Read David Einhorn's Brutal Presentation On Athenahealth That Had A Room Full Of Investors Laughing Out Loud

This week, hedge fund manager David Einhorn showed us what one of the ‘cool kid stocks’ he mentioned in his latest investor letter looks like. It’s not pretty.

‘Cool kid stocks’, according to Einhorn, are a pack of stocks that are way overvalued. His hedge fund, Greenlight Capital, is shorting a basket of them and on Monday he presented one, athenahealth to a room full of investors at the 19th Annual Sohn Investment Conference.

athenahealth is a business processing outsources for healthcare companies that, until Monday, enjoyed a stock price of over $US125. Einhorn’s bull thesis for the stock is for it to fall to $US50, his bear case is that it could go to $US14.

And this presentation has everything — a cookie CEO, super enthusiastic Wall Street analysts, jokes, cartoons, YouTube clips and more. By the time he was done presenting the stock was down 7%, at Tuesday’s close it was down almost 14%.

Wednesday morning the stock started falling, an hour after the open it was down 8%. Carnage.

Einhorn was kind enough to share the presentation on Greenlight Capital’s website, and allow Business Insider to upload it with his comments here. Enjoy!

'This is the 19th Annual Sohn Investment Conference. The first time I spoke here was in 2002. It is amazing how this great event has grown, and I am honored to be here.'

'A couple weeks ago, we wrote in our quarterly letter that we believe that a narrow group of cool kid stocks have disconnected from traditional valuations and formed a bubble. This got a lot of criticism. Half the critics thought we were talking our book, even though we didn't name names. The other half were upset that we didn't tell them which stocks we were short. Since we can't seem to please anybody, I've decided to validate both criticisms. Today, I'm going to illustrate the bubble basket doing a deep dive into one of the companies, while not disclosing the others. This company is an excellent company with an excellent product, run by a well‐meaning and honest, though occasionally promotional CEO. The world may be a better place if it succeeds, and even though we are short, I am in no way rooting for it to fail. Its main problem is that it isn't positioned to succeed the way the bulls hope, as the assumptions the bulls are making are not plausible. The stock is simply at the wrong price. It's caught up in a bubble and could easily fall 80% or more from its recent peak. Let me introduce you to athenahealth.'

'I think athena deserves a smaller capitalisation, and I'm not just referring to how it fails to capitalise the first letter of its name. Let's start with 'what does athena do'? Athena provides software and services primarily to what is called the 'Ambulatory' healthcare market, which consists mostly of non‐hospital based physician practices. Its services include bill collection and claims processing, electronic health records, patient communication, and care coordination.'

'AthenaClinicals is a service enabled by software that manages patient heath records electronically. AthenaCollector is practice management software combined with outsourced revenue cycle management, or RCM, where athena streamlines a practice's collection process. These two products generate the vast majority of athena's revenues, but there is also athenaCoordinator and athenaCommunicator, which enable care coordination among providers and communication with patients. For these services athena charges based on a percentage of collections, usually between 4 and 7 per cent.'

'Athena is also trying to enter the inpatient or hospital market, through a new service called Enterprise Coordinator. This offers small hospitals a range of care coordination functions including patient admissions, insurance pre‐certification, referral management, post‐care follow‐up, and preventative care outreach. Athena just announced its first two trial customers last month. This is very much a work‐in‐ progress, and it is unclear whether athena will succeed in this segment.'

'Let's get to the most eye‐catching thing about all the bubble stocks -- the stock chart. This one is from the 2007 IPO through the end of February. You can see that this was a nice stock that was doing well until November of 2012, when it went ballistic and more than tripled, from $US60 to $US204, in just 16 months.'

'What has been driving this exceptional share performance? The chart suggests enormous financial progress to justify the explosive re‐rating of the shares.'

'You'd expect results in excess of the 'targets' of 30% annual revenue growth, and improving gross and operating margins. But you'd be wrong.'

'Athena missed its organic revenue growth target for 2013, and analysts have cut revenue expectations for both 2014 and 2015.'

'And what happened to the intended margin leverage? The blue line is the historical margin and forward‐looking analyst estimates as of early 2013. The red line is what the company delivered in 2013 and shows the now lowered analyst estimates from here. As is fashionable with bubble stocks these days, margins that include stock compensation as an expense are very low and are now expected to remain there for at least the next couple of years.'

