Description

Quadramed (OTC BB: QMDC) is a back from the dead provider of healthcare IT software. However, at 6x my estimate of EBITDA for 2004, growing at over 20%, investors still think it’s moribund. Throughout 2002 and 2003, this former stock market darling was obliged to restate its financials, de-list from NASDAQ, complete an onerous financing in order to cure a technical default, and stabilize its operations. At this point, Quadramed has worked through most of its problems and is taking full advantage of a strong business environment for healthcare IT.

Catalysts

1. Settlement of enforcement action with SEC.
2. AMEX/NASDAQ listing.
3. Re-initiation of analyst coverage.

Background

Quadramed provides healthcare IT products and services to some 1,900 facilities. The company’s most important product lines are sold under (i) the Affinity brand for integrated enterprise information systems, (ii) the Quantim brand for health information management software, (iii) the Complysource brand for meeting regulatory compliance requirements and (iv) the Chancellor brand for financial software. Revenues are generated from licensing and services. The company’s recently filed S-1 provides a good overview of QMDC’s products and technology.

After a significant spending spree in the late 1990s and poor execution integrating acquisitions, in August 2002, Quadramed announced its intention to restate certain prior period financial statements. In February 2003, the SEC announced that it was investigating the company and, in October 2003, informed the company that it was going to institute an enforcement action.

As if the company did not have enough problems, in March 2003, NASDAQ de-listed Quadramed as a result of the company not being current on its SEC filings owing to the restatement issues. This triggered a repurchase event for Quadramed’s convertible note issue due in 2005. The repurchase was financed through the sale of new notes (due 2008) and warrants (for about 30% of the company).

Since these crises (and I have just described the tip of the iceberg), Quadramed has stabilized considerably. The company is current on its SEC filings and has a very positive business outlook.

Capitalization Profile

Recent stock price $3.15
52 week range $0.30 to $3.75
Shares outstanding 40.2 million (includes 11.3 million penny warrants issued with the 2008 notes and 1.1 million shares assuming cashless exercise of in the money options)
Significant owners William Jurika (14%), Zazove Associates (11%), David Knott (6%), Apex Capital (4%), Mackay Shields (has 6.6 million warrants)
Management ownership 5% +
Equity market capitalization $126 million
Total debt $84 million
Cash and cash equivalents $38 million (includes restricted cash of $5.5 million, excludes $4 million for the Détente acquisition)
Total enterprise value $172 million

Projected Financial Performance

($ in millions, calendar year) LQA 2004 2005 2006

Revenue (a) $146.9 $157.5 $173.3 $190.6
Growth % NM 7.2% 10.0% 10.0%
Gross margin 101.0 106.6 118.1 130.8
Gross margin % 68.7% 67.7% 68.2% 68.7%

Operating expenses (b) 87.9 91.3 95.3 99.3
Operating income 13.1 15.2 22.7 31.5
Operating margin % 8.9% 9.7% 13.1% 16.5%

Interest and other expense, net 9.0 9.0 8.5 8.0
Income before taxes 4.1 6.2 14.3 23.5
Taxes (c) 1.6 2.4 5.4 8.9
Net income 2.5 3.8 8.8 14.6

Capital expenditures 3.1 3.5 3.5 3.5
Depreciation and amortization 11.8 11.5 11.0 10.5 Change in deferred revenues (d) (2.6) 9.0 10.0 11.0

EBITDA 24.9 26.7 33.7 42.0
EBITDA - CapEx 21.8 23.2 30.3 38.5
Free cash flow (e) 5.4 20.8 26.3 32.6

Multiples:
TEV/sales 1.2x 1.1x 1.0x 0.9x
TEV/EBITDA 6.9 6.4 5.1 4.1
TEV/EBITDA - CapEx 7.9 7.4 5.7 4.5

Equity/FCF 23.5 6.0 4.8 3.9
Equity/net income 49.5 32.8 14.2 8.6

(a) 2004 revenues represent LQA results plus 7%. Even allowing for seasonality, I think the 2004 results should be easily achievable given recent new business wins and the acquisition of Détente Systems which rounded out the company’s product line in the laboratory and radiology area. I have used 10% growth thereafter.
(b) Adjusted to allow for (i) a $10 million run rate for g&a per management’s comments, and (ii) $7.5 million of non recurring costs in 2003 related to restatement and legal activities.
(c) At 38%. Ignores the impact of NOLs.
(d) This working capital item adjusts for the fact that the company receives cash in advance for many of its projects.
(e) Net income plus d&a plus the change in deferred revenues minus capital expenditures. I have ignored other working capital items.

