Anchiy

Investment Summary

We are bullish on Pediatrix Medical Group, Inc. (NYSE:MD) shares and see that the stock is at a turning point on the chart. Our findings show a high return on capital and a growing bottom line, two factors that investors have taken into account rewarding in FY22, as they increase their quality to avoid a decline in equity.

Exhibit 1. 12-Month MD Price Action

Data: update data

Technical studies also suggest that the price action may have reversed and a newly formed uptrend is now in place. MD is also holding up well under the macro regime and has the potential to revalue higher as its fundamentals strengthen, in our view. We’ve priced the stock at $33 on a mix of inputs and believe there are additional tailwinds to be had via the accrual effect on revenue and earnings. With a list of likely catalysts, we assess speculative buying of MD.

First quarter results illustrate the fundamental picture

First turning point in the quarter, and revenue came in lower than expected at $432 million. Management noted that the decline was due to the cyclical nature of the company’s revenue function. It should be noted that the company takes this into account in the pricing, which is potentially a tailwind that must be taken into account in the investment debate. More on that later. Operating profit was $40 million last quarter and has been gradually declining since 2019 (see Appendix 2). While cost inflation continues to present a key issue for medtech players, falling margins are an immediate red flag in our review.

We see a gradual increase in revenue to $2.07 billion in FY22, on a gross margin of $513 million (25.65%). This is basically consistent with Exercise 21 and illustrates the relevant issue is that MD has recognized a substantial downturn in operating leverage over the past few years to date. Moreover, this seems to have to continue. We forecast FY22 operating profit of $223 million and EBITDA of $270 million, a gain of about $5 million for the year.

Piece 2. Operating leverage has declined for MD since 2019 and has remained stable

Data: MD SEC filings; HB Insights

It also refinanced its CAPEX structure last quarter by absorbing borrowings of $799 million. As such, it now has roughly 3x gross and net leverage using Q12M EBITDA. The passive structure is also split between a floating/fixed structure. As a result, it now expects quarterly interest expense to be around $8 million from $17 million in the fourth quarter of 2021.

Given that it transferred its long-term liabilities to a lower refinanced term structure, this turned out to be a positive move. Core bond funds now offer starting yields of around 4-4.5%, implying that high-yield capital markets are a few points higher. In addition, refinancing rates increased amid tightening central bank regimes. For MD, it has realized some price increase in its acquisition pipeline, consistent with similar changes in the medical technology acquisition market. Nonetheless, management noted that it continues to seek out high-margin sub-specialties that are complementary to the portfolio mix.

Other Tailwinds

It is important to note that the volume of transactions remained solid in the context of an increase in the cost of capital. Here, it is prudent to deconstruct MD’s revenue mix to understand how its funding practices may impact revenue. First, accounts receivable (“AR”) gained about $16 million from last quarter, bringing open sales (“DSO”) to 59 days. However, MD’s AR is primarily an unbilled AR related to its transition to R1 (NASDAQ:RCM). This agreement makes R1 the leading provider of revenue cycle management services for Pediatrix. Therefore, given MD’s normal provisioning practices on its aging receivables, revenue could benefit from additional leverage in the second half of FY22.

In fact, we can observe the age in DSO. Traditionally, the protocol is to add higher reserves once they age, usually after certain payment cycles, for example 90 to 180 days. On its balance sheet, MD has a provision of around 79% for this, compared to 78% in the same period last year. This adjustment of about 100 basis points will probably have an effect of about. $15 million downstream impact of MD’s unbilled AR.

The important fact for investors to understand here is that $15 million (or a 100 basis point adjustment, for that matter) will be recognized over the next few quarters in receivables. Due to this time component, it is estimated that MD will recognize leverage on its revenue and cash conversion cycle in the future.

Positioning to absorb macro headwinds

Management noted that labor costs are within historical levels, but there was no mention of forward-looking labor costs in the last earnings call. However, this contradicts data from hospitals that note much higher labor costs in FY22. National hospital operating margins fell about 48% year on year in April and have been in the red since January 2022. This came as discharges grew 0.5% YoY and inpatient/outpatient revenue grew 30bps and 270bps YoY annually respectively.

We have noticed that investors are repositioning themselves to absorb macroeconomic headwinds in FY22. This is primarily a rate story amid central bank tightening policies, however, investors are also looking to improve quality. As a result, revenue growth was avoided in H2 FY22 and bottom line fundamentals were rewarded. As shown in Exhibit 3, MD is getting closer to its forward EPS estimates, supporting this point. With a 16.5% year-over-year gain in FY22 earnings, we believe the market will continue to reward the company being watched in the ways described below. One thing investors need to think about in positioning stocks in portfolios.

Piece 3. MD appears to be converging on earnings fundamentals after a period of divergence

MD Share Price vs. EPS Forward Estimates, Aug 2021-July 2022

Data: Refinitiv Eikon

Further evidence of the benefits of MD and the momentum of FCF are seen below. FYF earnings and yield have shrunk since 2022 and offer an upside premium as the market separates unprofitable from profitable names. We strongly believe that MD will continue to grow earnings and FCF over the next few years. Therefore, current multiples present attractive value as the stock has the potential to revalue towards its estimated late 2020 highs.

Piece 4. FCF earnings and yield have shrunk in 2022, offering a long-term upside premium

Data: Refinitiv Eikon

Evaluation

We noticed a gap in value between earnings and MD’s valuation, which provides the opportunity for the stock to return to its previous highs. It is valued on a forward PEG of 0.64x and trades at ~22x forward, P/E above the 3-year averages and the sector median 12.3x forward earnings. It also trades at ~2x the pound and is reasonably priced at 1x the sales. However, these multiples have been downgraded as MD’s stock price has compressed. The question then becomes whether MD is a source of value or whether thin multiples are justified.

Piece 5. Multiples downgraded along with MD stock price, albeit with wide divergence from earnings growth

Data: Refinitiv Eikon

Technical studies removing the noise of time have become an integral part of stock pricing in this environment. As seen below, the dot and number charts show that several downside targets have been predicted, ranging from $18.50 to $4.75. This is incredibly bearish price action and suggests that there could be more declines along the way. There is, however, an upside target which is the last to be set, at $25.25. This offers a small portion of the upside potential and therefore leaves us pretty muted on the outlook for MD’s stock price.

However, a forward P/E of 22x our F22 estimates of $1.90 provides a price target of $41, suggesting there is still upside to be had. Additionally, the latest upside target on the P&F chart lends weight to the bullish momentum that has yet to be priced in to the stock price.

Exhibit 6. Multiple downside targets set MD price at $16-$18 level

Data: HB Insights, update data

This most recent upside target should be taken into account as it corroborates technical studies showing that trends may have reversed to the upside. Stocks rallied above cloud support while OBV and momentum confirmed the trend. Both reversed lows in June. The lag line on the cloud chart is now testing the cloud and should it break through, we are bullish on MD.

Exhibit 7. Momentum indicators suggest bullish momentum if the lag line breaks through the clouds

Data: HB Insights, update data

In short

MD has a list of tailwinds that have yet to be priced into its stock price by valuation. Investors are rewarding bottom line fundamentals as they improve quality this year and MD’s stock price is converging towards this factor rotation. On the chart, it caught an offer recently and momentum indicators suggest the uptrend is now in place. This creates an opportunity for price discovery as the stock retraces higher. We demonstrate that it has potential tailwinds to realize in the way it accounts for unbilled accounts receivable, and that it holds up reasonably well in the macroeconomic climate.

We have priced MD at $33 per share and are looking for a return target of around 46% as a speculative position to budget for a small portion of the risk. Speculative buying rate on these grounds.