Description

Disclosure: our firm has a short position in MRN.

Investment Summary
I am recommending shorting Medical Staffing Network (ticker MRN). MRN is faced with demand for temporary nurses that is flat at best, increasing pricing pressure, and a continuing shortage of available nurse supply to fill job openings. The bull arguments that MRN will benefit from an aging population, a long-term shortage of nurses, and an increase in state-legislated nurse-to-patient staffing ratios are mostly long-term speculation and have yet to impact MRN’s results. The bottom line is that MRN is priced for a massive rebound that simply is not going to happen.

At $6.49 per share, MRN has a market cap of $196 million (30.2 million shares) and an enterprise value of $237 million (net debt of $41 million). MRN is trading at 29.0 times 2Q04 LQA (last quarter annualized) EBITDA of $8.2 million. We believe that using LQA is the best approach given that management gives no guidance and the business has been deteriorating. Using consensus analyst estimates, MRN is trading at 26.3 times 2004 EBITDA of $9.0 million and 15.7 times 2005 EBITDA of $15.1 million. MRN’s peers (AHS and CCRN), which we believe are overvalued, trade at 11.0-12.9 times 2Q04 LQA EBITDA, 11.3-12.7 times 2004 consensus EBITDA, and 10.2-11.5 times 2005 consensus EBITDA. Other healthcare service sectors trade at substantially lower multiples despite having lower volatility and higher liquidity: both hospitals and nursing facilities trade at 6-8 times 2004 EBITDA.

MRN is still overpriced; even at a wildly bullish peer multiple of 11.0 times 2004 EBITDA, MRN would be worth $1.93, or 70% downside from here. A multiple of 7.5 times LQA EBITDA yields a share price of $0.67, or 90% downside. Even using 7.5 times consensus 2005 EBITDA yields a share price of $2.39, or 63% downside. The most likely catalyst here is continued decline or stagnation of revenue. This is not a fraud-type short or one in which management will dispute the facts, rather it is a short where the market has not yet recognized the dramatic structural shifts in both supply and demand to the downside. We believe the changes here for MRN are SECULAR, not CYCLICAL. This short reminds us very much of DeVry, a short in which the bulls were slow to accept that there was a secular decline rather than a cyclical one.

Overview
MRN provides temporary nurse staffing services to hospitals and other healthcare providers. 72% of MRN’s revenues come from ‘per-diem’ nurse placements, staffing local nurses in assignments ranging from one-day to several-weeks. 17% of MRN’s revenues are derived from allied health placements (clinical, radiology, and lab workers). And 11% of revenues come from ‘travel-nurse’ placements, staffing nurses in assignments requiring relocation, typically for 13 week periods. As the per-diem model requires a local presence in each market, the company maintains a network of 140 local staffing offices in 43 states (as of 12/31/03), which limits their ability to cut costs when revenues decline. MRN earns a spread between the fees they charge the hospital and the amount they pay the temporary nurse, although this spread has been coming down due to increased pricing pressure from hospitals.

With FY03 revenues of $513 million, MRN is the largest player in the $4.5 billion per-diem market, holding an 11% share. AMN Healthcare (ticker AHS), with $714 million FY03 revenues, and Cross-Country Medical (CCRN), with $687 million FY03 revenues, are the two largest competitors in the nurse staffing space, however they both focus primarily on travel nurse staffing as opposed to per-diem. OnAssignment Inc (ASGN), with $210 million FY03 revenues also has a travel nurse subsidiary, HPO, with approximately $78 million in revenues.

The overall temporary nurse market has been impacted heavily in recent years by shifts in the supply demand balance. Demand for temp nurses, both per-diem and travel, depends upon admissions growth and how prepared hospitals are for growth (thus whether they find themselves under-staffed) and on hospitals’ approach towards using contract labor vs. flexing their internal nurse supply. Supply is driven primarily by the number of nurses choosing to work at temporary, rather than full-time, positions. Supply correlates closely with the strength of the economy; nurses are more comfortable leaving full-time positions for part-time work when their own job prospects are strong, their husbands are comfortably employed, and their family’s finances are secure.

The years 1999-2002 saw hospital admissions grow at 4%+ rates, after a decade of weak admissions driven by managed care and the push towards outpatient procedures. Hospitals had not anticipated such strong growth, had not hired full-time staff to meet it, and were thus willing to spend top dollar to get temporary labor. This high demand provided temporary nurses with limitless job opportunities and, combined with the job/financial security of a strong economy, resulted in a large number of nurses choosing to pursue travel or per-diem positions. As a result of all of this, the temporary nurse placement industry experienced a period of dramatic growth, capped by the three well-timed IPOs of MRN, AHS, and CCRN.

By 2003, the dynamics had shifted. Demand for temporary nurses fell sharply as hospital admissions weakened more than expected (high unemployment swelled the ranks of the uninsured) and hospitals dramatically cut their contract labor expenses as part of broad cost cutting. Simultaneously, the supply of per-diem and travel nurses began to shrink. Many nurses were (and still are) forced to return to full-time work as their households faced financial challenges. In addition, the lack of temp nurse work meant temporary nurses could no longer rely on getting the hours or assignments they wanted. Finally, hospitals got better at meeting nurses’ needs (flexible staffing, internal staffing pools, online bidding procedures), so nurses had fewer reasons to turn to an agency in the first place.

