, the share count is 40 million.) EBITDA is running at $180MM this year. I estimate about 30 million of on-going cap ex and 15 million of interest expense for pretax income of 115 million. The company has 300+MM NOLs but there was a change of control so the usage of these NOLs is uncertain. Management has not given clear guidance on the use of the NOL and this is something which they will likely address shortly. I estimate they will be able to utilize 20 million of the NOL each year for taxable income of 95 million and cash tax expense of 38 million resulting in cash earnings of $77 million or $1.93 per share (this is my FCF estimate). I think with a couple years of operations & some new business wins they can get to 200-230MM of EBITDA or $2.50-3.00 of free cash flow per share.

EBITDA is estimated in the original disclosure statement projections to decline to 140-160MM but it is critical to note that these projections were assembled by the prior management team back in Q2 2003. The new team had no incentive to update the projections. In fact, with their options packages, they have an incentive to keep the stale projections in play until the company emerged from bankruptcy. EBITDA could indeed be a bit lumpy as they are expected to lose a contract with Aetna which provides 20-30MM of EBITDA but I expect this business to be replaceable over the next couple years with social services contracts. The loss of Aetna’s contract t is a speedbump in my opinion, not a sign of a deteriorating business. Also, the Aetna issue is something of which all the current holders are very aware. And, there is a small chance MGLN gets to keep their business.

The comparable companies
There are two groups of public companies to consider as comparables: The correct comparable set is companies that provide outsourcing of state social services. State social services outsourcing comprises 25% of MGLNs current business and represents a large portion of Magellan’s potential future business. The comps include PSYS (27x EPS, 228MM mkt cap), MMS (21x EPS, 870MM mkt cap), and PRSC (31x EPS, 142MM mkt cap). Based on these companies, I think a valuation of 20+x EPS is attainable for MGLN. Using 2003 EPS of $2, a $40 stock price is feasible. With $2.50-3 of EPS, a target of $50-60 is possible.

The comparison to HMOs indeed will be made by shortsighted analysts unaware of companies like PSYS, MMS and PRSC. The national HMOs (AET, ATH, UNH, WLP) trades between 14-18x 2003 earnings implying $28-36 per fully diluted share. Magellan’s business is quite different from that of the HMOs because it has leading market share, 95% client retention and the business has a very high ROIC. Moreover, there is far less competitive pricing in MGLNs business, and the risk to reserve problems and a negative pricing cycle is lower.

The catalysts
My recommendation is timely in my view because management is planning to make their first conference call in March after filing their 10k. They will be breaking the silence imposed upon them by Reg FD, and I believe this alone is likely to drive the stock higher.

More fundamentally – since I’m not a greater fool investor we need to rely on fundamentals -- as the company gets new contract wins (it was precluded from bidding on large state contracts because it was in Chapter 11), it would not be far-fetched to see this business increase EPS as well as become worthy of a higher P/E multiple. The management team and equity sponsor (Onex) have terrific reputations (as well as big stakes in the business), and I believe Wall Street will find this situation quite attractive.

The risks
As I mentioned earlier, Aetna is likely to terminate their contract with MGLN at the end of 2005. A few managed care players are taking some of their business in-house. United, Cigna and Wellpoint have 11%, 6% and 3% market share in behavioral healthcare enrollment. Most HMOs outsource this business and have no interest in taking the business back in-house (thus the 95% retention rate). While the trend with the HMOs is on the margin negative, I think the positive trends with the public sector will be much more powerful. I do not think there is a large risk of finding a problem with reserves, weak management, or cash flow problems. I do not believe there any billing or fraud risk, because the flow of payments is, in the words of a behavioral healthcare HMO executive, “fraud-resistant” and there are no outlier payments or other Medicare billing issues.

When looking at insurance businesses, one risk is whether the company is appropriately reserved or not. Onex scrubbed the reserves of the company for some time prior to emerging from bankruptcy. Also, reserves are quite small at under $200 million ($177MM at 9/30/03) compared to $180MM run rate EBITDA so the risk of reserve problems is very small. Last but not least, the business of reserving for this type of healthcare is relatively simple as the cost increases for psychologists & other behavioral healthcare providers is relatively easy to control via contracts, and utilization of these services amongst the insured population is generally predictable.

The trading risk is minimal in my view but you should know there are a few distressed debt players who are probably still quite large equity holders. There has been some turnover in the shareholder base recently, but I do not see any of the holders puking their stock at today’s prices. The valuation is compelling and there is a wave of investors including all the large mutual funds that will, over the coming year, become shareholders in this attractive and well-managed business. VIC members are familiar with the power of investing in post-bk situations -- Arch Wireless, NII Holdings, Allstream, etc. have delivered profits to VIC members for some time now. Others are starting to pay attention to this area of opportunity. As an indicator of market sentiment, JP Morgan recently wrote a 100+ page (!!) research report describing the logic of investing in post-bankruptcy situations. MGLN fits their description of a compelling investment opportunity perfectly, but even this analyst did not notice it. Perhaps I should stop writing and give him a call.

Last but not least, I refer VIC members to a January 2004 13D filed by Dan Loeb of Third Point. Dan Loeb seems to be a bright guy and I for one am glad he is a shareholder. I suggest you read his letter to management in full (in the 13D filing under MGLN), but the important part is the following: “A bounty of new potential state business in 2004, a de-leveraged balance sheet that better enables the company to bid for new public sector business, potential cost savings from systems integration, a better than expected resolution regarding Tenncare, an improving economy likely leading to lower member utilization of psychiatric services, and an excellent management team lead us to our sanguine views. Finally, we are delighted that as a significant investor, Onex Corporation possesses a sound understanding of the business and will provide an active voice on the Board.” In my opinion, Mr. Loeb’s 13D puts a legitimate “blue light special” siren on top of this value investment.

Let’s break for some Q&A.

Catalyst

MGLN came out of bankruptcy in January 2004. First conference call coming in March. MGLN was precluded from bidding on new business due to Ch. 11 status. New business wins add significantly to EPS. Wall Street will find valuation, management team and former Berkshire Hathaway executive's involvement attractive. Comparable set trades at much higher multiples.