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CFA Research Challenge 2013-2014 Belmont University, Nashville, TN. 11% Increase in Sales in 2014 40% Increase in EBITDA EBITDA Margin Widens by 250bps over 2013E Economies of Scale $0.29 Forward EPS BUY Rating $19 Price Target. Summary NASDAQ: HWAY. $19.00. BUY. 18.60 % Upside.

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slide1

CFA Research Challenge 2013-2014

Belmont University, Nashville, TN

slide2

11% Increase in Sales in 2014

  • 40% Increase in EBITDA
  • EBITDA Margin Widens by 250bps over 2013E
  • Economies of Scale
  • $0.29 Forward EPS
  • BUY Rating
    • $19 Price Target
slide3

Summary

NASDAQ: HWAY

$19.00

BUY

18.60 % Upside

$16.02

Summary

Business & Industry

Financial Analysis

Valuation

Risks

slide5

Healthways Overview

NASDAQ: HWAY

  • Largest independent global provider of specialized population health management solutions for health related cost bearing entities
  • Scaled proprietary technology infrastructure and delivery capabilities serving >30M people on 4 continents
  • Return to growth and strengthening financial profile post 2011 customer transition

Summary

Business & Industry

Financial Analysis

Valuation

Risks

slide6

Customer Breakout

NASDAQ: HWAY

Health

Systems

Blue

&

Regional

Medicare

Advantage

Employers

slide7

Revenue Breakdown

NASDAQ: HWAY

Lives Under Management vs. Revenue

(5% increase in lives leads to appx. 4% increase in EBITDA)

Summary

Business & Industry

Financial Analysis

Valuation

Risks

slide8

Competitive Analysis

NASDAQ: HWAY

  • Advantages
  • First-Mover
  • Experience
  • Wide array of services
  • Individualized programs
  • Disadvantages
  • High fixed costs
  • Dependency on large contracts

Summary

Business & Industry

Financial Analysis

Valuation

Risks

slide9

Financial Analysis

  • Congressional Budget Office Actuary Data
  • Non-Partisan Healthcare Analytics
  • Surveys of Hospital Executives
  • Revenue Sensitivity Analysis
slide10

Growth Strategy

NASDAQ: HWAY

  • The ACA incentivizes the formation of ACOs
  • Healthcare sector moving from volume to value-based payment
  • Shifting trend in the global healthcare landscape
  • High expected revenues will widen gross margin

Summary

Business & Industry

Financial Analysis

Valuation

Risks

slide11

Healthcare Reform

NASDAQ: HWAY

Accountable Care Organizations

Summary

Business & Industry

Financial Analysis

Valuation

Risks

slide12

Healthcare Reform

NASDAQ: HWAY

Coverage Projections Post-ACA

Historicaland Projected Revenue vs. LUM

Summary

Business & Industry

Financial Analysis

Valuation

Risks

slide13

Sensitivity Analysis

NASDAQ: HWAY

Revenue Sensitivity Analysis

Summary

Business & Industry

Financial Analysis

Valuation

Risks

slide14

Valuation

  • Price Target:
    • EV/EBITDA
    • Free Cash Flow to Equity
    • Free Cash Flow to Firm supports BUY
slide15

5-Year Average

Enterprise Value / EBITDA

NASDAQ: HWAY

  • Premium to the five-year average:
  • Increased market presence
  • Wider gross margins
  • Additional lives under management

(Amounts in millions)

Industry Average

7.33

10.40

Summary

Business & Industry

Financial Analysis

Valuation

Risks

slide16

Free Cash Flow to Equity

NASDAQ: HWAY

(Dollars in Thousands, Except per Share)

Value Per Share: $19.26

Reaffirms BUY

25.77% Upside Potential

Summary

Business & Industry

Financial Analysis

Valuation

Risks

slide17

Free Cash Flow to Firm

NASDAQ: HWAY

(Dollars in Thousands, Except per Share)

Value Per Share: $22.80

Reaffirms BUY

48.92% Upside Potential

Summary

Business & Industry

Financial Analysis

Valuation

Risks

slide19

Risk Analysis

NASDAQ: HWAY

High

Probability

Moderate

Low

Insignificant

Severe

Moderate

Impact

Summary

Business & Industry

Financial Analysis

Valuation

Risks

slide21

Presentation Slides

  • Summary
  • Overview
  • Customer Breakout
  • Revenue Breakdown
  • Competitive Analysis
  • Growth Strategy
  • Healthcare Reform (ACO)
  • Healthcare Reform (CBO)
  • Sensitivity Analysis
  • EV/EBITDA
  • Free Cash Flow to Equity
  • Free Cash Flow to Firm
  • Risk Analysis
slide22

