Cabot Small-Cap Confidential Issue: July 6, 2023
This month we’re digging into a recovering healthcare specialist that is both a self-help and an AI automation story.
After a few missteps in 2022, a significant acquisition and a new management team have the stock on the right track again.
Moreover, high healthcare utilization and a rapid acceleration in the company’s automation capabilities suggest strong revenue and profit margin growth throughout 2023 and into 2024. Enjoy!
The Big Idea
The Centers for Medicare & Medicaid Services (CMS) estimate that in 2023 total hospital spend, plus physician and clinical expenditures, will total almost $2.5 trillion.
Roughly $115 billion (almost 5%) will be spent just managing payment collection.
That is a truckload of cash. And because of the insane complexity of the healthcare system, rising labor costs and regulations, collection costs are going up about 10% every year.
The industry term healthcare providers use to describe the process and systems surrounding payment collections is called Revenue Cycle Management (RCM).
The two main goals of RCM are to slash revenue waste and speed up payments. To accomplish these goals a whole slew of time-consuming, repetitive, error-prone and painfully boring processes need to be attacked, streamlined and done over and over and over again.
We’re talking things like document organization, patient data tracking, insurance claim submissions, billings and payments.
Thankfully, automation technology can help. It is a perfect match for the repetitive tasks of RCM. That’s why healthcare providers are investing more heavily in RCM automation technologies every year.
That said, developing and managing RCM automation solutions is not a core competency of most healthcare providers. They struggle to do it well.
A better strategy is to outsource some or all of their RCM processes to a specialist. Around 30% of healthcare providers already do. The remaining 70% represents a very large growth market.
Today we’re digging into a small, pure-play RCM company going after this $115 billion market.
It is arguably the best-positioned company in the industry. And after a rough patch in 2022, things appear to be going smoothly now, with upside from an acquisition, new management and ramping AI/ML investments.
R1 RCM (RCM) provides revenue cycle management (RCM) solutions to healthcare providers.
The pitch is that providers can outsource cash collection operations to a specialist instead of handling it in-house. And that R1’s solutions will help them bring in more revenue, cut costs and deliver a better patient experience.
It’s a solid pitch. R1 is arguably the best pure-play company in the market. And it has data to back up its claims.
Management says R1’s solutions deliver a mid-single-digit revenue boost, cut accounts receivable (AR) days by 20% and cut costs to collect by 30%.
R1’s healthcare clients include health systems, hospitals and physician groups. Its largest client, Ascension (49% of 2022 revenue), includes a number of hospital systems and operates under a long-term contract extending through 2031.
The company recently made a major move, acquiring the Cloudmed Platform on June 21, 2022.
Cloudmed is growing well over 20%. The company’s revenue intelligence platform uses cloud-based data architecture and machine learning (ML) to analyze large volumes of medical records, payment data, and complex medical insurance models. It then identifies opportunities to deliver additional revenue to customers using intelligent automation.
This acquisition is a good fit. It should help accelerate R1’s use of automation and AI and ultimately deliver a better product and value proposition to target customers.
From a leadership perspective, the Cloudmed acquisition was hugely significant. Cloudmed’s CEO, Lee Rivas, became R1’s CEO on January 1, 2023.
Just a few days later, on January 5, R1 announced Cloudmed’s CFO (Jennifer Williams) and CCO (Kyle Hicok) stepped into those same roles at R1.
These three appointments, a month and a half after RCM stock was whacked due to payment collection issues (no need to explain the irony here) illustrate the strategic significance of the Cloudmed acquisition.
Compared to a lot of our positions, R1 is a relatively large organization. It has a market cap of $7.6 billion. While I typically prefer smaller companies, size is an advantage in this case.
That’s because R1 already has scale. It has a lot of customers, a ton of data and enough resources to move quickly on automation, machine learning (ML) and artificial intelligence (AI) investments.
In other words, it’s big enough to be a major player in this market right now. That means bigger customers (and bigger investors) will be attracted to it.
Platform & Solutions
R1’s offerings run the gamut from front-end services (scheduling, patient intake, pre-registration, insurance, and benefit verification, etc.) to clinical process functions (level of care review, charge capture, etc.) to payment processing (billing, follow-up, denials management, etc.).
