Description

Overview

Centene is the nation’s largest provider of Medicaid managed care services with 16.3m members. Centene operates in 30 states and has a ~20% nationwide market share. Centene’s Medicaid business contributes ~65% of revenue and we estimate it contributes ~75% of profits. We think Centene’s Medicaid business is an excellent one with high returns on capital, predictable and stable growth, and favorable competitive dynamics. Centene currently trades at 10.8x NTM EPS despite an EPS growth outlook of 12-15%. We believe Centene’s stock will double over the next 3.5 years providing a ~20% IRR.

Business

Centene’s main managed care business is Medicaid which represented 67% of revenue in Q1-23. In addition, Centene has a Medicare business which was 15% of revenue in Q1-23, a Commercial business which was 14% of revenue in Q1-23, and other/eliminations segment which was 4% of revenue in Q1-23.

We believe the Medicaid segment is an excellent business and contributes the bulk of Centene’s value. This business earns infinite returns on tangible equity and is stable and recession proof. It even has some countercyclical benefits as we expect Medicaid enrollment to increase faster if unemployment rises. The business has good growth prospects and the CMS forecasts that Medicaid spending will increase 5.6% per year from 2025-2031. In addition, we note a few of the competitive dynamics that we believe creates an attractive market.

The Medicaid programs are run at the state level with Federal government funding providing about 65-80% of total funding. Some states opt to run the programs themselves and other select managed care providers to run the programs. Over time, more states have opted to use managed care providers. In 2000, ~55% of nationwide Medicaid enrollees were in managed care program. Today, that figure has grown to ~85%. We believe there are few aspects of the Medicaid business that may not be well recognized and contribute to it being a good business.

First, these contracts between the state and Centene are typically 3-5 years in length which gives Centene stable revenue. In addition, the contracts tend to be sticky with incumbents having a large advantage upon renewal. These combined create a remarkably high retention rate for Centene.

Second, states typically opt for 3-5 providers to provide some competition, but they do not want an overwhelming number of providers to oversee and do not view more as better. We believe this is favorable as one concern could be states continually add providers over time and grow from having 5 providers today to 10 providers in the future creating a market share headwind for Centene. This has not happened, and we do not believe it will happen.

Third, the rates paid by the state to Centene are set by an actuarial soundness requirement which ensures a fair rate to Centene and all players. Also, all providers are paid the same amount as well.

Fourth, the same rate paid to all providers eliminates any price competition in the RFP process. We believe any business competing on terms other than price is much more favorable than ones that have price competition as a potential risk factor and where a competitor can try to take market share by undercutting price.

Overall, we think these four characteristics make for a favorable competitive dynamic. Combined with managed care’s inherent high/infinite return on tangible equity and future growth prospects, we believe this is a very good business to be in.

We will briefly touch on the Medicare and Commercial segments as these are important but small.

Centene’s commercial business is very different than the commercial segments of its peers which focus on employer sponsored health plans. Centene’s commercial business operates in the state run healthcare exchanges marketplace which started in 2014 due to the passage of the Affordable Care Act (“Obamacare”). This has been a very challenging area for many of Centene’s peers and many have pulled back. Centene has organically built the Ambetter brand and has thrived in this sub-segment of managed care. Centene attributes their success to focusing on low-income subsidized members which have similarities to their Medicaid business. Management has stated the commercial business targets 5-7.5% pre-tax margins and therefore, we estimate that the commercial business contributes about 25% of net income.

Centene’s Medicare business is very challenged. Centene historically had a small presence in the Medicare market but grew its presence when it acquired WellCare in 2019 (Medicare was 1/3rd of WellCare’s revenues). Centene’s Medicare business focuses on the low-income population that is dual-eligible for Medicare and Medicaid. Centene received poor 2023 Medicare star ratings which will negatively impact the revenue per member that they earn and their profitability. Management attributes their current challenges to growing too much and losing focus on their core customer. Centene grew from 955k Medicare subscribers in 2020 to 1,511k in 2022. Management is now focused on returning to their focus of low-income populations. We believe with the recent impacts of the lower star ratings that this segment is close to breakeven and isn’t contributing much if any profit in the forward numbers. Management has said this segment could be at the company average margin and therefore provides potential to contribute about 15% of profits.

Valuation

We believe Centene is simple to value as the business performance will be similar in all economic scenarios. We forecast 2023 and 2024 based on management’s latest guidance of >$6.40 in EPS in 2023 and >$6.60 in EPS in 2024. Beyond that management has said they feel confident they can grow EPS 12-15% off this base. Management provided more details in the December 2022 investor day but essentially the EPS growth is from 7-8% revenue growth, 1-2% from margin expansion and 4-5% from capital deployment (buybacks/M&A). We think the current valuation of 10.8x NTM EPS is too low for a business that can grow EPS 12-15% and is recession proof. We think Centene’s valuation will expand from the current 10.8x NTM EPS to something more in line with its multi-year average of 13.8x (the average since 2016). We use 2016-2023 and exclude 2015 as Centene traded as high as 26x NTM earnings in 2015 due to exuberance about the impact of ACA and we do not want to use this high multiple as the basis for a conservative thesis on Centene.

One major current event to note is redeterminations. During COVID, the enforcement of checking that Medicaid members should actually be on Medicaid was minimal. Due to this, enrollment ballooned. Starting in 2023 and running through 2024, will be the process of redetermination, or determining which enrollees need to be removed from Medicaid. While this is a major event, we note the negative impacts from removing these members from Centene’s revenue and profit base are already incorporated into the guidance and no further adjustment is needed. This headwind is one of the reasons why EPS will only grow ~7% CAGR from 2022 to 2024, well below the target of 12-15% per year. Once the redetermination process is over, Centene will have a clean starting point to grow from.

In addition, prior management set a target of a net income margin of 3.3% by 2024. Current management has backed away from being able to hit that in 2024 but said they still intend to aim for it eventually. We view this as a potential upside scenario that isn’t incorporated into our valuation or outlook. The sell side has EPS returning to 13% growth in 2025 but still has net income margins at 2.6%. Therefore, there could be potential upside to the 12-15% EPS growth if more meaningful margin expansion occurs.

Capital Allocation

Historically, Centene was focused on organic growth and M&A and had a good track record doing that. Under that model, Centene generated a total shareholder return of ~20x over the past 20 years or 16% CAGR. More recently, Centene revamped the board and management under activist pressure in December 2021. The new CEO has been focused on cleaning up the portfolio and has made five divestitures that have generated $4B in proceeds. In addition, Centene had never repurchased shares in significant size and has started to and shrunk their share count by 5.5% in 2022.

Risks

Regulation/Politics – The number one risk for all managed care companies is the never-ending concern that the US moves to a single payer system. We think studying Centene is interesting as this is a case where it’s practically a single payer system already. The government sets the rates, the rates paid are significantly lower than private insurance, and the states have the option to manage these programs themselves. However, the states still opt to use managed care companies. Due to this, we believe Centene has substantially lower single payer system risk than a commercially focused managed care company.

Redeterminations – Redeterminations could be more painful than management expects.

Medicare Turnaround – The Medicare business needs to be turned around, while this could be a big positive, this could be a distraction for management, get worse than it already is, and weigh on sentiment. 

Catalyst

Redeterminations rolling over and Centene returning to high EPS growth

Investors appreciating the shift in capital allocation and increased repurchases

Time and EPS growth