Description

Update: At the time of the original idea submission before Q2 earnings, the stock was trading 10% below the current $5/sh, but the risk/reward remains very attractive. Q2 2022 update was positive, with revenue guidance raised to ~$290m for FY22 or 5% higher than previously guided for 2H 2022. The first divestiture for ~$120m net cash was closed in early August, and the remaining two sales are expected by the end of 2022.

Thesis

Tabula Rasa Healthcare (TRHC:US) is a highly leveraged small-cap stock priced as if it’s headed for bankruptcy. Many investors have written off the pharmacy service provider due to a failed expansion plan, liquidity concerns and a slowdown in the number of registered users. However, we believe there is a timely investment opportunity and recommend taking a position for more than 100% upside in our base case.

The company has an enterprise value of $478m with a market capitalization of $110m or $4.45/share; $325m of convertibles trade at a 30% discount to par. It will shortly complete the sale of its non-core software assets, bringing in around $250-300m, and injecting it with a healthy dose of liquidity. The company is set to post close to 10% top-line growth in 2022 and double-digit annual growth for the company over the next five years looks achievable.

Opportunity

Founded in 2011, Tabula Rasa is a high value-add pharmacy service provider taking 40% share in a growing market niche, with highly predictable revenues. A leader in medication risk management, it has developed proprietary risk matrices and algorithms to optimize complex medication therapies. Tabula Rasa’s USP is the way it manages multi-drug treatments for at-risk patients, producing better healthcare outcomes and lowering the costs for providers.

Due to poor strategic M&A decisions over the past four years, the company overextended itself into non-core SaaS (software as a service) verticals in larger markets. These are now being divested so the business can refocus on its profitable operations and deleverage the balance sheet.

Tabula Rasa announced its first divestiture in June, netting $120m in cash from a BlackRock-owned entity (with an extra $15m in earnouts). The closing is expected in Q3 2022. Another $130-180m will come from the sale of two further assets; active discussions are still ongoing. These sales will remove liquidity concerns, bring net debt to below 3-5x normalized EBITDA, and simplify the equity story.

Six reasons why the stock is undervalued

1. Shareholder base rotation: a busted expansion story spooked growth investors while the strong core business continues to be masked by a burdened cost structure.

2. Liquidity concerns: the company came close to breaching its covenants – 3.0x debt (excluding convertibles)/LTM EBITDA in Q1 2022 but it has assured investors with neutral free cashflow since the end of March. We believe Tabula Rasa will easily negotiate a waiver from its lenders in case it slightly exceeds its covenant leverage ratio. The company had $21m cash on its balance sheet in early May, with principal payments not due until 2025-2026 and annual interest payments of $8m.

3. Rumored margin calls for founder-owners: Tabula Rasa was founded by husband-and-wife team Calvin H. Knowlton and Dr. Orsula V. Knowlton, who continue to own and manage it. We believe the stock pressure from the rumored margin calls has already dissipated while providing an incentive for the Knowltons to quickly close the asset sale.

4. Slowdown in Program of All-Inclusive Care for Elderly (PACE) enrolment: Tabula Rasa’s core business is focused on PACE, which helps people meet their healthcare needs while living in the community. The latest Omicron wave reduced PACE enrolment in Q1 2022, with monthly figures below the number of PACE patients registered in December 2021 (52,700). However, the latest data shows a strong pick-up, with month-on-month growth back to 1%, and 53,817 PACE patients enrolled in July 2022. The company also indicated its continued expansion with a sequential growth in backlog from 17% to 25% of annualized revenue in 4Q 2021 / 1Q 2022 driven by several large new PACE contracts.

5. Convoluted equity story: the asset sale should simplify the picture, while concerns over Covid are starting to disappear.

6. Poor headline numbers: the unsustainably high leverage and negative growth rate in 2022 do not account for the upcoming SaaS divestiture. Meanwhile, a growing and profitable core business (which doesn’t fit the traditional healthcare tech description) is largely hidden from investors.

Another reason why some investors have taken a dislike to the stock is concerns over management. In July, Tabula Rasa’s biggest shareholder Indaba Capital issued a letter to the company demanding management changes and a board refresh, amid what it sees as a culture of poor disclosures and conflicts of interest. Tabula Rasa responded by pointing to its preliminary Q2 revenue performance and “significant opportunities ahead in the PACE market”, and said it would continue its dialogue with Indaba and other shareholders. Indaba then upped its stake from 20% to 25%.

