Description

Premier (PINC) is a hospital-owned group purchasing organization (GPO) and healthcare facility SaaS software provider.  The GPO business (i.e., “Supply Chain Services”) is 90% of EBITDA less capex, and its role is to aggregate buying power across its hospital and other healthcare facility members in order to negotiate pricing discounts of typically 7% to 10%.  The GPO does not actually distribute product, but instead solely negotiates contracts and gets paid an administrative fee of 1.5% (of product value) from suppliers.  Some portion of these administrative fees (called a revenue shareback) gets passed along to the hospital or healthcare facility member.  The SaaS software business is 10% of EBITDA less capex, and it provides software that aims to either lower cost or improve quality at healthcare facilities, along with wrap-around advisory services.

In terms of business quality, core growth and non-adjusted valuation, Premier actually seems like a good long candidate.  The company operates in a strong oligopoly, in which Premier and Vizient make up ~65% of the total GPO buying power, with the other large competitor (HealthTrust at ~15% share) having a somewhat different business model (i.e., mandates strict compliance that doesn’t work for many hospitals) and so is not an apples-to-apples competitor.  Scale acts as a moat in its business, given any potential new entrants wouldn’t be able to negotiate such meaningful discounts with suppliers.  Management checks have all come back positive.  Growth is recession resistant and consistent, with high-single-digit/low-double-digit % EPS growth driven by total healthcare facility spend.  Hospitals’ structural share loss to lower cost surgery centers does not impact Premier, given they serve all facilities, and you can see Premier continues to grow healthily even as hospital growth has slowed.   Lastly, the company trades at ~16x P/E (NTM), versus historical valuation of 20x to 24x for PINC, and takeout valuation of MedAssets (MDAS) at 23x despite MedAssets not being as competitively advantaged as Premier pre-takeout and having much greater leverage.

So why am I pitching PINC as a short? The thesis is that Premier is meaningfully over-earning on their contracts, and that this will become apparent to the market either when (1) their 2 largest contracts expire in 2020 and become the focus of renewal in 2019 or their other contracts opt for early termination around the same time or (2) Vizient goes public.

In order to explain why Premier is over-earning on its hospital member-owner contracts, some historical context is helpful.  Prior to the company’s IPO in September ’13, Premier was fully owned by its members (i.e., its hospital customers were also its owners), and fully distributed all earnings back to these member-owners.  In order to go public, Premier needed to convince its member-owners that the company could create more value by retaining cash that would otherwise be fully distributed to existing member-owners, and using that cash to reinvest back in the business (in particular, its SaaS platform).  So, Premier cut a deal with member-owners… the company received extremely favorable revenue-share economics in exchange for the promise that the company would create greater value for its owners over time by using this increased cash flow plus public shareholder financing.  They structured this deal with an initial 5-year contract term (’13 to ’18), with an auto-renewal in 2017 for another 5 years (’18 to ’23).  However, the auto-renewal in 2017 didn’t pose much risk to the company, because if its member-owners did not auto-renew in ’17, they would lose ~3/7^ths of their equity (equity vested ratably from ’13 to ’20).  The company recently announced that 90%+ of its member-owners renewed contracts in ’17 at similar economic terms, which isn’t surprising given the equity they would lose otherwise.

To Premier’s credit, the company is upfront about the fact that these contracts were structured at better-than-market rates for the company.  Premier currently pays out a 30% revenue share to member-owners, and we believe the market is pricing in an assumption that when these contracts expire, they will jump to 45% for members that sell their stake at expiry.  This has been suggested by the sell-side by looking at MedAssets (before being taken out by Vizient) as a comp, and if you speak to the company they suggest that 45% is the market rate as well. 

However, what we believe the market is missing is (1) that the market rate is 60% to 65% for revenue share, not 45%, and (2) that remaining owners will likely also demand this 60% to 65% revenue share at expiry, not just member-owners who sell their stake (currently, it seems ~1/3^rd of member-owners have been selling when given the chance).  Given their entire revenue base is made up of admin fees multiplied by (1 – revenue share), and given revenue share 100% flows through to the bottom line, this difference in revenue share makes a big difference, and as a result current EPS materially overstates true earnings power.  Going from 30% to 65% revenue share is literally cutting net revenue in half and is a substantially larger cut on earnings given the fixed expense operating leverage.

How do we know that the market rate is 60% to 70%?  Well, for starters, if you look at Premier’s S-1 filings at IPO, they actually show in a table that non-member owners were paid 66% revenue share (if you strip out Innovatix).  This is the only table that gives insight into their gross admin fees vs net admin fees, and thus implied revenue share… after the S-1, they stopped disclosing this metric.  However, I believe the real smoking gun is that Vizient currently structures contracts at a 60%+ revenue share which can easily be confirmed with Vizient management.  Vizient accounts for ~$80bn of healthcare spending, versus PINC at ~$50bn. 

And what about the comp of MedAssets that discloses a ~40% to 45% revenue share in its filings pre-takeout, that sell-side is relying on to justify their recommendations on Premier?  The issue is that MedAssets’ subsidized some of their outsourcing business with larger members through fee share.  When Vizient purchased MedAsssets, and adjusted their financials to account for true revenue shareback economics, MedAssets’ like-for-like shareback came out at ~60-65%.  Therefore, the 40% to 45% that the sell-side is using to justify Premier’s eventual revenue shareback is actually based on aggressive accounting that doesn’t reflect market rates.

In addition, it’s not clear that only Premier’s owners that sell their stake will jump up to a 60% to 70% revenue share, from 30% currently… I believe that even owners who retain their stake at the end of the 7 year lock-up (in ’20) will demand higher revenue share.  Owners we have talked to view their ownership stake separately from their revenue-share negotiations.  Why would remaining owners watch their peers monetize their stakes for fair value in ’20 and receive better contract economics at expiry, without demanding to receive better economics themselves?  Vizient will also be out in the market with a 60-65% revenue share proposal once these equity lock-ups expire, willing to take share if Premier doesn’t move to market rates for everybody (owners and non-owners alike).

Overall, I believe that the market is capitalizing an earnings stream that does not represent market economics and believe that investors will be disappointed in Premier’s true earnings potential over the next few years.

Catalyst

New contract renegotiations.  Vizient goes public.