2023-07-19 18:43:45 ET
Summary
- Evolent Health's sales and profitability are creeping back above pre-pandemic levels.
- The company's recent acquisitions have added incremental value, with revenues up 44% YoY and adjusted EBITDA up 94% with their inclusion.
- Net-net, reiterate buy.
Investment Briefing
Following my last publication on Evolent Health ( EVH ), numerous updates to the investment thesis have come across my desk. As a result of these changes to the critical facts, I am reiterating my bullish stance on the company going forward.
EVH presents with economic characteristics that are shifting higher as time rolls on. In particular, both sales and profitability are demonstrably above pre-pandemic levels. The firm also remains committed to its "3 core operating priorities", namely 1) organic growth [ex-acquisitions]; 2) expanding margins; and 3) optimal capital allocation. Priority (3) appeals to my own investment tenets, and I'll be running through the reasons why in today's analysis.
Net-net, I continue to see long term value in EVH, and reiterate it as a buy, eyeing price objectives of $35 then $40.50.
Figure 1. EVH price evolution [weekly bars]
Data: Updata
Risks to investment thesis
The following risks must be understood by investors in full before proceeding:
- EVH may not produce the guidance numbers it outlined in the last earnings report, thereby compressing its valuation upside.
- Markets are still digesting a series of macro-risks, including interest rates, inflation, and geopolitical risks.
- We can't discount the impact of EVH's recent acquisitions being a drag on earnings growth and equity performance.
These risks could very well nullify the investment thesis laid out here today, and thus must be recognized in their entirety.
Updates to critical investment facts
There's a lot to unpack here, so it's best to start with the company's latest numbers, extrapolate what this means going forward, and make inferences on the firm's intrinsic valuation and market sentiment from these. I will say, that EVH's Q1 FY'23 figures were strong— revenues were up 44% YoY to ~$428mm on adj. EBITDA of $50.5mm, up 94% YoY.
1. Breakdown of financials
In light of the above, I would note the following points:
- The growth rates include contributions of $48.5mm from NIA, which was settled in January this year. For reference, NIA is a specialty benefit management organization ("SMO"), with a footprint in radiology, musculoskeletal, physical medicine and genetic markets.
- Excluding the acquisition contributions, EVH's run rate was ~28% YoY. Critically, this fell in line with management's guided range of 25%—28% for the entirety of FY'23.
Based on this, management raised its FY'23 guidance to $1.935—$1.966Bn at the top line on $200mm in adj. EBITDA at the upper end of range. This to me is also a bullish sign, given the firm's confidence in doing so.
Perspective of the company's growth efforts is gained when utilizing a look back window to FY'16. Taking the first quarter of each year from FY'16—'23, several critical observations are made [Table 1].
For starters, quarterly revenues have stretched up from $49.5mm to $427.7mm in that period, therefore adding $378.2mm in turnover in 6 years, with $277mm of this Q1 total produced in the last 3 years.
Secondly, the absolute numbers are increasing, but the pace at which they are doing so is too. Q1 revenues were up 8.2% YoY in FY'18, then 31% in FY'19, 38% in FY'22, finally hitting the 44% growth last period. This is clear evidence of the fundamental momentum EVH is building moving forward.
Table 1.
Data: Author, EVH SEC Filings
2. Unit economics
EVH's unit economics support the findings from above. To illustrate, consider the following points:
- Memberships and per member per month ("PMPM") metrics are the key numbers to scrutinize for EVH.
- The company maintained an average of 3.2mm product members within its Performance suite, a significant increase from 1.5mm members in Q1 FY'22.
- The average PMPM fee for the segment stood at $24.66, down compared to $38.19 in the previous year, but aligning with average fees collected in Q4.
- The YoY change in average PMPM stems from higher contributions by the Medicaid and commercial lines of business. Both of these were lower than the corporate average.
- Conversely, memberships in the Specialty Technology and Services Suite were up drastically from 14.3mm members last year to 60.5mm members last period.
- Average PMPM fees for this suite rose to $0.36 from $0.32 in Q1 last year— underscored by the inclusion of NIA in its numbers.
- Lastly, product members on administrative services—formerly Evolent Health Services—amounted to 1.9mm. This was slightly lower than the 2.1mm booked last year. The average PMPM fee for administrative services stood at $14.91, compared to $17.34 in Q1 of '22.
It's also worth noting, EVH linked up with three major players last period in signing agreements to expand its surgical and oncology exposure. For one, it expanded its partnership with Humana, adding Arizona and Florida to EVH's network. This is said to bring in an additional $250mm in annualized revenue for the company moving forward.
