Voce Capital Long Letter to Air Methods
Voce Capital owns 4.9% of Air Methods (NASDAQ: AIRM) and has put out a lenghtly letter. See below.
September 16, 2015
Members of the Board of Directors
Air Methods Corporation
7211 South Peoria Street
Englewood, Colorado 80112
Attention: Corporate Secretary
Lady and Gentlemen:
Voce Capital Management LLC and its affiliates (collectively, Voce) beneficially own 1,951,551 shares of Air Methods Corporation (Air Methods or the Company), representing approximately 4.9% of its shares outstanding, making us the Companys sixth-largest shareholder. As you are aware, we are also long-term owners of Air Methods, having been shareholders since September 2011.
In our discussions with management over the past several months, and in our meeting with you in Denver on August 3, we have expressed our concern that Air Methods public ownership structure is increasingly problematic and has led to a sharp divergence between the Companys intrinsic and trading values. While Air Methods is currently valued at approximately 7.5x its 2015E EBITDA, similar assets have been repeatedly purchased by private equity firms for approximately 10x EBITDA including its closest competitor, which has traded hands twice in the past five years (and as recently as April of this year) in that range. That would imply a private market value for Air Methods of approximately $55-$60 per share more than 50% above its current trading price.1 In our opinion this wide discount is structural and unlikely to narrow as long as Air Methods remains public.
We were encouraged to hear that you share our view that Air Methods is severely undervalued. We continue to believe strongly that the clearest and quickest path to addressing this gap and maximizing the value of Air Methods is through a sale of the Company, most likely to a financial sponsor. Nothing we learned during our recent meeting or in our subsequent discussions with you has changed this view. In fact, management is on record publicly stating its willingness to explore a privatization if the Board will simply provide its blessing. Were therefore at a loss to understand the Boards refusal to do so.
Events subsequent to our meeting have heightened our concerns and motivated this letter. Follow-up discussions with you have confirmed a lack of any intention to even consider a potential sale at this time. Instead the Board has floated a variety of other initiatives, such as acquisitions and internal succession planning (including the announcement of a process to recruit senior executives by dangling the prospect of becoming a public company CEO) that could complicate or prevent a potential sale of Air Methods. Finally, weve learned that the Board has recently received highly credible inbound private equity interest which it wont pursue.
We no longer believe the status quo is tenable or in the best interests of the Companys shareholders. The time for a public discussion of these issues has therefore arrived.
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Air Methods is the market leader in the large and attractive $4 billion air medical market, transporting some 100,000 patients per year. In addition to its nationwide footprint of 199 community and 93 hospital bases, Air Methods has a young fleet of 408 rotary aircraft and 26 fixed-wing planes, most of which are owned by the Company rather than leased. It has built a network of strong preferred provider arrangements with hospitals and a flight call center business that directs a significant number of transports to its bases. The barriers to entry are high, given the capital-intensive nature of the business, complex relationships and required flight operations expertise. A unique market structure, with little to no direct competition or group purchasing contracts, is also very attractive: Because its prices are unregulated and demand is relatively inelastic, Air Methods has been able to take price routinely.
While we continue to believe that Air Methods is a great business, it has become a rather crummy stock. Due to Company-specific issues, the shares have been under enormous pressure well before the arrival of the markets recent increase in volatility: Year-to-date the stock has fallen approximately 19% and is down a staggering 37% in the last twelve months. Its performance also badly lagged in 2014, with a negative shareholder return of 24%.
We believe that several conscious choices have contributed to this change in fortune. First, Air Methods decision to tilt more heavily into community-based service (CBS) and away from hospital-based service (HBS), while financially astute due to its superior unit economics, has rendered the Companys results far less predictable, as they depend more heavily today on variable patient volumes than they did when a higher percentage of revenues flowed from fixed-contract HBS. This has increased the volatile nature of Air Methods earnings while obscuring visibility into its performance, with its quarterly results becoming wildly unpredictable as its business mix has changed. From 2010 through 2012, Air Methods met or exceeded consensus Revenue, EBITDA and EPS estimates in eight out of twelve quarters and negatively pre-announced only once. But beginning in 2013, it missed six out of the next ten quarters and pre-announced four times. These frequent surprises have routinely, and viciously, punished the stock.
Second, as the percentage of patients covered by private insurance has deteriorated for Air Methods (and for the healthcare delivery system as a whole), it has been forced to rely upon an ever-shrinking base of commercially-insured patients, paying an ever-increasing rate for its services, to balance its books. Its success in doing so has confirmed the pricing power that it wields, but the continuous rate hikes have also engendered additional economic and political risks to the Company. As the only publicly-traded, largely pure-play air medical company, Air Methods detailed financial and operating results are available for everyone including the commercial payors now responsible for the vast majority of its revenue to dissect on a quarterly basis. Transport volumes, gross and net pricing, payor mix and collection dynamics, just to name a few sensitive items, are fully visible to Air Methods ultimate customers and paint a clear road map for those whose interests are not necessarily aligned with the Companys. Air Methods candor regarding its pricing strategy, and disclosures about its collections and the aging of its receivables, have also ignited a raging debate about whether its pricing power has ebbed or if commercial payors are beginning to push back. Not surprisingly, the already active short-selling community has piled on, adding to the stocks downdraft.
