Description

Pediatrix (“PDX”) is a physician practice management (“PPM”) group that focuses on neonatology (pediatrics w/focus on high-risk newborns) and perinatology (obstetrics w/specialty in high-risk or complicated pregnancies). The company staffs and manages hospital-based neonatology units, as well as both hospital-based and outpatient perinatology units. From the market’s perspective, Pediatrix has suffered recently from the announcement of the CEO’s departure, as well as renewed interest from the Federal Trade Commission into a merger completed several years ago. Moreover, additional overhang has resulted from PDX’s reputation as an acquisitive company in a highly-regulated industry with the attendant regulatory and payment risk. Throughout this period of headline turmoil, however, the company has continued to execute impressively, improve operations, and generate strong cash flow. Company management is solid (the CEO issue has been addressed – more detail below), and has a strong history of managing its way through uncertain times. The shares currently trade for roughly 8x earnings, well below the 14x intrinsic value that I believe they should command. Unlike most, if not all other PPMs, PDX actually generates cash, even after acquisitions. Free cash, prior to acquisitions, has generally been in excess of reported earnings.

PDX contracts with independent physicians to provide neonatology and perinatology services, and takes care of all administrative support, scheduling, billing, and reimbursement. In neonatology, it is the nation’s largest provider. At year-end 2002 PDX contracted with roughly 620 physicians in 25+ different states. Annual turnover among the physician base is 5-7%, in-line with other well-managed PPMs. Payor mix is 20-25% government (principally Medicaid), 50% contracted managed care, and 20-25% other third parties (individually negotiated, non-contracted). Neonatology is an attractive niche of healthcare, with some good secular wind at its back. Over the years, obstetrics has become a major profit-center for hospitals due to the predictable, recurring nature of its demand. Neonatal intensive care units (“NICUs”), in turn, are a key element in the mix since most obstetricians refer their patients to hospitals with NICUs “just in case” something goes wrong during the birthing process. Up through the mid-1970s, NICUs tended to be found only in large, academic hospitals. However, as the profitable nature of obstetrics has solidified, they have moved much more broadly into smaller regional hospitals. PDX has ridden this wave to its current market-leading position.

PDX’s approach to growth is two-fold. Historically, the company has realized 6-10% organic top-line growth through a combination of volume (+3-5%) and pricing (+3-5%). Pricing improvements realized by the company over the last several years are myriad, and include fee schedule refinement, as well as improvements in contracting strategy, reserve rate methodology, and coding. Management has proved adept at successfully navigating the treacherous world of reimbursement, and has consistently done so in an ethical manner (see detail below on billing guidelines). The other component of the company’s growth is acquisition. Management has typically guided the Street to expect $40-50mm per annum in acquisitions. Acquisitions have historically been done at 3-4x EBITDA, which equates to roughly 6x after-tax net income. Assuming a 6% attrition rate on the physician base, and using the company’s current consolidated EBITDA margin, this works out to a 15-20% return on invested capital. The acquisitions are highly accretive from an earnings standpoint.

In 1998, PDX was the target of a concerted short attack. The company’s auditor, PWC, announced that an employee in its Tampa office had violated auditor-independence guidelines (a PWC employee, it turned out, owned 165 shares of PDX stock). In response, PDX hired KPMG to perform a concurrent audit. KPMG initially took issue with some of the company’s accounts receivable. The shorts smelled blood, began piling on the company, and some of the more activist shorts initiated calls to a number of state attorneys general alleging billing fraud by PDX. The headlines surrounding these actions demolished the stock, despite the fact that 1) KPMG ultimately blessed the receivables as-presented, and 2) none of the state AGs ever found any evidence of billing fraud. PDX stock has, since this time, continued to suffer from a modest overhang and tends to get extremely volatile (more so than is arguably typical) around times of perceived negative announcements. This, in part, explains the 20% downdraft following the recent CEO-change announcement. In this environment, management has focused on debunking negative press through impressive, consistent delivery of operating results. It is difficult to argue with their performance on this score. As a footnote, PDX’s reputation with respect to billing/coding practices is extremely strong (an obvious plus in today’s climate). The company has been writing billing guidelines since the early 1990s. In 1996 it acquired a quasi-academic practice that subsequently wrote an in-depth set of billing and coding practices that were ultimately adopted as rule by the American Association of Pediatrics.

