Imaging Is Everything

Farmington, Conn.-based Magellan (MGLN) is the nation's largest manager of so-called behavioral-health services, which treat depression, mental illness, drug and alcohol addictions, and more. The company serves 40 million enrollees, most through outsourcing deals with health plans and through employee assistance programs. It boasts a nearly one-third share of the behavioral-health market.

Prior to 1997 Magellan's primary business was operating psychiatric hospitals. Over the next year it bought three large behavioral-health-management companies and exited the hospital business, but took on more than $1 billion in debt to do so. The result was a 2003 bankruptcy from which the company emerged in January 2004.

Magellan's troubles aren't over. Behavioral health is a mature, slow-growth business. Health plans in recent years have found it more profitable to handle in-house behavioral-health services they had previously outsourced. Over the past year Magellan has lost business from large commercial customers like WellPoint (WLP) and Aetna (AET) and government ones like TennCare.

Management's plan is to offset declines in behavioral health by entering new, fast-growth businesses like radiology and specialty drugs. Spending on radiology, or medical imaging, accounts for 10% to 12% of total health care costs and is growing at 15% to 20% a year, industry watchers say. In January Magellan bought privately held National Imaging Associates, based in Hackensack, N.J., for $122 million in cash. The company specializes in advanced radiology technologies: MRI (magnetic resonance imaging), CT (computed tomography) scan, PET (positron emission tomography) scan and nuclear cardiology tests. Demand for such tests is growing faster than that for traditional tests like X-rays.

The newly announced Cigna deal covers advanced radiology services for three million plan members. Magellan will manage half of these on an ASO, or administrative services only, basis and the rest on an at-risk basis. ASO business pays a set fee while at-risk business places Magellan in the role of underwriter, with profits varying according to premiums and claims. The latter arrangement is much more profitable, analysts say. Carl McDonald, an analyst with CIBC World Markets, figures the deal will add at least 15 cents a share to Magellan's earnings. Before the announcement Magellan was forecast to earn $2.31 a share next year. McDonald believes the deal goes a long way toward validating management's new strategy.

In June Magellan bought Icore, a privately held manager of specialty-drug plans. Icore works with health plans to manage the use of high-cost drugs for chronic diseases: cancer, multiple sclerosis, hemophilia, rheumatoid arthritis and so on. Costs for such drugs grew 17% last year, analysts say.

Magellan's latest buying spree bears little resemblance to the one that drove it to bankruptcy. The companies it has bought generate healthy returns and Magellan itself is financially strong. Third-quarter results, released Thursday, showed expected declines in both sales and earnings, but the company's cash balance stood at $130 million. Analysts expect it to increase to $450 million, or $11.50 per share, by the end of 2008 thanks to the company's strong cash flow.

This column pointed out in July 2005 that Magellan was losing customers but that its stock was nonetheless a bargain. Shares at the time had turned up on our Takeover Targets screen, which doesn't try to predict buyouts but which does look for inexpensive stocks using the tactics of buyout pros. In particular, the screen makes use of the EV/Ebitda ratio, which compares a company's enterprise value (its total purchase price net of debt and cash) to its earnings before interest, taxes, depreciation and amortization (its underlying earnings power). See our screen recipe for details on everything it looks for and use our stock screener anytime to run the search for yourself. Magellan shares are up 26% since that first appearance, a little more than double the broad market's return. Recently they turned up on the same screen. The company's EV/Ebitda ratio as of Wednesday's close was 6.3, vs. a median of 10.4 for the S&P 500 index.

Using estimates that haven't yet been adjusted for the new contract, Magellan trades at 21 times forecast 2006 earnings. It's expected by analysts to boost its earnings by 15% a year over the next five years. Those numbers make for a PEG ratio (price/earnings ratios divided by earnings growth projection) of 1.4, or about a 7% discount to the broad stock market. Add the new earnings and the discount grows. Adjust for the company's recent habit of far surpassing earnings estimates, and the stock becomes even more appealing. Late Wednesday Magellan topped earnings estimates by about 13%. Over the prior four quarters it did so by an average of 33%.