Metropolitan Health Networks (MDF): There’s a reason it’s cheap

Current Price: $4.41
At first glance, Metropolitan Health Networks looks like an appealing small-cap value investment. Currently P/E is only 7.12 despite revenue growth averaging more than 60% per year over the past three years. There’s no debt, and cash on hand exceeds total liabilities. It sounds nice – so, what’s the catch? Is this just getting beaten down by unease over future healthcare changes in the U.S. or is it a ticking time bomb? More like the latter than the former, unfortunately.

The Catch, Part I (Earnings)

2010’s earnings growth is largely an illusion. The first sign comes from a comparison between net income and operating cash flow. It’s generally considered a negative indicator when income exceeds operating cash flow and in this case operating cash flow ($18M) is 30% lower than net income ($25.7M). That’s a big turnaround from the previous year, when operating cash flow ($20.4M) exceeded net income ($14.4M) by 40%.

Almost all of the change comes from a single payable/receivable account: Due From (To) Humana. This account jumped from a $1.4M liability in 2009 to a $9.1M asset in 2010. A value in the low millions is a historically normal value for this account; a value of $9M is quite high. As far as I can tell that’s the highest it’s been in a very long time, which makes me wonder if MDF is getting a little too aggressive in its revenue recognition.

The 2004 and 2003 figures are adjusted from the stated receivable values on the balance sheet (which themselves were net of $2.9M and $2.5M allowances) by Humana’s stated shares of 73% and 83%. The collection of this receivable is not guaranteed despite the company’s close relationship with Humana. An example of this occurred in 2006, when MDF wrote off $1.6M out of $4M originally due for the reimbursement of defibrillator implants. If the same occurs again – a distinct possibility since this account is unusually bloated – then future earnings could take a significant hit. The note regarding the amount owed by Humana (note 6) is two lines long and quite uninformative in this issue.

The “Major Customers” segment reveals that part of the receivable comes from an estimate of the retroactive Medicare Risk Adjustment capitation fee. The MRA is the result of changes in the health status – and therefore fee payments covering – Medicare users. In 2009, the company wrote off $800K after the retroactive fee came in below estimates ($3M versus an estimate of $3.8M). The current estimate for 2010’s fee is $2.2M.

The second sign that this extreme earnings growth might be illusory/unsustainable is the company’s extremely low – historically low, in fact – medical expense ratio (MER). The MER is total medical expenses divided by revenue. According to MDF, 2010’s decline in medical expenses is the result of the modification of plan benefits and co-payments along with the elimination of certain costly high risk plans. Compare to their results since 2003:

This is by far the lowest MER has been during the entire period. Operating expenses, on the other hand, increased from 5.4% to 6.7%. Adjusting 2010 to the average MER of the previous three years provides a net margin of 3.68% (after subtracting a MER of 87.4% and expenses of 6.7% with a 38.2% tax rate) and net income of $13.55M. That’s below 2009’s earnings even with the (tax-adjusted) profits from the HMO sale subtracted out for comparison. Due to the increase in other expenses more than 100% of this year’s gain can be attributed to the improved MER.

The changes in MER aren’t attributed to one-time non-recurring events, but if management was capable of sustainably achieving such a significant reduction in expenses – raising profits almost 80% on a 4% gain in sales – by simply altering benefits and removing expensive plans, then what took them so long? It’s not like there’s been a change of management lately.

Let’s examine what happens if the MER rolls back to the median between 2009’s and 2010’s values, 85.3%, if all else remains the same.

Suppose revenue increases by 4% again in the coming year. This results in revenue of $386.6M and net income of $19.1M using the above margins. That’s a disappointing step down from 2010’s results. Even if the company returned to 2009’s lower operating expenses in this scenario it would still slightly underperform the results of 2010, with net income of $24.1M.

The Catch, Part II (Concentration)

The receivables issue highlights MDF’s close and potentially dangerous relationship with Humana. Humana is Metropolitan Health Networks’ sole partner and is tied to it (for the most of their business) by a contract renewed yearly. Any disruptions in this relationship would be disastrous for MDF. As they note in the 10-K’s “Risks” segment, MDF has little ability to effectively bargain with Humana, presumably due in part to their dependent position. Compare their situation with that of Continucare, a publicly traded competitor mentioned in their annual report. Continucare has relationships with three HMOs, decreasing the dependence on any single partner.

25,000 of MDF’s patients are covered under an annual Humana contract, while 9,000 are covered under a separate agreement that lasts until 2013. According to the terms of both contracts the company is specifically restricted from forming relationships with other Medicare Advantage providers. This limits MDF’s ability to lower its immense concentration risk.

The long-term 9,000 patient contract also provides limited security. It does reduce the yearly renewal risk, but it doesn’t cover enough patients to ensure profitability in the absence of other revenue. As MDF points out, even if its other contract was not renewed it would still be required to treat the remaining patients and it would likely be doing so at a loss after fixed costs were spread across a smaller base.

The Catch, Part III (Regulations)

A number of upcoming changes to Medicare and other healthcare regulations due to recent healthcare reforms may have an unpleasant effect on MDF’s business. Risk scores, which determine the amount of money paid per Medicare patient, will be adjusted downward in the future to account for the fact that insurance companies and healthcare providers tend to emphasize negative information when reporting information to inflate risk scores and receive larger payments. Other changes will cap cost-sharing and decrease payment benchmarks.

What looks to be the most important change is the creation of a minimum MLR of 85% starting in 2014. MLR is the medical loss ratio, the percentage of insurance premiums spent on direct medical expenses.

Now, since MDF is a provider services network rather than an insurance company like Humana, I’m not entirely certain which company this cap will specifically apply to. Either way the result won’t be good for MDF. If it applies to Humana, then the two companies must split the 15% (maximum) for non-medical expenses. If it applies to directly MDF, then it means that 85% would be the minimum MER value in the future. In either case the current MER is probably not sustainable long-term in light of this regulation.

The Catch, Part IV (Boardroom Drama)

There have been strange goings-on at the higher levels of MDF over the past few years. In 2009 Earley agreed to step down as CEO and Chairman of the Board in the middle of 2010 or upon the appointment of his successor. Two months before the end of his tenure 5 independent board members resigned and their replacements re-hired Earley as CEO and Chairman. That’s a somewhat odd chain of events and the matter-of-fact description in the annual report (as if this weren’t an odd situation) is a bit unnerving.

Insiders – among them the CEO and CFO – have also been doing a lot of selling recently. I generally agree with Peter Lynch that a modest amount of insider selling aren’t necessarily a bad sign. Insiders can sell for a variety of reasons, some of which are benign (funding a fancy new home/Ferrari collection) and some of which are less so (fleeing an impending collapse). Modest is a key word here, and insiders at MDF haven’t been all that modest with their sales. Over the past 6 months, they’ve collectively made 23 substantial sales totaling almost $2.6M. Extend the timeline to a year and those numbers increase to 35 sales totaling almost $4.5M. The CEO and CFO unloaded $1.5M worth of stock between them during the past year. There were no insider purchases during that time period, despite the fact that MDF at times traded in the $3 range during that period.

Put it all together and there’s too much uncertainty in MDF’s future. There’s no financial integrity since the business is dependent on a single annually renewable relationship and earnings, the main driver of the company’s value since it sells at a large premium to book value, are unstable and possibly a bit inflated at the moment. Definitely not a buy, and as a value investor I’d close out the position if I owned it.

Insider trades: here
10-K: here
Financial Statement Comparisons: here

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