market folly

Today we're presenting an investment write-up that was a finalist at the Ira Sohn investment contest.  We've already posted up notes from the Ira Sohn Conference where you got to read about investment ideas from top fund managers.

Now, we're posting up some entries that made it to the final round of judging from the investment contest at Ira Sohn that was judged by the likes of Seth Klarman, David Einhorn, and Bill Ackman.  The following is Andrew Diaz's pitch of WebMD (WBMD).


Target Price and Rationale    

$26 - $30 per share 

Base Case:  A DCF valuation was used to determine intrinsic value, which assumed WebMD’s overall market share would decrease from ~40% today to ~20% in equal increments over five years, ~$530 million of revenues per year ($558 million in 2011) and 20% EBITDA margins (33% in 2011). The assumed cost of capital and terminal growth rate were 16% and 4%, respectively. Even in adverse conditions such as a highly competitive advertising environment, online pharmaceutical spending growth more than offsets any market share erosion that WebMD may experience and also builds in the potential for premium ad pricing declines. Advertising dollars continue to shift from offline to online sources.  

LBO:  In December 2011 the board conducted management meetings with several private equity funds but anticipated receiving bids below the Company’s then quoted market price of ~$38 per share. In a hypothetical take-private transaction with the price at $21.85 a PE fund could generate a 5 year IRR of ~20% by buying the business at ~7x LTM EBITDA (~$26 per share), using conservative leverage of ~3x and applying single digit revenue and EBITDA growth.  

Free Options: This valuation excludes (i) ~$250 million (~$5 per share) NPV of federal NOLs, (ii) mobile growth, (iii) international opportunities and (iv) an increase to the repurchase program.   

According to management, the NOLs could remain usable in a tax efficient change of control transaction with a private equity buyer. An important area of growth that was excluded from the valuation was mobile because it is only a small portion of revenues today, but it can one day be a meaningful contributor to revenue. Additionally, this valuation excludes the impact for international opportunities which includes new website launches in Europe and other emerging markets where there is meaningful revenue potential.  


Relevant Comps  

Epocrates (Ticker: EPOC) is a physician platform for clinical content, practice tools and health industry engagement primarily in the mobile space. Epcorates derives $100 million of revenues from 1.4 million physician members. Epocrates trades at ~8x Adj. EBITDA of $13.8 million and does not generate consistent free cash flow. The Company has grown revenue at a ~15% CAGR since 2007. 

HealthStream (Ticker: HSTM) provides internet based learning and research solutions for the healthcare industry. HealthStream derives $87.2 million of revenues from approximately 2.5 million hospital-based healthcare professionals. The company trades at ~30x EBITDA of $17 million and generates ~$10 - $15 million of free cash flow annually. The Company has grown revenue at a ~19% CAGR since 2007.  

Everyday Health (Private) provides online consumer health solutions. The Company offers content and advertising-based services across a portfolio of websites that span the health spectrum. It is estimated that the Company has revenues and EBITDA of $102 million and $2.6 million, respectively.  


Catalysts  

There are several catalysts: (i) Expiration of the shareholder rights plan, (ii) Sale of the Company, (iii) Increases to the authorized stock repurchase plan and (iv) Hiring of a new CEO  

(i)    In November 2011, the board adopted a shareholder rights plan limiting any shareholder to a maximum 12% ownership. The rights expire on November 1, 2012, or approximately 6 months from today. Currently, Carl Icahn and Kensico Capital Management are the two largest shareholders with stakes of 13.1% and 12.9%, respectively. (Both stakes are above the threshold due to the Company’s recent tender offer). These investors may seek to meet with the board and unlock shareholder value through strategic opportunities.  

(ii)    In late 2011, the board of directors engaged private equity buyers for a potential transaction, but the discussions never proceeded to a formal offer as a result of anticipated declines to 2012 results primarily due to its pharmaceutical customer base deferring marketing spend. Given the temporary nature of these declines, the board may re-engage private equity buyers as the poison pill nears expiration and 2013 revenue visibility comes into focus. The stock is currently 42.5% lower than the price when negotiations between potential buyers commenced. 

(iii)    In April 2012, WebMD offered to tender 5.8 million shares at a price of $26.00 per share, for an aggregate cost of $150 million (~10% of the common stock). There is approximately $86 million (~7% of market cap) remaining under the buyback plan authorized in October 2011. Management has indicated an interest in upsizing the repurchase program given WebMD’s $1 billion cash balance and undervalued stock.  

(iv)    Currently, the board is searching for a new CEO to lead WebMD after the CEO resigned in early 2012. A new CEO with relevant healthcare/online advertising experience would enable the Company to better monetize its online assets, 100+ million user base, and strong brand.   


Investment Thesis   

Why does WebMD trade at ~$22 per share today? I believe the main drivers of the recent stock price decline are (i) a failed sales process and (ii) temporary decline in ad spending by its pharmaceutical customer base. 

