First Health Group - Short Squeeze!

First Health Group (FHCC) got a nice little pop today, closing at 21.12 up over 10%. The catalyst was an earnings call that apparently scared the hell out of some short sellers. The company reported a nice rise in 4Q earnings per share (up 14%), as well as some fairly decent yearly results EPS (up 22%). The funny part of this announcement was the fact that management predicted flat EPS growth for 2004, despite signing up new customers.

The reason for the dramatic price increase was the result of some seriously misguided panic selling in November, when the company warned of weakening results in the near future. Adding to the misery was outright hostility to any company touching managed health care. President Bush's Medicare overhaul was cutting reimbursements, the evil drug companies were getting raked over the coals by any politician with a pulse (which is why I know it's an election year), and rising health costs were threatening to tear the very fabric of this fine country asunder! So, when you are the CEO of a "managed care" company, and you say that the numbers are coming in a little light, you watch the investment dollars fly out of the room like roaches fleeing the exterminator.

Why "misguided?" While I don't personally know the panic-stricken sellers of this company's stock, I can guess that a lot of them haven't read their SEC form 10-K, which outlines their detailed business plan in several pages of 8 point font. What I saw looked pretty good, earnings growth or not:

1. The company does not take significant "claims risk" like a regular HMO, which takes a stream of payments from the client and prays they don't get cancer or diabetes. Rising costs are bad for HMO's, because the cost of care rises faster than they can increase premiums. FHCC is a processor. They actually get paid by saving the client (insurer, corporation, government agency, etc.) money. The more that costs go up, the more opportunity to save the client money. Their forte is billing, claims processing, administration, etc. (although they do have some small risk-based contracts.)

2. Strong Free Cash Flow (which is NOT EBITDA!!!) or cash flow from operations minus capital expenditures. First Health generates mucho cash flow, but generally doesn't need to reinvest it all, since they can only purchase so many computers!

3. Good use of Free Cash Flow. First, the company looks for small companies to buy and integrate. They spent $91MM in 2003 alone. Normally, I am very wary of serial acquirers, or "rollups." Many companies have rolled themselves right into bankruptcy by botching integration and overleveraging, but FHCC is doing it right (for now, at least). I read a great article today in Section B of the Wall Street Journal by two partners at Bain & Company talking about acquisitions (and criticizing Comcast's bid for Disney.) First Health seems to meet all of their requirements for "companies that create significant shareholder value through acquisitions":

a) They make it a point to do lots of deals b) They do little deals (less than 10% of market cap) c) They do friendly deals d) They stay close to the core business e) The strategy is easy to understand

Now, I won't be so bold as to assume that there isn't risk in this practice, but the company is not being blatantly foolish with shareholder's money, especially since they buy back stock at every opportunity. One hint that the company may be undervalued - First Health took out a loan to buy $216MM of stock in 2003.

4. Stunning margins/return on capital. Based on yearly results, here are First Health's key numbers:

a) Operating Margin: 28% b) Return on Assets: 18% c) Return on Equity: 37%

That is why the company is drowning is cash flow!! My only concern is competition (or their customers) catching on and taking a whack at prices.

5. A decent price. When I look at a company, I pretend that I am a corporation that would buy all of the stock. A common yardstick for private market value (thanks Tweedy Browne!) is EV/EBIT (Enterprise Value/Operating Profit) of about 10x for an "average" company. An all cash deal that would retire the debt and get any balance sheet cash back would get a 10% pretax ROE. I would think that, given First Health's margins and cash flow, they would probably deserve a slightly higher multiple, maybe 11-13x EBIT. Right now, it trades at an EV/EBIT of 9.21x, which isn't bad. Those who bought in 2 days ago pretty much stole the company!

So what are the risks?

1. Watch the margins! Competition may chip away at them.
2. They may buy a bad apple or two, which could hurt.
3. They seem to be creeping into the risk-based business, which I don't think is their core competency. Their strength comes from not being an HMO.