Jenks Healthcare Business Report October 2002

In the October 2002 issue:

Profiting From Overreaction: Will Fallen Angels Rise Again?

Times may be tough, but some health care stock prices have tumbled irrationally and may be poised to turn profits for the optimistic investor. Are double-digit jumps still possible? See page 1

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Public Equity Market

Despite several companies pulling their IPOs during the summer lull, in mid-August a new health care REIT completed its IPO, and several other companies are lined up for secondary offerings. See page 6

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Venture Capital Market

Although not a record, the 22 venture capital financings during the past month is another strong showing for health care companies. The total volume was just over $300 million, or an average close to $14.5 million per deal. See page 9

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Acquisition Market

Unlike other industry sectors, the health care M&A market is on track to post a slight gain this year over 2001. The medical device sector, claiming more than 25% of the deals in the past month, continues its strong showing. See page 9

Jenks Healthcare Business Report

Profiting From Overreaction: Will Fallen Angels Rise Again?

During the opening days of the fourth quarter, nearly all of the major stock indexes hit five- or six-year lows. The Dow Jones Industrials Average came close to falling below 7,000 for the first time since early 1997, while the broad S&P 500 Index has already declined by 32% this year and by almost 50% since its peak in March 2000. Health care stocks have not been immune to this valuation panic and investors, both institutional and retail, are wondering when the markets will hit bottom. But at current levels, there is little reason to sell, unless you just lost your job.

Despite the market gloom, there are pockets of optimism. Goldman Sachs investment strategist Abby Joseph Cohen has a 12- to 18-month target for the Dow of 10,800, which was recently cut from 11,300. Although she has his-torically been a market optimist (to say the least), this means she believes there is a reasonable chance for a 44% jump in the Dow between now and the end of next year. While investors would welcome any sort of a double-digit jump in the Dow by the end of 2003, now may be the time to pick up some of the fallen angels in the health care sector at bargain-basement prices and perhaps even beat Ms. Cohen’s aggressive forecasts.

Last month, we explained why HealthSouth (NYSE: HRC), despite its reimbursement, legal and credibility problems, was severely undervalued, even in this market. At a current price of $3.60 per share, when the surgery center business alone is worth at least $4.00 to $5.00 per share, the downside is minimal (even with a 6,000 Dow) and the upside is for a 100% to 200% return in the next 12 to 18 months. As the market leader in its three major business units, and with strong cash flow even after the $175 million Medicare shortfall, HealthSouth is faced with an overreaction by investors for the third time in five years. While you may not like Mr. Scrushy, the founder and chairman, he built up a dominant, profitable health care provider that should never have fallen to $2.79 per share.

Although HealthSouth appears to have the highest upside potential, there are many health care companies that just seem too cheap relative to their growth rates, company fundamentals or recent price levels. All of these companies are currently trading at least 50% below their 52-week highs, and in some cases more than 75% below them.

Even though the sector was hot late last year when two very successful IPOs opened at 20% premiums and more than doubled in price in the ensuing months, temporary health care staffing companies have taken a severe beating in the last two months. The two IPOs, Cross Country Inc. (NASDAQ: CCRN) and AMN Healthcare Services (NYSE: AHS), are now both trading below their original IPO prices, while a third company, Medical Staffing Network (NYSE: MRN), has fallen 65% from its 52-week high.

The sell-off began in early August when Cross Country announced its second-quarter earnings results. Although CCRN’s earnings per share were one penny above estimates, the 31% jump in revenues to $156 million was $1.2 million below consensus estimates, and management’s estimate for third-quarter earnings was a penny below estimates. The shares plunged nearly 50% on the news to just over $14 per share, which is a typical overreaction, and continued to slide over the following weeks to a new low of $9.66 per share. Earnings in the fourth quarter are expected to be in the range of 28 to 31 cents per share, and between $1.02 and $1.06 per share for the full year 2002.

At current levels, CCRN’s stock is trading at just 5.0x annualized second quarter EBITDA and 0.52x annualized revenues, multiples that are lower when using next year’s projections. It is also trading close to 10x current earnings per share and well below that for next year’s earnings. At these multiples, with double-digit growth rates and a stock price that has fallen 72% from its high this year, CCRN is a good bet to rise regardless of what happens to the overall market.

An alternative, which will most likely move in the same direction as CCRN, is AMN Healthcare, with $191 million in revenues in the second quarter, representing an increase of 65% over the previous year’s results. While AHS’ gross margin was below CCRN’s, its EBITDA margin of 11.5% in the second quarter was about 110 basis points higher. And, with no debt and $40.4 million of cash as of June 30, 2002, the company has a high degree of financial flexibility. Its stock price has not fallen as much as CCRN’s (58% from its high in June), and its second quarter price to EBITDA and revenue multiples were higher, at 6.8x and 0.70x, respectively. Still, revenues in the third quarter are expected to jump by almost 50% from last year, and management has projected full-year revenues to be between $780 and $790 million.

One caveat is that temporary health care staffing can be perceived as somewhat risky because a company’s assets are its contracts and pool of staff, primarily nurses. If you agree that the sector is oversold, a basket of these two companies plus Medical Staffing Network, which has dropped by more than 60% from its high this year, will spread the company-specific risk. MRN is the smallest of the three, and with the lowest EBITDA margin in the second quarter and just $86,000 of cash as of June 30, 2002, is probably the weakest as well. All three companies will be reporting third-quarter earnings in late October, and if there are no negative surprises and the share prices remain in the cellar, the opportunity is there for the taking.

