Description

SUMMARY: Post it’s just announced restructuring/asset sale MDF will consist of a cash generating 20%+ ROIC business valued at 4-5x GAAP EPS with a EV/FCF yield of about 20%, a EV/EBITDA multiple of 2.3x on TTM results, a valuation one-third a similar company and selling at 60% of intrinsic value; making the stock a true value investment.

 

INVESTMENT THESIS: The announcement to sell off the company’s money losing HMO operations should remove the major issue that has been clouding the shares by: 1) helping to monetize the company’s prior investments in this area, 2) significantly improving profitability and cash flow, 3) allowing management to focus on its high ROIC core PSN business with a new growth opportunity and 4) making the company a more attractive pure play acquisition target. With the losses from its HMO operations soon to be eliminated, my conservative no growth model shows the company will deliver about $0.20 -$0.25 per share in GAAP earnings in 2009 and should be able to generate about $10.5 -$11.0 million in cash flow. With cash of about $0.75 per share (or over 40% of the current market valuation), the shares are currently valued at about a 4-5x cash adjusted P/E multiple on GAAP earnings and about a 20% FCF/EV yield on cash earnings. Excluding the impact of the losses from the soon to be sold HMO operations, the EV/EBITDA ratio on a TTM basis for the remaining PSN operations is only about 2.3x. Historically the core PSN business has demonstrated pretty consistent and very profitable returns (albeit slow growth) with healthy cash flow generation and a 20%+ ROIC. Excluding the losses from its soon to be divested HMO business, the shares of MDF sell at a valuation on GAAP earnings and EV/EBITDA of only one-third a similar publicly traded company. Thus, I believe that at its current valuation these characteristics should make the shares attractive to both value investors and possibly an acquiring entity. I believe the stock is currently selling at only about 60% of intrinsic value of +$3.00 per share, representing potential upside of 70% based upon my conservative assumptions. My intrinsic value calculation is based on: 1) a value of 10x 2009 FCF and 2) cash per share building up to close to $1.00 per share.

 

DISCUSSION POINTS: The investment case for MDF has been detailed by me and another VIC member in the past, so I will use this write-up to update you on the current business and valuation as well as detailing some of my assumptions.

 

• On June 30^th the company announced that it would be selling its Metcare Health Plans (MHP) HMO operations to its current PSN partner Humana for $14 million. The sale is expected to close during the September quarter and MDF will book a one time gain in Q3 from the sale of the assets, which is on the books for about $5 million. My read on the sale is that after a 36 month effort on the part of the company to offer its own HMO plan, I believe management came to the decision that despite growing membership to about 7,400 members the time and effort to reach critical mass to turn the operations profitable in the face of increased competition was more than originally expected. The agreement with Humana offers the company a way to monetize its prior investment to build the business and retain an ongoing stream of revenues and earnings from those investments in the future. The price per member of $2,000 is below what I would have expected in a sale. However, what is different than expected (and I believe somewhat misunderstood in the market) is the financial benefit from the provider service network (PSN) agreement that MDF signed with Humana to service these same enrollees in these 13 Florida counties under terms similar to its existing agreements with Humana. In addition MDF is expanding its existing agreement to service and ride the coattails of Humana’s growth plans in the Florida market through its CarePlus HMO offering. Noteworthy, my assumptions do not include any growth in membership in MDF’s core PSN business or from Humana’s aggressive marketing plans to grow its CarePlus operations.

 

• Historically MDF’s PSN operations have demonstrated slow growth, but high cash flow characteristics and a very attractive ROIC in the 20-30% range. Given the nature of the business and the role that MDF takes on as a risk provider, where it gets a fixed amount per Medicare member per month and provides the necessary medical services that these members require, there is some variability in its profitability. As illustrated in the table below, looking back over the last few years the annualized pretax cash flow for this operation has ranged from about $12 million in times when medical utilization rates were high and management lost focus (during the start-up of its HMO operations) to about $25 million in 2007 when management was focused on closely managing the operations and medical usage rates were unusually low (i.e. a mild cough/cold season with low hospitalization levels). While somewhat unpredictable, our model going forward assumes a profitability level towards the low end of this range with no growth in membership.

 

• With the sale of MHP expected to be completed during the September quarter, the 2008 financial model will represent a mixed picture of two more reported quarters (June & September) of HMO operations and a December quarter of the new PSN business from servicing these prior members. My model assumes HMO losses slightly less than those reported in the March quarter due primarily to the timing of the higher cost open enrollment period having just ended (when all competitors are spending to sign up new HMO enrollees) in March. For conservative purposes I have not assumed a complete curtailment in costs as a result of this decision to sell the division, which could lead to modest upside in my model. As for the new PSN business, I have assumed that it will take a few quarters to increase the profitability of this business by leveraging the lower cost agreements that Humana has with many service providers (i.e. hospital & clinics) and to gain efficiency savings. Thus I have modeled these new PSN revenues only beginning to be slightly profitable in Q1 2009 and increasing through the year. Thus, as illustrated in the table below, I have modeled pretax cash flow from this new PSN business at only about $2 million, or about one-half the profitability of the existing PSN business.

