Description

4/29/2019

ANTM $266.40

Concerns about single payer health insurance have led to a correction in managed care stocks, leading to what I think is an attractive buying opportunity for Anthem (as well as other MCOs). The stock has bounced from the recent lows as some recent Sanders excitement has worn off, so there could be a somewhat better buying price in the weeks ahead depending on the early Dem primaries.

There are a number of positives to an investment in Anthem today:

1)    One of the cheapest health insurance stocks trading at roughly 12x 2020 EPS with one of the strongest balance sheets in the managed care sector (roughly $26 billion of cash and investments set against $20 billion in debt and $11 billion in policy liabilities).

2)    More than $2 EPS from PBM savings will supplement double digit earnings growth in over the next two years (bringing total EPS growth over next two years to 20% and EPS to the mid $20s by 2021).

3)    Absence of a large legacy PBM allows for more flexibility in PBM design with fewer profit implications (fewer issues related to changes in rebate treatment)

4)    Flexibility to offset any lost rebate income through estimated savings of $4 billion from bringing PBM in house.

5)    From an operating standpoint, recession resistant business with relatively high degree of earnings predictability (occasional medical loss surprises, but typically mitigated by size of member base).

6)    40 million members and top market positions allows effective price negotiation and represents a barrier to new competition.

7)    Highly cash generative business with potential to deploy cash to tuck in acquisitions and share repurchase.

Health insurance has consistently had some of the best economics of the insurance industry. It’s a business that demands scale to spread risk, negotiate pricing, and build out sufficient provider networks to attract members. Two to three players (and sometimes fewer) typically dominate most markets, limiting price competition. In recent years the model has been driven by premium growth and growth of Medicare supplemental insurance, in addition to cost management. Share repurchases have helped boost longer term earnings growth. While premium growth rates may slow in the years ahead given increasing scrutiny and public outcry, there are likely significant opportunities in the years ahead to reduce cost. The business is highly cash generative given limited capital requirements. Looking ahead Anthem should generate more than $5 billion of operating cash flow per year, putting the shares at a low teens free cash flow multiple. The company also has an effectively cash free balance sheet, and could finance attractive M&A with debt in addition to free cash flow.

At its analyst day, the company targeted 10-12% revenue growth and 12-15% earnings growth, not including the additional gains from exiting Express Scripts, which would bring EPS growth over the next two years closer to 20%. With that growth, Anthem should be generating roughly $24/share by 2021, putting the stock at roughly 10x earnings looking out a year and a half.

Management expects to drive roughly half of the top line growth through expansion of Medicaid and Medicare Advantage members. Medicaid spending growth is averaging 5% per year, and ANTM also thinks it can increase its market share here. The company historically has a very high win rate on Medicaid business it competes for. Medicare spend is also growing mid-single digits, and the company is taking market share, with 35% (roughly 10% organic) membership growth in 2018 and more than 20% growth expected for 2019. Taken together, the company has the potential to grow its government business lines by low double digits annually for the next few years. The balance of top line growth would come from modest share gains in the company’s commercial coverage, modest premium increases, and from the company’s new PBM, IngenioRX, which is expected to add 2% of top line growth.

The IngenioRX replacement of Express Scripts should support an estimated $4 billion of cost savings over the next two years, more than $800 million of which ($600 million after tax), or $2.30/share, should flow to the bottom line over the next few years. Those cost savings also give the company some room to absorb regulatory changes related to PBM rebates and renewed ACA taxes with manageable impacts.

After the IngenioRX cost savings, costs will likely track revenue growth. However the business is highly cash generative, and the company will continue to steadily buy back shares and undertake bolt on M&A. Anthem has roughly halved its share count over the last ten years. On the M&A front, it has spent a few billion in recent years on tuck in acquisitions, with a late 2017 purchase of HealthSun and a 2018 purchase of America’s 1^st Choice adding a combined 170K Medicare Advantage members in Florida and South Carolina.

Much of the recent price weakness revolves around single payor healthcare (M4A) and what appears to be an ascendant Sanders candidacy (this seems to have dimmed marginally with the recent entrance of Biden). While Sanders has been outspoken in his plans for single payer care, I think if he (or another progressive) wins the Presidency, he will have to accept a significantly diminished version of that vision. The reasons for that are:

