Description

We are pitching Centene (CNC) as a very favorable risk / reward opportunity and a case of heads we win, tails we don’t lose (and likely win as well).  Tharp05 wrote CNC back in Nov and we refer you to his work for an overview of the business.  In this note, we would like to focus on the downside vs the upside embedded in the shares at current levels.

To start lets breakdown CNC segments of operation (proforma estimated for WCG):

-        Medicaid non-expansion: 55% of revs and 45% of ebit

-        Medicaid expansion: 10% of revs and 8% of ebit

-        Healthcare Exchanges (HIX):12% of revs and 18% of ebit

-        Medicare: 3% of revs and 16% of ebit

-        Medicare PDP: 2% of revs and 3% of ebit

-        Commercial Risk: 2% of revs and 3% of ebit

-        Other Services: 4% of revs and 6% of ebit

For 2020, CNC is guiding for $4.85 of eps, on 579mm shares, or an Adj Net Income of $2.8B.  Using an effective tax rate of 36% (due to HIF tax), implies Adj EBT of $4.4B.  Backing out $330mm of net interest, we arrive at an adjusted EBIT of $4.7B at the mid-point of guidance (which excludes amortization and deal costs).  In 2021 CNC will benefit from another $400m of synergy flow from WCG plus $260mm from the remaining WCG consolidation for a total adj EBIT base $5.4B (or a margin of 5%).  CNC will also generate around $480mm of investment income and pay $700mm of interest (net of the refi announced yesterday).  All in the EBT base for 2021e is $5.2B.  We will use this EBT base to analyze the impact of the two extreme scenarios that appear to worry the market these days:

Scenario 1: Trump wins and the ACA is overturned by SCOTUS without any replacement.  In this event, we completely wipe out 26% of EBIT (Medicaid expansion plus HIX).  We arrive at an EBT of $3.8. However, the company also benefits from capital release at a ratio of 10% of the lost revenue base, or $2.5B.  Let us assume CNC reinvests that cash at a 10% pretax return (lower than a buyback at current levels), so we get another $250mm of positive net income.  All in, our new normal EBT is ~$4B.  Applying a tax rate of 25%, we get Adj Net Income of $3B on 590mm shares, or adj EPS of $5/share.

Scenario 2: Biden wins and Democrats sweep.  In this event we assume Bidden introduces MA at 60. About 10% of the adult population is in the 60-64 age group. That would therefore cut off 10% of CNC Medicaid and HIX business, or 7% of the company’s total EBIT.  However, Biden will also drive for full Medicaid expansion by introducing incentives to Republican stronghold states.  There are 5mm people that would join Medicaid if all states expanded.  Let us assume only 50% expand and CNC grabs its 20% share of Medicaid, or another 0.5mm people.  That would equate to a tailwind of around 2% to EBIT. CNC would also benefit from 10% more business in its Medicare segment, worth another 1% to EBIT. All in CNC would lose less than 5% of EBIT.  That 5% is attached to about 6.8B of revenues that release 680mm of capital.  Reinvested back at 10%, we get a positive offset of 68mm.  All in the negative EBIT impact is just 3.5%. Our base Adj EBIT is therefore $5.2B and Adj EBT is $5.0B.  We increase the tax rate by 7% to 32% given the Biden adminstration's plans and get Adj Net Income of $3.4B and Adj. EPS of $5.75/share. 

We note that if Biden goes with a public option (instead of Medicare at 60) the impact will be lower as it will not affect CNC’s expansion business and likely impact only 10% of CNC’s HIX business (since 90% of CNC’s customers are already on subsidized plans). It also assumes that the government runs the public option on its own and does not outsource it to MCOs (unlikely).

What is CNC worth in each scenario? In both states we are holding a company that grows 5-7% top-line after the negative impacts (1-2% medical rate inflation, 1% population growth and 3-5% continued outsourcing to MCOs of the highest acuity members).  EBIT should grow modestly above that thanks to operational leverage, but we will assume 6-7%.  At CNC’s current valuation, its Debt to TEV is about 33%, so compounding of value to equity becomes ~10% before use of cash.  If CNC trades at an S&P multiple of 17X (normalized down vs the current multiple of 23x…) it would then be able to reinvest cash at least at 6% and generate total return of around 16% per year (through buybacks/dividends or by reinvesting cash flows at returns that would be far lower than CNC’s historical performance). Given the anti-cyclical nature of CNC’s business, we think receiving 16% annual return more than compensates investors for future regulatory risk on the remaining business (made up of mostly of Medicaid and Medicare)

               We arrive at target prices of $85 should Trump and Republicans win, or $98 should Biden and Democrats sweep.  Those target prices reflect upside of 55% to 80% from CNC’s current levels. In other words, heads we win and tails we win.  If you believe CNC will not warrant 17x from the market in a Republication controlled government, then you are receiving CNC at just 11x PE the downside case, while the company grows from there.  We view that scenario as “we don’t lose”

Finally, we will point out that a scenario of complete repeal of the ACA means about 26mm people lose coverage and that politicians do nothing about it. This scenario is unlikely.  Otherwise, introducing Medicare at 60 will be costly and will not serve Biden’s main goal of increasing coverage and reducing the uninsured rate. Instead it is more probable that Biden will opt to increase coverage by raising the minimum poverty threshold in the HIX market, which will benefit CNC.  In addition, both downside cases will not materialize immediately – at the minimum they will take 2 years to come into effect, while CNC generates another 21% of its market cap in Free Cash Flow (given it currently yield 10%). Further, for those worried about incremental negative impacts from rate pressure from states, we point out that they are transitory and reverse thanks to the actuarial soundness principle embedded in the Medicaid market.  Otherwise, if states decide to reduce benefit levels permanently, those impacts should not affect CNC’s margins.  Reduction of 3-4% at worse in benefit design therefore will not move the needle materially in terms of risk/reward.

Owning CNC entails going through a rocky experience until after the elections settle and the political landscape clears. Yet at current valuations CNC offers very asymmetric risk / reward.  It is a classical case of the market mis-characterizing uncertainty as risk. We recommend owning CNC today.

Catalyst

Earnings power shines through and valuation discount normalizes