Introduction & Elevator Pitch

TeamHealth is a very compelling stock for investors with a long-term horizon / mandate.  The quick elevator pitch:

TMH is a high quality GARP story.  For ~12x EBITDA you are buying a secular mid-teen earnings grower, with high margin, high ROICs, and sticky / contractual revenue (94% renewal rates).  The business has a healthy balance sheet with less than 2 turns of debt, requires little to no capex and generates significant FCF that can be reinvested profitably.

In a nutshell, TeamHealth is an outsourced provider of emergency department (ED) care for hospitals. 

The longer, more elaborate description of its business, from the IR website: TeamHealth (Knoxville, Tenn.) (NYSE: TMH) is one of the largest providers of outsourced physician staffing solutions for hospitals in the United States. Through its 18 regional locations and multiple service lines, TeamHealth's more than 9,700 affiliated healthcare professionals provide emergency medicine, hospital medicine, anesthesia, urgent care, specialty hospitalist and pediatric staffing and management services to approximately 860 civilian and military hospitals, clinics, and physician groups in 46 states.

TeamHealth addresses multiple pain points for hospitals.  ED’s are arguably the most complex part of a hospital from an operations management perspective.  It’s all about throughput, cost, and results.  Hospitals usually outsource ED’s to physician groups primarily to drive cost improvements; efficiencies in revenue cycle and complex HR labor contract management. 

Increasingly, hospital boards have increasingly chosen to unload their ER’s to third-party operators, like TeamHealth, to avoid potential conflicts of interest between delivering patient care and increasing inpatient admissions (biggest profit center of hospital).

TeamHealth provides the administrative functions and outreach programs to recruit and retain high-quality physicians from various sources, including residency programs, providing them with ongoing education and training, competitive compensation, liability insurance and attractive career options.  This translates into industry-leading low turnover (~92% retention), while providing turnkey solutions to hospitals by negotiating managed care contracts, billing, coding and collections from payors. 

Healthcare: An Attractive Theme that is Chronically Underappreciated

Before I jump into analyzing TMH’s business I want to briefly discuss some interesting points about the broader healthcare sector and how we’ve been thinking about it recently.

Part of our M.O. at our family office, as capital allocators, is to seek out themes we can invest in over a multi-year period.  Since we aim to be tax-efficient, we like investments where the compounding is internal and where tailwinds are strong and independent of the business cycle.

To develop themes, we work with banks, independent advisors, economists and strategist who constantly pitch us narratives around changes happening throughout the world.  Not surprisingly, a lot of the ideas don’t hold water, or simply play out too fast for us to effectively capitalize on them.  However, sometimes the best themes are the slow-moving ones that are widely reported on, hiding in plain sight, so to speak, populating headlines day after day.  The challenge in developing conviction in these ideas usually is the concern that one has surely missed the train since they are so terribly obvious.

While market prices are often quick to reflect new information, we suspect sometimes they are pretty inefficient in reflecting certain slow and large changes that develop over many years.  This is probably due to time-arbitrage or a lack of clarity & understanding in terms of the magnitude & impact of change. 

Whether we identify it as a “supercycle” or assign some esoteric term to describe the dramatic “shift”, you get the point, it is human nature to think linearly and we tend to systematically overestimate certain things and underestimate others. 

This, broadly speaking, is our contention for what is happening today in healthcare.

It is no secret that the demographic changes that are going to happen in the next two decades are monumental.  On the one hand, the impact on healthcare services is rather obvious – higher demand: currently, Americans spend about $3 trillion a year on health care, and the Centers for Medicare and Medicaid Services estimates that healthcare spending will increase by some 64% percent over the next seven years.  

On the other hand, we experience cognitive dissonance when trying to picture how the system for supplying these required services will work.  Add the complexity that arises with recent policy reform and this is a perfect recipe for excessive discounting of an otherwise certain future.  In other words, the question of how we will finance care in upcoming years, while critically important from a policy perspective, is largely mute when you consider that services will need to be delivered. 

