Premier's in Prime Position

In our opinion, Premier has fortified its positioning in this market over the past decade under the leadership of CEO Susan DeVore. By restructuring the company under a single sales organization, improving the company’s access to capital, and establishing capabilities that span a facility’s entire supply chain, Premier has positioned itself as a premier partner for care providers looking to deliver high-quality, low-cost healthcare. DeVore’s strategy has centered on internal development, accelerated through external acquisitions, to round out the company’s procurement reach (specialty pharmacy, direct sourcing, ambulatory group purchasing) and add market-leading capabilities to its technology platform (physician reporting, budgeting modules, labor productivity). We think this has been an effective route to bettering Premier’s position as a comprehensive solution to all problems emanating from a healthcare provider’s supply chain.

DeVore has been successful at widening and reinforcing the underlying competitive advantages that underpin Premier’s narrow moat--strengthening its bargaining power and leveraging its data warehouse to be an increasingly valuable partner to the healthcare provider group it serves. This has allowed the company to earn returns substantially ahead of its cost of capital, something that we believe will prove resilient over time.

Businesses' Intangible Assets Are Complementary We think Premier has been able to dig a narrow moat for itself as both business segments exhibit characteristics that we commonly attribute to moaty franchises. In supply chain services, we think the group purchasing organization, or GPO, benefits from cost advantage and intangible assets that allow the company to earn returns substantially ahead of the segment's cost of capital. We think the performance services segment is able to extract value through intangible assets built upon the company's proprietary data. In our view, the intangible assets generated through both segments are complementary, as Premier's ability to aggregate data from disparate areas of the hospital creates an analytics offering few competitors can currently replicate. While we believe the company exhibits traces of switching costs, we don't view this moat source as supportive of a narrow moat in isolation.

Premier operates the second-largest GPO in the U.S. by purchase volume, aggregating roughly $56 billion in annual spending across 3,900 hospitals and 150,000 alternate site providers. By our estimate, this places Premier at roughly 20% market share, compared with Vizient at 35% and HCA’s HealthTrust Purchasing Group at approximately 10%. Combined, these three entities control 60%-70% of the estimated $285 billion supplies budget spent by hospitals on an annual basis.

In our view, Premier’s GPO has earned a narrow moat underpinned by cost advantage and intangible assets as key moat sources. The GPO business model originated to solve one problem--to reduce input costs for the extremely fragmented healthcare provider industry. Premier fulfills this function by aggregating purchasing power, contracting with and curating a list of preferred vendors, and applying data and analytics to help hospitals more efficiently manage their supply chain. The central source of moat in this instance is cost advantage, as purchasing scale and contract management typically generate roughly 10%-20% savings for the average hospital member off vendor list pricing. Premier is able to better negotiate volume discounts, utilize sole- or limited-source contracting to encourage vendor competition, and scale standardized commodity products better than providers are able to do on their own. Premier also offers specialty pharmacy distribution and direct/private-label sourcing initiatives to help reduce instances of product shortage for its members while further ensuring lowest possible cost across a wide variety of products.

Intangible assets add to Premier’s moat in this area through long-duration relationships with its members. The company’s GPO maintains long-term contracts with its provider members, with contract lengths averaging five to seven years. Importantly, a bolus of contracts that came up for renewal discussions in 2017 (five-year contracts initiated in tandem with Premier’s 2013 initial public offering) were almost all renewed at similar economics, which highlights the staying power of these relationships. This can be measured through Premier’s GPO retention rate disclosures, which have averaged near 98% over the past six years, and through the tenure of its member-owners, which averages near 18 years.

Recently, there’s been a perceived risk of disruption in the healthcare supply chain and services space due to potential entry from margin-agnostic competitors, such as Amazon. While this may be a realistic concern for more commoditized products, the majority of Premier’s GPO exposure is largely insulated from retail competition. Pharmacy, medical/surgical products, and catering make up 50%-60% of Premier’s GPO volume, which we view as more difficult for a nonhealthcare entity to replicate. Most of this spending is in areas where clinical evaluation is key to determining utilization, versus commodities that are more easily sourced and distributed with little differentiation. Premier’s direct sourcing capability, on the other hand, focuses on aggregating, standardizing, and contracting out for the manufacture of these commoditized products, which we view as most at risk to potential competition.