Another interesting situation involves disease management company Matria Healthcare (NASDAQ: MATR). In January of this year, MATR’s shares peaked at $40.00 per share, but in late June the company announced a decrease in its 2002 financial outlook, lowering revenue, earnings and EBITDA estimates. This news eventually sent the shares plunging to a low of $5.89, or 85% below the high, before recovering slightly to above $8.00 per share. The primary reason given for the revised 2002 outlook was information system constraints on the company’s pharmacy, laboratory and supplies component of its largest business segment.

Basically, because the company’s Health Enhancement Business (70% of total revenues) grew so quickly, management has been trying to implement a state-of-the art customer relationship management, billing, inventory and pharmacy system. That has been delayed by a quarter, resulting in increased labor costs until full implementation. Profit margins were also squeezed by a significant increase in the cost of one of MATR’s key drugs used for the control of pre-term labor. The former supplier sold the drug to another pharmaceutical company that quickly doubled the price. In the near term, the new price cannot be passed on to Matria’s health plan customers, causing a 200-basis-point drop in the gross profit margin of the Women’s Health Division beginning in this year’s second quarter.

While results in 2002 will be slightly disappointing, they do not merit an 85% plunge in value. With the new information system in place during the first quarter next year, plus new contracts, management forecasts a 16% to 18% increase in revenues for 2003, a 38% to 55% increase in EBITDA and a 69% to 107% increase in earnings per share. At the low end of the EBITDA forecast, the stock is trading at a multiple of just under 2.0x, and just 7.0x the low end of the EPS forecast for 2003. With just 9.1 million shares outstanding, there is little liquidity in MATR, but anything below $10 per share is certainly a bargain.

In the still-beleaguered e-Health sector, Cerner Corp. (NASDAQ: CERN) stands out as one of the few companies with a large, solid base of business with great growth prospects. CERN’s share price is down almost 50% from its 52-week high of $60.00, but its second-quarter earnings came in a penny above consensus estimates on a 39% increase in revenues to $180.6 million. The company, which provides clinical and management information systems to health care companies, has a revenue backlog of more than $900 million. Last July, CERN raised its earnings guidance slightly for the full year, and provided initial guidance for 2003 that includes a 19% increase in revenues to a range of $850 to $870 million and EPS of between $1.75 to $1.80, or 32% above 2002’s new estimate.

With financial results, and prospects, as good as this, especially in this economic environment, punishing a stock by cutting its value in half does not seem justified. Unlike our other picks, however, CERN is trading at a relatively high 17x 2003 estimated earnings. But with a 32% antici-pated earnings growth rate, that still seems cheap, and as consumers and legislators continue to focus on reducing medical errors, health care software companies such as CERN will only benefit. This stock should hit $40 per share next year, if not higher.

In the long-term care sector, an area of the health care arena where five of the seven largest publicly traded companies filed for bankruptcy protection two and three years ago (four of the five have emerged), the environment remains troublesome, especially regarding Medicare reimbursement and liability insurance. One of the perennially underperforming companies in the sector, but one that did not go bankrupt at the end of the last decade, is Beverly Enterprises (NYSE: BEV). In terms of number of nursing facilities, it still ranks as the largest chain in the nation, and revenues this year should be close to $2.5 billion. The company has had its share of quality issues, and it settled a large Medicare fraud case more than two years ago, but how long can it stay at $2.08 per share, or 78% below its 52-week high?

Like HealthSouth, BEV has a history of trading in a relatively wide band every year. In each of the past five years, the spread between BEV’s low price and high has been between 133% and 437%. This year has been no different, except that now it is at its low point and at a level that is usually regarded as a pre-bankruptcy valuation. Unlike some of the other companies previously mentioned, BEV is not a growth stock and there is no expectation of this changing. However, bankruptcy is doubtful, and once there is a resolution to what is known as the Medicare "cliff," or the end of temporary reimbursement increases, management will begin to deal with the new environment. With total debt under $15,000 per bed, BEV does not have the capital structure problems its competitors had a few years ago.

On October 11, most nursing home stocks declined after Kindred Healthcare (NASDAQ: KIND) withdrew its 2002 earnings forecast amid disclosures that third-quarter liability claims would be $55 million above its normal provision, largely because of problems in Florida. KIND indicated that it would try to divest its 18 Florida nursing facilities. Beverly, despite having sold off its Florida operations last year, was thrown into the nursing home "sell pool" and hit a low of $1.60 per share on October 11, while KIND plunged by almost 50%. BEV immediately reiterated its third-quarter earnings guidance, and affirmed that reserves for liability claims were adequate, having already increased them in July by $43.3 million.

At the $2.00 per share level, even before the Kindred announcement, there had been rumblings about a potential buy-out of Beverly because of the inherent value of the hard assets. A theoretical break-up value of BEV would produce a value at least double the current level, but we say theoretical because in this market it would be next to impossible to break up the company and sell various pieces with the current lack of financing. Regardless, look for that spread in trading range again next year, but don’t wait until BEV’s stock goes to $4.00 per share.

Read the past headlines.