Tabula Rasa has now launched a rights plan where existing stockholders (with a record date as of August 5, 2020) can dilute the potential acquirers, in a bid to protect the company “from being controlled or acquired in a manner or at a price that are not in the best interest of our stockholders”. The company is issuing one option right to purchase twice as many shares of common stock for the market value of $26.0 at the time of the exercise. The rights will initially trade with Tabula Rasa's common stock and will become exercisable only if any person acquires 10% or more of the company's outstanding common stock, or Indaba Capital through a “grandfathering” condition preventing it from additional common shares purchases. The new acquirer (or Indaba Capital if “grandfathered”) will be devoid of such rights.

Financial analysis

Focusing on the core business and how Tabula Rasa will perform once it’s sold its SaaS assets is the key to understanding how the share price could improve in future. We see an asymmetric 2:1 upside/downside ratio in our base case, with a high skew towards the positive outcome:

• Before its SaaS acquisitions, Tabula Rasa’s core business generated over 10% EBITDA margins (after stock-based compensation) in 2015-2017, and had been growing its top line at double digits each year.

• Core revenue is expected to be $280m this year (and could be upgraded post Q2 outperformance). At normalized 9% margins for the core business, this would produce $25m of EBITDA.

• At a 15x EBITDA multiple, this would bring Tabula Rasa’s enterprise value to $375m.

• Coupled with the sale of its SaaS assets for at least $250m, this implies an equity value of $260m, more than a double from the current price with additional upside optionality close to 4x (assuming $265m total divestitures and a 18x multiple-2023).

• Even if, in addition to the $120m sale closure, Tabula Rasa sells the remaining assets for $110m (at 30% discount to the acquisition price), and fails to recover its 6% EBITDA margin from the level of 2021 (as it’s burdened by SaaS losses), the current valuation still implies a reasonable 15x multiple.

Business description

A capital-light business, Tabula Rasa listed on Nasdaq in 2016 with an almost clean balance sheet (with $30m debt fully repaid from the IPO proceeds). Its main business is CareKinesis, a PACE-centric pharmacy providing medication management, consulting and fulfilment services to more than 150 healthcare providers. To recap, PACE helps older people meet their healthcare needs while living in the community rather than going to a nursing home or other long-term care facility.

PACE patients are often prescribed dozens of drugs and optimizing the dosing, intake calendar, and even organizing the pills in the right order is a highly complex task with costly consequences for mistakes.

In a study by Tabula Rasa published in The American Journal of Managed Care, pharmacists noted 9,716 drug interactions among 36,455 medication-related problems. By looking holistically at drug interactions, Tabula Rasa’s service alerts pharmacists when intervention is required to change non-opioid drugs so they no longer compete with opioids. This could help prevent an opioid overdose.

But how much does this cost? We estimate that providers pay Tabula Rasa less than $500 per member per annum in administrative fees (or less than 1% of the total $90,000 that PACE organizations expense per member annually). A research paper published in the peer-reviewed Journal of Healthcare in Q1 2022 suggests that each person in Tabula Rasa’s PACE program saves more than $5,000 in medical expenses each year, versus other PACE organizations that do not utilize medication risk management services. While the return on investment (ROI) of over 10x is hard to validate, the perceived benefits of Tabula Rasa solutions to PACE organizations are clear to see.

Tabula Rasa also enjoys highly recurring revenue streams from other products and services, such as patient risk-profile assessment software, tele-consultations, and pharmacy benefits management (PBM). Our research shows that providers are generally happy to offload these highly critical but relatively low-cost workstreams and rarely switch their partner since it would be costly and time-consuming for the provider’s clinicians and pharmacists. As a result, Tabula Rasa has a net revenue retention rate consistently above 110% as clients rarely downgrade or churn (client retention has been above 95% historically).

In terms of competitors, Tabula Rasa serves around 40% of the market with its closest competitor, Grane Rx, taking a 20% share, and the rest split between local players and in-house provider solutions.

Business economics (excluding assets to be divested)

Tabula Rasa’s revenue model is mostly based on charging PMPM (per month per member) rates. The average contract is two to three years long. PMPM rates plus dispensing fees account for about 75% of revenue. This model allows Tabula Rasa to grow along with its customers, provided they enrol more PACE patients.

The company earns about 25% gross margins on its pharmacy products dispensing business, and 60-70% gross margins on core SaaS and other services. On a blended basis, the company’s long-term target is 35-40%. This is because services, aided by cross-selling, are expected to expand faster than pharmacy products.

In 2015-2017 - before Tabula Rasa burdened its operating expense by developing new verticals - it managed to earn around 30% blended gross margins and 10% adjusted EBITDA margins (after around 4% normalized SBC).

