CFA Research Challenge 2013-2014 Belmont University, Nashville, TN

1. CFA Research Challenge 2013-2014 Belmont University, Nashville, TN

2. 11% Increase in Sales in 2014 • 40% Increase in EBITDA • EBITDA Margin Widens by 250bps over 2013E • Economies of Scale • $0.29 Forward EPS • BUY Rating • $19 Price Target

3. Summary NASDAQ: HWAY $19.00 BUY 18.60 % Upside $16.02 Summary Business & Industry Financial Analysis Valuation Risks

4. Business & Industry

5. Healthways Overview NASDAQ: HWAY • Largest independent global provider of specialized population health management solutions for health related cost bearing entities • Scaled proprietary technology infrastructure and delivery capabilities serving >30M people on 4 continents • Return to growth and strengthening financial profile post 2011 customer transition Summary Business & Industry Financial Analysis Valuation Risks

6. Customer Breakout NASDAQ: HWAY Health Systems Blue & Regional Medicare Advantage Employers

7. Revenue Breakdown NASDAQ: HWAY Lives Under Management vs. Revenue (5% increase in lives leads to appx. 4% increase in EBITDA) Summary Business & Industry Financial Analysis Valuation Risks

8. Competitive Analysis NASDAQ: HWAY • Advantages • First-Mover • Experience • Wide array of services • Individualized programs • Disadvantages • High fixed costs • Dependency on large contracts Summary Business & Industry Financial Analysis Valuation Risks

9. Financial Analysis • Congressional Budget Office Actuary Data • Non-Partisan Healthcare Analytics • Surveys of Hospital Executives • Revenue Sensitivity Analysis

10. Growth Strategy NASDAQ: HWAY • The ACA incentivizes the formation of ACOs • Healthcare sector moving from volume to value-based payment • Shifting trend in the global healthcare landscape • High expected revenues will widen gross margin Summary Business & Industry Financial Analysis Valuation Risks

11. Healthcare Reform NASDAQ: HWAY Accountable Care Organizations Summary Business & Industry Financial Analysis Valuation Risks

12. Healthcare Reform NASDAQ: HWAY Coverage Projections Post-ACA Historicaland Projected Revenue vs. LUM Summary Business & Industry Financial Analysis Valuation Risks

13. Sensitivity Analysis NASDAQ: HWAY Revenue Sensitivity Analysis Summary Business & Industry Financial Analysis Valuation Risks

14. Valuation • Price Target: • EV/EBITDA • Free Cash Flow to Equity • Free Cash Flow to Firm supports BUY

15. 5-Year Average Enterprise Value / EBITDA NASDAQ: HWAY • Premium to the five-year average: • Increased market presence • Wider gross margins • Additional lives under management (Amounts in millions) Industry Average 7.33 10.40 Summary Business & Industry Financial Analysis Valuation Risks

16. Free Cash Flow to Equity NASDAQ: HWAY (Dollars in Thousands, Except per Share) Value Per Share: $19.26 Reaffirms BUY 25.77% Upside Potential Summary Business & Industry Financial Analysis Valuation Risks

17. Free Cash Flow to Firm NASDAQ: HWAY (Dollars in Thousands, Except per Share) Value Per Share: $22.80 Reaffirms BUY 48.92% Upside Potential Summary Business & Industry Financial Analysis Valuation Risks

18. Risk Analysis

19. Risk Analysis NASDAQ: HWAY High Probability Moderate Low Insignificant Severe Moderate Impact Summary Business & Industry Financial Analysis Valuation Risks

20. Questions

21. Presentation Slides • Summary • Overview • Customer Breakout • Revenue Breakdown • Competitive Analysis • Growth Strategy • Healthcare Reform (ACO) • Healthcare Reform (CBO) • Sensitivity Analysis • EV/EBITDA • Free Cash Flow to Equity • Free Cash Flow to Firm • Risk Analysis

22. Additional Slides • RIM Valuation • Free Cash Flow 2-Way Tables • EV/EBITDA Sensitivity • Management • Bear Price Justification • Global Legislation • SWOT Analysis • Comparable Firms • Pro-Forma Financials & Assumptions • CBO Projections • ACO & Pop. Health Management • Leavitt Partners Data • Bull, Base, Bear Sensitivity • LUM Estimates • EV/EBITDA • Beta Regression • Free Cash Flow Assumptions • FCFE • FCFF

23. SWOT Analysis NASDAQ: HWAY S W O T

24. Comparable Companies NASDAQ: HWAY (Dollars in Millions, Except per Share)

25. Historical and Pro-Forma Income Statement (Dollars in Millions, Except per Share) Source: Company Financials and Team Estimates.

