Oak Street Health: Bar Of Expectation May Be Set A Little Too High
Summary
- Oak Street is pioneering a new approach to primary care provision for Medicare patients managing chronic conditions.
- The company operates branded healthcare centers supported by a digital data analytics platform focused on providing cost-effective, streamlined, value-based care.
- Oak Street is based in Chicago and raised $328m in an August '20 IPO to fund expansion into new territories, followed by an $800m convertible debt offering.
- The company has ambitious growth plans, operating almost like a franchise, as a middleman between payors, providers, and patients.
- At current price of $62, and market cap >$15bn, I think Oak Street could struggle to meet the market's growth expectations, but an entry point of ~$50 could be attractive.
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Investment Thesis
Oak Street Health (OSH) looks to be a strong emerging player in the primary care sector, albeit with a share price to match.
Oak Street IPOd in August last year, raising $328m at a price of $21 per share, and its shares trade at $63 at the time of writing, representing a 200% gain in a little over eight months.
The Chicago-based business was founded in 2012 with a mission to "build a primary care delivery platform that directly addresses rising costs and poor outcomes, two of the most pressing challenges facing the United States healthcare industry," administered via a network of physical health centers.
Management estimates the company's addressable market to be 27m Medicare members in its target demographic, which translates to a market opportunity of ~$325bn in annual healthcare spend (~$12,000 per member).
The target demographic is lower income Medicare eligibles primarily using Medicare Advantage with a high prevalence of chronic conditions - a population which Oak Street believes is underserved, pointing to the lower life expectancy in the US compared to other developed countries (78.6 years compared to 82.2 years) and the rise in chronic conditions such as obesity, diabetes, hypertension, and mental health conditions including depression and isolation.
Essentially, Oak Street - which currently operates 79 primary care centers across 16 markets catering for ~97k patients - believes that it can improve patient outcomes while reducing overall healthcare spend by investing more in primary care - which currently accounts for ~$25bn, or 3% of current Medicare expenditure, in order to save on hospitalization costs - which its research shows accounts for $455bn, or >85% of expenditure.
Leveraging its proprietary "Canopy" data and analytics platform to focus on concepts such as population health management, value based care, omnichannel communications and cross-team collaboration, Oak Street's goal is to serve patients better and benefit from the resultant cost savings, while increasing membership by identifying and targeting underserved populations and building more local care centers to cater for them.
Oak Street works with Medicare plan providers, entering into globally capitated or full risk contracts and receiving a percentage of each plan members' monthly premium on a fixed basis, providing patient-centric care while streamlining costs and eliminating wasteful spending via its platform, theoretically resulting in improved patient outcomes and a net profit to the company.
Its largest clients are the health insurance giants Humana (HUM), WellCare/ Meridian and Cigna (CI) HealthSpring - these three payors accounted for 71% of Oak Street's $882m of revenues in FY20 (up 59% year-on-year), with Humana alone accounting for 45% of revenues.
Oak Street's growth story has been phenomenal to date - the company operated just two centers catering for 300 patients in 2013, rising to 79 centers, and 97k patients by the end of last year - and its growth drivers are if anything more compelling - management believes its target market is only ~3% penetrated and considers its platform-based business model to be highly scalable, and capable of supporting as many as 1,300 centers.
This explains why Oak Street's current market cap valuation of $15.2bn runs some way ahead of its current intrinsic value, calculated using e.g. a discounted cash flow or EBITDA multiple model.
Oak Street's price to sales ratio is ~17x - far higher than its health insurer clients who tend to have P/S ratios <1x. The company also is loss making - reporting net losses of -$192m and -$109m in 2020 and 2019 respectively, with operating expenses of $1.1bn in FY20 accounting for 121% of revenues.
Although it reported no debt as of 4Q20, Oak Street has since issued $800m of convertible notes to private institutional investors, albeit they are non-interest bearing, with a conversion price of ~$79.16 per share.
Finally, Oak Street has a high share count of 241m, which is why, even assuming a long-term revenue growth rate of 35% per annum, coupled with a 5% per annum reduction in OPEX as a percentage of total revenue, my DCF / EBITDA analysis model implies a present day firm value of $5.6-$8.1bn, and a present day fair value share price of ~$29 - less than half the current trading price.
That neatly encapsulates the bet that investors are taking when opening a position in Oak Street. On one hand you have a business that has grown top line revenues by 75% and 59% over the past two years, and is forecasting growth of 47% in FY21, with the number of primary care centers in operation expected to rise to a forecast 117 - 121.
The business is targeting a large and growing market in Medicare Advantage- spending within the sector is expected to grow at 7% per annum - with a first-mover advantage and a range of blue-chip health insurer clients, as well as an opportunity to move into direct contracting with the Centers for Medicaid and Medicare ("CMS").
