What's The Deal: Misdiagnosing Healtheon/WebMD

SAN FRANCISCO (01/27/2000) - It's enough to make Steve Case jealous. AOL stock has been under pressure because the merged AOL Time Warner Inc. will have a growth rate half that of AOL alone. But on Monday investors appeared oblivious to similar circumstances surrounding Healtheon/WebMD's $2.5 billion acquisition of Envoy, the $250 million medical claims processing unit of Quintiles Transnational Corp.

Recent revenue growth rates of traditional claims processing businesses have been 35 percent at best, and often much less. Profitability has been inconsistent, including at Envoy and at Mede, an $85 million claims processor acquired by Healtheon in a $450 million deal that closed last November.

The Envoy acquisition will make traditional claims processing nearly 70 percent of Healtheon's business. On a pro-forma basis, that slashes Healtheon's total revenue growth rate to at least half the Net (like 100 percent sported in the nine months ending last September). That would clip Wall Street's projection of Healtheon's five-year bottom line growth from 50 percent to somewhere between 25 to 30 percent.

What's more, the stock Healtheon will issue to Quintiles will dilute Healtheon's yet-to-be achieved profits by 20 percent.

Despite all of that, Healtheon stock soared as much as 27 percent on the announcement. It closed up 9 percent while the Nasdaq was hammered 160 points.

The stock tacked on another 6 percent Tuesday.

Healtheon's Envoy deal is another high-profile reflection of an epiphany that's been overtaking Netcos: To change the old economy, it's necessary to become enmeshed with it. Simply acting as an opposing force won't work. The AOL-Time Warner merger took this new perspective far beyond the click-and-mortar concept of cooperation. So does Healtheon's purchase of Envoy.

But while investors immediately grasped the implications for growth in AOL Time Warner, they seemed to miss what's really going on at Healtheon.

The company's original vision was to use the Internet to revolutionize medical transactions such as claims processing. It still is. But the approach has been changing.

Envoy and Mede are electronic clearinghouses. They mediate communication among the creaky, incompatible systems of health services providers and those of payors such as insurance companies and Medicare. But going head-to-head against the deeply rooted legacy system by trying to forge direct links is incredibly arduous.

So, contrary to the sacred Internet e-commerce tenet of eliminating intermediaries, Healtheon is becoming one. The strategy is to change the rules from within - evolution more than revolution - and as importantly, obtain a base of steady cash flow during the long metamorphosis. But the price of that strategy is slower growth.

In addition, with 70 percent of revenue from claims processing, there will be a tug of war between preserving the Old Economy business and the risk of trying to replace it with Internet solutions - perhaps even while competitors such as the $1.2 billion Shared Medical Systems seek to convert Healtheon's clients to the same thing.

AOL and Time Warner haven't yet been able to sell the argument that AOL's web savvy can transform Time Warner's old media to financial growth worthy of Netco valuations. Yet investors appeared to express faith that Healtheon can dramatically improve the performance of the claims processing business sometime soon. Or was that just naivete about Healtheon's business?

The glitzy WebMD health information portal grabs investor attention, but it accounts only for about 20 percent of Healtheon's pro-forma 2000 revenue.

Moreover, WebMD's Net-like revenue growth so far has been mainly from "strategic alliances" with the likes of Microsoft and DuPont. The alliance partners obtained more than 25 percent of Healtheon/WebMD's stock at insider prices, along with low-risk deals that have Healtheon paying out nearly as much in cash and services as its press releases trumpet that it stands to receive.

Make no mistake, the engine room of Healtheon's revenue and cash flow is medical claims processing - a messy, grind-it-out business that definitely should not be confused with business-to-business hot buttons such as "vertical market trading communities." Apparently, some investors do.

Indeed, action in Healtheon shares even before the Envoy announcement reflected a chat-room mentality. In the five trading days prior to the announcement, the stock surged 53 percent on rumors that Healtheon/WebMD would be acquired by a major portal such as Yahoo! - obviously silly, given Healtheon's business mix.

When the real deal turned out to be something completely different, and certainly less compelling, the stock continued to rise anyway. It's called momentum.

In December, National Data Corp., a major transaction processing competitor with Healtheon, put a point on all of this. Frustrated with its stock's failure to attain any "Internet premium," NDC announced a spin-off. But it didn't look for that allure from its $226 million health services segment. Instead, the spin-off will be of its $174 million credit card authorization, cash management, and other merchant support services, touted as b-to-b enablers of the explosive growth of consumer e-commerce.

David Simons is managing director of Digital Video Investments, an institutional research firm. Write to him at simonsd@digvid.com.

At the time of publication, neither DVI nor any of its employees had securities positions in any of the companies mentioned herein. This column is solely for informational purposes. Under no circumstances is it to be construed as a recommendation to buy or sell securities. Neither DVI nor the author can provide investment advice to individuals.

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