While the company does not break out the exact composition of revenues by service type, I estimate that a significant majority of MD’s revenues are generated from the company’s Pediatrix segment, with the balance generated by the American Anesthesiology unit. The typical contract with a hospital provides Mednax with the responsibility to staff and manage hospital-based units (such as NICUs). As part of the contract, Mednax is responsible for billing patient and third-party payers for services rendered by physicians affiliated with Mednax. In some instances Mednax will also earn an administrative fee from the hospital. MD has used acquisitions to augment organic growth and diversify into anesthesiologist practices. Management has done well in growing the business despite the challenging economic backdrop, and I have confidence in the longer-term story, given historical track record and financial flexibility. “It is one of the best-managed health care companies" said Andreas Halvorsen, founder of Viking Global Investors in a conference last year. The company has several positive factors:
Proven Business Model: Founded in 1979 as Pediatrix Medical Group, a single practice neonatology group, Mednax has grown into a national practice management firm that focuses on neonatology, pediatric care, and anesthesiology. The company has built a strong track record of growth through acquisition. Since inception, MD purchased a significant number physician practices, growing its number of affiliated physicians to 1,675 at the end of 2010. Despite the significant contribution from acquisitions, the company has exhibited consistent same-store growth, most recently in the low to mid single digits. Even in a difficult environment, MD was able to rely on its ability to collect more efficiently at recently acquired companies (roughly 20% more effective in billing and collecting) to help augment slower volume.
Consistent Same-Store Growth: Despite the challenging macroeconomic backdrop, Mednax has posted organic volume growth in 12 of the past 14 quarters. I believe these results are a testament to the company’s operating strategy and focus on expansion in key demographic areas that are more resilient than the nation as a whole. Also, given the amount of acquisitions completed in 2010, I expect Mednax to improve operations and growth by the time the newly acquired practices are included in the same-store metrics.
Business Diversification out of Pediatrix: American Anesthesiology is Mednax’s physician group practices associated with the company’s anesthesiology business. Founded in 2007 when MD purchased its first anesthesiology practice group, Fairfax Anesthesiology Associates, American Anesthesiology now consists of eight anesthesiology practice management groups located in Georgia, North Carolina, and Virginia. The segment employs more than 300 anesthesiologists and over 400 advanced practice anesthetists (certified registered nurse anesthetists and anesthesia assistants). Since 2007, Mednax has acquired six anesthesiology practices, growing the proportion of anesthesiologists to approximately 18% of the company’s total physicians The build-out of anesthesiology will likely allow Mednax to insulate itself from the impact of lower birth rates on the Pediatrix side of the business, while widening its exposure to the aging U.S. population I also believe there is a potential benefit from the higher-quality payor mix associated with the typical anesthesiologist (more managed care and Medicare patients).
Long-Term Demographic Trends: The most recent U.S. Census population projections also forecast accelerated population growth for individuals aged over 65 years old. In 2010, the Census projected that roughly 40.2M individuals were at least 65 years old. This population is expected to grow to nearly 47M in 2015 and to almost 55M by 2020. This equates to a growth rate in the five-year periods of 16.4% and 17%, respectively. “The current demographic trend is one of the biggest drivers in our businesses” said Mr. Joseph Calabro, COO of MD.
Mednax has two main risks, one associated with Medicaid and the other from integration risk in recent acquisitions. I estimate that approximately 21% of Mednax revenues are from Medicaid. Given the budgetary concerns many states are currently facing, I believe the Medicaid funding could be at risk and create a potential negative mix shift from Medicaid volume growth. Given recent news from various providers regarding Medicaid mix shift, along with Mednax’s payer mix deterioration in fourth quarter 2010, I believe there is a possibility that price/mix could drag on results if Medicaid volume growth jumps unexpectedly. When Mednax reported fourth quarter 2010 EPS of $1.12 (in line with consensus EPS expectations) the company’s share price declined 7% as the company reported negative price/mix trends. In fourth quarter 2010, same-store revenue growth was 0.2%, despite 1.6% growth in same-store volumes, as Mayor price/mix deteriorated dramatically. The primary driver of the mix deterioration was unexpected growth in the Medicaid population that exceeded growth in other payers. With data points from several providers indicating patient mix shift toward Medicaid, there is potential for Mednax to experience similar mix deterioration. Given the strong financial position of MD, the company could face this kind of risk.
MD is a company that depends on acquisitions in growing its business. With any acquisition, there is risk that the integration does not proceed efficiently. Given the acquisition activity of MD over the past few years, it seems plausible that there could be an acquisition that creates an inefficient integration. While smaller deals would likely have a minimal impact on aggregate results, larger anesthesiology-focused deals could pose greater risk to aggregate results.
One of the more attractive aspects of the MD story is its ability to generate consistent free cash flow. Since 2007, Mednax has grown cash from operations by nearly 10% year over year on average (in line with top-line growth). Over the same time period, MD has been able to keep maintenance capital expenditures below $20 million annually. This has led to impressive free cash flow growth in the past few years, from $166 million in 2008 to a projected $243 million in 2011. I note that my 2011 free cash flow projection includes $18.5 million related to an office building purchase made in first quarter 2011. If I were to remove the building acquisition from my estimates, FCF would be over $251 million in 2011. Mednax currently maintains a healthy 8.3% free cash flow yield, in line with its historical average. The combination of cash flow, low capital expenditures, and stable operations provides the company financial flexibility.
Taking into consideration the historical average of MD and its peers, along with current valuation, I derived a $70 target price for MD by averaging my target prices from P/E and EV/EBITDA methodologies. For my P/E valuation, I peg a multiple of 14.5 times the average analyst 2012 EPS estimate of $4.93, which yields a price of $71. It is important to note that my target P/E multiple is a discount to MD’s historical average which is warranted given the current economic backdrop. There is a possibility for upside to earnings, either as the result of faster organic growth or additional acquisitions beyond the average projections, which could drive upside to my target price.
On an EV/EBITDA basis, I pegged a multiple of 8 times the average 2012 analyst EBITDA estimate of $426 million, which yields a price of $70. This target multiple again represents a slight discount to the historical multiple of MD and its peer comps over the past five years. Considering the upside of 12% from current levels, I plan to initiate a long position in this stock.