The table below shows how R1’s various solutions fit in a healthcare provider’s revenue cycle and gives a few details on the products in each cycle.
In many cases, R1’s technology is fully integrated into a customer’s existing IT framework as the biggest customers sign up for R1’s soup-to-nuts package – referred to as end-to-end solutions.
But smaller and/or new customers can use just a few modules to handle specific processes, then ramp up their relationship as time/needs evolve.
The different delivery models have different economics, so I’ve included a few notes on each below.
End-to-End – Operating Partner: R1 provides all the staffing and infrastructure needed to deliver all the RCM capabilities it has available, including technology, workflow, operations and analytics.
Not surprisingly, these types of engagements generate the most revenue and greatest profits. But they also require the most resources to deliver. These types of engagements also take a few years to ramp up to full profit potential (30% to 45%).
End-to-End – Co-Managed: R1 provides all the technology and some subject matter and management specialists, but customers use a lot of their internal human and infrastructure resources too. The revenue opportunity is a bit smaller than with the Operating Partner arrangement, but R1 doesn’t cover nearly as many costs either. At full engagement, profit margins are about half of the Operating Partner arrangement (15% to 20%).
Modular Solutions: R1 sells modules that address whatever specific RCM needs the customer has, be it automation, patient experience, revenue integrity or whatever. The revenue opportunity here is the smallest of the three engagement models, and so is the profit margin potential (3% to 12%), but there are very few upfront costs.
R1’s products work for all payment models, including fee-for-service, patient self-pay, and value-based.
Automation and AI: Labor costs are a major issue in the healthcare space. RCM is a perfect market for automation and AI since a lot of tasks are data-based and repetitive. R1 has been developing automation, ML and AI capabilities for years.
The company’s R1 Intelligent Automation software utilizes robotic process automation (RPA), natural language processing, and machine learning (ML). Cloudmed’s platform also uses ML to recognize inaccuracies throughout the revenue cycle.
In mid-2022 R1 had automated 110 tasks. By the end of the year 150 were automated. I expect the pace of automation to increase, both helping R1 operate more efficiently and attracting new customers.
Cloudmed acquisition: The Cloudmed acquisition brings in-house a 20% plus growth operation (+25% in Q1 2023, better than expected) that operates with a better profit margin than R1. It also brings a new client base to sell legacy R1 solutions into, and vice versa. Of the top 100 health systems, 94 have at least one Cloudmed solution. And there is cost savings potential. Integration appears to be going well. As of February, management said synergies are now expected at the high end of the previously discussed $15 to $30 million range.
High Utilization Rates: Analysts see the high utilization rates recently discussed by healthcare providers (like UNH) as suggestive of a strong second half of the year (and into 2024) for RCM.
Execution: R1 faltered in 2022 when it came to managing customers and getting paid. With a new CEO (Lee Rivas) already speaking publicly about improving execution and moving quickly to integrate Cloudmed, there is significant potential for investor interest/confidence to improve after the Q2 earnings call.
The Business Model
R1 makes money by charging a percentage of collections based on hospital net patient revenue (NPR). The more revenue a healthcare provider generates the better R1 does.
Revenue is reported in three segments: Net Operating Fees (72% of 2022 revenue), Incentive Fees (6% of 2022 revenue), and Modular & Other (22% of 2022 revenue).
Net operating fees are what R1 charges customers for operating their revenue-cycle processes, minus any operating costs R1 has agreed to cover in the RCM contract.
Incentive fees are based on the operating and financial performance improvements resulting from R1’s services. They are assessed each quarter and charged that same quarter.
Modular & Other revenue captures variable monthly fees and service charges for R1’s modular relationships and Cloudmed revenue.
The company tends to collect revenue on a one-quarter lag. That means good healthcare provider utilization in Q1 will pay off for R1 in Q2, Q2 pays off in Q3, and so on.
The Bottom Line
R1 has grown revenue at an average annual rate of 32% since 2017. In 2022, revenue grew by 22.5% to $1.8 billion. The main growth drivers have been growth in net patient revenue (NPR) under management, strategic partnerships and acquisitions.