Additional Slides

  • RIM Valuation
  • Free Cash Flow 2-Way Tables
  • EV/EBITDA Sensitivity
  • Management
  • Bear Price Justification
  • Global Legislation
  • SWOT Analysis
  • Comparable Firms
  • Pro-Forma Financials & Assumptions
  • CBO Projections
  • ACO & Pop. Health Management
  • Leavitt Partners Data
  • Bull, Base, Bear Sensitivity
  • LUM Estimates
  • EV/EBITDA
  • Beta Regression
  • Free Cash Flow Assumptions
  • FCFE
  • FCFF
slide23

SWOT Analysis

NASDAQ: HWAY

S

W

O

T

slide24

Comparable Companies

NASDAQ: HWAY

(Dollars in Millions, Except per Share)

slide25

Historical and Pro-Forma Income Statement

(Dollars in Millions, Except per Share)

Source: Company Financials and Team Estimates.

slide26

Income Statement Assumptions

Depreciation Expense:

  • Expected to remain at a constant percentage of PPE

Cost of Goods Sold:

  • Remains at the 2012 percent of sales (78.84%) until 2015 at which time it declines by 1% per year until 2018, returning to the pre-Cigna-loss average of 73.61% of sales

SG&A Expense:

  • Expected to remain at 9% of sales

Interest Expense:

  • Expected to remain at 5% of Long Term Debt

Effective Tax Rate:

  • Expected to remain at the historical average of 30%

Share Count:

  • Forecasted EPS assumes constant share count of 35.06M
slide27

Historical and Pro-Forma Balance Sheet

Assets

(Dollars in Millions)

Source: Company Financials and Team Estimates.

slide28

Historical and Pro-Forma Balance Sheet

Assumptions – Asset Side

Current Assets:

  • Expected to remain at a constant percentage of sales

Leasehold Improvements:

  • Held constant over the forecast period

Computer Equipment:

  • Expected to increase by 5% of sales from year to year

Furniture & Office Equipment:

  • Held constant over the forecast period

Capital Projects in Progress:

  • Expected to remain at a constant percentage of sales
slide29

Historical and Pro-Forma Balance Sheet

Liabilities, Stockholders’ Equity & Metrics

(Dollars in Millions)

Source: Company Financials and Team Estimates.

slide30

Historical and Pro-Forma Balance Sheet

Assumptions – Liabilities and Stockholder’s Equity

Current Liabilities:

  • Expected to remain at a constant percentage of sales

Long-Term Debt:

  • Expected to remain at a constant percentage of sales
slide31

Congressional Budget Office Projections

(Millions of Americans)

*Non-elderly

Source: CBO’s May 2013 Estimate of the Effects of the Affordable Care Act on Health Insurance Coverage

slide32

Excerpt from Premier Fall 2013 Economic Outlook

“In an ACO, providers take responsibility for the health of a defined population, coordinate care across settings and are held to benchmark levels of quality and cost. Unlike some previous delivery system reforms, ACOs seek to balance cost control with efforts to improve outcomes and enhance people’s satisfaction.”

“[ACO] participation [is] projected to double by the end of 2014 to 50 percent. Overall, 3 out of 4 respondents say their hospitals have future ACO participation plans.”

slide33

Excerpt from Premier Fall 2013 Economic Outlook

Continued

Source: Premier Fall 2013 Outlook, Published December 2013

slide34

Levitt Partners ACO Registration Data

“The current trajectory shows that providers and payers are recognizing the need to shift toward accountable care arrangements, or at the very least to shift away from fee-for-service care.”

slide35

Excerpt from American Medical Group Association

“The shift to population health management, which will require an entirely different way of looking at health care.”

“In an ACO practice, however, attention must shift to the management of all patients in a practice across the entire spectrum of health, from those who are well to those with the most complex conditions, including individuals at the end of life.”

This will be a major transformation for providers and the healthcare systems they are associated with. Making the transition even more challenging, the Patient Protection and Affordable Care Act of 2011 will extend health insurance to an additional 32 million people and require enhanced coverage for preventative care. At the same time, the aging and growth of the U.S. population will increase the number of patients who need chronic care management.”

slide36

Excerpt from American Medical Group Association

“In the ACO population health model, it is the aggregate results across all patients that matter – even if some individuals are not cooperative or engaged, their results still count in the world of accountable care.”