26. Income Statement Assumptions Depreciation Expense: • Expected to remain at a constant percentage of PPE Cost of Goods Sold: • Remains at the 2012 percent of sales (78.84%) until 2015 at which time it declines by 1% per year until 2018, returning to the pre-Cigna-loss average of 73.61% of sales SG&A Expense: • Expected to remain at 9% of sales Interest Expense: • Expected to remain at 5% of Long Term Debt Effective Tax Rate: • Expected to remain at the historical average of 30% Share Count: • Forecasted EPS assumes constant share count of 35.06M

27. Historical and Pro-Forma Balance Sheet Assets (Dollars in Millions) Source: Company Financials and Team Estimates.

28. Historical and Pro-Forma Balance Sheet Assumptions – Asset Side Current Assets: • Expected to remain at a constant percentage of sales Leasehold Improvements: • Held constant over the forecast period Computer Equipment: • Expected to increase by 5% of sales from year to year Furniture & Office Equipment: • Held constant over the forecast period Capital Projects in Progress: • Expected to remain at a constant percentage of sales

29. Historical and Pro-Forma Balance Sheet Liabilities, Stockholders’ Equity & Metrics (Dollars in Millions) Source: Company Financials and Team Estimates.

30. Historical and Pro-Forma Balance Sheet Assumptions – Liabilities and Stockholder’s Equity Current Liabilities: • Expected to remain at a constant percentage of sales Long-Term Debt: • Expected to remain at a constant percentage of sales

31. Congressional Budget Office Projections (Millions of Americans) *Non-elderly Source: CBO’s May 2013 Estimate of the Effects of the Affordable Care Act on Health Insurance Coverage

32. Excerpt from Premier Fall 2013 Economic Outlook “In an ACO, providers take responsibility for the health of a defined population, coordinate care across settings and are held to benchmark levels of quality and cost. Unlike some previous delivery system reforms, ACOs seek to balance cost control with efforts to improve outcomes and enhance people’s satisfaction.” “[ACO] participation [is] projected to double by the end of 2014 to 50 percent. Overall, 3 out of 4 respondents say their hospitals have future ACO participation plans.”

33. Excerpt from Premier Fall 2013 Economic Outlook Continued Source: Premier Fall 2013 Outlook, Published December 2013

34. Levitt Partners ACO Registration Data “The current trajectory shows that providers and payers are recognizing the need to shift toward accountable care arrangements, or at the very least to shift away from fee-for-service care.”

35. Excerpt from American Medical Group Association “The shift to population health management, which will require an entirely different way of looking at health care.” “In an ACO practice, however, attention must shift to the management of all patients in a practice across the entire spectrum of health, from those who are well to those with the most complex conditions, including individuals at the end of life.” This will be a major transformation for providers and the healthcare systems they are associated with. Making the transition even more challenging, the Patient Protection and Affordable Care Act of 2011 will extend health insurance to an additional 32 million people and require enhanced coverage for preventative care. At the same time, the aging and growth of the U.S. population will increase the number of patients who need chronic care management.”

36. Excerpt from American Medical Group Association “In the ACO population health model, it is the aggregate results across all patients that matter – even if some individuals are not cooperative or engaged, their results still count in the world of accountable care.” “ ‘Practice-based population health’ which refers to the responsibility of primary care groups and networks for the health of their patient populations.” “This would also be the level at which risk-bearing ACOs would stand or fall on a financial basis.” PBPH, by definition, must address the health needs of a total patient population. Thus, ACOs must proactively reach out, not only to patients who have visited their doctors recently, but to every individual who has a relationship with an ACO physician”

37. Business Segment Sales and Sensitivity Analysis Base Case As discussed in the Investment Risks section of the report, unexpected developments in ACO growth, ACA mandate implementation, or internal lives under management growth will generate revenues outside of our base projection. To compensate for unforeseen events, be they positive or negative, we ran our valuation models with three different sets of assumptions briefly mentioned in the Valuation section of the report. Base Case: Our base case growth projections are based on a close analysis of ACO growth, macroeconomic shifts in the healthcare sector, international demand, and our estimates of Healthways’ potential for organic growth. These assumptions drive our $19 price target and buy decision for the stock. We expect HWAY can reasonably capture 3% of the new ACO demand for population health management and grow lives under management in the regional health plan, Medicare, and international segments by 10%, 4%, and 5% respectively. The base case also assumes -3% year-over-year decline in sales from the employer segment as described in the report.

