Healthways, Inc. (HWAY) provides specialized, comprehensive solutions to help people improve their well-being, thereby improving their health and productivity and reducing their health-related costs (Source: Company 10k 03/14/2014).
Based on our Economic Value model and Monte Carlo simulation, our probability distribution of "fair value" for HWAY affirms that the current share price of $16.02 is overvalued (as of 3/14/2014). The expected value of the share price based on the mean and median is estimated to be $9.13 to $8.98, respectively (Table 1).
Table 1: Monte Carlo Simulation - Statistics
(Figure 1) While GAAP EPS has rebounded (red line) along with the share price (green line), Economic Value (also known as Economic Profit, Economic Value Added, or EVA) per share (blue line) continues to decline.
Figure 1: Price, EPS, Economic Value Per Share
As a result, we anticipate that a continued decline in Economic Value will result in a share price with a skewed distribution to the downside (Figure 2).
Figure 2: Historical Share Price and Forecast
Hence, the probabilities of realizing a 20% return from either a long or short position is as follows (Table 2):
- Long: approximately 0% chance of 20% Return or Higher. 100% chance of a loss.
- Short: approximately 93% chance of 20% Return or Higher. 0% chance of a loss.
Table 2: Monte Carlo Simulation Probabilities
MARKET EXPECTATIONS VERSUS ECONOMIC REALITY
To further validate and provide context to the reasonableness of our analysis, we compare market expectations versus actual operating performance of the company relative to a peer set.
The peer set selected is from a universe of companies based on S&P Capital IQ's Health Services industry classification. Where possible we include up to 30 peers in order to get a better statistical sample. For this analysis our peer set includes: Accretive Health, Inc. (AH), Addus HomeCare Corporation (NASDAQ:ADUS), Air Methods Corp. (NASDAQ:AIRM), Alliance Healthcare Services, Inc. (NYSE:AIQ), Almost Family Inc. (NASDAQ:AFAM), Amedisys Inc. (NASDAQ:AMED), AMN Healthcare Services Inc. , Bio-Reference Laboratories Inc. (NASDAQ:BRLI), BioScrip Inc. (NASDAQ:BIOS), Catamaran Corporation (NASDAQ:CTRX), Chemed Corp. (NYSE:CHE), CorVel Corporation (NASDAQ:CRVL), Cross Country Healthcare, Inc. (NASDAQ:CCRN), DaVita HealthCare Partners Inc. (NYSE:DVA), Envision Healthcare Holdings, Inc. (NYSE:EVHC), ExamWorks Group, Inc. (NYSE:EXAM), Express Scripts Holding Company (NASDAQ:ESRX), Gentiva Health Services Inc. (NASDAQ:GTIV), Healthways Inc. , IPC The Hospitalist Company, Inc. (NASDAQ:IPCM), Laboratory Corp. of America Holdings (NYSE:LH), Landauer Inc. (NYSE:LDR), LHC Group, Inc. (NASDAQ:LHCG), MEDNAX, Inc. (NYSE:MD), National Research Corp. (NRCI.B), Omnicare Inc. (NYSE:OCR), Providence Service Corp. (NASDAQ:PRSC), Quest Diagnostics Inc. (NYSE:DGX), and Team Health Holdings, Inc. (NYSE:TMH).
Market expectation can be observed through Market Value Added (MVA), which is the Market Value (Debt plus Market Value of Equity) less the Capital invested, and represents shareholders' expectations of the future stream of Economic Value or Discounted Cash Flow (DCF) that the business will generate. Mathematically the Net Present Value of a DCF is always equal to the Present Value of Economic Value. Consequently, we can calculate the Implied Economic Value Growth in MVA (Table 3) embedded in the current share price. HWAY's Implied Growth in MVA is at the very bottom.
Table 3: MVA and Economic Value Ranking
Similarly, adjusting Economic Value for both size in Capital (-13.7%) and Revenue (-18.9%), HWAY's operating performance is also at the bottom (Table 4).
Table 4: Economic Value Ranking
Although market sentiment of negative growth seems to be consistent with the company's inability to create Economic Value, the stock price still reflects an exceedingly optimistic view.
ECONOMIC VALUE DRIVERS AND PERFORMANCE
To determine whether the company's recent performance will be a good indicator of future performance, we take a deeper look into the drivers of Economic Value. (Table 5) Unfortunately, the company is poorly ranked on both Revenue Growth (-2.1%), and Return on Capital (0.1%).
