Description

Metropolitan Health Networks is a Florida based (Daytona & South Florida) Healthcare provider, operating a provider service network (PSN), also called a managed service provider (MSO). Their business is providing medical services for Humana’s Medicare Advantage in the Daytona and South Florida markets. 99% of their business is Medicare coverage through contracts with Humana. They are paid under a capitation model, fixed monthly per patient fees.

The story is the previous management expanded into a Pharmacy and Diagnostic Laboratory, both of which were money losers. This effectively precipitated a crisis that almost destroyed MetCare's balance sheet, caused it to miss paying it's payroll taxes, and saddled it with a series of very dilutive, very high cost debt offerings. A new CEO was brought in last year, who spent the year cleaning up this mess, selling the Pharmacy (the lab was shut down earlier), and negotiating a settlement with the IRS. As part of this process almost all the debt has been converted to equity, and the company was further diluted with a private placement to pay the IRS payroll debt.

So what is left is a company that did about 144M in revenues in 2003, and based on proforma estimates from the company (which excluded the laboratory and pharmacy losses), earned about $7.8M excluding the lab/pharmacy losses. Monday they released their first quarter earnings, which were $1.44M and showed the balance sheet is in much better shape, with $5M in shareholder equity (up from –$500k year end 2003, and –$6m year end 2002), and a 2-1 ratio in tangible assets to liabilities. All debt has been paid off with the exception of a single $1.2M three year loan (at 12%) and the last payment on their IRS settlement.

Looking inside the earnings the PSN’s first quarter profitability is almost identical to the proforma from Q1 2003 ($1.49M vs $1.486M). Revenues were up 4.5% year over year, but increased expenses kept the PSN profitability flat. Note that their business has a minor seasonability component, namely flu season, the makes Q1 & Q4 their “high cost” quarters, lowering profitability. Q1 was also hurt by some minor final restructuring costs.

The rest of this year should benefit by about $300k per quarter as restructuring costs and interest/penalty costs should drop now that all the debt has been paid/renegotiated. So if MDPA just matches last years proforma (not factoring in the benefit of higher revenues), and without restructuring costs in the remaining three quarters, total profit would reach $8.6M. Free cash flow should be around $400k-$600k higher given the difference between annual capital expenditures and depreciation/amortization. So effectively, “owner earnings” are on pace to be around $9M this year.

So what’s the per share numbers? This quarter, the company’s weighted average diluted count is 45.3M. But doesn’t include options. “True” share count is 51.7M shares, based largely on 6.1M employee options that were exercisable below $1. Note that the company converted much of it’s debt to equity in the last year, did a large private placement, and used shares in lieu of cash compensation in some cases, which accounts for a large year over year increase in share count. These actions were taken due to the dire situation the company was in, and I don’t expect them to be repeated.

So my estimate is that diluted per share earnings for the year will be 16.6 cents (based on 51M shares) with free cash flow about a half cent higher. At today’s price (96 cents) that provides a PE ratio of six times earnings and similar ratio for cash flow. Note that so far, we haven’t spoken about taxes. This is because MDPA has $28M in NOL’s, and a $11.7M (as of Dec. 31, 2003) deferred tax asset. This should shield taxes for about three years. Removing it from consideration, and using an estimated 40% combined federal/state tax rate for simplicity’s sake, would jump the PE and Cash Flow ratio up to 10x. But by that time, earnings should be higher.

And why should earnings grow? Well, the biggest potential driver of MDPA growth is changes to Medicare made in the Medicare Modernization Act in 2003. Last year their membership actually shrank 4.4% due to the Medicare Advantage program being less attractive to patients. They expect the Medicare changes to entirely reverse that trend, and also provide increased funding. They’ve been given a 9.8% increase in Daytona & 17.8% in South Florida. Management expects some of this increase will be paid out in higher benefits, and some will fall to the bottom line. The program will be more attractive for Humana to market and promote the Medicare Advantage program as well, along with increased benefits, should turn around the trend of a small shrinkage in membership (in fact it has for the first three months of the year).

Management also feels the higher funding levels for Medicare Advantage provides opportunities to enter new, smaller markets that Humana doesn’t serve (they can’t compete with Humana) as their own HMO. Combined with Management’s ability to focused 100% on their core PSN business, with no more restructuring or the other segments, one would expect they should be able to improve financial performance even if they don’t enter new markets. Historically, year over year revenue growth in the PSN was only 2.5% in 2003, but 12% in 2001, so they have had better growth before. I view the 4.5% growth year over year shown in Q1 is a sign of improvement over 2003 and am using it as my baseline goal for the company going forward. The higher fees and potential new markets are a little speculative, so I’m just treating anything beyond that as upside.

Risks
The key risk with MDPA is that it has but a single customer, Humana. If it were to lose Humana it would force the management to scramble to line up a new HMO (or start their own). Either could be very expensive and it’s impact on profitability would likely be negative, though with the balance sheet improvements the company is better situated to handle events like this than before. Fortunately the relationship with Humana appears very strong, they do have occasional minor billing disputes, but the last contract renegotiation led to Humana paying Metcare a higher percentage of revenues. Humana also stepped up and loaned Metcare money last year during their darkest period. But it’s a competitive market, in April, Humana signed the Adventist Healthcare System to also provide benefits in MDPA’s markets. The company spun this news in a positive way as benefiting their members, but it still makes me nervous.

Intrinsic Value
A DCF analysis with 4.5% EPS growth rate, 8% discount rate, and starting with 10 cent (pre tax earnings) provides an intrinsic value estimate of around $3, plus maybe another 15 cents in value for three years of tax free earnings. Obviously, the upside is that a higher growth rate would increase this, hopefully substantially.

Disclosure:
I have 20% of my portfolio in MDPA with an average cost of $.73 cents. I apologize for not writing it up sooner, but spent some time waiting for a friend to write it up before he declined.

Catalyst
Short term MDPA has one interesting catalyst, liquidity, as I expect the management to file for listing on the AMEX or NASDAQ soon now that they have sufficient positive shareholder equity. This could drive awareness and demand for the stock. Also, final elimination of the pharmacy losses should almost double earnings year over year (which is what they touted in their Q1 report).

Long term the driver is increasing earnings and book value in a very cheap stock as Medicare changes and focused new management combine to grow business at a good rate.

Catalyst

Doubling earnings year over year and enhanced liquidity, as I expect management to file for listing on the AMEX or NASDAQ.