MEDNAX Inc. -- Only 10% Growth Last Week?!

MEDNAX Inc. -- Only 10% Growth Last Weel?!

Company Overview

MEDNAX Inc. (MD, Financial) was founded in 2007, successor to Pediatric Medical Group Inc. which was incorporated in 1979, and is a leading physician services company providing newborn, anesthesia, maternal-fetal and other pediatric subspecialty care. The company is a significant $2.2 billion player in a moderately growing industry. As of December 31, 2013, MD's national network comprised:

• Over 2,300 affiliated physicians, including approximately 1,050 physicians who provide neonatal clinical care, in 34 states and Puerto Rico, primarily within hospital-based neonatal intensive care units, to babies born prematurely or with medical complications;
• Over 775 physicians who provide anesthesia care to patients in connection with surgical and other procedures, as well as pain management; and
• Over 200 affiliated physicians who provide maternal-fetal care to expectant mothers experiencing complicated pregnancies and obstetrical hospitalist services in many areas where its affiliated neonatal physicians practice.

MD's network also includes other pediatric subspecialists, including approximately 120 physicians providing pediatric cardiology care, 110 physicians providing pediatric intensive care, 60 physicians providing hospital-based pediatric care and 15 physicians providing pediatric surgical care. Overall, since 2009, MD's physician base has grown from 1,484 to 2,367. Approximately 58% of its net patient service revenue is generated by operations in five states--Texas, North Carolina, Florida, Tennessee and Georgia--and its payer mix, expressed as a percentage of net patient service revenue, comprises 69% contract managed care, 24% government, 5% third parties and 2% private pay patients.

Purchase Considerations

While relying heavily on acquisitions (bringing some additional risk to the company), we do like that since 2009, MD has been a consistent growth story. Specifically, top line growth of about 15% per year has been driven largely by revenue generated from aggressive acquisitions completed after December 31, 2011 in which MD completed the acquisition of 11 physician group practices including six anesthesiology practices and five neonatology practices (bringing its total anesthesia platform to 23 groups). That being said, same-unit net patient service revenue also increased at a modest 4.2% clip, fuelled by net reimbursement-related factors and a modest uptick in overall patient service volumes. In total since 2009, the number of births handled by MD staff grew from 744,202 to 790,597 in 2013. The number of anesthesia cases grew from 244,127 to 1,045,794 and the total number of neonatal intensive care unit patient days grew from 1,658,845 to 1,847,577. Acquisition driven and patient visit driven growth is expected to continue. Improvements in U.S. economic conditions will also reduce the number of unemployed workers pressured into shifting towards government-sponsored care programs (payments received by MD from government-sponsored programs are substantially less for equivalent services than payments received from commercial insurance payers). This will also help to support patient volumes and decrease the number of bad debts due to patients’ inability to pay for services.

Other purchase considerations include:

• Reasonable pricing power in most markets.
• Consistently generates positive residual income.
• Stable performer.
• Solid financials.
• Reasonably attractive share price.
• MD has a broad and well established distribution network with perpetual market demand.
• Room for more acquisitions and an attractive takeover target.
• Strong ROE and ROI performance.
• Strong free cash-flow generator.
• Physician base continues to grow.
• Negligible debt-load.
• Strong growth in anesthesia medicine.
• Potential market size is enormous.
• Quality image and reputation.
• Short interest only 6.7% of float.

Cautionary Notes

What we dislike most about MD is the ongoing uncertainty related to health-care regulations and reimbursement rates and what risks these bring to the company. We also dislike that, due to massive State budgetary shortfalls, government's are looking for new ways to reduce and delay funding for Medicaid programs and, in turn, reduce or delay reimbursement rates for physician services.

Other cautionary notes include:

• Faces intense competition in most markets from smaller- and larger-scale competitors.
• Long-term downward trend in birth rates expected to continue.
• Facing growing pressure to find new ways to make money.
• Operating costs rising faster than revenues.
• No dividends and no share repurchase activity.
• Insider ownership only 2% of float.
• Affordable Care Act may negatively affect reimbursement rates.
• Physicians can move easily between competitors.
• Subject to regular lawsuits.
• MD's asset base is made-up of almost entirely goodwill and other intangibles.

