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The business end of the delivery of medical care in the U.S. has been a mess ever since cost containment became a mantra of the industry way back in 1983. That year Diagnostic Related Groups (DRG’s) were instituted in all hospitals as a way to reel in the runaway healthcare cost inflation that started shortly after the enactment of Medicare and Medicaid in 1965. Prior to DRG’s the costs of healthcare services were reimbursed on a “cost plus” system. The more you spent the more you got back. It seems that the government budget forecasters neglected to consider that doctors are just as money motivated as the rest of us. The absence of cost constraints also opened the throttle for pharmaceutical, medical device and equipment manufacturing firms. Their ability to price their products at a healthy premium financed a monstrous wave of innovation but also with substantial price inflation. At the time of enactment the Government’s worst case scenario for the cost of these new programs was ~$900M. Today, we spend more than this amount EVERY 12 HOURS.

DRG’s established a fixed reimbursement amount for a particular group of patients, say, heart attack or diabetes. This put the onus on the hospital to improve its efficiency. If it could treat the patient for an amount less than the DRG paid it could keep the surplus. If it went over it had to absorb the loss. The balance of power shifted from the providers to the payers for the first time.

Hospitals are notoriously inefficient due, in large part, to the overwhelming complexity of caring for patients. One source of this complexity originates from the payer side. There is some degree of uniqueness in almost everyone’s insurance coverage. When this is combined with the wide variety of claims processing procedures the situation quickly morphs into a 1,000-headed hydra. Even a modest sized out-patient clinic can employ 6-8 office people just to manage the payment/cash flow process. I didn’t know whether to laugh or cry when, a few months ago, I received a notice from my primary care facility about a disputed co-pay of mine FROM 2 YEARS AGO. That’s ancient history as far as a receivable is concerned. They didn’t seem embarrassed over the timing, though. Something tells me they’ve done this before ...

Despite the profound changes in the healthcare system since 1983 hospitals still struggle with getting promptly paid what they are owed. Some of the mistakes are home grown, of course, but the principal reason is the ever-increasing complexity of the task. It’s as challenging as ever. This is where Accretive Health (NYSE:AH) comes in.

Their core service offering helps providers improve the efficiency of their revenue cycle. This process encompasses patient registration, insurance and benefit verification, medical treatment documentation and coding, bill preparation and collections. Accretive assumes full responsibility for managing the entire cycle including personnel, technology and process improvement. The company believes that it is unique in this respect. Other competitors only target components of the cycle.

In assuming full responsibility for managing the revenue cycle the company supplements the medical facility’s existing staff with Accretive personnel. They also imbed their technology, expertise and culture into the organization. In short, they take control over the entire operation.

Most of their revenue consists of base fees and incentive fees. Base fees are what they charge for managing the revenue cycle and total cost of care operations net of any cost savings that they share with the customer. Incentive fees are Accretive’s share of the increased revenue that the customer gains from the impact of the partnership. They also earn a portion of the provider community cost savings for those customers contracting for Accretive’s Quality and Total Cost of Care solution. This offering, launched in 2010, helps the providers more efficiently manage the health of a defined patient population. Their systems enable the provider to better identify those patients who are most likely to experience a cost-inflating adverse health event so they can proactively manage them across the delivery system, including the home. Accretive provides the technology infrastructure and manages the care coordination process.

The company’s customer base includes multi-hospital systems, academic centers, ambulatory clinics and physicians offices. At the end of 2010, they had 26 customers under contract for their revenue cycle management service representing 66 individual hospitals. They had 7 hospitals and 42 clinics utilizing their quality and total cost of care solution.

Revenue cycle customers typically improve their revenue yield (cash collections measured against the contractual amount due for medical services) 4% - 6% by the third or fourth contract year. How big is the macro opportunity in the U.S.? Total healthcare expenditures are ~$2.5 trillion. If we keep things simple and assume that the upside is only for services then we have a total theoretical system-wide potential gain of $1.3 trillion (hospital care (31%) and physician/clinic services (21%) comprise 52% of the total). If Accretive could capture only 5% of this opportunity they would have a total potential market of $65 billion. Size matters. These modest percentages translate into colossal numbers.

According to the company’s prospectus 43% of hospitals have a negative operating margin and 73% have reduced their capital spending due to lack of funds. In addition, approximately 20% of net patient revenue is uncompensated care. Again, assuming a 5% capture rate, this represents a $13 billion potential opportunity.

As a general rule, if a customer’s yearly revenue is at least $1 billion they expect to earn 5% (4% base fees + 1% incentive fees) once their contract matures (2-3 years). For quality and total cost of care customers the figure is 6% (1% base fees + 5% incentive fees).

For FY10, Accretive revenues consisted of 86% base fees, 12% incentive fees and 2% other.

The company’s value proposition is enabling healthcare institutions to improve their operating margins by helping them improve their net revenue yield, increase their charge capture (making sure all services delivered are included in the patient bill) and making their revenue cycle operation more efficient. The efficiency is gained by implementing advanced technologies, streamlining operations and avoiding unnecessary re-work. Cost reductions are achieved by implementing their proprietary technology and procedures (automation), moving selected processes to shared operating facilities (efficiency) and transferring certain 3rd party services, like Medicaid eligibility review, to Accretive’s operations center (scale advantage).

