Description

Summary

While healthcare insurers have been trading poorly given the uncertainty with respect to 1) potential Obamacare (ACA) repeal, as Ruth Bader Ginsburg has now passed and a looming court case in November may rule to repeal it, and 2) a Biden public healthcare option, we view these as relatively immaterial to the long-term earnings trajectory of Anthem. 

When political uncertainty is high, particularly amidst a potential transition from a Republican to Democratic administration, investors seem to flee the healthcare insurers.  In 2008 similar uncertainty (plus of course the GR), pushed them these stocks down from roughly market type multiples in the mid 2000’s, to lows in the high single digits by 2008 and 2009.  But by 2013-2014, as earnings continued to grow and the impact of the ACA became fully known, the industry and Anthem traded back to near market multiples.

Purchasing a basket of insurers in October 2008 turned out to be a market beating strategy, even as the industry faced even more uncertainty back then.  We sense that a similar set up today will lead to outsized medium to long term market performance for Anthem.

Big picture, Anthem is a high quality company that:

• Has compounded EPS at a 12% CAGR since 2005 through the cycle and implementation of Obamacare, and 16% from 2014 to 2019.

• Has a solid balance sheet, BBB+ rated; their 2030 bonds yield a miniscule 1.9%,

• Often generates higher free cash flow than net income,

• Today, targets long term annual revenue growth of 10% to 12%, and EPS growth of 12-15%,

• Now trades at one of the largest discounts to the S&P in history, at under 12x 2021 earnings, 35% cheaper than the S&P 500 despite far better growth, and 

• Has earned shareholders 16.5% annual returns since its IPO in 2001, over twice the S&P at 8.0%.

Anthem has been written up twice on VIC, the last time in April 2019 at a price of $266, not far from today’s levels.  The thesis then remains roughly the same.  Political uncertainty has kept a lid on these names, but by this time next year, resolution will likely cause a re-rating back to normalized levels, i.e. a 15-25% discount to S&P 500 multiples.

At just 15x 2021 earnings, ANTM would trade to $373, up 27%. We like the longer term set up too, as ANTM is an impressively run non-cyclical.

Capital Structure

ANTM has plenty of liquidity, and will generate tons of free cash flow this year. There is close to zero balance sheet risk, and leverage at 2.8x debt/EBITDA is manageable. We only included above the unrestricted cash held at the parent.  There is another $30BB roughly of cash and investments held at various insurance subsidiaries, primarily held to fund future policy claims. We excluded both from EV/EBITDA calculations.

Industry

Insurance is a scale business, an oligopoly that generates low to mid-teens ROE’s. Size and scale are mandatory, competitors must build complex healthcare networks, have negotiating leverage, and a solid reputation for paying claims.  This is not an industry easily disrupted by a Silicon Valley startup. 

There are generally speaking 4 buckets that Anthem operates in:  Private pay insurance (aka their commercial and individual segments), ACA run exchanges, Managed Medicaid, and Medicare Advantage.  We estimate the company earns roughly 20% of operating earnings from Medicaid and Medicare each, and the balance in their private insurance buckets.  The ACA run exchanges total only 1.6% of their members today, and probably are even less in terms of profits (if any).

Premiums re-price every year as this is short tail insurance, and float duration is kept quite short and low risk.

Managed Medicaid insurance is the least profitable insurance bucket, with 3% type operating margins. Members are younger and healthier, and basic care offered via managed plans leads to lower premiums. 

While lower margin, Medicaid enrollment has grown lately from two dynamics, 1) states continue to add individuals eligible for Medicaid, and 2) states continue to outsource Medicaid to private insurers, who by putting members in an HMO type plan, offer preventative, higher quality care that actually reduces medical expenses per individual.

With Covid-19 causing unemployment rates to spike, the number of Medicaid-eligible has grown radically in just a few months.

Worth mentioning is Anthem’s comment that annual recertification has been suspended for Medicaid members. That is, states generally review income levels annually to insure that members still qualify. If incomes rise too much, then they can force members out. The trend has been to relax recertification’s generally speaking, and to suspend them entirely this year.

This chart shows the secular tailwinds to the Managed Medicaid names.  Note the dark blue column above which represents Managed Medicaid Care spending in the aggregate. CNC forecasts 5.5% Medicaid revenue growth through 2027. Managed Medicaid should grow even faster.

On the Medicare side, private insurers offer supplemental insurance for retirees, called MA or Medicare Advantage. Part D plans include benefits for prescription drugs. These are quite profitable given higher premiums and utilization, especially on a per person basis. With 11,000 Baby Boomers retiring every day, enrollment trends look extremely favorable. The market share of these retirees selecting an MA plan (over simply enrolling in Medicare) is also expanding.