On the other hand, you have a model that's largely untested at scale, is not yet profitable, and will likely require high levels of investment to achieve the kind of market share and revenue growth that supports its current high valuation. For context, Oak Street's market cap is 4x smaller than Humana's, but Humana's revenues of $77.2bn in FY20 were 88x greater than Oak Street's revenues.
At the beginning of March, Oak Street stock traded at $50, and analysts consensus price target range is $62 - $79. As such, much may depend on the company's performance across the remainder of 2021. Management may need to exceed its own forecasts in order for Oak Street's share price to grow much higher, whilst any signs that growth is beginning to plateau may result in downside momentum.
I'm therefore remaining neutral on Oak Street at this time, but if the stock were to touch recent lows of $50 while earnings indicate that goals are being met, I would consider an investment worthwhile, based on adding goodwill, market tailwinds etc. into the valuation equation. In the rest of this article I will take a deeper dive look at the company, market opportunity, growth strategy and valuation, and highlight some potential risks and catalysts to look out for.
Oak Street Overview
Arguably, the increasing use of technology-enabled products and services has had less impact on the healthcare services sector than almost any other industry.
Although companies like Teladoc (TDOC) are pioneering the use of telemedicine and holistic healthcare, there remains significant doubt over whether the industry can be automated in the way that e.g. commerce or finance have been, due to its high administrative burden, the sensitivity of patient data, risks associated with asking machines to do the work of physicians, and patient's preference to physically visit a doctor when they have a health condition.
There's much that can be done to improve the use of technology as a behind-the-scenes enabler of value-based care, leading to improved patient outcomes however, which is key to Oak Street's business strategy.
Oak Street's care model. Source: Oak Street investor presentation.
Oak Street's care model features a "Data IQ" model which uses >400 data analytics tools to precisely determine each of its members' patient risk level and the level of care required, allowing all of the company's stakeholders - patients, payors, providers, and the company itself, to "win."
Oak Street says its proactive approach has resulted in a 51% reduction in hospital admissions, and improved overall patient experience (reflected in a net promoter score of 90, compared to an industry average of 3), which results in savings to payors, and better quality scoring (which helps payors negotiate better Medicare deals with the CMS), while providers enjoy higher levels of job satisfaction and technology enabled support, plus the prospect of higher overall compensation.
The virtuous circle is completed by Oak Street itself, enabling it to grow all areas of its business and earn a substantial margin which management estimates to be >25% in centers with >2k at-risk patients.
How Oak Street earns profit margins. Source: investor presentation.
Oak Street's branded health centers are placed in accessible, convenient locations based on algorithmic assessments of population health statistics and local knowledge input from payors, and its Care Teams are comprised of a "Primary Care Physician or Nurse Practitioner who is partnered with a Registered Nurse, a Medical Assistant and a Scribe to deliver value-based, coordinated care."
The centers also are staffed with community-based outreach associates and employ a mix of marketing channels to try to attract new members and drive referrals. In essence, Oak Street operates as a kind of franchise business for healthcare providers who are able to join a ready-made practice with a lower administrative burden and access to scalable value-based care technologies, as opposed to attempting to build their own clinics from scratch.
Presently, Oak Street employs ~3,200 team members, 300 of whom are primary care providers. The success or otherwise of Oak Street's model is dependent on the company's ability not only to attract new members, but to attract qualified and capable physicians to serve these populations.
Market and Competition
Oak Street market opportunity. Source: investor presentation.
As shown above, there are few question marks in relation to Oak Street's addressable market, with a pool of 27m patients to attract and an aging population increasing the market size on a daily basis.
Oak Street contracts with ~25 payor partners altogether, including the top five in Medicare Advantage (according to the company's 2020 10K submission), which is impressive for a company that only began accepting fully capitated contracts in 2016, and provides attractive recurring revenue streams.
The company certainly seems to enjoy a first mover advantage in its market, listing ChenMed and IoraHealth as its chief competitors - neither company has gone public, which may restrict their access to growth capital - on the primary care front, as well as independent practices.
To justify its high levels of expenditure on technology and marketing Oak Street's business model needs to succeed at scale, however.
Presently the company's operations are almost exclusively focused in Chicago, although 2 clinics have been opened in Ohio and management expects to expand into New York and Mississippi. Oak Street also has three clinics located within Walmart stores, which is an interesting development comparable to CVS Health's Minute Clinics, perhaps.
Direct contracting with CMS also is a growing area of Oak Street's business - this is a test model being trialled over a seven-year period aimed at reducing expenditure and enhancing quality of care, and Oak Street has 7-8k members in this scheme, and expects to add 2-3k members per quarter during 2021.