In 2001, PDX acquired MAGELLA Healthcare – its largest acquisition to-date. At the time of the acquisition, MAGELLA represented roughly 1/3 of the consolidated entity’s EBITDA. Regulatory authorities blessed the acquisition. In June of 2002, the Federal Trade Commission (“FTC”) sent the company a written notice (i.e. opened an informal probe) asking for a voluntary submission of information related to the MAGELLA merger. The assumption is that the FTC’s interest lies in the company’s position as dominant supplier in several of its individual markets post-acquisition, and potential pricing power arising from that position. Upon the June 2002 request, PDX stock dropped 40%, but subsequently recovered fully following several quarters of strong operating results. In early February of this year, the FTC ratcheted up the level of the investigation with a subpoena requesting additional information. The stock dropped roughly 30% upon this announcement. Ultimately, if the FTC finds evidence of anticompetitive action the remedy could be a forced divestiture of some or all of the MAGELLA assets. A full divestiture is highly unlikely. The MAGELLA acquisition took PDX into 12 new markets – 8 of these were entirely new markets for PDX; in the remaining four PDX already had a presence. It would be counterintuitive to force a divestiture in those markets where PDX had no prior presence since the merger didn’t result in any new pricing leverage for the combined entity. As a result, I am assuming that in a worst-case scenario the FTC forces a divestiture in 4 of the 12 MAGELLA markets. Assuming PDX receives a pro-rata price for the assets commensurate with what it paid, and if it uses proceeds to repurchase stock, total earnings dilution would be less than $0.15/shr.

Another issue investors have focused on is insurance. PDX has always self-insured a fair amount of its coverage needs, and in mid-2002 it increased its reliance on self-insurance. This has concerned some, as a result of the unfavorable trends in jury verdicts for malpractice. This issue is fairly easy to dispense with. Given the focus of neonatologists on high-risk pregnancies, most of a NICU’s “problem” cases are inherited. By definition, for a newborn to make it into a NICU a problem has arisen either during the pregnancy or during the birthing process. This means that the problem has arisen on somebody else’s watch, and it is the obstetrician’s attendant during these procedures prior to NICU admittance that bear the brunt of the malpractice awards. Moreover, as the largest neonatology PPM in the country PDX has excellent claims experience to work off in setting reserves.

On Thursday, March 27th PDX announced the resignation of Kris Bratberg, the company’s president and CEO. Bratberg had been elevated to the CEO position in January of this year, after founder and former-CEO Roger Mendel stepped upstairs to the Chairman position. “Personal reasons” were cited for Bratberg’s departure. Market reaction was swift, with the stock dropping over 20% that day. Bratberg was fairly well regarded on the Street, and his departure is clearly not a positive, but I do believe that there are a number of factors to give investors comfort. First, Mendel agreed to immediately step back into the CEO role, and relinquish his Chairmanship to a non-executive chairman. This is a plus from a corporate governance standpoint. Second, Mendel signed a 3-year employment agreement so there is no leadership vacuum while an “interim” CEO fills the gap. Third, the company reiterated its financial guidance and, in private conversation, has been emphatic that nothing is awry operationally and they are very confident in the business. My personal take is that there were personality issues and, possibly, that the company’s founder (Mendel) had issues with the way “his” company was being run by a relative newcomer.

With respect to valuation, I have used a DCF approach. I assume no acquisition activity, although this activity is likely to continue albeit at a depressed rate given the current FTC overhang. Continued acquisition activity would be accretive to both earnings and value. I assume that the company’s organic earnings (i.e. pre-acquisition) this year are $2.85/shr (the difference between this number and consensus of $3.15/shr is primarily acquisitions, plus a slightly more conservative margin assumption on my part). As mentioned, I pro forma my numbers beginning in 2004 to assume a 40% divestiture of MAGELLA properties and the attendant earnings hit (roughly $0.15/shr in 2004). I grow revenue 6% for the next 3 years (at the low end of both historical organic growth and management guidance), and 4% per year thereafter. I give the company credit for slight margin improvement, with operating margins rising to 26% over the next five years. The company has generated fairly substantial margin improvement over the last several years. These variables yield a target price of approximately $41/shr, or 14x this year’s organic earnings.

At current levels, you are purchasing the stock of a dominant niche healthcare provider with a great balance sheet ($2.70/shr cash) at only 8x EPS. There are clear, identifiable announcements that have taken the stock down which I believe are overblown. Management has consistently navigated through treacherous times, and buys back stock aggressively (recently completed its $50mm authorization). Lastly, from a technical perspective over 20% of the stock’s float has traded over the past two days. This is a far more than is typical for what I regard as a garden variety management announcement.

Catalyst

Resolution of FTC inquiry – for better or worse, I believe that anything short of a full divestiture would be viewed as a major positive
Continued delivery of strong quarterly results (will remove overhang of recent CEO resignation)
Resumed stock buyback