The market is a great discounting mechanism. Current share price is supposed to reflect future earnings, hence discounting the opportunity. Sometimes there is a wide gap between the expectations of the market and what the future really holds. When this happens, there’s an opportunity for an investor to take advantage of the disparity and enter stocks that will outperform the market as the disconnect between expectations and reality converge.
Catasys is a classic example of this disconnect between investors’ assumptions and what is really happening. In this case, investors have been selling CATS shares lately as they assume that, since Q3 is looking flattish, despite a very large increase in Eligible Lives, something in this story is not adding up.
Frankly, I was getting concerned that something wasn’t adding up, too. This led me to spending the time to develop a model for Catasys’ billings. I always find it helpful to model out key drivers for a stock and am honestly kicking myself for not having done so earlier on CATS. Because, what my model has told me is that Q3 should be flat over Q2 despite the uptick in Eligible Lives and that things are actually going just fine during this flattish-type quarter.
Modeling the billings…how come a flat Q is not an issue?
For Catasys, billings is the key metric to follow. This is because they bill out monthly for every patient in the OnTrak program. Meanwhile, their cash flows vary based on the contracts in place with the insurers (each is unique) and their GAAP revenues reflect lower numbers due to reserves, with large makeups at year end.
The reserves the Company takes are an important indicator of their success, but we’ll discuss these in greater detail later. However, when looking for billings numbers, they don’t come into play. Simply, if you take the number of patients in the OnTrak program, multiply that by $8,400 (yearly rate), and then divide by 12, you’ll have the monthly billings and a very good sense of how the business is going at that point in time.
In Q3, the Eligible Lives currently in outreach with Catasys jumped from 6,000 to 24,000. On the surface, one would think that billings would have a large increase as well, right? Not exactly. Let’s dig into the current enrollees to understand this better.
The first thing to realize is that enrollees come on for 12 months only. Thus, after a year, they drop off the billings, to be replaced with new enrollees. This is important to note as Catasys’ business was impacted substantially in the first half of 2017 due to the failed Humana merger and data integration issues with Aetna. Thus, instead of outreaching to replace enrollees, Catasys was somewhat restricted, resulting in recent enrollment rates being lower.
What this means is that during every month in the first half of 2017, they were signing up fewer new members than were rolling off after 12 months. Thus, the base billing number coming into Q3, the number which to we are adding 18,000 potential Eligible Lives, was dropping.
Due to this fact, had the Company not increased Eligible Lives in the second half of 2017, revenues would have been down for two more quarters before bottoming out. This is a major headwind facing the Q3 and Q4 results.
The second thing to keep in mind is that an increase in Eligible Lives doesn’t translate into an immediate, large impact in bookings. Let me explain…in my model, I have Eligible Lives increasing by 6,000 per month in Q3, to get to the total of 24,000 at quarter end.
The 6,000 additional Eligible Lives added in July will translate into 1,200 additional enrollees, per the 20% rate the Company expects to enroll. However, it takes 11 months to reach this target of 1,200. (I use 11 months as most, but not all, of the current Eligible Lives are addiction…when the Company gets more depression and anxiety patients, this timeline will shorten) I model an increase in Eligible Members as a straight line increase in billings over the 11 months, starting in the month after the increase.
The result of this, in my model, is that 6,000 additional Eligible Members in July leads to 133 new enrollees starting in August and 133 more in September. With 133 new members for two months and 133 for only one month, we should get additional revenue in Q3 of only $186,900 from the new enrollees, right?
Not quite. The increase in revenue is not even this strong because of the way that Aetna, a large part of the increase in Eligible Lives, calculates their billings. Aetna is different from other insurers and, to put it simply, there is a 2-month delay in billings, which puts a further near term damper on revenue increases.
There is, therefore, not a substantial increase in revenues at all from new members, despite the large uptick in Eligible Lives. Compound this with the fact that the first half of this year was weaker than the previous year, and you are looking a declining base billings number added to a modest increase from new members. The result of which is a very flat quarter according to my model, even with the Company firing on all cylinders.
How does this translate into coming quarters? My Base-Case…
Here’s where the disconnect between expectations and reality start to get interesting, and potentially profitable, for investors. With Catasys increasing Eligible Lives to 24,000 in Q3, billings will really start to ramp up over the next 11 months as they approach full 20% enrollment.
My model shows an increase in Q4 billings of just over $200,000, or around 10%. This number increases more in Q1, with a jump in total billings to $3.0M (up 30%, Q/Q), and again in each of the next three quarters.
It’s VERY important to note that, at this time, I’m not modeling in any more increases in Eligible Lives as this is just my base-case scenario. I see the Company, just looking at its currently signed deals, generating about $20M in billings in 2018, and getting close to cash flow positive in the first half of the year.