'Earnings estimates have followed the same path. It's noteworthy that in 2009, when the stock was less than $US50, analysts thought the company would be earning more than $US3.00 per share by now. 2015 estimates have also fallen dramatically.'

'Not that it seems to matter…'

'So, athena missed its top and bottom line estimates, and the stock almost quintupled in the three years through early March of this year. What might explain the move?'

'Of course, sell‐side analysts are happy to fuel the fire. Here is one, using pretty much every hot buzzword he can think of. Actually, athena is none of those things, but it's a great way to promote the stock.'

'There are many stocks that can't be valued as amultiple of profits or cash flows because they have little or none. So analysts are left with relative valuations. Here is how athena seems reasonable next to its peers. But the implication is that its peers are properly valued.'

'It's all a matter of perspective. Depending on which stock you are thinking about, all these stocks seem reasonable compared to the others. This is what happens in a bubble.'

'I believe when investors attempt to value the disconnected stocks using conventional methods, they typically can't come close to current values. However, on April 23rd, Morgan Stanley issued a 22‐page report about athena that put my theory to the test. In it, the analyst uses a discounted cash flow to arrive at values that arguably justify the current share price. And, I will stipulate that the DCF model uses a proper and standard technique. It even incorporates non‐cash stock comp as an expense so that long‐term dilution is taken into account.'

'By trying to bridge the gap between the bubble prices and conventional valuations, the report does a great service to those of us who can't fathom the prices of bubble stocks. It answers the question of ''What do you have to believe will happen in order to justify the stock price?''

'The DCF shows the revenue buildup by product category. The existing business will grow from$743 million this year to about $US5.7 billion in 2030. On top of that, the hospital service offering that athena just launched will add another $US1.2 billion. This is expected to be followed by an as‐of‐yet undeveloped hospital collections service that Morgan Stanley is hoping the company will launch in 2017, and a patient records software offering expected in 2018. Together these will grow to be a $US3.1 billion business by 2030. If all goes according to forecast, revenues will compound at 18% for the next 15 years and athena will become a $US10 billion revenue company.'

'According to Morgan Stanley, athena is worth $US192 per share in a base case DCF. This is broken down into $US120 for Ambulatory and $US72 for Inpatient.'

'Let's test Morgan Stanley's assumptions. Today athena serves 37,000 doctors and earns $US16,000 per doctor. In 2030, Morgan Stanley estimates athena will have 86,000 doctors and get $US63,000 per doctor. We believe that these assumptions are quite aggressive and likely to prove too optimistic. For the moment, let's assume Morgan Stanley is right about the number of doctors and challenge only the revenue per doctor.'

'Morgan Stanley says the average doctor currently collects $US636,000 annually, on the way to $US1.3 million in 2030. Currently, athena's doctors collect only $US370,000 of which athena keeps about 4.4% or $US16,000. Athena's doctors get much less than the national average because athena has a concentration in low‐earning primary care physicians. Even if athena were to win higher‐billing physicians, athena would adjust its billing rate downward because it prices its business to earn a certain amount per physician, and uses a sliding scale so higher‐billing doctors pay a lower percentage. Without explaining why or how, Morgan Stanley assumes that the average athena doctor will catch up to the national average, and that athena won't offer sliding scale discounts to higher‐billing doctors. This appears to be a modelling error. Morgan Stanley assumes athena will recognise $US63,000 in revenues per doctor by 2030 from $US16,000 today. We think it is more reasonable to assume that revenue per doctor grows with Ambulatory spending. On that basis, Athena's revenue per doctor would still more than double to $US36,600 in 2030.'

'If we cut Morgan Stanley's revenue per doctor assumption from $US63,000 to $US36,600, it reduces the DCF value by $US44. This reduces Morgan Stanley's base case DCF value for athena's Ambulatory business from $US120 to $US76 per share.'

'Now, let'stalk about Morgan Stanley's EBIT before stock‐based compensation margin assumption. Morgan Stanley's report goes for 22 pages detailing its analysis of the addressable market, and athena's revenue opportunity. And then without a word of explanation it plugs in a 30% EBIT margin assumption in 2030. Morgan Stanley's predicted near‐term EBIT ramp from about 10% today to 13% at the end of the decade is possible. 30% margins are not. And it is this assumption that drives the bulk of the DCF‐derived value.'