38. Business Segment Sales and Sensitivity Analysis Bull & Bear Case Bull & Bear Case: Our bull and bear case projections give us best case and worse case scenarios for company growth. The bull price of $23 represents a 50.23% upside from the January 31 closing price while the $13 bear price constitutes a 15.09% downside. The assumptions for each of these scenarios are listed in the figures on the right. Running the revenue projections with bull assumptions gives us the forecast of $839.41M by the end of 2018 while the bear case assumptions project $735.38M. We expect actual reported revenues to fall somewhere between these two numbers for the next five years. The chart below displays these three set of assumptions, our revenue projection range, and the Street consensus as provided by FactSet.

39. Business Segment Sales and Sensitivity Analysis Bull & Bear Case

40. Estimated Lives Under Management Calculation The year 2006 presented several significant changes to Healthways business model. The acquisition of Axia represented a shift from high-risk case management to total population health management with emphasis on prevention. As displayed in the table below, revenue per life since the acquisition has been constant relative to the years before the business model shift. Healthways has not reported total lives under management since 2009, to estimate this number; we took an average of the 2007-2009 revenue per life figures ($21.86) and divided reported revenue into this number. Our forecasting method maintains this $21.86 revenue per life to predict total future sales.

41. Lives Under Management

42. EV/EBITDA Pricing Model

43. Free Cash Flow Valuation Assumptions Beta We arrived at a beta of 1.07 by running a 60 observation regression of S&P monthly returns against those of HWAY.

44. Free Cash Flow Valuation Assumptions Continued Risk Free Rate • Our free cash flow models assume a risk free rate of 3.54%, consistent with the 20 year treasury rate in January 2014 Terminal Growth Rate • We assumed a terminal growth rate of 3% based on a combination of company expectations and estimates for GDP growth. A sensitivity analysis is conducted on the terminal growth rate via our two way tables Tax Rate • Our assumed tax rate of 30% is a 2006-2012 average of income tax expense divided by taxable income (Dollars in Thousands)

45. Free Cash Flow Valuation Assumptions Continued Risk Free Rate • Our free cash flow models assume a risk free rate of 3.54%, consistent with the 20 year treasury rate in January 2014. Terminal Growth Rate • We assumed a terminal growth rate of 3% based on a combination of company expectations and estimates for GDP growth. A sensitivity analysis is conducted on the terminal growth rate via our two way tables. • Weights of Debt & Equity • Our Free Cash Flow to Firm valuation discounts using WACC rather than cost of equity. Calculations for debt & equity weights are shown below.

46. Free Cash Flow to Equity Pricing Model Our free cash flow to equity model supports our price target of $19 proposed by the EV/EBITDA valuation.

47. Free Cash Flow to Firm Pricing Model We valued HWAY equity with an EV/EBITDA model, a Free Cash Flow to Equity model, and a Free Cash Flow to Firm model. The price target using free cash flow to firm is not as consistent with the other two valuation methods, and hence is not mentioned in the report, but it does confirm our upside expectations for the stock.

48. Free Cash Flow to Firm Pricing Model Continued

49. Price to Earning and Residual Income Valuations We valued Healthways’ equity share price 6 different ways including the buy-out prices discussed in Appendix 15. Of those 6, we discredited price to earnings and residual income valuations for the following reasons. Price to Earnings Model There were several issues with P/E ratios industry wide. Healthways currently has no P/E multiple because EPS ttm is negative. Premier, one of the closest competitors for ACO business, is a new firm with no earnings. Our earnings per share forecasts for Healthways are too low to rely on industry average P/E multiples for share valuation, and hence this model is discredited and does not contribute to our target price. Residual Income Model Forecasted earnings per share for Healthways were less than the 12.10% cost of equity multiplied by the book value per share, hence residual income is a negative number. Earnings per share is too low for residual income valuation and we discredit the model as a valid contributor to our target price.

50. Discount Rate and Terminal Growth Sensitivity Two-Way Tables