While we think some of the hospital-level disruption caused by changing GPO membership creates traces of switching costs for the business model, we lack confidence that this dynamic alone creates a defensible moat. Shaking up existing vendor relationships, creating friction with physicians, and reorganizing supply chain logistics are meaningful costs incurred by a hospital system when making the decision to switch GPO providers. The significance of this decision can be seen through the length of discussions required during the contracting process; requests for proposals typically take 12-24 months to fully resolve. However, we don’t view this dynamic as supportive of a narrow moat in isolation. While market share doesn’t turn over too often in the industry, recent wins by Premier illustrate that these costs can be overcome, catalyzed by industrywide disruption in the wake of the merger of the MedAssets and Novation GPOs, creating the Vizient entity.

The performance services business is primarily a software-as-a-service analytics platform, along with a consulting function, which again focuses on optimizing cost and clinical outcomes for acute-care and outpatient facilities. PremierConnect, the company’s flagship product, offers analytics packages that cover areas such as quality and regulatory compliance, supply chain, clinical safety, and operations. We think the company’s IT business is also deserving of a narrow moat, underpinned by intangible assets.

In our opinion, the data derived through the GPO function and shared through a coordinated IT infrastructure is the most compelling source of moat for the company’s SaaS platform. While the healthcare IT landscape remains in the relatively early innings of meaningful utilization, we think Premier has carved out an interesting niche that falls squarely within its circle of competence: focusing on data to reduce the cost burden for healthcare providers. PremierConnect’s most interesting features include the ability to benchmark cost and quality data across peers using Premier’s national reach to compile a highly relevant data set. Administrators are able to use detailed analysis to improve a facility’s procurement function and use an outcomes-based evaluation to change physician behavior when need be. In a world where government reimbursement payments are increasingly tied to quality and cost metrics for both facilities and physicians, we think the ability to compare in real time will be invaluable for the highest-performing facilities. Premier has data on more than 40% of all patient discharges nationwide, which we think makes the resulting data set one of the most robust in the industry.

In addition to the valuable intangibles derived through proprietary data, we think the company’s contracting terms bolster its competitive advantage. Subscription revenue from SaaS contracts contributes roughly 60%-70% of the revenue in performance services, with the remainder driven by annual fees for advisory services and professional collaboration initiatives. SaaS subscriptions are generally under three- to five-year contractual arrangements, which helps create valuable relationships while giving Premier time to demonstrate its value-add through the IT implementation and advisory service function. The company has reported an average renewal rate of roughly 94% annually over the past six years, which helps quantify the stickiness of the IT relationship. While there are a multitude of competitors in the healthcare IT arena, we think the niche served by Premier requires a unique, all-encompassing data set that few companies have developed. The company is able to combine data stored on traditional electronic medical records with data on physician operations, postacute outcomes, claims and reimbursement, facility quality scores, and patient satisfaction to obtain a holistic perspective that many in the healthcare IT business today are unable to provide.

Acquisition Activity Is Primary Risk Given the highly visible nature of the company's revenue and lack of significant volatility in the underlying demand drivers for Premier's services, we give the company a medium fair value uncertainty rating. The most prominent risk to our forecasts of the company's future cash flows is the likelihood of acquisition activity over the coming years, given management's stated capital-allocation priorities and substantial balance sheet capacity currently available. We believe management has shown discipline in valuing and acquiring assets, but the potential for poor performance post-acquisition remains the biggest risk to our forecasts, in our view.

Longer term, we think the potential for competitive disruption in the healthcare industry presents a risk to our forecasts. While the noise around behemoths such as Amazon potentially entering the healthcare industry is a constant rumble, Premier’s narrow moat protects it from material near-term threats, in our view. Should a company like Amazon attempt to compete for business in the hospital supplies arena, we think it would probably be most effective in sourcing commodity products rather than more-advanced and clinically relevant medical/surgical equipment. While this poses a real risk to Premier’s direct-sourcing business, this capability is more strategic for Premier than it is financially relevant. Disruption in this area wouldn’t change our cash flow forecasts much and, more important, doesn’t change our assessment of Premier’s competitive position.

We think an outsider to the healthcare industry would be hard-pressed to quickly develop the expertise, relationships, trust, and clinical data that most prominently defines Premier’s narrow moat. While we plan to closely monitor developments on the competitive front, we expect Premier to effectively defend its position in the medium term while working to strengthen its moat over the long term.