First-quarter 2023 revenue grew 41% to $546 million (a hair less than expected) while EPS of $0.02 missed by a penny. Breaking down the mix, revenue from Net Operating Fees was $361 million (+11%), Incentive Fees was $23.6 million (-22%) and Modular & Other Services was $161 million (+392%) thanks to $125.8 million in revenue from the Cloudmed acquisition. Analysts tend to focus on EBITDA for this company and on that measure R1 beat expectations, delivering adjusted EBITDA of $142 million.
A major focus on the conference call was cash collections from R1’s customers. Management has been very focused on this and said operational improvements are bearing fruit.
Management reiterated full-year 2023 guidance, which calls for revenue of $2.28 billion to $2.33 billion and adjusted EBITDA of $595- 630M. The consensus 2023 EPS estimate is $0.29.
Customer concentration: In 2022 49% of revenue came from Ascension’s health system and 11% came from Intermountain Healthcare.
Execution: R1 ran into some issues collecting payments in Q3 2022 and getting some customers up and running. The stock dropped significantly, and investor confidence was shaken. Management has devoted considerable resources to improve execution and there is a new management team at the helm. While the recent trends are better, investors will closely monitor operating metrics (incentive fee recovery, NPR onboarding, payer reimbursement timelines, utilization and patient self-pay) for another couple of quarters. And the stock could react negatively to any missteps.
Industry Resistance to RCM: While outsourcing RCM seems like the way to go, the estimated opportunity will be smaller if a good number of healthcare providers don’t want to go this route.
Data Breach: Data privacy is the Holy Grail in healthcare. Should any privacy issues arise that are the fault of R1, confidence could be shaken.
Ensemble Health Partners (private), Conifer Health Solutions (private), Health Catalyst (HCAT), NextGen Healthcare (NXGN) and Veradigm (MDRX).
Trading Volume: RCM’s 90-day average trading volume is 2.75 million shares per day. We won’t influence this stock’s trading action.
Historical Price: RCM came public at 12 in May 2010. Shares were trading in the low teens just prior to the pandemic then challenged all-time highs in the low 30s at the peak of the 2021 bull market. RCM was above 25 last August when the company ran into some payment and execution issues, which ultimately drove a decline to 6.7 by mid-November 2022. The stock has been steadily climbing back since. It has been above its upward-sloping 50-day line almost every day since January 5 and above the downward-sloping 200-day line since May 5.
Valuation: RCM currently trades with an EV/2024 EBITDA multiple of a little over 12. That’s a discount to a target valuation multiple of 15 that many analysts currently have. Upside to EBTIDA estimates would mean that multiple is even lower than it should be.
Buy Range: Prior to the Q2 earnings report in early August, expect to buy RCM as low as the stock’s 50-day line at 16.7 and up to 20. BUY
The Next Event: Q2 2023 earnings around August 3.
|Stock Name||Date Bought||Price Bought||Price on 7/5/23||Profit||Rating|
|Duolingo (DUOL)||6/1/23||152||140||-8%||Buy 1/2|
|Flywire (FLYW)||8/4/22 & 11/9/22||21.62||30||37%||Buy|
|Inspire Medical (INSP)||10/4/19||59||315||437%||Hold 2/3|
|R1 RCM (RCM)||NEW||--||18||--%||Buy|
|Repligen (RGEN)||11/2/18 & 12/31/18||59||137||132%||Sold 3/4, Hold 1/4|
|Si-Bone (SIBN)||5/3/23||24||27||11%||Buy 1/2|
|Terex (TEX)||3/3/23||60||59||-1%||Buy 1/2|
|TransMedics Group (TMDX)||7/7/22||34||82||141%||Hold 3/4|
Please email me at firstname.lastname@example.org with any questions or comments about any of our stocks, or anything else on your mind.
Buy means accumulate shares at or around the current price.
Hold means just that; hold what you have. Don’t buy, or sell, shares.
Sell means the original reasons for buying the stock no longer apply, and I recommend exiting the position.
Sell a Half means it’s time to take partial profits. Sell half (or whatever portion feels right to you) to lock in a gain, and hold on to the rest until another ratings change is issued.
Disclosure: Tyler Laundon owns shares in one or more of the stocks mentioned. He will only buy shares after he has shared his recommendation with Cabot Small-Cap Confidential members and will follow his rating guidelines.
The next Cabot Small-Cap Confidential issue is scheduled for August 3, 2023.