Compounding matters, the popular press now characterizes Air Methods business decisions in response to these changed market conditions as greedy and predatory.2 Ironically, this narrative depicts Air Methods as a villain that victimizes the very patients whose lives it saves, allegedly gouging them with rapacious pricing and then targeting them with aggressive collection efforts when they fail to pay. The merits of these preposterous claims are irrelevant; the granular availability of the Companys results, and its status as the only public entity in the space, make it in an irresistible target for such demagoguery. Once a company has a target placed on its back in this manner it can take years to efface it, if it is able to do so at all.
As a result of the foregoing, public investors have re-rated Air Methods to compensate for what they perceive as a lumpier, murkier and riskier business. At roughly 7.5x TEV/EBITDA, Air Methods now trades below its own five-year average of 8.3x EBITDA. As discussed in the next section both of these values are sharply lower than the Companys intrinsic value.
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Juxtaposed against the turbulence Air Methods has encountered in the public markets has been strong private equity appetite in the emergency medical space. Air Methods closest competitor, Air Medical Group Holdings Inc. (AMG), was purchased by KKR earlier this year from Bain Capital for what was reported to be approximately 9.5-10.0x EBITDA. Interestingly, the multiple paid in that transaction is quite similar to what Bain is believed to have paid in 2010 when it bought AMG from yet another group of private equity owners. A predominantly ground-based competitor, Rural Metro, was acquired by Warburg Pincus in 2011 for nearly 11x EBITDA and another competitor, Emergency Medical Services Corp. (EMS), was bought by Clayton, Dubilier & Rice for 9.5x EBITDA in 2011; EMS later changed its name to Envision Healthcare and went public again in 2013.3Rural Metro was then scooped up earlier this year by Envision for a similar multiple (10.3x EBITDA).
Its no surprise that financial sponsors love these kinds of businesses. The quarterly ups and downs, exaggerated by funky accounting, just arent as big a deal for private owners with committed capital and long-term horizons. The unusual market structure has little direct competition which allows participants to regularly raise prices (although as previously discussed it is this controversial practice that is increasingly difficult to sustain as a public company). As a result, Air Methods generates very strong margins and cash flow, which have allowed it to invest heavily in upgrading its fleet and buying out aircraft leases on attractive terms.
The repeated investment of the industrys premier private equity firms in the medical transportation space suggests to us that Air Methods is likely to attract similar demand were it to formally explore the possibility of going private. Significant private equity interest was expressed in Air Methods following the original AMG sale, and based on recent conversations weve had with private equity firms we believe Air Methods would find similar interest again were it to seriously entertain a potential go-private transaction. In fact, Air Methods has recently received highly credible inbound private equity interest yet the Board refuses to even consider it.
Our conservative analysis, based solely on publicly-available information, suggests that a financial sponsor could acquire Air Methods at a price substantially above the current level, using a manageable amount of leverage and earning an attractive (but not egregious) rate of return on the equity invested. More specifically, assuming gross leverage of 6x (less than AMGs) and a cost of debt of 7.5%, and utilizing reasonable growth forecasts, we believe that a sponsor would realize an IRR of 21% over a four-year horizon were it to pay $55-$60 per share for Air Methods implying an EBITDA valuation of about 10x, right in line with what KKR paid for AMG. Against Air Methods current stock price of $35.64 and volume-weighted average prices of $44.79, $44.75 and $38.39 over the past one-, three- and five-year periods, thats a deal we believe long-term shareholders would heartily applaud.
A proactive process to explore a potential sale would have many benefits. A key advantage is that the raging controversies about Air Methods could be definitively evaluated by potential acquirors in a way that public investors simply cannot (as much as we might like to). Critical questions concerning Air Methods pricing, mix and collections are the crux of the debate over the durability of the Companys strategy and business model. A limited number of qualified parties, with the protection of a non-disclosure agreement and through a robust but properly managed due diligence process, would review this information and reach an informed conclusion that could support a purchase price far in excess of the pessimistic valuation that public investors have assigned the Company, given the lack of visibility into this data. A sale process led by a skilled financial advisor also increases the odds of a competitive bidding situation, which could result in outlier pricing.
A growing consensus within the investment community supports the view that privatization of Air Methods is a superior alternative to remaining under the public microscope. In recent discussions with other institutional owners of the Company we have encountered strong endorsement of such an outcome. Many of the Companys sell-side analysts have also openly raised this prospect.4 No one can say it better than the Companys long-time CEO, Mr. Todd, did earlier this year:
[I]f the Board of Directors were to suggest a privatization&this management team is going to support the Board . . . . [W]hen youre trading at a large discount to what private equity transactions have recently manifest, I think the Board will have to be very reflective of its many options that it has.5
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During our August 3 meeting, and in subsequent conversations, weve been struck not only by the Boards inertia but by its lack of understanding of how potential acquirors would evaluate an acquisition of the Company. We cant concur with the Boards conclusion, which it stated repeatedly, that it will await the return of a higher stock price before considering a sale of the Company because doing so would create more value for shareholders. While the Board expressed several variations on this theme, they are united by the common assumptions that (1) such a higher valuation is not achievable now and (2) by waiting longer a higher valuation will materialize at some point in the future. Both of those could well be wrong and most importantly, even if they are correct, they disregard the time and execution risks the Board is imposing upon shareholders through its continued inaction.