“ ‘Practice-based population health’ which refers to the responsibility of primary care groups and networks for the health of their patient populations.”

“This would also be the level at which risk-bearing ACOs would stand or fall on a financial basis.”

PBPH, by definition, must address the health needs of a total patient population. Thus, ACOs must proactively reach out, not only to patients who have visited their doctors recently, but to every individual who has a relationship with an ACO physician”

slide37

Business Segment Sales and Sensitivity Analysis

Base Case

As discussed in the Investment Risks section of the report, unexpected developments in ACO growth, ACA mandate implementation, or internal lives under management growth will generate revenues outside of our base projection. To compensate for unforeseen events, be they positive or negative, we ran our valuation models with three different sets of assumptions briefly mentioned in the Valuation section of the report.

Base Case:

Our base case growth projections are based on a close analysis of ACO growth, macroeconomic shifts in the healthcare sector, international demand, and our estimates of Healthways’ potential for organic growth. These assumptions drive our $19 price target and buy decision for the stock. We expect HWAY can reasonably capture 3% of the new ACO demand for population health management and grow lives under management in the regional health plan, Medicare, and international segments by 10%, 4%, and 5% respectively. The base case also assumes -3% year-over-year decline in sales from the employer segment as described in the report.

slide38

Business Segment Sales and Sensitivity Analysis

Bull & Bear Case

Bull & Bear Case:

Our bull and bear case projections give us best case and worse case scenarios for company growth. The bull price of $23 represents a 50.23% upside from the January 31 closing price while the $13 bear price constitutes a 15.09% downside. The assumptions for each of these scenarios are listed in the figures on the right. Running the revenue projections with bull assumptions gives us the forecast of $839.41M by the end of 2018 while the bear case assumptions project $735.38M. We expect actual reported revenues to fall somewhere between these two numbers for the next five years. The chart below displays these three set of assumptions, our revenue projection range, and the Street consensus as provided by FactSet.

slide40

Estimated Lives Under Management Calculation

The year 2006 presented several significant changes to Healthways business model. The acquisition of Axia represented a shift from high-risk case management to total population health management with emphasis on prevention. As displayed in the table below, revenue per life since the acquisition has been constant relative to the years before the business model shift. Healthways has not reported total lives under management since 2009, to estimate this number; we took an average of the 2007-2009 revenue per life figures ($21.86) and divided reported revenue into this number. Our forecasting method maintains this $21.86 revenue per life to predict total future sales.

slide43

Free Cash Flow Valuation Assumptions

Beta

We arrived at a beta of 1.07 by running a 60 observation regression of S&P monthly returns against those of HWAY.

slide44

Free Cash Flow Valuation Assumptions

Continued

Risk Free Rate

  • Our free cash flow models assume a risk free rate of 3.54%, consistent with the 20 year treasury rate in January 2014

Terminal Growth Rate

  • We assumed a terminal growth rate of 3% based on a combination of company expectations and estimates for GDP growth. A sensitivity analysis is conducted on the terminal growth rate via our two way tables

Tax Rate

  • Our assumed tax rate of 30% is a 2006-2012 average of income tax expense divided by taxable income

(Dollars in Thousands)

slide45

Free Cash Flow Valuation Assumptions

Continued

Risk Free Rate

  • Our free cash flow models assume a risk free rate of 3.54%, consistent with the 20 year treasury rate in January 2014.

Terminal Growth Rate

  • We assumed a terminal growth rate of 3% based on a combination of company expectations and estimates for GDP growth. A sensitivity analysis is conducted on the terminal growth rate via our two way tables.
  • Weights of Debt & Equity
  • Our Free Cash Flow to Firm valuation discounts using WACC rather than cost of equity. Calculations for debt & equity weights are shown below.
slide46

Free Cash Flow to Equity Pricing Model

Our free cash flow to equity model supports our price target of $19 proposed by the EV/EBITDA valuation.

slide47

Free Cash Flow to Firm Pricing Model

We valued HWAY equity with an EV/EBITDA model, a Free Cash Flow to Equity model, and a Free Cash Flow to Firm model. The price target using free cash flow to firm is not as consistent with the other two valuation methods, and hence is not mentioned in the report, but it does confirm our upside expectations for the stock.

slide49

Price to Earning and Residual Income Valuations

We valued Healthways’ equity share price 6 different ways including the buy-out prices discussed in Appendix 15. Of those 6, we discredited price to earnings and residual income valuations for the following reasons.