 

• The change from eliminating the company’s money losing HMO operations and adding the new PSN business from Humana will have a notable impact on the company’s profitability and cash flow. As illustrated in the table below, in 2007 the HMO operations lost about $15 million and my estimate is that for the nine month period of 2008, when they will be part of MDF’s operations, they will lose about $9 million. Conversely, the impact of servicing these same customers through the new PSN agreement with Humana will likely translate into a positive contribution of about $2 million in 2009 and $3-4 million in the following year. Looking at it another way, my estimates show that eliminating the impact of the losses from the HMO operations in the 2007 fiscal year (and assuming no contribution from the just announced new PSN agreement with Humana), EPS would have been about $0.29 per share compared with the $0.11 per share reported.

 

• While I have not assumed any growth in revenues or membership in my future forecasts, this may prove conservative. Over the last few years MDF has been successful in growing its HMO membership to about 7,400 members. Given the marketing strength of Humana coupled with the fact that penetration levels in these 13 Florida counties are still only one-half or less the levels in some of Florida’s more mature counties, there is a good likelihood that Humana will be able to grow membership through its CarePlus operations in these counties. Thus, assuming a favorable medical usage year, more normalized profitability from the new PSN agreement with Humana and some growth in enrollment at MDF or CarePlus, I believe the underlying EPS power of the company could be in excess of $0.30 per share, or more consistent with the EPS from continuing operations reported in FY 2007 (see table below).

 

• Currently the company has a very healthy balance sheet with no debt and as of March cash of $40.7 million, or $0.78 per share. Included in the company’s cash is about $15 million restricted for use in the HMO that will be part of the transaction. This amount will be offset by the $14 million (less fees and taxes) received from the sale and some additional cash generation from the business, which should be about a wash. Noteworthy, despite self funding the start-up of its HMO operations and incurring meaningful losses, the company’s cash position has recorded very healthy growth. For example, in the last 24 months, cash has about doubled from about $20 million in the similar period of 2006. My estimates show that the company will continue to generate cash over the next few quarters and at an increasing rate post the MHP sale, with cash building to about $1.00 per share in 2009. Management has so far decided to let the cash build to look for possible acquisition targets (i.e. physician’s practices) and not return any back to shareholders or buy back stock. I don’t believe management will do anything foolish with the cash and believe there is increased pressure on management to something shareholder friendly with the cash, which I believe is a real possibility post the MHP sale. Nonetheless, with the HMO operations separated, cash on the balance sheet is another reason I believe the company could be an acquisition target for another entity.

 

• 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 very 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 P/E (the company has a slight net debt position) of about 13x fiscal 2009 earnings versus a cash adjusted P/E for MDF of only 4-5x my estimate of $0.20-$0.25 per share. Moreover, looking at a relative comparison of trailing twelve month EV/EBITDA multiples, CNU sells at a valuation of about 6.8x, while MDF’s PSN operations (what will be remaining after the sale, but not including the additional business from Humana) is valued at only a EV/EBITDA of only 2.3x. I submit that what is responsible for this difference and the low valuation accorded the shares in general is the overhang of the losses from the HMO operations. I believe investors have not understood the value this transaction will unlock and this valuation disparity will clear up over the next few quarters as the true underlying earnings power and cash flow dynamics of the company will become visible.

 

A summary income statement follows:

 

Metropolitan Health Networks
Income Statement
	2005	2006	2007	2008E	2009E
Revenues:
Existing PSN Business	180.9	200	222.5	230.9	230.9
New PSN Business	-	-	-	14.6	58.5
HMO Business	2.8	28.2	55.1	54.9	-
Total Revenues	183.8	228.2	277.6	300.4	289.4
PreTax Income:
Existing PSN Business	12.2	15.8	24.6	15.0	15.0
New PSN Business	-	-	-	-	2.2
HMO Business	(8.3)	(15.0)	(15.1)	(8.9)	-
Total Pretax Income	3.9	0.8	9.5	6.1	17.2
Taxes (@ 38% rate)	1.5	0.3	3.5	2.3	6.5
Net Income	2.4	0.5	5.9	3.8	10.7
Shares Outstanding	52.3	52.0	52.4	52.0	52.0
Reported EPS	$0.05	$0.00	$0.11	$0.07	$0.21
EPS from Continuing Ops.	$0.14	$0.19	$0.29	$0.18	$0.21
Notes:
-- Included in the FY 2008 estimate is a contribution from the HMO
business for 9 months and the new PSN business for 3 months.
-- EPS from continuing operations include only the company's PSN
operations & exclude the losses from the soon to be divested HMO operations.

Catalyst

-- With the company likely to report its PSN business as continuing operations, investors will get a clearer picture of the true underlying earning and cash flow dynamics of its PSN business.
-- A further build up in the company’s already significant cash position over the next few quarters.
-- Management using its cash to make an additive acquisition or using a portion of it to repurchase its shares.