Commercial and private insurance is perhaps the most profitable of the three. Obamacare (aka ACA) plans have generally been unprofitable, but depend on the state and even the county in which they operate.  Adverse selection (only those with pre-existing conditions), has led to a terrible pool of customers in the exchanges.

On both the Medicare and Medicaid side, Medical Loss Ratios (MLRs) are monitored carefully. MLR’s represent the percentage of premium revenue paid out for medical services. CMS requires that over a three year period, insurers must pay out at least 85% of premiums in the form of medical claims.

Health Insurance Provider fees (HIP) were implemented in 2014 by the ACA, and were a non tax-deductible charge that all industry participants paid. To offset the fee, insurers simply raised premiums. In 2021, these fees will go away, and for Anthem HIP was an $0.80 hit to EPS last year. 

The company suggests that even under Biden and a Democratic Congress, HIF’s are unlikely to come back.  They understand that insurers simply raised premiums to offset them.

Seasonally speaking, one insurer I spoke to described these stocks as AA names – in a good underwriting year, these stocks all rally from April to August.  In the fall and early part of the year, investors fret over underwriting, rates, and how medical loss ratios will evolve in the coming year.  State’s budgets are no doubt a concern, weighing on the space, and Medicaid eligibility requirements will also be re-determined.  By Q1, we will know how Anthem has priced their book.  Election results will also remove some uncertainty too.

History

Anthem went public in 2001 at $20 per share and 15x earnings. They operate a somewhat recession resistant business, but can lose members during periods of unemployment.

A bit different from Cigna for example, who doesn’t take healthcare cost risk (with 85% of members in a fee for service plan), Anthem takes medical cost risk on about 40% of their members. This is their “Fully-Insured” business as per below. The “Self-Funded” is fee for service like Cigna.

By the end of 2019, Anthem had 41mm members, with about 30mm of these in Commercial and Specialty plans. 7.3mm, or 18%, of members were in Medicaid plans, and 2mm in Medicare Advantage/Supplement plans.

The company originally guided to 42.1mm members by the end of 2020.

In 2018, Anthem purposefully dropped out of many states ACA plans. The Individual customer count in that bucket dropped from 1.588mm to 655k members. Apart from that, membership tends to grow in the 2.0% to 3.0% range every year.

Managed Medicaid is part of their Government Business segment, as is Medicare Advantage.

Here is the segment breakdown going back ten years:

Helping on the cost side, Anthem’s 10 year contract with Express Scripts (now owned by Cigna) expired in 2019.  Rather than continue to outsource, ANTM launched their own Pharmacy Benefits Management (PBM) business in Q2 last year called IngenioRx. PBM’s offer mail order pharmacy benefits, devise formularies to reduce costs for members, and negotiate prices on behalf of their insurance customers.  EXRX was likely overcharging ANTM for their PBM services.

Over time, IngenioRx should help reduce costs by $4BB for Anthem’s insurance businesses, with management estimating that 20% of this will fall to the bottom line. It is a nice tailwind for Anthem.  ANTM actually attempted to purchase Cigna back in 2017 for $175 per share, about a 17x multiple at the time. 

Big picture, Anthem has grown its members 2% each year over the past decade. Premiums tend to track healthcare inflation, or 5-6% per year.

In 2019, Anthems costs were up 6%, and are expected to increase by 3.5% to 4.5% in 2020.

With 4-6% premium increases, plus 2-3% membership growth, Anthem can grow topline by 6-9% per year organically. Excluding the attempt to purchase Cigna, the company is not terribly acquisitive, closing 3 smaller acquisitions in the past five years.

With buybacks reducing share count by 2-3% per year, plus the occasional acquisition using free cash flow, growth in EPS can easily reach the 10-12% range.

Management has guided to 12-15% EPS growth looking out to 2023, as well as 10-12% revenue growth per year.

Their guidance suggests EPS in 2023 will range between $28 and $32 per share. We modeled closer to the high end given stellar performance in 2019, with EPS growth of 22%.  Management seemed to exclude the effect of IngenioRx in their forecast.

At $30 in EPS in 2.5 years, ANTM could easily trade to $450 per share at a 15x multiple, up 53% (19% IRRs).

Q2 Results

Anthem’s Q2 earnings beat Street forecasts, with EPS of $9.20 for the quarter. Given the low levels of medical utilization as consumers forgo treatment, Anthem’s earnings were almost double those from a year ago. Utilization has lead to ANTM overearning of course, but the market has given them no credit for solid results year to date.