Table 5: Drivers of Economic Value
(Figure 3) Since 2009 HWAY's Revenue Growth (solid black line) has been flat to negative (for more detail see Table 6 under Valuation Assumptions).
Figure 3: Revenue Growth Benchmarked Against Peer Set
However, (Figure 4) HWAY's profitability or Spread (solid black line), which is the Return on Capital less the Cost of Capital, has declined below the 90% confidence interval.
Figure 4: Spread Benchmarked Against Peer Set
The decline in Spread is attributable to both a decline in Return on Capital and an increase in the Cost of Capital.
Return on Capital is driven by both NOPAT Margin and Capital Turns. (Figure 5) HWAY's NOPAT Margin (solid black line) has declined significantly and is toward the bottom of the 90% confidence interval.
Figure 5: NOPAT Margin Benchmarked Against Peer Set
Comparatively, (Figure 6) HWAY's Capital Turns (solid black line) has remained toward the lower interquartile range of its peers.
Figure 6: Capital Turns Benchmarked Against Peer Set
The company's decline in NOPAT Margin has been the key contributing factor in its declining Return on Capital (Figure 7).
Figure 7: Return on Capital Drivers - NOPAT Margin and Capital Turns
In particular, the company's Cost of Services Sold as a percentage of Revenue has increased to 82.5% from a low of 68.5% as recent as 2010 (Figure 8), which has caused Gross Profit Margin as a percentage of Revenue to decline from 31.5% in 2010 to 17.5% in 2013.
Figure 8: Cost of Services Sold as % of Revenue
As a result of the deteriorating operating performance, the financial risk of the company has increased, which is reflected in the Cost of Capital (Figure 9). The company's Cost of Capital (black solid line) has increased significantly, well above the 90% confidence interval of its peer set.
Figure 9: Cost of Capital Benchmarked Against Peer Set
The combination of poor operating performance and high leverage has increased the risk of default, which can be illustrated in its declining Interest Coverage Ratio (Figure 10).
Figure 10: Interest Coverage Benchmarked Against Company's Own Historical Performance
As a result, the company's Cost of Debt and Cost of Equity have both increased the Weighted Average Cost of Capital, which is placing additional financial distress over and above the company's deteriorating operating performance.
Although past performance is not always indicative of future performance, historical data can provide a good estimate of the range of possibilities. The ranges we use for our key drivers of Revenue Growth, Spread, NOPAT Margin and Capital Turns represents our 90% confidence interval. For each scenario of our valuation, a random value is generated for the drivers of our discounted Economic Value model (Figure 11).
Figure 11: Overview of Economic Value and Monte Carlo Simulation
These random values are based on reasonable ranges derived from Trailing Twelve Month (TTM) 10-year historical distributions of company and peer data. While point estimates are often "precisely wrong," range estimates provide a more realistic view of market variability and have a greater chance of the actual outcome falling within the estimated range. Additionally, we scrutinize the inputs of our Monte Carlo simulation through our Economic Value calculation, where adjustments are made to accounting statements to more accurately reflect the economics of each driver.
In some cases where our initial assumptions generate a valuation substantially different from the current trading price, we attempt to be conservative and create a margin of safety by taking an optimistic outlook for a short position or a pessimistic outlook for a long position. In the case of HWAY, despite our optimistic projections for the key drivers, the company remains a clear short (Figure 12).
Figure 12: Monte Carlo Simulation - Fair Value Distribution
Our range assumption of 4 to 15% for Revenue Growth is fairly optimistic given the current trend (Table 6).
Table 6: Revenue Growth - Range Assumptions
(Figure 13) Most recently HWAY's TTM quarterly Revenue Growth has declined, settling at approximately -1.9%, which is around the 25th percentile of its historical performance.
Figure 13: Revenue Growth Benchmarked Against Company's Own Historical Performance
(Figure 14) However, we aggressively projected that Revenue Growth would range from 4 to 15% beyond the first year.
Figure 14: Revenue Growth -Historical and Projections
The distribution of Revenue Growth in our Monte Carlo simulation (black solid line) overlaid against the distribution of the peer set (dark blue dotted line), IPCM (light blue dotted line), and the company's historical performance (orange dotted line), shows how our overall Revenue Growth estimates compare to different benchmarks (Figure 15). Despite the recent decline in Revenue Growth, the Monte Carlo distribution is in line with the industry and the company's historical performance.