First, we dont agree with the Board that value is capped because potential buyers will reflexively pay no more than a 25% premium when acquiring a public company, regardless of stock price or fundamentals. This cynical view fails to appreciate that private equity, like any asset class, is a returns-driven business that can be expected to pay the highest price necessary (but no more) to purchase an asset that suits its strategy and clears its return hurdles. Those returns are dictated by the cost of the debt it can access to buy the business, the residual amount of equity required and the projected cash flows. While the ultimate price can be expressed as a premium, thats a function of the valuation rather than the other way around.
Moreover, while private equity acquisition premia do tend to average a mid-twenties range (the same is generally true for strategic acquirors), there are many examples where private equity firms have paid substantially more (or less) for assets. Set forth in Exhibit A is a broad sample of premia paid in private equity acquisitions, across a wide variety of sponsors, industries and deal sizes, in the last five years. The dispersion of these outcomes is instructive. The key to maximizing value in such a process is to highlight sources of value that are not properly recognized by the public markets. As previously discussed, Air Methods is a textbook case where private equity should be able to unlock exactly this type of latent value, given its private ownership structure and longer time horizons.
Second, at the same time we think the Board underestimates the ability to maximize value today, its belief that it retains the option to sell the Company any time it wishes in the future for a 25% premium seems overconfident. A sale to a financial sponsor is neither a get out of jail free card nor a break the glass in an emergency back-up option. The denouement of one of the greatest credit bubbles in modern economic times is at hand. While no one can predict its exact end, its highly unlikely that credit markets will continue to be as attractive as they are now. As the cost of debt financing escalates, this will directly impact private equity returns and therefore the ability of these buyers to pay. As a result, these transactions will be significantly less attractive or may be totally unavailable for extended periods. Now is an incredibly propitious moment in time for a business whose best and perhaps only exit alternative is privatization. To fail to even explore this option, which the Companys owners may never enjoy again, would be a grievous disservice to them. As fiduciaries, the Board must not squander this opportunity.
Third, we believe the Boards decision making framework is seriously flawed in that it fails to take account of the time and execution risks of waiting when compared to the certainty of value that could be unleashed by a possible transaction today. Assuming a transaction price of $55 per share (the low end of our range), and an equity discount rate of 12% (which we all agreed when we met was likely conservative), and applying the Companys approximate 7.5x multiple of TEV/EBITDA, the Board would have to believe that it could grow EBITDA from a projected $270 million in 2015 to $466 million by 2018 to deliver an equivalent value to shareholders. That implies a compounded annual EBITDA growth rate of 19.5%, which would far exceed anything Air Methods has ever posted. Even including the Omniflight acquisition in 2011, the largest in its history, and crediting the tourism acquisitions too, the business has compounded EBITDA over the last four years at 12.8%. (Based on Company disclosures, we estimate that removing the huge step-up from Omniflight reduces that growth rate to approximately 9.2%.)6 Basing strategic decisions on an assumption that Air Methods can grow cash flows at 20% or anything close going forward is neither rational nor responsible.
Finally, we question how the Board can legitimately believe that an acquisition price of $55-$60 would not be attractive to shareholders given the pattern of insider selling at prices substantially below this range. Since 2012, Directors Belsey, Bernstein, Carleton, Kikumoto, McNair and Tahbaz a majority of the independent Board members have all dumped Company shares.7 Not only does this signal a lack of confidence by the Companys leaders but it raises doubt as to whether the Boards reluctance to evaluate a sale is premised on a genuine belief that the stock is worth substantially more: None of the Director sales have occurred at prices above our valuation target, and the weighted average price of these insider sales was only $40.91!
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Given the significant destruction of value that Air Methods shareholders have suffered, and the robust acquisition market for similar assets, the time to formally pursue a sale of the Company is long overdue. Wed hoped that months of private dialogue would motivate it to act, but Air Methods shareholders cannot wait any longer for the Board to come to this realization on its own. We fear that recent announcements concerning potential acquisitions and succession-based recruitment could result in a potential sale of Air Methods becoming more difficult. We caution the Board against taking such steps at this time, or to at least defer them until it has fully explored a potential sale of the Company.
As noted earlier, weve already begun communicating with other shareholders and potential buyers and we plan to continue to do so. If necessary, we may also consider retaining an investment bank to represent shareholder interests by formally identifying acquisition interest in the Company. We once again urge the Board to immediately pursue a potential sale of Air Methods with the assistance of a credible, independent financial advisor. Should the Board continue to refuse to act we are reserving the full range of options available to protect shareholder interests.
VOCE CAPITAL MANAGEMENT LLC