1)      Cost is a significant hurdle. CMS reports 2018 government health spend of roughly $1.1 trillion (including $200 bil lost tax revenue due to employer tax deductions). The NY times (https://www.nytimes.com/interactive/2019/04/10/upshot/medicare-for-all-bernie-sanders-cost-estimates.html) provided a range of estimates from various researchers ranging from $2.76 trillion annual on the low end (Friedman, study cited in the past by Sanders) to $3.87 trillion on the high end (Urban), implying incremental annual spend ranging from $1.66 trillion to $2.77 trillion, or $17 to $28 trillion over ten years. Sanders recently provided possible means of raising offsetting tax revenue (https://www.sanders.senate.gov/download/options-to-finance-medicare-for-all?inline=file), with a laundry list of higher taxes and reduced exclusions adding roughly $16 trillion in revenue over ten years. However, there are good reasons to think the Friedman estimates he relies on are much too low, and it’s highly unlikely the majority of Sander’s tax ideas would achieve political consensus. Assuming the true cost is somewhere in the middle of estimates, would imply a ten-year shortfall of $23 trillion, and assuming an aspirational half of his tax increases and cost saves were implemented, it would reduce the shortfall to $15 trillion.  That would triple the annual deficit and add more than 50% to national debt over ten years.

a.       Note that Friedman’s estimates are probably too low because they assume no adjustment to Medicare rates. Today, private health reimbursement rates in many cases subsidize low Medicare rates. A large-scale expansion of Medicare would likely require a substantial upward recalibration of Medicare rates or would massively disrupt the health services sector, with a range of unintended consequences for employment, wages, and care availability.

2)      About half of Democrats in the house are centrist (“The New Democratic Coalition”), and many represent Republican leaning states. Few of these members have spoken in support of single payer, rather their message, which they campaigned on, has been fixing ACA. A subset of these members, roughly 20 ‘Blue Dog’ democrats, are focused on a balanced budget, and would not support any legislation that increases the deficit. The house at present is not setting up any investigational committees that would imply serious interest in crafting a single payer bill.

3)      Health insurers employ several hundred thousand people, and hospitals and other providers employ hundreds of thousands of billing personnel – probably around a million workers in total. Many of these would be unemployed under single payer. That represents a significant political obstacle not to mention an additional cost as those workers go on government assistance. In effect the current billing system represents a massive jobs program that would tough to replace.

4)    Democrats are currently the minority in the Senate, and have roughly even odds of retaking the senate over the next two elections. If they do retake the majority, Democratic senators Doug Jones (Alabama) and Joe Manchin (WV) might not support M4A. It’s also possible Senators from states with large health insurers like CT could vote against M4A (Lieberman pushed back on a public option in 2010). That suggests Dems would probably require at least 53 senators, if not more, to pass legislation in the senate, even assuming a removal of the filibuster or the use of budget reconciliation to move legislation.

5)    Early polling suggests popular support for single payer drops dramatically when voters are told it would likely mean higher taxes and they would lose their existing coverage. The health industry has just begun efforts to amplify those concerns. Lack of clear voter support makes a transformative bill even more of a political reach.

I think the Sanders plan should be seen as a starting point for negotiation in the event Democrats win the house, senate and presidency, from which some compromise would emerge. DeLauro and Schakowsky’s Medicare for America bill is one possible model. That bill would provide a public government option for underserved areas.

I think the risk to the MCOs is not so much single payer, but rather a public option that steadily takes market share due to lower reimbursement rates, which permit lower pricing. The health industry will lobby hard to limit the reach of any public option, and given the complexity of these issues and the make-up of the house I suspect they will have some success. Regarding possible near-term downside, in 2009/2010 ANTM shares traded at a high single digit PEs. Today, the stock trades at roughly 11x forward EPS. So if the political noise gets worse I think shares could trade cheaper for a period of time. I would expect the company to be a significant buyer of its shares at those price levels, and could theoretically reduce shares outstanding by close to 50% over the next six or seven years, leading earnings per share to more than double over that period.

I think absent political setbacks, Anthem should trade back to its prior 52 week high of $320, or up 20%, over the next year and then track low double digit earnings growth from there. However, given the political risks, it’s a good exercise to probability weight various scenarios. Assuming the democrats would need three branch control and at least a 3 seat margin in the senate to pass a transformative bill, I estimate roughly a 10%-20% chance they get there by 2022, based on a 60%-70% chance Democrats win the presidency in 2020, a 20%-30% chance they get 52 senate seats by 2022, and a 90% chance they maintain the house majority over the next two congressional races. The chance of three branch control with Sanders as president would be lower. 

I then risk the likelihood, in the event of Democratic control of all branches, of full blown single payer, a strong public option, a moderate public option, and a weak pro industry public option, or simply no new legislation. For all the reasons previously described I view the likelihood of single payer as close to zero, but if you generously assume 1% it doesn’t change the math significantly. I view the other scenarios as roughly equal weighted (I actually think the strong public option is lower probability, but doesn’t move the numbers much). Only the strong public option has real negative implications for share prices, and that would compute to less than a 5% possibility, based on 10%-20% Dem control times a 25% risk if Dems do control. In that scenario I think near term growth would likely be offset by multiple compression, leading to flat to modestly down share prices over two years. Obviously these probabilities are guesses, and you can pick your own numbers, but putting it all together I see risk-weighted upside in the mid to high teens over the next year, with solid earnings based gains thereafter.

Catalyst

More clarity on 2020 election outlook, continued earnings growth.