'Jonathan Bush likes to compare athena to Amazon. And he believes that because athena's customers access the software through a web‐based portal, athena is a cloud company 'just like amazon.' When a store adds a website, it does not magically become a 'cloud‐based retailer'. Likewise, when my bank allows me to check my account balance online, it does not suddenly become a 'cloud‐based financial institution.''

'His use of the word 'cloud' is somewhat nebulous. Here he describes some of the services behind the software:' (video clip)

'When other industries take mundane or not‐so‐mundane tasks off a company's hands, we call that 'business process outsourcing''or BPO. When the company gets better at it because it has more customers, more data, and a web‐ based interface, it doesn't make them a 'fusion of SaaS, mobile, social, and crowdsourcing.' It makes them a more efficient BPO. Before everybody got lost in the clouds, athena was grouped with other financial and transaction processing companies. These are good businesses, but they don't merit triple digit P/Es. Currently, BPO companies mostly have high teens P/Es'

'We believe the most direct comps for athena are AccretiveHealth, MedAssets, and Tenet Hospital's Conifer division. These businesses have, on average, a 10% operating margin before stock‐based compensation. The CEO of Accretive Health -- a company focused purely on outsourced hospital RCM -- stated that the company's target operating margins were in the mid‐teens shortly, before the company ran into regulatory trouble.'

'So, now let's go back to Morgan Stanley's margin estimates. The low operating leverage makes the EBIT ramp to 13% by the end of the decade plausible. But, the proposed ramp to 30% by the end of 2030 is not. By the way, in the Morgan Stanley 'bear' case that yields an $US82 valuation, they assume EBIT margin ramps to only 27.5%. That is what passes for conservatism during a bubble.'

'If we change the revenue per doctor to $US36,600 and assume a peak margin of 15%,rather than Morgan Stanley's 30%,this reduces Morgan Stanley's base case DCF value for the Ambulatory business by an additional $33. Our adjusted DCF value for the established ambulatory business is therefore $43 per share. This represents a good, optimistic value for athena's established business.'

'So what about the inpatient or hospital market? Here are Morgan Stanley's assumptions. As you can see, the hospital segment is forecast to grow from zero to more than 40% of athena's revenues... How likely is that?'

'Instead of waiting until it has a full suite of software to offer hospitals, athena has developed a new BPO offering called 'Enterprise Coordinator', in which it will take over a hospital's admissions, referrals, pre‐billings, and patient communication functions. Athena's first alpha customers for this new service are long‐time athena clients, Steward Health Care and Griffin Hospital. When asked on the April earnings call about athena having to cut its already negative‐ margin pricing structure for this new offering, Jonathan Bush was his ever‐candid self.'

'And what about the future products? Morgan Stanley's Inpatient forecast assumes athena launches a new revenue cycle management service in 2017 that will reach $2.5 billion of revenues by 2030.'

'That $US2.5 billion implies that athena wins 6% of the hospital industry. This is 200% of the current market because less than 3% of hospitals outsource their revenue collection today. Hospitals don't outsource because they have customised contracts with larger payers so there is little benefit from the standardization of collection methods that outsourcers offer. Morgan Stanley assumes that hospitals will embrace outsourcing, and that athena will launch a viable service that wins significant market share at 30% EBIT margins.'

'Morgan Stanley's assumptions are not just optimistic, they seem to ignore the reality that even athena's current solution is half‐baked.'

'This is what a fully integrated hospital software package looks like. It involves every part of the hospital,from billing to patient monitoring to supply chain management. They take years to design and a fortune to build. The company that dominates this space is Epic Systems.'

'Epic makes complete software solutions for hospitals, large medical groups, and integrated healthcare organisations, and has emerged as the undisputed winner from the fragmented IT market. It costs anywhere from tens to even hundreds of millions of dollars to install Epic, but this hasn't deterred the most well‐respected hospital CIOs. In fact, there are cities in this country where every major hospital is on Epic, or moving in that direction because of the ease of sharing data.'

'Epic's client retention rate is near 100%. Wall Street analysts don't promote the EPIC perspective on healthcare IT because it is a private company. Oh, and they are from Wisconsin. Go Packers...'

