Description

Centene provides health insurance (Medicaid, Medicare, Individual) on behalf of the US government.  It is the country’s largest Medicaid managed care insurer and is on the verge of growing its Medicare presence with the pending acquisition of WellCare (WCG), expanding revenue from ~$72B to PF $100B FY19E.

The company benefits from secular growth in Medicaid and Medicare members and overall health care cost inflation driving mid/high single digit underlying revenue growth.  Currently trading ~16x earnings, below long and short-term historical 20x, valuation implies medical cost trends well above historical levels.  

An 87% cost ratio forecast results in ~$5/sh eps, or 10x implied P/E.  This implied fear generated by 2020 election uncertainty is an opportunity.

First, the different types of insurance Centene administers:

Medicaid is insurance for low income citizens, run by states with a portion of funds contributed by Federal government.

Medicare is federal insurance program for US citizens aged 65+.

Commercial plans are purchased on the exchange under the Affordable Care Act (Obamacare).  Buyers earn too much to qualify for Medicaid and are too young for Medicare. Most CNC members are low enough income to receive federal subsidies offsetting the cost of insurance.

This opportunity likely exists because of concerns around how CNC would be impacted by a Warren/Sanders presidency.

Business model

Centene 1) receives a per member per month (PMPM) premium from states (Medicaid) or Federal (Medicare) govt for each member covered under its plans in exchange for assuming their medical costs.  2) contracts with providers to set up a network of hospitals and doctors where members can receive care.  3) engages with members to improve health behaviors (preventative medicine, primary care instead of ER, prenatal care, etc) and lower medical costs.  4) targets a 3-5% pretax margin, net of medical and overhead expenses, for this service.

As the chart above shows, the company pays roughly $0.87 of every dollar on medical costs, varying by patient group.  The remainder goes to overhead, technology spend, salaries, etc.  

The chart below shows approximate reimbursement by patient type, based on actuarial risk profiles.  Low income kids and their parents require less care and are reimbursed ~$300 pmpm while seniors in Medicare require more services on average, so CNC is paid $1,000+.

In addition to varied reimbursement, different patient groups have different average medical costs.  Medical cost ratio (MCR or MLR) is how many cents of each premium dollar go to care:

Source: Citigroup, 2012

Value proposition  

Centene delivers better health outcomes at lower cost to its government clients.  This is why it has steadily grown for the last 20 years and is likely to participate in any “Medicare for All” or other future reform scenario.  A few key advantages of managed care versus fee for service, especially in Medicaid.

The success of delivering better service at lower cost is why more states are shifting health care spend to managed care, and why MCOs are likely to play a role in Medicare for All scenarios.

Big picture  

Despite over a decade of strong growth, there remains a long runway as <50% of Medicaid spend is managed, although ~70% of enrollees are in a managed care plan.  As higher cost patients are folded under private coverage, state savings are substantial.

Significant scope for further MCO consolidation with >50% of the market highly fragmented

Medicaid is the largest budget item for many states, so curbing inflation is a top priority

WellCare acquisition  

In March 2019, Centene announced its intention to acquire WellCare (WCG), expanding FY19E revenue from $72B to ~$100B and bolstering its Medicare exposure.  Pro forma for the deal, Centene will be the largest government-sponsored MCO: 

The transaction continues a trend of M&A that has diversified Centene’s revenue base:

CNC is acquiring WellCare for $120 cash and 3.38 CNC shares per WCG share, roughly $15B at current share price.  Deal is expected to close in early 2020.

Risks

Screw up the acquisition.  CNC has executed well on its recent large deals, but WCG is the largest to date.  There is some precedent for success, as WellCare successfully integrated HealthNet, and is mostly completed Fidelis.  Integrating WCG raises the risk profile though. 

Medicare for All completely dismantles health insurance industry.  Hard to handicap, and largely source of opportunity, but if a Democrat 1) wins the Presidency and 2) moves to single payer system, Centene could suffer.  Probability weighting the odds of these happening is a low %, but is not zero. The main reason MfA is unlikely is that people generally like their insurance.

https://www.kff.org/health-reform/issue-brief/whats-the-role-of-private-health-insurance-today-and-under-medicare-for-all-and-other-public-option-proposals/

Another possibility in this scenario is that “Medicare for All” happens but is administered through private insurers such as Centene.  Today, much of Medicare and Medicaid is delivered via private insurers and beneficiaries tend to rate their plans highly.

https://www.npr.org/sections/health-shots/2017/07/10/536448362/survey-says-medicaid-recipients-like-their-coverage-and-care (Medicaid)

https://www.healthaffairs.org/doi/10.1377/hlthaff.2015.0816 (Medicare)

The market does not seem to discount much possibility that a Warren/Sanders win could be good for like Centene, but it is a real possibility if added coverage were delivered via a Medicare/Medicaid expansion via private insurers.

Finally, as MfA details emerge, people tend to like the plan less.  Surprisingly, people are less in favor of the plan if it eliminates private insurers.  

https://www.kff.org/health-reform/event/may-21-web-briefing-making-sense-of-medicare-for-all-and-other-plans-to-expand-public-coverage/

Executive compensation.  Centene management has done a good job for many years, but compensation is high.  Do not love the fact that revenue growth (with no capital offset) is a key bonus metric or that CEO Michael Neidorff’s compensation has averaged $24m over the last 3yrs.  Seems excessive and opens the industry to scrutiny. On the plus side, he has presided over massive shareholder value creation, joining CNC in May 1996 and IPO in December 2001, (21% share price CAGR over 18yrs).  Neidorff owns 7.67m shares worth ~$400m.

Valuation

I value the business using a simple income statement with the biggest assumption being MCR.  An 87% MCR implies a 10.2x P/E, versus 3 & 10yr avg 20x, current ~16x and financial crisis trough ~10x, when CNC had far more volatile earnings due to fewer state customers.  If we assume 16x is the “right” P/E for pro forma CNC, this implies an 88.4% MCR, well above historical levels.

For context, my base MCR ~87% should be conservative relative to PF member mix 

In a simplified pro forma income statement, 87% MCR implies nearly $5 EPS

All of this is very subjective, so the following matrix accounts for a range of assumptions.  At 16x earnings, an 87% MCR and 8.5% admin cost ratio implies nearly $80/share:

Conclusion

Government managed care is a somewhat controversial area.  It appears poorly understood and overly complicated based on press headlines and general displeasure with the US health system.  This is a source of opportunity. CNC provides a useful government service, administering benefits to low income and senior populations.  The likelihood of a massive system overhaul is non-zero, but upside in a reasonable base case scenario compensates investors for this risk.  Centene, as the leading pure-play government insurer, is a logical way to benefit from this uncertainty.

Lastly, headline risk

Despite many years of stellar performance, managed care is subject to significant headline risk.  The chart below shows 1yr underperformance and the associated headlines.

This chart of the last decade chart below shows periods of underperformance followed by outperformance versus the S&P and related headlines.  

Bad headlines have historically been an opportunity to own MCOs, especially Centene.  Investors must decide whether this time is different.

Catalyst

December investor day

Election clarity

WCG merger closed/integrated