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Metropolitan Health Networks, Inc. (MDF) was incorporated as a physician practice group in Florida in 1996 and by the end of that decade had acquired a number of other physician practices and ancillary service providers. MDF begun managed health care in 1999 starting their first contract with Humana, and by 2000 were contracted to manage all of Humana’s Medicare Advantage lives.
Medicare Advantage came about as a result of the "Medicare Prescription Drug, Improvement, and Modernization Act", and is basically where eligible patients can receive their Medicare benefits through private health insurance plans. So it is sort of a public/private healthcare hybrid mainly funded by the government.
The contract meant that much of the revenue Humana received from the Government they would pass onto MDF and MDF was obligated to provide all covered health care benefits for members.
In December 2003, a new Medicare law was passed which significantly increased funding for the Medicare Advantage program, benefiting Humana and in turn MDF. Note the financial performance as well as the shareprice of MDF went up in 2004 as a result. Today MDF services Medicare Advantage patients in 18 Florida counties under Humana, and 13 additional counties are contracted for future expansion.
In 2011 MDF confirmed it will acquire Continucare Corporation, a competitor of MDF, for approximately $416M. MDF’s equity is $68M, and total revenue for 2010 was $368M (net income of $26M) so an acquisition of $416M is huge and it adds significant risk to the business. More on the merger later.
Much debate has transpired over the last few years on healthcare reform, and the new regulations that are set to be put in place. The dominant payment method for health care providers has always been under what’s called a Fee For Service (FFS) model, where health care providers get paid for each treatment separately and thus had the incentive to provide more treatment. There was little incentive to provide quality of healthcare, just quantity.
Under the proposed reforms, the incentives on health care providers will be more focused on quality and efficiency. The reforms intend to move away from FFS and move towards Pay For Performance (“P4P”) integrated care and capitation. Capitation (no, it’s not the removing of the patient’s head) is where all patients grouped under a certain category incur the same fee, regardless of the treatment.
The P4P will involve a long list of metrics measuring quality and efficiency of service. Clinical measures, customer service metrics, quality of medical care as well as call center performance will be monitored and compensation will be based on the score achieved. The system will involve a 5 star system, and healthcare providers begin to receive bonuses when they achieve 3 stars with the bonus increasing up to 5 stars. Business systems and computer software for tracking these metrics will be important, as will business practices to achieve the metrics. Healthcare providers will not be able to hide from the effects of the new legislation.
Because MDF, since inception, has been a subcontractor under Humana, they have become accustomed to working under performance metrics. A number of new stringent quality metrics will have to be implemented by MDF and some of the changes will no doubt have an impact on the business. But MDF generally appears to be in a good position to adapt to the changes. The agreements under Humana have always involved performance metrics of some sort to determine the level of compensation MDF receives.
Compared to some of their competitors, MDF should be able to tackle the new reform measures well. Indeed, if MDF adapt better to the changes than their competitors, they may even increase their market share.
The Quality Rating of MDF is great. The only metric it scores poorly on is its gross profit margin which is not surprising considering it is a subcontractor that operates on a low margin - low risk type arrangement. The net profit margin is strong meaning MDF keeps its overheads under control.
There is some commentary below on the acquisition of Continucare. Continucare has a quality rating of 61, considerably less than MDF’s 79. Interestingly Continucare’s gross profit margins, though still not great, are much better than that of MDF.
The intrinsic Value of MDF is expected to go sideways in the short term as the large transaction costs of the Continucare acquisition affect the income statement. But the performance of 2012 and beyond is expected to boost intrinsic value.
The IV Graph shows that MDF, along with all other health care providers, has been out of favor with the market over the last few years while the healthcare reform debate has been ongoing. Anomalies such as this, where whole industries are frowned upon by the market, creates some potentially wonderful opportunities. The important thing to establish in these sorts of situations is whether or not the company can still prosper moving forward with the new regulatory requirements.
Current & Future
EPS for 2011 is forecast to be around the same as that for 2010. Earnings for the 6 months to June 2011 was slightly better than the performance for the 6 months to June 2010, and this is accounting for $1M in transaction fees for their acquisition of Continucare. In the second half of 2011 MDF expects further, much larger, transaction costs to get the Continucare deal done – which will show up in the Income Statement in Q3 and Q4. These of course will be one-off items, but the market does not like poor EPS results so expect continued pressure on the shareprice.
MDF is not being affected significantly by the economic downturn – people get sick regardless of the strength of the economy. Plus MDF serves largely people who are retired. Other healthcare providers – such as those offering elective surgery – would certainly be affected by macroeconomic cycles, but MDF not so.
A big portion of MDF’s end patients are seniors in Florida. This is a massive emerging market as the baby boomers are reaching retirement age, and a huge positive for MDF.
The Management of most companies love acquisitions. It puts them in control of a bigger ship and increases their sense of importance. It increases EPS and increases bonuses. They love the idea of creating an empire of companies through acquisitions. We are always very wary of acquisitions, as the corporate graveyard has a lot of headstones of failed acquisitions.
At the purchase price of over $400M, we feel MDF is overpaying for Continucare (NYSE: CNU). We calculate the Intrinsic Value of CNU to be around $200M, around half of the current purchase price. We note that CNU has $162M in equity including $50M in cash and no debt, but its NROE, the most important measure of a business’ performance, has been around the 15% mark while MDF’s NROE is up above the 30% mark. Adding CNU will only decrease the NROE of MDF, at least in the short term, and hence its profitability and attractiveness as a company. If MDF can exploit some “synergies” (the buzz word when an acquisition takes place) and turn CNU into a more profitable business, then the acquisition has merit. CNU is a direct competitor of MDF, and taking out your competitor and increasing market share you would expect should provide some benefits for MDF.
MDF has arranged debt of $355M as part of the purchase of CNU. They are likely to use most if not all of their cash at bank as well as CNU’s cash at bank as part of the transaction also. The combined result will give MDF equity of around $200M and a net debt to equity ratio of over 170% which is dangerously high. For a number of years the balance sheet of MDF has been squeaky clean (they have actually been buying back their shares which we like to see), and now it is taking a full backflip. We don’t like to see high leverage because it leaves the company vulnerable to a downturn.
Bringing the two companies together will certainly create some savings – one board of directors instead of two, 1 auditing process instead of 2, 1 set of lawyers instead of 2, and 1 executive management team instead of 2, and these costs aren’t insignificant. But MDF management, once the acquisition is finalized, will need to focus on bringing CNU up to the levels of NROE that MDF achieves.
The negative for MDF is the overpriced acquisition of CNU which will turn a once pristine balance sheet into a dangerously leveraged one.
The positive for MDF, and it is a huge positive, is the growing demand for their services over the coming years as the American population continues to get older. The baby boomer generation is hitting retirement age and MDF are well placed to cash in on the boom. MDF provides managed health care particularly for seniors in Florida, and regardless of how the new regulatory requirements will exactly pan out, elderly people will need healthcare.
MDF is well situated to take advantage of the aging population, and if investors can stomach the new excessive debt on the balance sheet as a result of the overpriced acquisition of CNU, the current shareprice looks attractive.