The market disruption that will arise from the implementation of Obamacare undoubtedly will be dramatic; as will changes from future administrations.  This might create short-term volatility here and there, no doubt.  However, an interesting observation we’ve made is that when politicians get involved, regardless of whether policy ultimately succeeds or fails, the healthcare industry as a whole tends to underperform in the early stages of debate (gets cheaper) followed by strong outperformance as healthcare continues to grow as a percentage of GDP. 

For example, when the Clinton-era health care reform proposal failed in the 1990s, this created a three-year overhang in healthcare stocks.  Once the market digested the uncertainty, the S&P Healthcare Index dramatically outperformed the S&P 500 for nearly four years.

Obamacare will create both winners and losers for many years to come; and determining how spending pie gets distributed, is no easy task.  From our perspective, this calls for specialized analysts and PMs who spend their days constantly getting up to speed on the ever-changing regulatory environment, while assessing the demand and supply side dynamics, and ultimately finding efficient ways to express certain views.   With that in mind, we’ve invested in a few health and life sciences L/S managers who we trust will navigate these waters successfully. 

In our dialog with these managers, we’ve discussed some of the longer-term beneficiaries who will win regardless of who end up in the White House in the next election cycle. 

For instance, a lot of healthcare services businesses will benefit from broad demographic and financial realities.  Healthcare IT and revenue cycle providers, who focus on the cost / efficiency aspect of healthcare, will play an increasingly important role in keeping the healthcare system solvent.  While biotech is arguably quite expensive, the upside is tremendous, as they’ve become the sole source of Pharma R&D. 

Team Healthcare – Outsourced ER Service Provider

In terms of current reform, we believe TMH is one of the most levered beneficiaries given its exposure to non-paying uninsured patients (>22% of visits). 

Broader and better insurance coverage, as well as improving reimbursement from government (Medicare & Medicaid) & private payors, will translate to higher volumes and revenues, and lower bad debts.

Delays in the benefits of reform, has temporarily lowered expectations on TMH’s volume performance, something that we view as an opportunity.

There are 57 million uninsured individuals in the US.  According to the CBO the uninsured population in the US should drop by 24.1% in 2014, and as provisions ramp up, the drop is expected to accelerate to 34% in 2015 and 46% by 2016. 

So, in essence, as coverage expands TMH gets a dual benefit as a sizeable portion of its existing patient pool converts from a low margin liability to a profitable asset, and as more insurance translates into higher utilization.

The impact of new coverage for an uninsured patient, in terms of collectable revenues, is dramatic: estimates for the average uninsured patient is approximately $35/visit, compared to $250/visit for managed care, $135/visit for Medicare, and $75/visit for Medicaid.

Team Health will treat approximately ~11.2 million patients in 2014 of which, before reform, approximately 2.5 million would have been uninsured. 

Taking the above volume numbers and rate differentials into account, a reduction of 24% of uninsured visits, with a 65/35 Medicaid - MCO mix equates to $60 million in marginal revenue with 70% contribution margins (note: some of these benefits are expected to be somewhat offset by lower subsidies from hospitals toward their EDs).

The net impact in terms of added revenues and cost savings, as coverage expands, will initially be around ~$40 MM in EBITDA in 2014/early 2015 and expand to $75MM in EBITDA in 2016.  This translates into around $0.50 - $1.00 in added earnings power on a per share basis. 

In terms of growth in patient volume, emergency rooms have two tailwinds:

1)   Bottlenecks in the primary care setting due to higher coverage & demand, coupled with a shortage of GP’s, create an overflow into emergency care that serves as a substitute

2)   Demographic / people getting older with higher incidence of cardiac and stroke events will inevitably make the emergency room the first stop before a patient gets admitted to the hospital

Interestingly, higher ER utilization with socialized medicine, is phenomenon that has already been observed since the passage of Obamacare – http://www.nytimes.com/2014/01/03/health/access-to-health-care-may-increase-er-visits-study-suggests.html?_r=0

We estimate incremental volume of 3 - 5% range due to reform in the next few years; plus 2 – 3% of yearly growth, due to demographic trends.

The reform benefit translate into ~450,000+ patients or $61 MM in marginal revenue with 24% EBITDA contribution margins. 

