Tuesday, January 28, 2014

KKR & Sedgwick - Gold In Hills

If you thought I would have something provocative to say about Kohlberg Kravis Roberts purchase of Sedgwick for $2.8 billion, you'd be wrong.

The deal had been in the rumor mill for months but everyone was mums about it. Those in the know and involved were very good at keeping a big secret.

There seems to be agreement by observers that this move is good for workers' compensation because the resources that KKR brings to the sector will deliver greater efficiency and speed in claims handling and systems.

Some believe that this is just the first of several deals coming down the pipeline for this year as workers' compensation attracts new, fresh investment capital from a variety of sources.

"It's going to be a pretty exciting business for the next few years," industry analyst and principal of Health Strategy Associates Joe Paduda said.

Whether or not this is good for the industry overall I can't say.

But what this deal does tell me is that claims servicing, particularly in workers' compensation, must be much more attractive than what those of us typically think.

We forget that this is a business; a big business, with lots of moving parts, lots of areas where competition, efficiency, and profit can be derived simply by providing expertise in the delivery of medical treatment and indemnity to injured workers and their dependents.

Because of the complexity of delivering medical services and indemnity under one umbrella, there are friction points in the process and if a company can lubricate and minimize the friction then it can profit off a percentage of the trimmed fat.

On the macro scale its easy to get antiseptic in our observations of the industry because it is so heavily metric driven.

For instance, Sedgwick annually handles more than 2.1 million claims and oversees claims payments totaling more than $11 billion, mainly in auto insurance and workers' compensation. It has 11,000 employees in 200 offices in the U.S. and Canada.

That's a big operation.

If we analyze this deal from the operational cash flow perspective then every dollar of claims payment is roughly worth 20% of the company. That cash flow must generate some impressive numbers on the investment back end to warrant the two billion dollar price tag.

EBITDA, Earnings Before Interest Taxes Depreciation and Amortization, is a common deal evaluation metric. It is net income with interest, taxes, depreciation, and amortization added back to it, and can be used to analyze and compare profitability between companies and industries because it eliminates the effects of financing and accounting decisions.

EBITDA is used to evaluate profitability, but not cash flow. EBITDA also leaves out the cash required to fund working capital and the replacement of old equipment, which could be significant, but in a service business such as Sedgwick old equipment is not going to be a big factor.

A typical EBITDA value comes in around 10 times earnings. If a company is highly valued EBITDA can be as high as 20%. So if we reverse engineer the KKR/Sedgwick deal at the 10% level we can assume that Sedgwick generates about $280 million per year in earnings.

This is just a guess of course because I don't have access to the books - just an observation. And there may be other factors that either increased or decreased the typical valuation - since Sedgwick wasn't in distress, then likely KKR paid a premium rather than a discount, which might mean that EBITDA is as high as $460 million per year, or more.

KKR already owns claims-payment technologist, Mitchell International. You see Mitchell at all the big trade shows. So KKR has some previous experience and exposure to the work comp claims industry.

KKR is a big investment firm with lots of money ($90.2 billion in assets under management as of last September). And we have to assume the firm has lots of smart people that understand investment, understand markets, and know where the good money should go.

That they chose workers' compensation claims handling is indicative of the health of the industry.

So whether or not KKR's purchase of Sedgwick is good or not I can't say. What I can say is that obviously, "there's gold in them hills."

I reckon that in the grand scheme of things, workers' compensation is still a pretty good financial deal. Services necessary for the redistribution of wealth to account for work place injury claims are not going away any time soon.

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