PART 2
Few other PPMCs have used interim agreements, and no other PPMC we contacted currently collects implementation fees. Some have questioned whether interim agreements and consulting/implementation fees correspond to services provided and justify the recording of such revenues in the period during which they are recognized. The auditors and we are convinced such is the case. Keep in mind that each deal has been concluded in competition with larger, more established competitors, and we do not believe PMCO has won by outbidding (paying up for deals) other PPMCs. The typical consideration paid by the Company for affiliated practices is in line with the amount paid by competitors. PMCO does not pay a higher EBITDA multiple for practices that pay implementation fees than for practices that do not pay such fees.
Decreased Reliance On Nonrecurring Revenue - One concern investors may have is that ProMedCo is deriving a portion of operating profit from fees that may be nonrecurring. While we believe that supplemental fees have been an important contributor to earnings, we do not believe they fall straight to the bottom line. The Company does commit significant resources to improve newly acquired practices. Start-up activities include market analysis, business planning, and operations enhancement. We observe that other revenue has become an increasingly smaller component of total revenues over the past several quarters. In the first quarter of 1998, other revenue totaled $1.5 million dollars, or 3.7% of total management fee revenue. This compares to 11.5% and 6.7% in the third and fourth quarter of 1997, respectively. Earnings per share grew from $0.11 to $0.15 during that same time period.
An analysis of the impact of other revenues on earnings is dependent on a number of assumptions. For discussion purposes, one could assume that all the revenues fall straight to the bottom line. Using this 100% margin assumption, other revenue accounted for 38.3% of pretax operating profit in the first quarter of 1998. Eliminating this revenue, but no offsetting expense, core recurring earnings would have been somewhere between $0.09 per share and the reported figure of $0.15 per share in the first quarter of 1998. We do not believe this scenario accurately reflects the situation at ProMedCo.
Clearly investors expect continued acquisitions in each quarter as a key component of PMCO's growth strategy. We expect a portion of earnings in future quarters will come from implementation fees. The bottom line is that PMCO, like all other PPMCs is a young, fast-growing company that is dependent on both new affiliations and solid internal growth for success. Accounting for new affiliations will vary deal-by-deal and company-by-company. We expect deal structures to evolve with the changing dynamics in the industry.
For ProMedCo, we expect that other revenues will quickly diminish as a material contributor to earnings as the Company completes additional affiliations, and operating margins for affiliated practices continue to expand. Again, other revenues have decreased both absolutely and as percentage of total revenue over the last three quarters. Revenues based upon a percentage of physician groups operating income (recurring fees) have increased strongly for five straight quarters. Same-store revenue growth has grown an average of 19% over the past five quarters. ProMedCo continues to add new physicians at a rapid pace. During the first two quarters of 1998, the Company added over 100 affiliated physicians, slightly ahead of projections. Serious discussions are underway with up to 500 additional physicians at this time.
Comfortable With Earnings Forecast - Our published earnings forecasts are included in the table at the top of this note. We continue to be comfortable that PMCO will earn $0.15 vs $0.08 (+88%) during the second quarter. We remain confident the Company can hit or exceed our forecast of $0.63 vs. $0.38 (+64%) for 1998. Our forecast does assume acquisition activity during the balance of the year. We believe the Company is well-positioned for rapid growth. Consolidation pressure in the physician services market continues to intensify. The Company recently strengthened its balance sheet with its successful secondary offering. Many of PMCO's competitors have stumbled over the last year. The IPO market appears temporarily closed to new entrants. The improved competitive picture has the impact of reducing bidding pressure (pricing) to "win" affiliations. When combined with the fundamental strength of ProMedCo's management team and strategy, we are excited about the outlook for the Company.
Strong Buy Reaffirmed - We continue to recommend ProMedCo as a Strong Buy with a 12-month price target of $18.00, 20-25 times our 1999 forecast earnings per share. We believe that the current valuation reflects investor concerns over recent troubles at other large, multispecialty physician practice management companies. We expect that the multiple will increase significantly as the Company continues to execute its growth plan, and investors begin to differentiate between companies. Our basic thesis on this stock remains as follows:
1. The fundamental dynamics driving consolidation in the physician market have not changed. Payors and hospitals continue to consolidate, technology is increasingly complicated and expensive, and managed care poses a whole new set of clinical and business challenges for physicians. Physicians need scale and sophistication in order to compete in today's health care market. It is becoming increasingly evident that hospital-based MSOs and staff-model HMOs have not been effective vehicles for managing physician practices. We continue to see significant growth opportunities for well-managed physician practice management companies.
2. ProMedCo has a powerful strategy. The Company targets primary care-based, multispecialty groups in pre-managed care secondary markets. As a result, it is able to establish a strong presence and achieve tremendous leverage with payors and hospitals in each market that it enters. No other physician management company is focused exclusively on this market segment.
3. The Company has been extremely effective at executing its growth plan. ProMedCo has added 306 affiliated physicians, 72 mid-level providers and 540 IPA physicians since its initial public offering in March of 1997. Revenue increased nearly 200%, and EBIT margins increased nearly 350 basis points during that same time period. Same-practice revenue has increased by an average of 19% over the past five quarters.
4. The prospects for continued rapid growth are outstanding. ProMedCo reports that serious discussions are underway with up to 500 additional physicians at this time. The Company has identified 1,200 markets which fit its market profile. These communities represent over 50% of the U.S. population. The Company reports that it has been facing little-to-no competition for deals over the past several months. We expect revenue to grow by $169.5 million (132.7+%) in 1998 and $142.3 million (+47.9%) in 1999. We forecast earnings per share of $0.63 vs. $0.38 (+64.0%) in 1998 and $0.82 (+29.5%) in 1999.
5. The valuation is compelling. Given the recent pullback in the stock price, we see significant upside to this stock. At 6 1/2, the stock is priced at just 10.5 times our forecast 1998 earnings. As the Company continues to execute its plan, we expect the P/E multiple to expand to a level more in line with the projected long-term growth rate of 30%. We have a 12- month price target of $18.00, 20-25 times our forecast 1999 estimate, suggesting significant near-term upside for investors.
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