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.
Regulatory Climate
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.
Quality Rating
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.
Intrinsic Value
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.
Continushare Acquisition
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.
Conclusion
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.
