Description

Summary:

eHealth is a stock without a home. Given the high multiple and annual losses, eHealth could be categorized as a growth stock – the only problem is, the company is not growing. Strike 1. Given Trump’s desire for healthcare reform, eHealth could be categorized as an event driven investment – the only problem is, the hope for a quick repeal/replace has passed. Strike 2! Finally, given the 70% stock decline from its peak, eHealth could be categorized as a value investment – the only problem is the company has no earnings. Seems like eHealth has struck out!

While the path is not entirely clear, we believe there are multiple ways to win with eHealth and the odds are stacked in the company’s favor. Several catalysts later this year should jumpstart the process. If we are right, we believe the stock could be worth $30-50 (50-150% upside). This is not a traditional value/growth investment, which is exactly why the opportunity exists. If we are right, we believe it will appeal to both sets of investors.

Situation Overview:

eHealth (“EHTH”) is an online health insurance broker operating in two segments: Individual and Family Policies (“IFP”, 55% of revenues) and Medicare (45% of revenues). The Affordable Care Act (“ACA” or “Obamacare”) was all but sure to render this business useless. After healthcare.gov was launched in late 2013, EHTH became a consensus short. How could a tiny company compete with the US Government? With three straight years of net losses since ACA’s rollout (-$26mm cumulative), and the expectation for a $30mm net loss in 2017, it appears the shorts have been right. That being said, EHTH is still alive and kicking, albeit producing negative cash and sporting a stock price that is 70% off its peak.   

The current sentiment is somewhat mixed as the stock is in no-man’s land -- growth investors do not seem interested because of a lack of growth, value investors do not seem interested due to a lack of earnings and valuation, and catalyst driven investors do not have an event. The market believes EHTH has little chance to compete against the USG and with chaos in D.C., the prognosis for a quick repeal of the ACA is bleak. We believe this thesis appealed to some event-driven investors and helped to lift the stock off of its single digit bottom but do not believe anyone still owns this stock based on regulatory change (the company’s own long-term guidance which we will discuss later assumes the status quo). For years, the IFP segment has generated strong cash flow, which has been used subsidize investments in the high growth (but unprofitable) Medicare segment. As detailed in the table below, IFP membership has declined nearly 70% since its peak and Medicare losses are not showing much improvement.

The key controversies central to an investment in EHTH are:

1.       Can Medicare sustain its growth trajectory and turn profitable?

2.       Can IFP stabilize or is it in terminal decline?

Source: company reports.

Investment Thesis:

We expect 25%+ growth in Medicare membership for a multi-year period, which should drive significant profitability in 2-3 years and be the primary driver of stock performance. More importantly, the structural dynamics of this business are far superior to IFP, creating a more robust business going forward. We believe the IFP business is also at an inflection point. While there are still some headwinds, we believe IFP should grow after four years of declines. We think there is good visibility to $50mm of EBITDA in 2-3 years from -$15mm in 2017 (while management is targeting $120mm in 5 years). Anywhere close to our estimate or management’s could yield a $30-50+ stock.

We will state from the outset that our thesis assumes the status quo regarding the regulatory environment and any changes (such as repeal or replace of Obamacare) offers further upside optionality.

Investment Point #1: Medicare Should Grow 25%+, Turn Profitable Next Year, and Increase the Quality of the Company. The Medicare business has many secular and structural dynamics that make it an attractive business. The most important being the target market, which is expected to grow at 10,000 individuals per day for the next 15 years (6.4% annual growth). eHealth currently has 300k Medicare members so it is working off a small base enabling the growth numbers to get very large. Please see page 12 of the investor deck (I was not able to post it in VIC). As you can see, this business has gone from 13% of commission revenue in 2011 to 43% in 2016 and we expect the share to look further disproportionate over time. This is important because Medicare is a superior business to IFP as discussed below.

1.       Growth: Medicare has significant growth runway and carriers are eager to participate in this market. IFP is facing many more headwinds and carriers are exiting the market.

2.       Duration: average duration of a Medicare member is 4-5 years vs. 1-2 years for IFP member.

3.       Lifetime value: eHealth garners roughly $712 from a Medicare member vs. $273 from an IFP member.

4.       Seasonality: Medicare does not have open enrollment like IFP and is therefore not as seasonal of a business.

As Medicare becomes a greater portion of total members, we believe the overall quality of EHTH’s business improves. However, despite 25%+ annual membership growth, the Medicare segment remains a money loser ($54mm of cumulative losses in 2015-2016) as the company spends heavily on marketing and technology. We believe EHTH is at the tail end of its investment cycle and profitability is imminent. With the recent win of a large retirement account in Q2, we believe this segment can turn profitable in 2018.

1.       Management is guiding to a $12 million loss in the segment, improving from a $33 million loss the prior year. Modeling this business is extremely difficult. While the company parses out technology costs (fixed) and marketing costs (variable) on a consolidated basis, it does not on a segment basis. The company estimates it costs $884 to acquire a Medicare customer. While the figure is high, the lifetime value of a member is nearly $1,600. However, we believe there is significant opportunity to lower that cost. First, around $350 is call center costs. Around 90% of new membership is acquired via call center and the company has a significant opportunity to transition traffic to the web. Even within those costs, there is room for improvement as the company looks to outsource its call centers so it can flex during more seasonal months. Second, we believe 10-15% of current costs are fixed and therefore do not scale as new membership grows. Both of these should significantly drive down acquisition costs over time.