Second, it linked with AMSURG, a national player that has contracts in situ with EVH's IPG business, agreed to utilize IPG's surgical management solution as its preferred surgical implant provider nationally. In my eyes, the deal is symbiotic—AMSURG will likely pay less for its surgical device purchases off EVH, whilst EVH benefits from the multitude of cross-selling opportunities within the matrix.
Third, EVH announced a significant expansion in its oncology specialty technology partnership with Centene. As a reminder, EVH bought NIA off Centene last year. the revised agreement extends the existing partnership between both parties beyond Medicaid. Critically, this enables EVH to capitalize on the rapidly growing Medicare Advantage (" MA" ) market. This move is expected to add another 800,000 MA members by FY'23 yearend.
3. Capital budgeting looks more appealing
Part of EVH's 3 priorities is capital allocation. In my view, this is one area where the company is set to unlock shareholder value moving forward. I'd start by saying that deleveraging the balance sheet is a priority under this umbrella. It left Q1 with $523mm in debt, resulting in net leverage of 3.9x adj. EBITDA. As a testament to its IPG and NIA acquisitions, net leverage clips to 2.9x when adding pro forma results in for both going forward.
This opens up an interesting debate. On the one hand, the acquisitions look to have been immediately accretive to sales and earnings. A good sign. In the same breath, however, there's been a large goodwill charge on each of the acquisitions. For instance, EVH booked an additional $726mm in goodwill on the balance sheet from Q1 FY'22—'23 due to the NIA transaction. That amount was therefore transferred from the wealth of EVH shareholders to NIA's shareholders, despite the former laying claim on the latter's net assets and future cash flows.
As such, thoughtful analysis is required to extrapolate the true profitability of the company, by comparing figures with and without a goodwill "charge". Figure 2 shows just this [rolling TTM figures are used]. Note several critical facts from the table:
- The difference in total capital provided to the business (from debt and equity holders) ex-goodwill is >$1.1Bn at the time of writing.
- Profitability is therefore subject to major compression when factoring in the goodwill charge. Based on Q1 FY'23, the difference is 650bps (TTM figures).
- Trailing returns on existing capital have therefore been sub-standard when including the premium paid over market value for IPG and NIA (i.e., the calculation of goodwill).
- Despite this, profitability continues to ratchet higher on a sequential basis, no matter what the convention. Ex-goodwill—just looking at operating assets—EVH produced 9.5% trailing ROIC last quarter, up from 5.3% in FY'22, and 2.7% the year prior.
What this says for the company moving forward is telling. It demonstrates EVH is growing profits at a faster rate than its capital commitments, creating a snowball effect to earnings and therefore, intrinsic valuation. Looking ahead, my assumptions suggest these trends will continue, and even increase. It isn't unreasonable to expect ~10% ROIC this year, pushing to ~13% in FY'24 and reaching 15% in FY'25, in my estimation.
Figure 2. EVH trailing and est. returns on existing capital commitments
Note: All figures are shown as TTM values. All estimates are shaded in sky blue, with actuals preceding this above. (Data: Author, EVH SEC Filings)
4. Valuation factors
It appears the market values EVH based on pre-tax earnings—versus sales or asset growth—as evidenced in the correlations shown below [Figure 3]. Unsurprisingly, therefore, with the sequential declines in pre-tax income EVH has derived since FY'18, its market valuation has slipped towards 10-year lows. Based on these same principles, however, the recent acquisitions provide a solid case for EVH to rate back to former highs.
Figure 3.
Data: Seeking Alpha
A firm can compound its intrinsic valuation as a function of its return on capital, and what amount of earnings it reinvests at these rates of return. Based on my FY'23—'25 growth assumptions, I've got EVH compounding its intrinsic value from $3.4Bn at the time of writing to $3.88Bn by yearend, stretching to $4.5Bn then $5.2Bn over the coming 2-years. That's a 24% compounding rate of growth, thereby supporting a buy rating in my opinion. Hence, I'm looking to EVH at $35/share over the coming periods, and $40.50 by FY'24.
Figure 4.
Note: All figures are shown as TTM values. (Data: Author)
In short
EVH's economic characteristics are gaining pace with each passing turn, and its recent acquisitions look to have added tremendous value to the offering. In particular, I'm attracted to the increasing rate of change to its returns on capital provided to the business. My assumptions have these trends to continue moving forward, and potentially even increasing. Key support of this is found via the accretive nature of its acquisitions, as mentioned, but also the improvements in unit economics, shown by PMPM and membership statistics. Consequently, I remain bullish on the long-term outlook for EVH, and reiterate it as a buy, eyeing price objectives of $35, then $40.50.
For further details see:
Evolent Health: Business Economics Still Appealing, Reiterate Buy