Price to Earnings Model

There were several issues with P/E ratios industry wide. Healthways currently has no P/E multiple because EPS ttm is negative. Premier, one of the closest competitors for ACO business, is a new firm with no earnings. Our earnings per share forecasts for Healthways are too low to rely on industry average P/E multiples for share valuation, and hence this model is discredited and does not contribute to our target price.

Residual Income Model

Forecasted earnings per share for Healthways were less than the 12.10% cost of equity multiplied by the book value per share, hence residual income is a negative number. Earnings per share is too low for residual income valuation and we discredit the model as a valid contributor to our target price.

slide51

EV/EBITDA Sensitivity

Two-Way Tables

slide52

Note on Vertical Integration

It may be the case that Healthways becomes a viable enough ACO contractor that the Company presents an enticing buying opportunity to a larger healthcare conglomerate. Mergers are common in the healthcare sector, and our analysis of recent acquisitions has led us to conclude that when smaller health services providers are bought out, the acquirer typically pays a premium between 20% and 40%. Wellpoint, for example, paid an estimated 20% premium for 1-800-CONTACTS in 2012 in an effort to raise its MLR to comply with new federal regulations. Later that year the company also acquired Amerigroup for 43% above its equity value at the time. We estimate that HWAY’s probability of being bought out before 2018 is 10%. Applying this data to our price targets gives us the value of shares weighted according to buy-out probability.

slide53

Note on Management and North Tide Capital

North Tide Capital, LLC

North Tide Capital, LLC is a Boston-based hedge fund that currently owns approximately 10% of HWAY shares, making the fund the second largest shareholder. In December 2013, North Tide began raising its position in HWAY stock, taking an activist position and calling for the immediate removal of CEO Ben Leedle. The fund claimed that Leedle was harming the value of Healthways stock by missing attractive trends in the domestic healthcare marketplace. Along with the removal of Leedle, North Tide also called for Healthways to discontinue its international expansion efforts and focus on shorter-term trends centered in the United States. Healthways’ board of directors issued a statement defending Leedle and claimed that it had no plans to seek a replacement for the CEO position.

We are not convinced that outing a CEO who’s been with the firm for almost 30 years in the midst of a critical macroeconomic healthcare shift would create value for shareholders. We believe that there is value in Leedle’s experience with the firm and the level respect paid to him by the board of directors. However, if North Tide manages to bring in a new CEO its obvious that this new executive would run the company in favor of the hedge fund, most likely by shifting focus away from global expansion and implementing a short-term capital restructuring plan to pay off debt and increase the value of equity. The situation should be monitored closely as it develops; for now, it is not factored into our valuation models.

Current Management Team

Under the direction of current CEO Ben Leedle, Healthways revenue has grown by over 300%. Approximately half of that growth was organic, meaning that it doesn’t include revenue captured simply as a result of the 2006 acquisitions of SilverSneakers® and Axia. Leedle has been CEO since 2003, but has been with the Company since 1985. The current upper-level management team has a combined total of 116 years of experience in health care and a combined 58 years with Healthways. While management has been criticized in the years following the loss of the Cigna contract, we are not convinced by the accusations that the firm is not being run in the best interest of shareholders. Our analysis attributes declining revenues to shrinking gross margins after the Cigna loss and slower than expected implementation of Affordable Care Act mandates. The dependency on Cigna before 2011 was a huge weakness and the loss of the contract had an enormous adverse effect on revenue, but our analysis has led us to believe that Healthways will recover, adding lives under management in a more diversified array of contracts thereby securing a more profitable future.

slide54

Management

NASDAQ: HWAY

  • Ben R. Leedle, Jr.
  • President & CEO
  • Joined in 1985, CEO since 2003
  • Steered HWAY towards Population Health Management
  • HWAY revenues have grown by over 300% under his leadership

Current Executive Team

  • Combined 116 years of experience in Health Care
  • Combined58 years at HWAY
  • Average of 5 years as executive
slide55

Bear Price Justification

NASDAQ: HWAY

Feb. 14 Price Movement

Source: Bloomberg

slide56

Global Legislation

NASDAQ: HWAY