Anthems MA business is small in terms of numbers of members, but grew 17% last quarter. This slide from CI illustrates why this will likely continue. Its about 20% of EBIT at ANTM.

Total Medicare Advantage membership could grow from 22mm members to 30mm in five years.  

Analysts however zeroed in on Anthem's commercial membership, with growth just under 1%. Their business mix offers nice diversity however.  Lost commercial members often end up in a Medicaid plan (roughly 40-50% according to management, plus another 30% can end up on the public exchanges).

Note above, in yellow, some key membership data. Medicare Advantage and Medicaid are growing very rapidly. Commercial still did ok, up despite the spike in unemployment.

Anthem is forecasting a 70%/30% breakdown of EPS for 1H/2H. That is, 70% of their 2020 guidance will be earned in the first half of the year.

Seems a conservative breakdown, but we anticipate that should medical utilization remain down, the company will “give back” premium, either with credits or enhanced benefits. Anthem does not intend to profit off the pandemic and stay at home orders.

Still, they are set up to beat for the second half, and their free cash flow already means that management is buying back shares. The repurchase authorization is $3.3BB, and the company anticipates spending $1.5BB in buying back shares in 2H 2020. Given the stock’s cheapness, we think a good use of capital.

Model

Below is our income statement back to 2009, and forecasts through 2024.

Here is a more easily readable cash flow spreadsheet.

I encourage anyone who is interested in modeling Anthem to listen to their Q4 2019 conference call. They discuss in detail expectations for 2020 and over the longer term. They also discuss plans for improving efficiencies, revenue growth and capital allocation. Naturally the pandemic is skewing results, but the long term plan remains intact.

With zero evidence of slowing secular demand, or any permanent margin shift post Covid-19, the insurers remain attractive, investable names for the long term. Aging demographics will work in our favor, as will a growing population.  The over 65 crowd votes the most, and means Medicare spending cuts/coverage is highly unlikely.

Comps

In November 2018, Aetna was acquired by CVS for $145 per share, or about 13x forward earnings.

UnitedHealth (UNH), the biggest name in the space, is a steady double digit EPS grower. UNH is currently trading at 17.8x 2021 earnings, and not as approachable at Anthem at 11.6x today (or 13x using 2020 EPS).

With Cigna, about 40% of their earnings are related to their PBM, so is a different bet and should trade at a discount. 

CNC is more government focused, with 70% of their earnings from Managed Medicaid and Medicare Advantage plans.  Only about 15% of their members are commercial (with 100% of those related to the public exchanges).  There is a good write up of CNC here last month too.

From 2021 to 2022, ANTM is expected to grow earnings roughly in-line with UNH.  UnitedHealth hasn’t grown quite as fast as Anthem since 2005, but remains the dominant player, especially in Medicare Advantage plans. We think Anthem deserves a 15x multiple post policy uncertainty resolution, which seems conservative/fair when viewed against the 20.5x multiple on the S&P today and its expected growth over the next 5 years (12-15%).

Below are comps:

Below is Anthem's P/E multiple since its IPO in 2002.  At 11-12x forward, we are at what we deem to be trough multiples.  It has peaked a couple of times at 20x.

In 2009, the market traded at 10-12x forward earnings when ANTM did in fact trade to its lowest multiple in history. At the time, as discussed, a Democratic controlled DC began to push for healthcare reform, and fear of government disintermediation / regulation crushed these names.  At the lows, insurers like Anthem fetched 6-8x earnings multiples.  Of course, Obamacare or ACA passed in 2010, and implementation began 2 years later.  Once that uncertainty cleared up, ANTM’s earnings multiple rebounded sharply, to roughly equal that of the S&P 500 from 2013 to 2019.

Of course Joe Biden helped to craft the ACA, and likely expands it should he win the presidency. We recognize that political noise can create selling pressure with these stocks, but as we sit today, generally view the industry as safer from incremental regulation or political upheaval than it was 12 years ago.

The occasionally mentioned public option seems one that is pretty unlikely to impact Anthem.  A government run plan or public option frankly seems unlikely (given the enormous build costs, and likely tremendous inefficiencies inherent in a government option).  Like ACA, they probably just outsource it to private players.

Should the Supreme Court overturn the ACA, then ANTM loses 1.6% of their members, many of which may migrate into Managed Medicaid plans.

Catalyst

Policy certainty over the next year. 

Earnings.

Buybacks.