Historical Financial Performance

About $2,154M in revenues moved through MD's door in 2013. Increased capacity utilization continued to support top-line growth with revenues for the Dec 2004 to Dec 2013 period clocking in at an average annual rate of growth of 15%. MD has been able to maintain this 15% annual rate of growth over each of the last 3 and 5 year periods respectively. The company saw especially strong sales in anesthesia medicine and pain management services. Year-over-year EMN continues to make substantial sums of money off revenues after subtracting costs of goods sold, with gross profits reaching $710M in 2013. Gross profits have grown steadily by 13% per year over the last 3, 5, and 10 year periods respectively.

MD's production costs are growing a little excessively, with COGS rising by 16% per year over the last 10 years against revenue growth of 15%. MD appears to be experiencing some difficulties passing on the full healthcare cost of inflation to consumers. Gross margins have compressed from 39% in 2004 to 33% in 2013. In addition to being on a downward trend, MD's gross margins are only moderately strong (averaging 36%). As a general rule, we want to see consistent gross profit margins above 45% for firms in the sector. While, MD has not been able to meet this requirement in any of the last 10 years, gross profits margins consistently between 30% and 40% for firms in the sector is, in our opinion, indicative of a firm with a reasonably strong competitive advantage and moderate pricing power.

MD spends about 31% of gross profits on hard costs associated with selling expenses, advertising, management salaries, payrolls, advertising and legal fees. We consider spending 31% of gross profits on SG&A a very good result. Cost of SG&A have been growing at a stable rate, rising by 12% per year over the last 3, 5, and 10 year periods respectively. We consider this a great result when viewed against annual revenue growth of 15% over the same periods.

MD has shown continued strength and tremendous stability in its operating earnings picture, rising by 13% per year over the last 3, 5, and 10 year periods. The long-term trend is clearly upward, rising from $153M in 2004 to $452M in 2013. MD has earned on average about 23% in operating earnings on total revenues over the last 10 years--a very good result. MD also carries a negligible amount of debt on its books and pays out only about 1% of operating income on interest payments annually, which is a great result.

Bottom line results show a strong upward long-term trend in earnings, with minimal volatility, growing at an average annual rate of 13% over the last 10 years. Earnings are expected to tick upwards in 2014 and 2015 supported primarily by strength in the U.S. economy, the aging of the population, and the recent uptick in core city concentration birth rates. MD’s reasonably strong competitive position has allowed it to maintain net margins of about 14% over the last 10 years. This is a reasonable finding but we do not expect to see much margin expansion from this company over the short- to medium-term.

Diluted EPS grew from $0.97 per share in 2004 to $2.78 in 2013. We don't like seeing that, since 2004, earnings growth has lagged revenue growth by 2% per year. Though a minor concern, to us this is a sign of earnings quality weakness. We also dislike that the firm's share-base has not fallen over the last 10 years and remains at about 100M. MD's ROE performance has been exceptional, averaging 15% over the last 10 years. Its ROA performance has also been strong averaging 11%.

Free Cash-Flow to Equity Valuation

A company’s fair value estimate can be calculated as the present value of expected future free cash-flows to equity. Free cash-flows to equity represent the amount of cash-flows available to common stockholders after all operating expenses, interest and principal payments to lenders have been paid and necessary investments in capital equipment and working capital have been made to maintain and grow operations.

Here we estimate fair value in 5 steps:

(1) We forecast the firm’s free-cash flows to equity for the next 10 years using econometric processes;

(2) We discount those cash-flows to the present;

(3) Calculate a terminal value for the firm 10 years out based on a long-term expected growth rate and terminal discount rate and discount it to the present;

(4) Add the discounted terminal value to the discounted value of free-cash flows to equity over the next 10 years; and

(5) Divide the present value of all cash-flows by the number of shares outstanding.

Results are presented in Table 1. Model inputs are presented in Table 2.

Table 1: Free Cash-Flows to Equity Estimation

Table 2: Model Inputs

Conclusion

MD’s per share earnings in 2013 were $2.78. Historical earnings per share grew at an annual rate of approximately 12.5% per year since 2004. MD’s sales per share in 2013 were $21.33. We project that sales will grow at a rate of about 6.0% per year between 2014 and 2023. We expect stable gross margins but compressing net margins. Interest expenses will remain negligible and capital expenditures will remain at recent historical levels in the amount of approximately 2% of sales. Our fair value estimate of MD equals $75.37. Following the recent 10% run-up in prices in last week, settling at $62.43, this suggest there is still a 21% margin-of-safety in the position. For new entrants, this might not be enough. For recent buyers, continue to enjoy the ride.