It’s my belief that, at this time, investors are hyper-focused on near-term results and also not understanding the delay in translating new Eligible Lives into revenues. This is the opportunity that investors who can see through the near term haze can profit from.
The upside scenarios are mind-boggling…
Having done the base-case scenario for 2018 (a scenario in which they add zero new Eligible Lives, which is beyond extremely unlikely), I’ve come up with the aforementioned $20M in billings for 2018, a number that takes the Company well into cash-flow positive territory by year-end.
What are the variables that could change this figure? There are several factors that can add to my estimates for billings, and each of these can do so in a meaningful way. First off, there are some very large new customers yet to launch. We have the possibility of the following customers coming online sometime in the next 6-9 months, each with a potential 40,000 or more customers:
- United Healthcare
Any one of these customers adds a far greater than 100% increase to Eligible Lives and brings the company above its internal goal of 50,000 Eligible Lives in 2018. A combination of any two and we reach over 100,000 Eligible Lives. To put this in perspective, a constant run rate of 100,000 Eligible Lives is about $150,000,000 or more in annual billings.
On top of announced new rollouts, the Company has also said it expects to get two of the three remaining largest healthcare plans as customers soon. The three that are left are Anthem, Cigna and Kaiser. I believe Kaiser is unlikely as they like to keep things in-house as much as possible, so my guess is Anthem and Cigna both sign up soon. We all know it takes a while to roll this out, but either one of these two would be incrementally huge to 2018.
Other factors that could increase billings are:
- the enrollment percentage increasing…currently I’ve modeled 20%, but the Company has been seeing 25%
- the time to full enrollment shortening…this has been the case for diseases other than addiction, which are the larger opportunities
- current customers increasing states covered or diseases covered…highly likely to occur
Putting all this together, it is quite clear that Catasys has the opportunity to dramatically increase billings next year far beyond the base-case which I’ve laid out.
The base-case is solid, the upside is huge, but how do we know they are executing???
If you’re still reading, my guess is you have bought into my opinion that CATS will do a bare bones minimum of $20M in billings in 2018, and that there is substantial upside to this number. This is all based, of course, on the Company’s ability to execute. If the Company can’t treat patients properly, or can’t deliver results to customers, they will likely never achieve my base-case, much less any upside.
The good news is that my checks tell me that, not only is the Company executing properly, they are beating expectations. This is evident in the numbers that they have presented on their earnings calls and in their financials.
Starting with patient results, Catasys is retaining 80% of their patients the whole way through the one-year OnTrak treatment program. This is a very strong number, based on the fact that patients with Behavioral Health Disorders are quite likely to quit programs. Add to this general attrition where patients change health care providers, or simply lose their insurance, and it’s quite reasonable to think that only 20% dropping out is a great rate.
While there aren’t great comparisons for CATS, the best one I could find is “Able to Change”, which runs a chain of treatment facilities. Comparing them to Catasys, Able to Change’s dropout rate is 50%, a number that speaks to the quality of the program being managed by Catasys.
The quality of the work being accomplished by Catasys is further evidenced in their fee structure. CATS promises insurers a savings on enrollees. As a matter of fact, they guarantee them a certain level of savings and takes reserves against this. If Catasys doesn’t save a certain amount per patient on average, they have to start returning fees to their insurance provider partners.
To date Catasys has never had to dip into the reserves and return any money to its customers. This is absolutely huge as it speaks volumes to the quality of the treatments performed by Catasys; the patients are improving and are less of a drag on the healthcare system.
It also speaks to the compelling value proposition that CATS offers its customers. There seems to be little reason why an insurer wouldn’t work with Catasys if the Company is guaranteeing results, right? This is a fundamental reason why most large insurers in the country have signed up as clients and why I believe, despite the delays, they will continue engaging CATS.
For insurers, Catasys represents a limited risk means of lowering your patient costs and they guarantee results; I’m fully expecting the upcoming launches to happen and to be huge for CATS.
The bottom line…
I started off by saying there is a disconnect between expectations and reality in regards to Catasys. It appears that investors are getting increasingly focused on the Q3 numbers for CATS and are disappointed that there’s no growth in those numbers.
My model predicts that there shouldn’t be any growth, however, and this is not in the least disturbing to me. On the contrary, the research I’ve done into understanding the value proposition of Catasys’ OnTrak program, the success they are seeing in patient treatment, and the upcoming growth based on current Eligible Lives has me more excited than ever about CATS.
With $20M in billings in 2018 (once again a base-case scenario), CATS stock should be trading at many multiples of this number. Instead, the stock is languishing at around 3X next year’s base-case. If they can achieve even a fraction of the potential upside, the multiple drops dramatically.
I believe CATS represents a compelling opportunity going into Q3s earnings numbers. The street is missing the big picture. Yes, the billings will be flat. However, this is what they are meant to be and any weakness related to this is simply misunderstood selling and a chance to accumulate more shares.
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