Description

Security:                  CANO COMMON STOCK

Recommendation: LONG

Current Price:          $11.73/shr

Market Value:         $5.6BN

Enterprise Value:    $6.4BN

Executive Summary

Cano Health (“CANO”) provides a necessary service to a rapidly growing market in the context of a highly visible and profitable recurring revenue model.

CANO is a primary care provider (PCP) to Medicare Advantage (MA) patients in the high growth market of “value-based care”. The secular trends are significant including an aging population, the growing shift towards value-based care and the increasing adoption of Medicare Advantage, all largely due to the well-documented inadequacies of the original Medicare/existing healthcare system. CANO’s business model is simple: the company gets paid a recurring fixed (capitated) fee per member per month (PMPM) from the health plan payer (insurance company) and earns the “margin” between the capitated fee it receives and the amount it costs CANO to treat the patient. The capitated fee is effectively a pre-negotiated percentage of the premium that the health plan payer receives from the CMS (Centers for Medicare and Medicaid Services). 

CANO recently went public via a SPAC transaction and currently trades at a significant discount to the disruptive healthcare peer group (principally Oak Street Health (“OSH”)), implying that the company’s value proposition and growth trajectory are meaningfully underappreciated by the market. Despite similar size (in terms of revenue), capitated-oriented business models (+90% of total revenue), revenue growth rates ~40-50% CAGR expected over the next few years), same largest customer (Humana), macro tailwinds and TAM opportunity set, OSH currently trades at 4.3x EV/’22e Revenue compared 2.4x for CANO. Simply ‘rightsizing’ the valuation disparity on a growth-adjusted basis (see Valuation section) would generate ~80% appreciation in the stock, to~$21/shr. 

Potential reasons for the mispricing: (i) SPAC vs IPO - it has been suggested that the discount is partly due to “SPAC negativity” which I view as uneconomic and a temporary overhang given that OSH is a direct comp to CANO; (ii) OSH is expected to grow a little faster over next few years (51% vs 43%) - this argument may hold some merit but I would posit that given CANO’s superior relative performance on KPIs (Medical Loss Ratio (MLR) in particular), CANO’s growth is more profitable and the material discount that exists today is not justified. 

Even assuming a more conservative multiple, say 3.5x, that would still imply +50% upside to ~$18/shr. 

Brief Description/History

• History: Founded in 2009, CANO is today one of the largest independent primary care physician groups and one of the leading value-based care providers in the US

• Revenue Model: The company gets paid a fixed recurring fee per member per month and is incentivized to provide care at a lower cost. Like all capitated players, CANO takes all the risk of increased costs but also reaps the full benefit of lower costs. Around ~85% of the company’s revenues are Medicare captivated revenue, and ~95% of revenues are capitated (including Medicaid and ACA).

• PCP-centric Technology Platform: The company has invested in developing a proprietary technology platform, CanoPanorama, which enables a highly personalized approach to primary care, chronic care, preventive care and the patient’s general healthcare needs and ultimately results in improved patient outcomes (fewer hospital visits, shorter stays) which leads to lower medical costs and higher margins.

• Member Population: CANO is focused on dual-eligible Medicare and Medicaid patients (+50% of members), Hispanic population (+80% of members belong to minority groups), slightly older population than the MA average and with more chronic conditions. Including recent acquisitions of University and DMC, CANO now provides capitated care to ~211k members (120k Medicaid, 64k Medicaid, 27k ACA) at its 126 owned medical facilities across 40 markets in principally FL, TX, NV and Puerto Rico. The company also has over 1,000 physician affiliate relationships.

• Growth Strategy: CANO pursues a combination of de novo (organic new build) and acquisitions to grow its membership base and platform. The primary care market is fragmented and the company is focused on underserved populations. The company has grown membership by ~100% CAGR from 13.7k in 2017 to 218k in 2021E.