'As far as cloud‐based IT goes, Epic's continued success shows that hospitals aren't looking for a cobbled together best‐in‐breed solution. Just as hospitals impose structure from the top down, the hospitals themselves seem comfortable having a proprietary solution imposed upon them, provided it is integrated, efficient, and interoperable. Epic is all of these things. And it's not just hospitals…'

'Epic is now expanding into other markets. CVS's Minute Clinic has been a long time athena client in practice management and revenue collection. In February, when CVS decided to stop using its own proprietary electronic health records product, it should have been an easy win for athenaClinicals. Instead, CVS went with Epic, further cementing Epic's place as the go‐to application.'

'Yet Jonathan Bush continues to believe that of course cloud‐based solutions will be the standard for healthcare IT. It doesn't work that way. The standards have been decided in the last five years, and the winners aren't the single‐ digit‐share cloud companies. The standard is the 2000 lb. gorilla from Wisconsin that has the biggest hospitals, the 275,000 doctors, and now even the local clinics. And as these large institutions keep acquiring smaller hospitals and doctors' practices, and pushing Epic IT systems down the chain, Epic's dominance will only grow.'

'So where does that leave us? While athena may be able to create an Inpatient software offering, it will be an expensive and risky undertaking. Cerner, another large healthcare IT company, has spent $US2.7 billion in the last decade on R&D, while Epic reportedly will spend more than $US300 million in R&D this year. Morgan Stanley's 30% margin assumption for Inpatient is even less realistic than it is in Ambulatory. It will be even harder for athena to generate attractive margins from large enterprise customers than from small physician practices. We think we are being quite generous by adjusting to a 15% margin. It would be easy to argue for something even lower. Though we are inclined to value Inpatient at zero, we cannot disprove that which does not exist. And investors like to dream. However, we think it is appropriate to discount this potential at a rate reflective of a venture investment. A 15% margin and a 20% discount rate still seem rather forgiving. You can see these adjustments have a lot of impact on the Inpatient opportunity. $US7 per share seems much more realistic than $US72 for a product that for the most part is years away from commercial introduction, let alone success.'

'Putting it together:We started with Morgan Stanley's base case DCF value of $US192 per share and took it out of the clouds by adjusting various implausible assumptions in the model. This leads to a still optimistic, but at least conceivable $US50 value.'

'Of course,there is a bear case, which is worse…'

'There has been a great deal of consolidation in healthcare, with hospitals buying up physician practices and directly employing doctors in order to collect higher fees and better control the cost of care. And it's happened faster than some people expected. Certainly faster than Jonathan Bush anticipated. (video clip) As hospitals acquire physicians, the hospitals will choose the IT systems and athena will lose doctors that will be moved to a system like Epic.'

'We have identified these six customers that we believe athena may lose in the coming years.'

'A few years ago, doctors were paid $US44,000 to implement and use an EHR. Late last year this dropped to $US24,000, and in a few months the incentive will disappear altogether. Accordingly, most doctors who are going to adopt EHRs have already done so, and the greenfield opportunity has been penetrated.'

'As for the remaining doctors who are still shopping for EHRs, athena's success in the lower end of the ambulatory market has led to competition there, too. Companies like kareo, eClinicalWorks, and CareCloud have all introduced competing packages of RCM and EHR at lower prices. It may be hard for athena to achieve much margin growth in such a competitive market.'

'We believe that there are serious risks to this business model that are being mostly ignored by bullish investors and sell‐side analysts.'

'A less optimistic scenario that may be even more likely than the $US50 DCF case would have the number of doctors capping out at 74,000 rather than 86,000, with revenues per doctor increasing roughly at the rate of inflation until the end of decade, at which point capitation and/or competition slows the growth to 1% per year. EBIT margins expand to 13%, in line with athena's best comparables, but don't improve further. The inpatient segment does not become a profitable business, but does not become a cash sinkhole either. On that basis, the DCF falls to $US14 per share or about a market multiple on current non‐ GAAP earnings. With the stock at $US127, I don't think it is worthwhile to further parse the assumptions.'

'Now here's the complete stock chart. In recent weeks the shares have fallen sharply. Perhaps the bubble is deflating. The thing about bubble stocks is that the best reason to own them is that they are going up. When they stop going up, there is no reason to own them. The gap between the top of the bubble price and the price where a disciplined growth investor will become interested is very large. When they stop going up, these stocks become falling knives. I think this one has much further to fall. But you don't have to listen to me.'

'Here is a snippet from another company that tried to change healthcare.'

'This comes from WebMD about a decade ago. It turns out it is harder to transform healthcare than some might think.'

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