Given that claims for TMH are mostly “physician payments for ER services”, over time we also expect less pressure from Managed Care Organizations (MCOs) for reimbursements, which suggests better pricing for services – another driver of contract SSS growth.

Broadly speaking, over a multi-year period rates will also rise at a higher rate than inflation.  Recent legislation in Congress and state fiscal positions have allowed for physician rate increases in both Medicare and Medicaid and we expect this trend to continue. 

Enacted in 2013 and extended for 2014, the Patient Protection and Affordable Care Act (PPACA) established Medicaid Parity, for select procedures, at the higher Medicare rate; management believes this to be a $26 to $28 million-dollar revenue benefit for 2014, which basically drops straight to the bottom line.  We expect the program to rollover beyond 2014.

High Quality Business

As mentioned at the beginning of the write-up, TeamHealth has a very attractive business model with high margins and extraordinary returns on capital employed.  Given the predictable & growing revenue, and a stable contracted client base (15 year average tenure for top clients), the business model can withstand a healthy level of leverage.  Sales and EBITDA growth in recent years has delevered the B/S to under 2.0x leverage – which management believes is low, and could lead them to initiate buybacks.

The business operation is quite complex from an IT perspective, which is a significant point of differentiation.  Internal proprietary systems manage consolidated accounting, payroll, HR, legal and compliance, while another IT platform processes over 10 million patient claims across different payors.  Meanwhile the 19 regional offices are the client-facing assets that drive contract sales, provide local market knowledge for regional M&A and increasingly advise hospitals on a consulting basis.

Patient volumes in 2013 came in somewhat below consensus expectations due to Obamacare delays.  This was offset by deal growth, new contracts won organically, and same-contract revenue growth driven primarily by pricing increases (revenue cycle) – which translated into top-line growth of 15% in 2013 (5-yr CAGR of 12.3%). 

Management expects to deliver more or less similar results for the next few years, albeit with better SSS numbers.  In the long run, reform, demographics and a more mature rolled-up industry should deliver accelerating top-line growth with expanding margins.

Despite Obamacare being perceived as a disaster, politically speaking at least, certain implementation delays were expected.  The deadlines for compliance have been pushed out, but the rollout will happen, in time.  The employer mandate has been pushed out to 2017, which essentially pushes out the main “event” that will convert a lot of the uninsured / insured.  There is uncertainty as to the exact timing for converting a critical mass, but our research leads us to think it will be sooner rather than later.

Acquisition Strategy 

The ED market is extremely fragmented.  There are 5,000 Community Hospitals in the U.S. of which only 2,600 have outsourced ED’s.  TeamHealth has a 16% share of the market while local and smaller regional groups have a combined 66% share.

TMH has a very disciplined approach towards acquiring revenues.  While there is some competition for deals, multiples remain attractive, and the pipeline for more transactions in the ED and anesthesia businesses is strong.

13 transactions were closed in 2013 – that added almost $190 MM in revenue, while M&A added $170 MM in revenue in 2012.  Not including efficiency improvements, the combined $387 MM spent in the last two years translates into paying ~6x multiples on a blended basis.

Management has stated that tuck-in deals are still currently in the 5–7x range, while larger deals are coming in a little higher but with less risk and more scale benefits that can be implemented over time.

For 2014, guidance implies another $143 – 191 MM in acquired revenues.  We believe acquisitions will be a major contributor of growth for the next 2 years.

Valuation

We expect TeamHealth will earn around $310 MM of EBITDA in 2014 assuming mild benefits from reform. 

Note: D&A is mostly composed of amortization of intangibles linked to acquisitions, which we view largely as uneconomic in nature.  Capex has been $20 MM in the last two years, mostly to upgrade IT systems; other than this there is little to no maintenance capital costs.

This translates into a 12x multiple of unencumbered EBIT.  We think this is cheap for a defensible business that we expect to grow earnings in the low to mid teens for many years.

In the short term, clarity on the benefits of reform / coverage expansion in upcoming quarters could be a catalyst for the stock.  However, over the long run, as argued in the beginning of this write-up, we expect service healthcare names to be an interesting theme for many years to come.