• Unit Economics: In the most recent quarter, MA patients generated ~$1,241 in revenue PMPM which translates to ~15k per year. This is on the high end of the range over the last three years:

  Source: Company SEC filings

Business Model / Contract Economics

There are two basic business PCP models in the Medicare system:

• Traditional payment model (Medicare FFS/non-value-based) – ~60-65% of Medicare enrollees: PCPs are paid on the amount of healthcare services they deliver which incentivizes volume over quality; there is less focus on preventative care, health strategies and care coordination, and therefore more expensive for health plan payers and ultimately patients

• Capitated care model (Medicare Advantage/value-based) - ~35-40%; the capitated model better aligns incentives across the supply chain (providers, patients, health plan payers) where providers achieve higher profitability by improving patient outcomes. This is the market in which CANO competes and there is significant opportunity for the capitated model to both: (i) grow organically with the growing market of Medicare enrollees, and (ii) take share from the traditional payment FFS model.

  Source: Company SEC filings

Industry Dynamics/TAM Opportunity

The company operates in the $800bn Medicare market which is growing ~8% per annum, and is focused on the $270bn Medicare Advantage market, which is growing ~14% per annum. The Medicare Payment Advisory Commission estimates that 10,000 seniors age into Medicare every day which results in an increase of ~$1bn in total addressable market every week. 

Source: Company, CMS, Kaiser

Within Medicare, it is estimated that Medicare Advantage will grow from ~35% of the Medicare market in 2019 to 47% in 2025 and 51% by 2030. As aforementioned, CANO focuses exclusively on the value-based care segment which enjoys broad bipartisan political support given the reasons/supporting data relating to superior outcomes, lower cost and the general alignment of incentives across the supply chain.

• In Medicare Advantage, CMS pays health plans a monthly sum per member to manage all health care expenses of the participating member. This provides the health plans with an incentive to deliver lower-cost, high-quality care. Health plans in turn are incentivized to contract with provider groups that deliver superior patient outcomes and satisfaction levels to their members.

• There are significant tailwinds to the structural move to Medicare Advantage given the prevailing problems with the existing healthcare system: (i) 28% of Americans with +2 chronic conditions vs 18% in OECD avg, (ii) 6% spend on primary care in the US vs 14% in OECD avg; (iii) according to UnitedHealth ~18MM avoidable visits to US emergency rooms per annum; (iv) according to a JAMA study authored by Humana, 20% of the US healthcare spend or ~$760bn is wasted annually. The reality is that the majority of physicians are still on the Medicare FFS (fee-for-service) vs capitated care and are therefore not appropriately incentivized to improve outcomes/reduce costs. 

• CANO focuses on dual-eligible patients that have a “higher prevalence of chronic conditions”; this patient population (two or more chronic conditions) accounts for ~67% of Medicare FFS-eligible patients and ~94% of Medicare FFS spending. It is also estimated that dual-eligible seniors cost 3x more per capita than Medicare-only seniors.

  

  Source: Company SEC filings

  Why is this relevant? Given the lower level of primary care for this cohort, it is an opportunity for CANO to improve patient outcomes: (i) dual-eligible have a higher risk for Medicare which translates to higher premium for the health plan payer and higher revenue for companies like CANO; and (ii) dual-eligible population is growing faster than Medicare overall. 

  

  Source: Company SEC filings

  

  KPIs:

   

  Patient Outcomes: While CANO’s patients tend to be sicker (more chronic conditions) than the average Medicare patient, they experience better outcomes as evidenced by: (i) lower mortality rates: 1.75% mortality rate compared to the Medicare FFS benchmark of 4.3%, a ~59% improvement; (ii) 57% fewer hospital stays compared to the Medicare average; and (iii) 59% fewer emergency room visits compared to the Medicare average. Additionally, in 2019, the Healthcare Effectiveness Data and Information Set (the “HEDIS”) quality score for CANO’s members, a tool used by health plans to measure performance on KPIs, was 4.7 out of 5.0, as compared to the national average of 4.06.

