Description

Magellan Health Services is the largest provider of managed behavioral health programs covering over 70 million lives with a network of 40,000 service providers and 5,000 treatment facilities. Magellan receives a “per member per month” fee to manage both risk and non-risk lives on a “carve out” basis for health plans, corporations and government agencies.

The opportunity in Magellan equity is the result of a brush with bankruptcy last year that led the equity to trade at option value while the company restructured its business. The stock fell from the low thirties in 1997 to $1.30 in 2000. The company is now firmly in a recovery mode but is still 80% to 190% undervalued. There is often a lag in equity value relative to enterprise value both on the way into a potential bankruptcy and following a recovery. The leverage to the equity in recovery can provide very significant returns to equity holders, as has been the case for Magellan for the past nine months.

How did they get into trouble? Prior to 1996, Magellan’s primary business had focused on facility based inpatient psychiatric hospital services. The management recognized the threat to the core business from managed care, which was reducing length of stay and per diem rates. The decision they made to deal with this issue was essentially “if you can’t beat’em then join’em”. Magellan entered the managed care business in late 1995 with the purchase of 61% of Green Spring Health Services from four Blue Cross Blue Shield plans for $90 million (12 million lives). On December 4, 1997 Magellan purchased the Human Affairs International (HAI) division of Aetna for $112 million in cash plus certain contingency payments to Aetna over a five-year period ($300 million, $60 million per year based upon Aetna adding members). The HAI business added 19.5 million lives as of January 1997. In February of 1998 Magellan acquired the Merit Behavioral Care Corporation for $750 million. The combination of the debt added to the balance sheet as a result of these acquisition and other non-core businesses as well as steep deterioration in the impatient facility business led to a liquidity crisis and near bankruptcy in 1999-2000.

How has the company responded? The company has sold all non-core assets including the psychiatric facilities, psychiatric physician practice management business, and foreign operations. Texas Pacific Group invested in Magellan in December of 1999 through a convertible preferred that provided much needed capital and expertise. The recent sale of the National Mentor business and the refinancing of $250 million in term debt puts the company on a firm balance sheet footing with no significant maturities until 2007. The capital structure is as follows:

Cash and equivalents $ 25.1
Bank revolver ($150 m) $ 0.0
Term loan B $ 60.0
Term loan C $ 60.0
Senior notes due 2007 $250.0
Senior notes due 2008 $625.0
Aetna purchase obligation $120.0
Common (including TPG) 39.7m $12.40 $492.3

Enterprise value $1,582.2

Industry fundamentals: Awareness and treatment of mental health issues has been growing due to the success of new pharmaceutical products, cost/productivity benefits for corporations and new government regulation. The number of covered beneficiaries has grown from 86.3 million in 1993 to 209.2 million as of July 2000 (13% CAGR) according to the “Open Minds Year Book of Managed Behavioral Health Market Share in the United States 2000-2001” published by Open Minds, Gettysburg, Pennsylvania. The at risk portion has grown even faster from 13.6 million to 62.9 million (24% CAGR) over this period. Approximately 250 million Americans have some form of health insurance according to the United States Census Bureau. Growth going forward will slow due to saturation of the insured base and will approach population/employment growth over the next five to seven years. The growth in the risk portion should continue to be robust (10-12%) as more of the self-insured population takes advantage of large low cost provider networks like Magellan’s. The federal government and 32 states have passed “parity” legislation that requires government agencies to provide mental health coverage to agencies employees.

Magellan’s Business: Magellan is by far the dominant provider in an industry with tremendous scale benefits and barriers to entry. Market share of the ten largest players in the industry is as follows:


Organization Enrollment Share

Magellan 69,353,000 33.18%
ValueOptions 22,154,498 10.60%
United Behavioral Health 20,015,000 9.58%
CIGNA Behavioral Health 12,250,653 5.86%
MHN, Inc. 9,427,219 4.51%
APS Healthcare, Inc. 7,200,000 3.44%
First Health of Tenn 6,039,748 2.89%
ComPsych Corp 5,486,000 2.62%
FEI Behavioral 4,200,000 2.01%
PacifiCare Behavioral 4,141,518 1.98%

Magellan Health is comprised of three business segments. The first segment, referred to as the Health Plan business, sells full-risk and claims administration mental health services to HMO’s, predominantly Blue Cross Blue Shield plans that have found maintaining their separate mental health networks to be distracting and costly. The second business segment, the Employer business, sells non-risk employee assistance plans (EAPs) and administrative service only (ASO) contracts. The third business segment, the Public Sector business, sells carve out full risk mental health services to state Medicaid plans. The segment breakdown is as follows:





1999 member Rev est. % of total

Health Plan
risk 17,628 742.3 50.0%
non-risk 17,465 104.8 7.1%
total 35,093 847.1 57.1%

Employer
risk 9,175 124.7 8.4%
non-risk 17,654 105.9 7.1%
total 26,829 230.6 15.5%

Public Sector
risk 1,755 400.8 27.0%
non-risk 776 4.7 0.3%
total 2,531 405.5 27.3%

TOTAL
risk 28,558 1267.8 85.5%
non-risk 35,895 215.4 14.5%
total 64,453 1483.2 100.0%


Source: Company filings, Morgan Stanley Dean Witter estimates

Estimates and valuation: Given Magellan’s high debt levels, enterprise value to EBITDA is the best valuation metric. The HMO group trades at an average EV/EBITDA multiple of 11.4 with a range of 7.0 to 14.0 times gross cash flow. Magellan Health has a better margin profile (13% vs 8% avg for HMO EBITDA) with similar cap-x requirements and return on invested capital. Magellan also has a more stable margin due to the lack of catastrophic event risk and lack of coverage of drugs (high cost growth area). Magellan has endorsed a 2001 EBITDA estimate of $250 million with at least high single digit growth going forward. Using a range of 8-10 times for fair value equates to equity value of between $22.00 to $35.00 per share or 80% to 190% increase from the current price of $12.25 per share.


Summary: Magellan Health is in transition from distress to a comfortable balance sheet position. The business that has emerged from the restructuring is a dominant high return business with significant competitive advantage. Significant de-leveraging of the balance sheet will occur once the final Aetna payouts have been paid in 2003 as free cash flow is used to pay down debt. The equity return leverage is significant to reach fair value and will then be enhanced further through debt pay down from free cash flow.

Catalyst

parity legislation increasing enrollment, growth from admin only migration to risk based contaracts, continued strong execution, increased exposure to new equity investers, lower interest rates, post goodwill accounting creates very low P/E (I don't generally agree with this - but it works, investors are lazy), and deleveraging following final Aetna payments. Stock may digest recent gains for some time but a very solid 12 to 18 month return likely.