(i)    Last summer, the board held preliminary discussions of a transaction involving one or more potential private equity buyers. However, neither transaction was pursued in light of the market turmoil. In November 2011, the Company re-engaged discussions with four private equity funds who conducted a due diligence investigation of the Company’s business. The board believed it would receive offers well below the then quoted price of ~$38 per share. On January 10th, after announcing that 2012 would be weaker than previously anticipated, the stock price fell to ~$27 per share. At which point management contacted three new potential private buyers. Once again, the board felt that offers would be lower than the stock price and therefore took the Company off the auction block. I believe management made the right choice by not selling the business at a most inopportune time.  

(ii)    The underlying business value has been overshadowed by a temporary decline in ad spending by pharmaceutical companies. This is due to uncertainty surrounding FDA regulations for healthcare advertising as well as several blockbuster patent expirations. Many pharmaceutical companies have been sued over false portrayal and advertisements. As a result of uncertainty surrounding the FDA’s new standards, pharma customers have temporarily postponed advertising spend. Ad spending currently goes through a rigorous 3-step process including legal, medical and regulatory reviews. However, as customers become attuned to the new approval process, advertising spend should normalize.   


Compelling Long-Term Value 

Media advertising is undergoing a fundamental shift, from print to online, especially in mobile areas such as tablets and smart phones. In the search for alpha, one can find no relationship between the numerous tail risks present in the macroeconomic environment today and the secular growth of online media advertising. As proof, WebMD has grown revenue and EBITDA since 2007 at a CAGR of ~15% and ~17%, respectively.  

Broadly speaking, WebMD is in the business of online media advertising. WebMD markets to 107 million unique consumers per month which collectively generate over 10 billion page views per year. Additionally, WebMD has a professional network that averages ~2.6 million physician visits per month. While WebMD has not yet monetized its mobile customer base, ~11.5 million people have downloaded the WebMD mobile app and more than 2 million physicians have downloaded the Medscape Mobile app. It should also be noted that WebMD derives minimal revenues from abroad, but has recently launched German and French sites for physicians and is in discussions to launch sites in other international markets. International markets could contribute a meaningful portion to revenue growth in the future, but have not been considered for this thesis.  

WebMD has positioned itself to take part in favorable secular trends impacting online media. According to eMarketer, healthcare and pharma advertisers’ US online ad spend is expected to see double-digit growth over the next few years, rising from $1.03 billion in 2010 to $1.86 billion in 2015. This currently represents ~3.5% of the annual $28 billion spent on pharmaceutical advertising. By 2015, eMarketer’s suggests ~7% of total pharma ad spending would be online. WebMD’s is in an enviable position to capture this growth due to its strong brand and 100+ million unique visitors per month. 

Over time a long term horizon, the percentage of online advertising spending should become a bigger portion of the overall spending pie. Cost-conscious drug makers are seeking less expensive marketing strategies. For example, the number of US pharmaceutical sales reps has declined since 2005 and may accelerate further once the Physician Payments Sunshine Act takes effect in late 2013. This law requires all US manufacturers of drug, device, biologics, and medical supplies to publically report physician payments. This should help shift advertising dollars to relatively cheaper and more effective alternatives such as online advertising. Assuming that one day 30% of the total pharma ad spending will be online and suppose that total market gets cut in half due to more cost effective advertising. One could project online pharma ad spending to be ~$4 billion sometime in the next decade.  

As evident by the lack of comparables, WebMD is undeniably the market leader in its niche, representing ~40% of total online pharma ad spending in 2011. One might wonder what the “moat” is and how WebMD can maintain its share of a growing market. WebMD’s value is powerful and stems from its first mover advantage which has allowed the Company to amass a large user base that would be difficult to replicate. Unlike most online advertisers, WebMD offers targeted advertisements to individuals researching a specific topic or condition. Through providing information about therapies available to treat that topic, WebMD’s advertising can be viewed as a valuable source of information provided to a potential prescriber or patient when they are already focused on finding said information. Conversely, other media advertising is focused on diverting the user’s attention away from what they are already doing. I believe this fundamental difference between WebMD and other online advertisers helps to alleviate risks of potential declines to premium ad pricing.  

Selling into a weak 2012 did not make much sense for shareholders and I believe management made the right choice to call off discussions. Instead of selling the business entirely, the Company held a tender offer to repurchase $150 million of common stock at a price of $26 per share which suggests that management is shareholder friendly. I believe directors and management still have a strong incentive to sell the business since they own ~8% of the outstanding stock (~$100 million market value) and would be entitled to receive an additional ~$30 million of compensation in the event of a change of control. The CEO resigning certainly raises some concern, but as previously mentioned, I believe the right CEO could be a positive catalyst. With the poison pill expiring in 6 months and management motivated to sell, I believe WebMD is an attractive takeover target with a strong competitive advantage attributable to its 100+ million user base and strong brand coupled with favorable long term trends for online pharma ad spending.


Embedded below is Andrew Diaz's slideshow presentation on WebMD from the Ira Sohn investment contest where he was a finalist:




Were you also a finalist in the contest?  Please click the contact link at the top of the page and get in touch.  And if you haven't seen them already, check out notes from the Ira Sohn Conference.