Figure 15: Revenue Growth - Forecast Monte Carlo Distribution versus Historical
Again, our estimates of Spread exhibit a fairly optimistic view, when compared to historical performance (Table 7).
Table 7: Spread - Range Assumptions
(Figure 16) Most recently, HWAY's TTM quarterly Spread has declined below the lower bound of the 90% confidence interval.
Figure 16: Spread Benchmarked Against Company's Own Historical Performance
(Figure 17) Despite recent historical negative Spread, we optimistically forecasted that Spread would climb to a range of 0 to 3% into perpetuity.
Figure 17: Spread - Historical and Projections
The distribution of Spread in our Monte Carlo simulation (black solid line) overlaid against the distribution of the peer set (dark blue dotted line), IPCM (light blue dotted line), and the company's historical performance (orange dotted line), shows how our overall Spread estimates compare to different benchmarks (Figure 18). The Monte Carlo distribution is representative of the company's recent trend.
Figure 18: Spread - Forecast Monte Carlo Distribution versus Historical
Our range assumption for NOPAT Margin is also optimistic (Table 8).
Table 8: NOPAT Margin - Range Assumptions
(Figure 19) Most recently, HWAY's TTM quarterly NOPAT Margin has fallen below the 90% confidence interval.
Figure 19: NOPAT Margin Benchmarked Against Company's Own Historical Performance
(Figure 20) We forecasted that the range in NOPAT Margin range would be between 4 to 7% for the next 5 years and then extend beyond the 90% confidence interval to form an optimistic "hockey stick" outlook.
Figure 20: NOPAT Margin - Historical and Projections
(Figure 21) The NOPAT Margin distribution in our Monte Carlo simulation (black solid line) overlaid against the distribution of the peer set (dark blue dotted line), IPCM (light blue dotted line), and the company's historical performance (orange dotted line), shows how our overall NOPAT Margin estimates compare to different benchmarks. The Monte Carlo distribution takes a similar shape as the company's historical performance and its peer set, but with higher upside.
Figure 21: NOPAT Margin - Forecast Monte Carlo Distribution versus Historical
Our range assumption for Capital Turns is in line with the company's recent historical performance (Table 9).
Table 9: Capital Turns - Range Assumptions
(Figure 22) Most recently, HWAY's TTM quarterly Capital Turns has declined close to the 25th percentile of its historical performance.
Figure 22: Capital Turns Benchmarked Against Company's Own Historical Performance
(Figure 23) Similarly, we forecasted that Capital Turns would remain near the 25th percentile after the first projected year to a range of 0.76 to 0.80x.
Figure 23: Capital Turns - Historical and Projections
(Figure 24) The Capital Turns distribution in our Monte Carlo simulation (black solid line) overlaid against the distribution of the peer set (dark blue dotted line), IPCM (light blue dotted line), and the company's historical performance (orange dotted line), shows how our overall Capital Turns estimates compare to different benchmarks. The Monte Carlo distribution is in line with the company's historical performance and its peer set.
Figure 24: Capital Turns - Forecast Monte Carlo Distribution versus Historical
HWAY remains a short despite an optimistic outlook. Further support for our short position can be observed through two key strategic forces, namely the industry's market economics (average Industry Spreads) and the company's competitive position (Company Spread minus Market Economics). The analysis concludes the following (Figure 25):
- Market economics has worsened.
- HWAY's competitive position is negative.
- HWAY's competitive position is worsening.
Figure 25: Market Economics versus Competitive Position
Key challenges to the company's competitive position are as follows:
- Declining revenue due to contract terminations (10k 03/17/2014, pg. 31).
- Declining NOPAT Margin due to the increased Cost of Services Sold, which is a function of retaining customers with a higher cost to serve and losing customers with a lower cost to serve (10k 03/17/2014, pg. 32).
- HWAY's stock price has experienced an unwarranted 24.4% run up in the last twelve months (as of 3/14/2014), which is not commensurate with its ability to create value, making it a strong candidate for a correction. This will increase the company's debt to market value ratio, which in turn will increases the company's leverage and possibly reduce it's credit rating, which in turn would further increase the Cost of Capital. All of which can increase the likelihood of greater financial distress.
Disclosure: I am short HWAY, EXAM. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: I am long: BRLI, LHCG.