They employ 5 principal techniques to improve their customers’ operating performance:

  1. Gathering complete patient and payer information. Accretive’s systems automatically measure the completeness and accuracy of up-front patient profile information and other data, including billing and collections data, throughout the lifecycle of every patient account. Their customers typically achieve rates of 90% + for the percentage of non-emergency in-patient admissions that have complete information profiles. This improves cash flow by avoiding billing delays and reducing billing cycles.
  1. Improving claims filing and 3rd party payer collections. The company employs their proprietary algorithms and modeling to determine how the customer should allocate time and resources across a pool of outstanding claims prioritized by risk level. This prioritization scheme results in increased reimbursement.
  1. Identifying alternative payment sources. They use various methods to find payment sources for uninsured patients and reimbursement for services not covered by 3rd party insurance. After the implementation period, their customers are able to find a 3rd party payment source for ~85% of admitted patients who identified themselves as uninsured.
  1. Employing proprietary technology and algorithms. Their data analytics and predictive models streamline collections operations by focusing the effort on those accounts with the highest probability of increasing revenue yield or charge capture.
  1. Using analytic capabilities and operational excellence. They train customer staffs on best practices in their revenue cycle operations.

The company was founded in July, 2003, as Healthcare Services, Inc. In August, 2009, they changed their name to Accretive Health, Inc. Their IPO was consummated in May, 2010. The first trading day was May 20. They completed a secondary offering of 6.5 million shares in March, 2011. All shares sold in the secondary offering were by existing shareholders. The company received no proceeds.

So what do the numbers look like? Here are the results from the last 5 FY’s:

2010

2009

2008

2007

2006

(000's)

(000's)

(000's)

(000's)

(000's)

CAGR

Net Services Revenue

39.4%

606,294

510,192

398,469

240,725

160,741

Cost of Services

35.5%

478,276

410,711

335,211

197,676

141,767

Operating Margin

61.1%

128,018

99,481

63,258

43,049

18,974

Operating Expenses

39.8%

105,700

81,916

60,461

43,529

27,652

Operating Income/Loss

263.9%

22,318

17,565

2,797

(480)

(8,678)

Income taxes/Int Inc/Exp

62.2%

9,700

2,975

1,554

1,710

1,359

Net Income

248.3%

12,618

14,590

1,243

774

(7,319)

Basic Fully Diluted EPS

0.13

0.33

0.03

0.02

(0.28)

Preferred Stock Dividend

0

8,044

8,048

0

0

Net Fully Diluted EPS

0.13

0.15

(0.19)

0.02

(0.28)

ROE

8.8%

68.6%

15.7%

4.9%

NMF

ROA

4.8%

14.1%

1.4%

1.3%

NMF

Net Services Revenue

100%

100%

100%

100%

100%

Cost of Services

79%

81%

84%

82%

88%

Operating Margin

21%

19%

16%

18%

12%

Operating Expenses

17%

16%

15%

18%

17%

Operating Income/Loss

4%

3%

1%

0%

-5%

Income taxes/Int Inc/Exp

2%

1%

0%

1%

1%

Net Income

2%

3%

0%

0%

-5%

These numbers reflect an attractive growth stock story. Top line sales are growing at ~40%/year and net income at ~250%. Cost of services is growing at a lower rate than revenue which is what you would expect as their scale advantage grows. The only negative is the fact that operating expenses are growing at the same rate as revenue, albeit from a smaller base. Ideally, this would be a lower number. The investment returns are decent but not world class yet. Accretive’s business will never boast fat Apple (NASDAQ:AAPL)-esque margins, though, because their customers will always insist on their fair share of the pie. The upside here is the sheer size of the potential market. The top line numbers are so huge that even modest returns will drive the share price upward if they continue to close new business at a decent rate.

Cash flow looks good as well. I always insist on a minimum CF/NI ratio of 1.2 in any investment candidate. A healthy company should always be generating at least 20% more cash than earnings. For the most recent 3-year period Accretive’s ratio is a robust 3.0.

In reviewing the balance sheet I see only one negative. The Q2 accounts receivable line item has ballooned to $92 million from ~$54 million at the end of December. According to the company ~$22 million of this is Ascension Health, a large hospital group that is their charter customer and an owner of 7.4% of Accretive’s stock. This may mitigate the situation a bit, but AR has still increased $16 million or 30% in 6 months without the Ascension piece. They consumed ~$28 million in cash over the period because of a deficit of $38 million in AR.

In the IBD database, Accretive Health has a current market cap of $2.3 billion which is 3.4 times ttm sales. It ain’t cheap but the fundamentals are attractive so this is a reasonable and customary valuation. Its EPS rating is 99 (the top 1% of all stocks) and relative strength of its industry group, Commercial Services – Healthcare, is rated A- indicating strong market support.

Is it time to buy? Well, no. The company’s accumulation/distribution rating is D- which means that there has been recent heavy selling. Also, its RS line is trending down. And let’s not forget the general market. Although it’s in a confirmed uptrend there is hardly any healthy action. Large up/down swings on atypical volume is not what you want to see. If the market settles down then you should wait for Accretive’s chart action to improve before taking a position. It hasn’t even begun to build a good base yet.

I’ve put Accretive Health on my potential buy list. They are well positioned with enormous upside potential. This stock is a good defensive play as well. There is an acute need for their services in an economic-cycle-resistant industry. Sweet.

Source: Accretive Health: Rx For Hospitals' Bottom Line