My understanding here is that direct contracting cuts out the insurance payor middle man, which would be beneficial to Oak Street, but also could damage its relations with its payor clients.
In fact, my main concern in relation to Oak Street's business model would be whether the healthcare industry needs yet another administrative layer between payor and patient.
Although Oak Street's illustrative economics in the slide above show how all of the different stakeholders take a portion of the CMS' payments to Medicare Advantage plans, with Oak Street retaining whatever is left after it has administered its products and services as profit, health insurers typically earn low profit margins, while their substantial scale delivers high EPS and profitability for shareholders.
Oak Street Health vs Health Insurers and other complementary health insurer service providers. Source: my table using data from Google Finance, TradingView.
In other words, Oak Street may find it hard to generate a profit margin as a "middleman" service provider generating revenues in the single-digit billions, with its clients under pressure to earn their own margins, and its employees requiring additional compensation / cost savings in order to be persuaded to align with Oak Street as opposed to working independently.
This is typical of the economics of most franchise type models, but with its extra spending on marketing and expansion, which resulted in a -27% profit margin in FY20, it's hard to determine if Oak Street will be able to achieve satisfactory margins at the present time, particularly as it moves from a familiar territory in Chicago, to new locations with different market dynamics.
Valuation
It seems unlikely that Oak Street would be permitted to earn high profit margins by a healthcare industry that often faces criticism for being too profit driven, and as such I believe there is a limit to how much OPEX can be reduced and revenues increased going forward.
Oak Street Health forecast income statement. Source: my table and assumptions using historic company financials, management guidance.
As such for my DCF / EBITDA multiple model I have used the midpoint of management's FY21 revenue forecast for $1.3bn of revenues, and set a 5-year growth CAGR of 35%, and a CAGR for OPEX of 25%. That provides a total revenue figure of $5.8bn by FY26, with OPEX of $4.5bn, and a net profit of $1.1bn, and margin of 18.4% - as high as I think may be achievable.
After adding depreciation (1.3% of revenues as per prior years) and deducting tax (I am using an estimated tax rate of 16%) my free cash flow figures are -$196m in FY21 - close to the midpoint of management's forecast range of -$165m - -$215m, and $1.1bn by FY26. I'm using a weighted average cost of capital of 14.4%, which is based on a risk free rate of 1.67%, expected market return of 15% and beta of 1, and after applying discount factors I calculate a firm value of $5.6bn, and present day share price value of $23.
Using the EBITDA multiple method and an estimated industry multiple of 12x, I calculate a firm value of $8.1bn and present day share price of $34.
Conclusion
My growth forecasts may be well short of Oak Street management's. To match the current trading price, a revenue growth CAGR of ~65% would be required by my calculation, and given annual growth Oak Street's recent $800m capital raise, market headwinds and platform scalability, that figure does seem achievable - in fact it's more or less the average of the past two years annual growth.
With that said, the scalability of the health care centers themselves is less compelling, in my view, when we consider that Oak Street is targeting new territories, although its property leasing model and partnership with Walmart (WMT) may result in a supercharged rate of expansion.
That appears to be the market's view, but when a CAGR of 65% per annum needs to met in order to support the current share price, I would not be overly confident that Oak Street's valuation will deliver sufficient upside to make it a worthwhile short-to-medium term investment opportunity at the current time and at the current price.
Looking longer-term, if, in five year's time, Oak Street centers could be found within municipal locations across e.g. 15-20 states, with >500 in operation, and relations with the top 5 major healthcare payors cemented, Oak Street's model would look significantly de-risked and attractive to investors.
As such I believe there are pros and cons to an investment in Oak Street, but the growth trajectory required to support upside looks a little too steep for me at this time, and the company's 241m share count also significantly dilutes the shareholder value. A dividend or share buyback using some of its extra funding would be welcome, but these funds are likely to be allocated to driving growth instead.
Oak Street has forecast revenues of $280-$285m in Q121, and expects to add 5-6 new centers during the quarter and ~40 across the full year. The growth is impressive, but based on the available evidence, possibly not quite fast enough to justify a $15bn market cap.
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This article was written by
Edmund Ingham is a biotech consultant. He has been covering biotech, healthcare, and pharma for over 5 years, and has put together detailed reports of over 1,000 companies. He leads the investing group Haggerston BioHealth.
The group is for both novice and experienced biotech investors. It provides catalysts to look out for and buy and sell ratings. It also provides product sales and forecasts for all the Big Pharmas, forecasting, integrated financial statements, discounted cash flow analysis and market by market analysis. Learn more.Analyst’s Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.
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