Investment Considerations

Quadramed is an attractive investment for a number of reasons:

Growth Industry – To paraphrase QMDC’s S-1, the health care industry is under enormous pressure from multiple sources to improve efficiency, eliminate errors and enhance the quality of care. As a result, according to Sheldon I. Dorenfest and Associates, an industry consultant, spending on healthcare IT is expected to grow at around 9% over the next few years. Certain segments of the market, such as that for clinical systems, are expected to grow at 15% to 20%.

A recent WSJ article highlighted that hospitals plan to boost capital spending by 14% over the next five years, with much of the spending on IT. Some examples of what is motivating the spending include:

1. The Institute of Medicine and various industry groups are advising health care organizations to adopt IT systems that collect and share information on patients and their care in order to reduce deaths and injuries caused by medical errors (44,000 to 98,000 deaths/year).

2. The Center for Medicare and Medicaid Services (part of the federal government) is encouraging the use of Electronic Health Record Systems to improve care quality based on better clinical data.

3. The Department of Health and Human Services reporting that “the delivery of cost effective, high quality health care in order to meet national goals for healthy people and healthy populations is now clearly linked to the availability of information.”

4. Legislation, such as the Health Insurance Portability and Accountability Act of 1996, which mandates privacy requirements for patient data and standards for the maintenance and transmission of such information.

In any event, the business environment in which Quadramed operates offers substantial growth opportunities. Keep in mind, however, the healthcare sector has been slow to adopt IT. Even so, a number of industry participants, such as Cerner, are reporting strong results and outlooks because healthcare providers are increasingly willing to consider IT solutions. In addition, the usefulness of many applications has increased over the last several years.

Growth Position - Quadramed sells software, primarily to hospitals, for high growth applications: clinical information systems, computerized physician order entry (CPOE), electronic medical records, and medication management. The company has a strong presence in the market for smaller hospitals and for medical records systems where 3M is a market leader (Quadramed is a strong number two). Quadramed’s new web-based CPOE system has been well received and should generate strong sales growth in 2004 and 2005.

In particular, Quadramed has a significant opportunity to cross sell new products to existing customers that may have only purchased one of the company’s products. An example of this potential comes from the acquisition of Détente which will round out Quadramed’s product offering to include laboratory and radiology IT packages. Customer checking confirmed this type of cross selling potential.

Sales Momentum – During the first half of 2003, Quadramed was operating without audited financial statements. This was a significant impediment to new business activity. With the availability of audited financials in the second half of the year, the company was able to drastically improve its credibility with potential customers. With lag times of up to 18 months between submitting proposals for projects and such projects being awarded, Quadramed is anticipating increased new business over the next few months. Management is currently reporting that business is good. In addition, at the recent HIMSS conference in Florida, Quadramed generated significant positive word of mouth.

Higher Quality Earnings – Since initiating their turnaround efforts, management of Quadramed has gradually increased the proportion of the company’s revenues attributable to licenses as compared to services. As such, Quadramed will benefit from higher margins and greater earnings stability. Also, in 2003, Quadramed expensed all r&d costs and has adopted much higher standards for capitalizing such costs.

Downside Protection – Given the complexity of the IT solutions that Quadramed supplies, once a product is installed, a customer will typically stay with the IT provider thus providing the provider with some client stability. As an example of this, Eclipsys, a competitor, which has had technical problems with some of its products, has not reported any customer losses. Further, through its restatement period, Quadramed did not lose any customers.

Effective Management – Led by the former president of CIGNA, Larry English, management has implemented a stable capital structure after addressing the restatement issues that almost forced the company into bankruptcy at the start of 2003. The group has also sold unattractive and non-core businesses, integrated acquired businesses and refocused new business activities. In short, they have done what they said they would do and I believe they will continue to be effective.