In Q1 2022, the company reported depressed EBITDA margins of just 4%, which worried some investors. However, this number appears to be impacted by two things. First, roughly 100bps from gross margin inflationary pressure should dissipate as soon as the company reprices its contracts next year. And second, R&D plus SG&A costs of 30% (vs. historical 20% achieved in 2015-2017) are high due to elevated hiring ahead of the PACE contract expansion and a still bloated R&D spend. As highlighted before, we expect the company to recover to at least 6% EBITDA margins already in Q2 2022.

We are pleased that Tabula Rasa intends to return its focus to its profitable PACE niche. It appointed a new CFO in February, who is guiding a return to pre-2018 profitability levels of 10-15% EBITDA margins by the end of 2024. The company has already started implementing a number of cost-cutting initiatives targeting SG&A.

For 2022, the company expects revenues (excluding divestitures) of about $280m with an 8-9% growth rate. Going forward, we should see a return to its historical double-digit % growth rate.

Focus on PACE

PACE is a unique and comprehensive managed care benefit for frail individuals, most of whom are eligible for Medicare and Medicaid benefits, and provided mostly by not-for-profit entities. The program features a medical and social service delivery system using an interdisciplinary team approach in an adult day health center, which is supplemented by in-home and referral services.

Unlike traditional fee-for-service health care programs, PACE providers receive a monthly risk-adjusted payment for each participant from Medicare and Medicaid to manage the totality of medical care that an enrolled participant needs. Fully capitated models, such as PACE, incentivize organizations to better manage chronic conditions to avoid high-cost acute episodes and to invest in value-added services – such as medication risk management provided by Tabula Rasa – that fall outside the scope of a fee-for-service model.

States can elect to provide PACE services to Medicaid beneficiaries as an optional benefit. On average, costs under the PACE program are estimated to be 13% lower than for a comparable dual-eligible population aged 65 and older under Medicaid. Meanwhile, one of the leading PACE providers, InnovAge, estimates that PACE program costs are about 8% lower on a weighted average basis than costs for comparable fee-for-service Medicare beneficiaries.

Without PACE, high-cost, dual-eligible seniors would overutilize healthcare in higher-cost settings, such as emergency rooms and nursing homes. Research has shown that PACE reduces hospitalization, emergency room visits and nursing home stays. Participants survive longer than similar patients in less comprehensive programs. A study last year by the federal Department of Health and Human Services noted that the PACE program “stands out from our analysis as a consistently ‘high performer’.” According to the National PACE Association, Covid deaths among PACE participants have been about one-third those of nursing home residents and the pandemic has apparently only intensified older Americans’ desire for alternative forms of long-term care.

Currently there are 144 PACE organizations, operating 272 centers across 30 states and collectively serving around 60,000 people, up from 25,000 patients in 2012.

However, there is still so much untapped potential. The overall eligible population is estimated at around 2 million, representing seniors dually eligible for Medicare and Medicaid and meeting the nursing home eligibility criteria for PACE. This means the penetration is just 3% (reaching 6% in the most advanced states). Furthermore, there are 21 states that have no PACE program, and 11 have just one.

The good news is that PACE has bipartisan support and several bills introduced in Congress, if passed, should remove awareness and barriers to growth. For example, one bill calls for partnerships with Veterans Affairs hospitals to make PACE more accessible to veterans.

A number of centers are opening in California and Florida this year, while Washington D.C. has selected two organizations to begin serving residents in 2023, and Illinois has passed legislation to adopt PACE for 2024. In total, 45 new programs are expected to begin enrollment over the next two years, in part because of higher federal incentives. The National PACE Association also has a call to action for growth known as PACE 2.0. This has a goal of 200,000 participants by 2028, implying a 35% compound annual growth rate (CAGR) from the current 60,000 participants.

Tabula Rasa has historically managed to outgrow industry growth rates by 1.5-2.0x. While further share gains might prove more difficult, the tailwinds for at least double-digit annual growth in the next five years are clear - even if PACE growth rates fall short of 35% CAGR aspirations.

Tabula Rasa public history

Orsula and Calvin Knowlton launched Tabula Rasa with CareKinesis in 2011. Before CareKinesis, the couple had grown and scaled a national pharmacy that was eventually sold to Omnicare. Tabula Rasa IPO’d in 2016 at $12 a share at 18x EV/EBITDA-2016. The Knowltons still own over 5% of the stock.

Recognizing the benefits of all-encompassing pharmacy services for patient outcomes and client convenience, Tabula Rasa then pursued an active M&A strategy acquiring electronic medical records solutions, PBMs, and other software systems for medication risk management (and services like risk adjusting and third-party administration) for over $400m, supplemented by over $100m in R&D since 2017. This allowed Tabula Rasa to build an unparalleled and loyal customer base in PACE and develop unique IP in multi-drug risk assessment. Buoyed by its success in PACE, the company made a risky bet on venturing into adjacent pharmacy services (including medication therapy management) in non-PACE segments while levering its balance sheet in benign capital markets conditions.