Currently, these supply and demand trends do not show many signs of improving. Hospital admissions appear to be up only slightly so far in 2004 and the trend is worsening; public hospitals reported average admissions growth of 2.9% in Q1 and only 1.1% in Q2. Admissions are expected to be sluggish for Q3 as well (private hospital comments). Based on comments made on hospital companies’ conference calls, contract labor expenditures are still far below last year and are likely to stabilize at these new low levels. There continues to be increased pressure on hospital management teams to reduce contract labor.

Nurse supply remains even weaker than demand, as few nurses are choosing to leave the comfort and security of their full-time positions for uncertain temp work. This is likely due to continued weak job growth driving spousal unemployment (or job insecurity) and general household economic malaise (high debt levels, rising gas prices, etc.) As case in point, AHS recently commented that “potential nurse recruits remain cautious,” and nurse applicant activity year over year is “down pretty significantly”. All in all, not an environment that suggests dramatic growth.

Financial trends
MRN’s revenue growth has fallen off a cliff since 2003, and looks even worse when you strip away acquisitions. MRN grew revenues at 90%/yr in 2000 and 2001 (organic growth unclear), 41% in 2002 (33% organic), and then only 6% in 2003 (an 8% decline in organic revenue). By Q303, revenue growth was at -2% (-15% organic), sliding to -21% (-26% organic) in Q4, and remaining in the negative mid-20’s for the first half of 2004.

MRN has managed to generate cash in 2003 and YTD 2004 through tighter management of receivables (DSO’s down from 63 to 53, while peers remain in the upper 50’s) and reduced working capital driven by shrinking revenues (working capital is 13% of revenues). These one-time cash extractions are largely complete. In fact, like other staffing companies, when and if MRN grows its revenues, working capital needs will keep free cash flow generation minimal.

In addition, to conserve cash MRN essentially cut off ‘de novo’ development (organic growth in staffing offices); this does not bode well for future growth. In 2002, MRN opened 40 branch locations, ended the year with 180 locations, and stated plans to open 20 more in 2003, however in 2003 MRN actually closed 29 branch locations (June 03) and has since closed more, as MRN management listed 135 current locations in a recent presentation.

Outlook
MRN has not given guidance since withdrawing FY03 guidance on 9/15/03, citing a lack of visibility. MRN has missed consensus expectations for the last 2 quarters and consensus estimates have been coming down consistently for the past 4 quarters. In addition, there has been significant management turnover during the first half of 2004. In March, Chairman and CEO Robert Adamson unexpectedly announced his intention to retire. And in May, President and COO Gregory Guckes resigned unexpectedly. Finally, MRN hired a new CFO in August to replace Kevin Little, who has assumed the role of President and COO.

Consensus estimates for MRN call for $427 million FY04 revenues, a 17% decline over FY03, and $454 million FY05 revenues, implying 6% growth over FY04. EBITDA consensus is $9.0 million for FY04 (a 2.1% EBITDA margin) and $15.1 million for FY05 (a 3.3% EBITDA margin). These estimates imply significant growth and margin improvement (+120bps) and yet still value MRN stock at 15.7 times ’05 EBITDA. MRN has commented that incremental EBITDA margins are only 17-18%, thus even if MRN were able to grow the business 7.5% from 2004 levels (above consensus of 6% growth and our 0-5% view), yielding revenues of $459 million, incremental EBITDA would only be $5.6 million ((459-427) * 17.5%), total EBITDA would be $14.6 million (’04 EBITDA of 9.0 + 5.6 incremental), or 3.2% of revenues (14.6 / 459), and EV/EBITDA would be 16.2 times. Note that the EBITDA we generate with 7.5% growth is lower than consensus EBITDA on 6% growth; it appears that the sell-side is using incremental EBITDA as high as 36%, well above management’s estimate. At the end of the day, this is clearly not a situation where a moderate recovery will take MRN’s EBITDA margins back to their 10% levels of 2002. We believe that low to mid single-digit growth is a more realistic outlook and that margin improvement will be modest at best. MRN’s shares are enormously overvalued given any reasonable view of the business.


Other issues:
- Warburg Pincus owns 14.5 million shares (47%). Although there could be risk that they would take MRN private again if the share price collapsed, the shares aren’t currently anywhere near the valuations that interest private-equity firms. Can you imagine the letter to L.P.’s explaining a doubling-down in MRN at 26 times ’04 EBITDA? Clearly MRN is nowhere near the ‘cheap’ valuations that Warburg, Welsh Carson, and others typically acquire healthcare companies in going-private transactions.
- There is $12 million remaining of a $17 million term note due in December 2005. This will likely need to be refinanced and may help refocus investors’ attention on the marginal EBITDA being generated by MRN.

Catalyst

The most likely catalyst here is continued decline or stagnation of revenue. This is not a fraud-type short or one in which management will dispute the facts, rather it is a short where the market has not yet recognized the dramatic structural shifts in both supply and demand to the downside.