Resolution of SEC issues – Quadramed needs to address is its outstanding enforcement action with the SEC. I understand that Quadramed is negotiating with the SEC, but is holding out for the best terms. I think the monetary impact, if any, of the settlement with the SEC should be small since Quadramed has cooperated effectively with the SEC and the magnitude of the restatement was relatively small (about $15 million on the December 31, 2001 balance sheet). Also, the SEC has stated that none of the current management will be subject to any legal action. Consider, for example, that Xerox settled its SEC issues with the SEC about a year ago for $10 million. Even so, it’s hard to predict an outcome with any accuracy.

Additional Value From NOLs – At year end 2003, I estimate Quadramed will have approximately $100 million of NOLs that may be worth some $20 million, or $0.50 per share, depending on how quickly the company is able to generate earnings. In my valuation analysis, I have assumed the benefit of any NOL value is used to offset any costs related to a SEC settlement and that the company is fully taxed in the future. I think this is very conservative.

Low Valuation – Quadramed is a cheap stock trading at multiples of 1.1 sales, 6.4x EBITDA, 7.4x EBITDA – CapEx, and 6.0x free cash flow for projected 2004 results. On a PE basis, Quadramed trades at 32.8x 2004 results, 14.2x 2005 results, and 8.6x 2006 results.

Looking at comparable companies is not always a reliable valuation technique. However, with Quadramed, at least it emphasizes the company’s low valuation. Depending on the 2004 forecasts you use: Cerner (CERN) trades at a revenue multiple of 2x, an EBITDA multiple of 13x, and a PE of 28x; IDX Systems (IDXC) has a revenue multiple of 2x, an EBITDA multiple of 20x, and a PE of 37x; ProxyMed (PILL) trades at 1.5x revenues and a PE of 80x; Allscripts (MDRX) trades at 3x revenues and is just turning profitable; even Eclipsys (ECLP) trades at 2x revenues and is not profitable (and this company has a lot more issues than Quadramed).

Where should this company trade? If you assume Quadramed can produce free cash flow (after full taxes and interest) of $20 million in 2004 (I think this is a low measure of the company’s earnings power) and you apply a dividend growth model multiple (i.e. 1/(r-g)) with r, the expected rate of return on investment/discount rate equal to 20%, and g, the expected growth rate of the free cash flow number equal to 10%, the projected industry growth rate, or a multiple of 10x, we get an equity market capitalization of $200 million. Divide by 40 million shares outstanding you get a per share price of $5.00. However, Quadramed should grow free cash flow at a rate closer to 15% to 20% given the company’s turnaround capability, leverage and product growth potential. Using 15% as the growth rate, the multiple becomes 20x, and the valuation goes to $10.00 per share. If Quadramed delivers strong results, the possible appreciation is obviously greater.

Exchange Listing – Quadramed has filed an application to have its shares listed on the American Stock Exchange and is also discussing re-listing on NASDAQ. Based on management’s comments, I think a listing will be contingent on issues with the SEC being resolved. A successful listing should broaden the investor base that might own shares, increase liquidity, and encourage re-initiation of sell side research.

Possible Sale of the Company – Given the fragmentation in the healthcare IT sector, Quadramed would be an attractive acquisition candidate for other companies in the sector. Quadramed’s attractions to an acquirer include its re-developing franchise and installed customer base. With no market recognition of the company’s value, this may be something the CEO, who is in his mid 60s, chooses to pursue.

Words of Caution

The healthcare IT sector has had a pretty good run. Pairing a long Quadramed position with a short of other players in the space may make sense.

Watch out for selling pressure on the stock as investors who received warrants in the note/warrant financing in April 2003 exercise their warrants and sell their positions - hopefully this overhang will be addressed through an underwriting/controlled offering.

Given Quadramed’s leverage, its earnings multiples do not make the company look cheap until one focuses on 2005 and 2006 ratios.

Quadramed has had relatively poor sales of certain financial software products. In an effort to turn this group around, I understand the company has installed a new management team for this area.

Quadramed will incur some non-recurring charges in 2004 that are not included in my projections such as litigation/SEC costs and expenses related to moving financial staff from California to the company’s HQ in Virginia.

Catalyst

1. Settlement of enforcement action with SEC.
2. AMEX/NASDAQ listing.
3. Re-initiation of analyst coverage.