The market got overly excited and rewarded it with a lofty $2bn valuation ($90/share). However, the company faced a different market landscape with no brand recognition outside of PACE. Coupled with a less evident value proposition, more intensive competition, and more sophisticated and consolidated customers in these areas, Tabula Rasa experienced slower than expected growth.

Operational hiccups - such as a post-Covid hiring challenge for pharmacists’ technicians - a slowdown in core PACE census growth, an overextended balance sheet, and depressed profitability combined with growth stories falling out of market favor led to a quick share price drawdown of over 80% since mid-2021 to the current $4.45 a share.

Time to dispose of the non-core assets!

In May 2022, Tabula Rasa announced the completion of a strategic review with the intention to divest most of its MedWise-branded solutions that are focused on MTM (medication therapy management). MTM is generally acknowledged to be less sophisticated and a more commoditized service than the full-suite support of PACE targeted at complex patient cases. Importantly, Tabula Rasa will keep the opportunity to sell its most differentiated product – multi-drug risk assessment services – through bundles with the divested SaaS via a partnership model.

Then in June, the company announced the sale of PrescribeWelness – community pharmacies’ patient engagement SaaS – for $140m total cash consideration, including $15m in earn-outs. The total price implies a 7% discount to the price paid for the asset by Tabula Rasa in 2019. The buyer is Transaction Data Systems. As part of the deal, Tabula Rasa agreed to purchase certain IP assets for $6.8m, netting the total proceeds upon the closure (excluding earnouts) to around $120m.

The remaining assets listed for sale are:

• SinfoniaRX, acquired for $130m (incl. earnouts that were fully satisfied) in 2017 – support (outsourced call center) and software for MTM with the clients including Walmart pharmacies.

• DoseMe, acquired for $28m (incl. earnouts that were fully satisfied) in 2019 – decision support software to guide dosing based on proprietary models with a focus on community hospitals.

In our base case estimate, we apply 20% discounts to the previous purchase price to arrive at a $130m target for the remaining assets. The total assets divestiture will therefore bring in $250m net proceeds (assuming zero earnouts), implying around 3-4x sales estimated multiple (vs a blended 5.6x sales multiple at the time of purchase).

In our bear case, we assume Tabula Rasa realizes only 50% of the original purchase price value and sells the remaining assets for $80m, bringing the total net proceeds to $200m.

Bear – Base – Bull scenarios

Tabula Rasa had 24.8m outstanding shares (excluding deep out-of-money stock options) and $368m of net debt at the end of Q1 2022. A significant chunk of debt is in convertibles ($325m) that mature in 2026 with an interest rate of 1.75%.

While there are no direct public peers, we note that:

• Omnicare had a similar ~10% EBITDA margin profile but lower mid-single-digit growth rates before being acquired for 14x LTM EBITDA by CVS in 2015;

• InnovAge, the for-profit PACE organization with similar normalized growth and margin profile to Tabula Rasa, currently trades at 18x NTM EBITDA multiple despite being in the middle of eliminating CMS and state audit deficiencies.

We run bear-base-bull scenarios for valuation based on normalized EBITDA margins to demonstrate a very attractive asymmetric risk/reward from the spot price to the respective $1.40 - $10.50 - $18.20 /share targets. Below we show the figures for bear-base-bull. (Bear and base are based on 2022 multiples, bull is based on 2023.)

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Bear Base Bull

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Divestitures total: $200m $250m $265m (incl. $15m earn-outs)

Sales in 2022: $280m $280m +10% to $308m in 2023

EBITDA-22 normalized margin: 6% 9% 10% (by 2023)

EBITDA-22 normalized: $17m $25m $28m ($31m in 2023)

Target multiple: 12x 15x 18x (on EBITDA-2023)

Target share price: $1.40 $10.50 $18.20

Upside / (downside) to spot: (69%) 136% 309%

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The sensitivity to our key assumptions in the base case are:

• Every $10m in the divestiture’s net proceeds (8% of the remaining to-be-divested assets’ original purchase price) correspond to $0.40/share change.
• Every 100bp in EBITDA-22 normalized margin correspond to $1.70/share change.
• Every 1x turn in target multiple on normalized EBITDA-22 corresponds to $1.00/share change.

Catalyst

• Non-core assets divestiture
• Removal of liquidity concerns
• Management refocusing on core profitable businesses
• PACE growth re-acceleration post COVID
• Management changes and a board refresh called by the largest outside investor