  Medical Claims Expense Ratio (or Medical Loss Ratio, ‘MLR’): The value-based care model incentivizes primary care providers to invest in preventive care given that hospitalizations (particularly inpatient) represent the majority share (~60%) of Medicare costs. By contrast primary care represents only ~3% and investing more in primary care can reduce spending on virtually everything else. It is estimated that PCPs directly influence over $2 trillion of downstream healthcare spend every year, and most do not invest in preventive care or in health strategies to impact downstream health. CANO has made such investments and has demonstrated a significant improvement in patient outcomes (as referenced above) which has translated to a meaningful decline over time in the Medical Claims Expense Ratio (= Third party medical costs / capitated revenue):

  

  Source: Company SEC filings

  Membership Growth: CANO has shown that it is well positioned to benefit from the structural shift in the healthcare industry where the entire system is embracing the value-based model of delivering superior outcomes at lower cost as compared to the traditional Medicare FFS. Through a combination of organic and acquisitions the company has grown total membership by ~100% CAGR between 2017 and 2021E:

  Direct Contracting (DC) program - By way of background, DC is a new delivery program in which the CMS contracts directly with a select group of primary care providers (known as Direct Contracting Entities (DCEs)), of which CANO is a member. Fundamentally, DC will enable 100% of Medicare enrollees to potentially be patients of value-based care providers as compared to the existing 35-40% via MA. This is an effort by the CMS to drive healthcare reform by accelerating the shift from FFS to value-based by enabling DCEs to take on the full risk of the original Medicare patients. Unit economics are potentially greater for DCEs as the withholding is only 2% by the CMS as compared to ~15% by health plan payers. DC is potentially rocket fuel for value-based TAM growth and is generally not factored into forecasts.Capital Structure: CANO and OSHFinancials: CANO

Valuation: CANO vs OSH

• Given the high top-line growth rates (40-50%), recurring revenue profile and visibility on operating leverage/margin trajectory of these two companies and their peers in the disruptive healthcare space (companies such as Teledoc, Accolade, One Medical, HealthEquity), I am using EV/Revenue and EV/Revenue/Growth as the relevant valuation benchmarks for now, until these companies turn profitable.

  

Risks/Downside:

1.     Costs exceed revenue:

Risk: The capitated nature of contracting with payers requires that CANO prudently manage medical costs which is the largest expense category (82% of Opex). Members retain the freedom to seek care at emergency rooms or hospitals without the need for referrals, and CANO is liable for potentially large medical claims that can result from excessive ER visits or long hospital stays.

Mitigant: (i) Recurring Medical claims: The value-care model focuses on investing in preventing care, maintaining health and leveraging the primary care setting as a means of avoiding costly downstream healthcare costs, and such strategies have improved patient outcomes over time; (ii) Outlier Events:  To mitigate the exposure to larger than expected medical claims CANO utilizes stop-loss insurance for protection from medical claims per episode in excess of certain levels.

2.     Geographic concentration in FL:

Risk:  Of CANO’s 211k members, 200K are based in FL. Clearly any significant shifts in policy/economics in FL can materially impact operations.

Mitigant: CANO is actively looking to expand membership beyond FL.

3.     Payer concentration:

Risk: CANO contracts with a variety of health plan payers to access patients and provide care but has significant exposure to three (HUM, UNH and ANTM) which account for ~75% of revenue. As such, any disruption from renegotiation or termination can have a material impact.

Mitigant: Given CANO’s HEDIS score, the company is a desirable partner for payers in the value-based care space. Additionally, CANO proactively has discussions with payers to negotiate terms. Finally, DC will enable CANO to contract directly with the CMS which will remove the exposure to the insurance company “broker” relationship.

4.     Third-Party Marketing Agents:

Risk: OSH disclosed on its Q3-21 call that it is subject to a DOJ investigation in relation to the use of third-party marketing agents and specifically to potentially violating the False Claims Act. Generally, value-based care providers target chronic patients given the propensity for improvement and the sicker the member, the higher the health plan's reimbursement. That has led to allegations of plans hiking risk scores to overinflate members' health needs, resulting in higher payments from the CMS. While OSH and other value-based care providers aren’t traditional plans themselves, they enter into full-risk contracts with MA plans via the CMS' direct contracting program. The DOJ has been finding higher incidence of fraud and abuse as the MA program has gained in popularity in recent years. OSH stock promptly corrected ~20% partially as a result of the DOJ investigation.  

Mitigant: CANO recently confirmed that it has neither ever used third-party marketers nor does it intend to and maintains strict control over its marketing activities and oversight of its members health plans.

Catalyst

• Organic growth: track to meet/exceed expectations of 54-59 de novo openings in 2022

• Medical Claims Expense: continued control around ~75% of capitated revenue

•  Expansion/M&A beyond FL

• Traction on DC rollout