2.       One of the key strategies led by new CEO Scott Flanders is to sign Medicare partnerships with unions and groups to serve as the de facto broker for the members. An example of this is the UnionPlus deal announced on April 27 in which EHTH will provide Medicare products to its 12.5 million members starting in Q3 this year. This is a staggering amount considering 300,000 of these members age into Medicare each year (compared to current membership of 300k). While it will take time to create the portal and back-end technology to support UnionPlus’ 60 or so unions, it is a large opportunity long term. EHTH announced a second partnership with Sutter Health on its Q2 call. We expect more of these partnerships going forward, which will accelerate both growth and profitability.

Investment Point #2: IFP Business Should Begin to Grow Next Year due to Regulatory Changes and Product Innovation

The IFP business has been decimated by the ACA, with membership down 70% from its 2013 peak. Despite the lack of repeal/replace, there have been some policy and product changes that should benefit EHTH. Before we delve into these, it is helpful to put the situation in context: Under the prior CEO (Gary Lauer), EHTH aggressively lobbied to become the exchange of choice to sell individual policies under the ACA. Lauer pushed hard to make healthcare.gov an information only web site and wanted portals, like its own, to transact the policies (a worthy objective). In the end, healthcare.gov rolled out as the portal of choice, the Obama administration spent massive amounts of marketing dollars pushing consumers to the site, and imposed several other restrictions on the market, all of which seemed like a death sentence to eHealth’s IFP business. Aside from competing against the US Government, the ACA restricts the sale of IFP plans only to the open enrollment period (creating a very seasonal business) and has also made the market uneconomic for some carriers (less product for EHTH to sell). A further blow to EHTH was the implementation of the double redirect, which required consumers who elected to purchase plans on sites other than healthcare.gov (ie. ehealth.com) to leave the portal during enrollment in order to check subsidy eligibility on healthcare.gov. This often led to customer loss as eHealth visitors would not return to the site after being redirected. eHealth estimates that they lost 80% of customers because of this.

There are three recent developments we believe will stabilize the IFP business this year and lead to growth next year:

1.       Elimination of the double redirect. On May 17, the double redirect was eliminated.  We believe this will be a significant contributor to membership numbers when open enrollment begins in November 2017. EHTH estimates it lost 80% of its customer traffic during this process.

2.       Cuts in Healthcare.gov marketing budget. The Obama Administration spent an exorbitant amount of money promoting the government’s internal exchange web site. EHTH discloses in filings that the USG’s marketing efforts have created significant competition and increased the cost of generating demand of IFP plans online. President Trump’s budget cuts funding by 20%, from $2.1 billion to $1.7 billion. While EHTH had already reduced IFP marketing spend considerably, this should further help the economics of the business.

3.       New Product Innovation.

a.        Short-term Medical: The ACA has caused premiums to skyrocket and has priced many out of the market. The IRS estimates 6.5 million individuals pay the penalty to not have coverage. However, a portion of this population still wants coverage but cannot afford or desire a comprehensive package. Instead, individuals have been buying short term medical plans. HIIQ (recently posted to VIC by jelly621) has been a large beneficiary of this dynamic. While EHTH was late to the market, they have since rolled out their own short-term products and have seen solid growth.

b.       Small and Medium Businesses: EHTH is also making a push into the SMB market, which it has not traditionally served. Approximately half of this year’s EBITDA loss ($8mm) is due to the SMB rollout. The opportunity is quite large for this mostly underserved part of the market.

Investment Point #3: New Accounting Policy Could Have Significant Implications for EHTH Valuation.

In theory, accounting policies should not affect a company’s value. However, they often do. We think the upcoming revenue recognition change will be a positive event for EHTH – mostly because the company will transition from negative to positive, revenue growth and EBITDA/EPS. Currently, the company books the majority of a policy’s cost upfront but recognizes revenue over the life of the policy. For example under current policy, every new Medicare member adds roughly $300 to revenue but $884 in cost in year 1. In year 2, revenue is $300 and cost is 0. Therefore, in periods of high growth, profit is negative. Under the new policy, the estimated lifetime value is booked in year 1, so revenue would be roughly $1,600.  From an accounting perspective, this will lead to some very large revenue numbers in the first year of adoption. For a small cap company that is valued off of revenue multiples that will likely show huge growth numbers, this will most likely draw some positive attention. We would note that if the company fails to generate growth in year 2, revenue numbers will fall off a cliff. Finally, the company will have to make some assumptions regarding its policies and will be subject to true-ups or impairments if those assumptions are off mark. The company plans to present pro-forma financials when it releases its Q4 earnings.

Investment Point #4: CEO Highly Motivated to Increase Stock Price via Compensation Package.

Scott Flanders joined the company as CEO in May 2016 after spending eight years on the Board. He has a fairly impressive resume, including CEO stints at Playboy, Freedom Communications, and Columbia House. A key theme in his prior experience are significant accomplishments in direct to consumer marketing. His bio can be found here.  Most importantly, Mr. Flanders seems to be a believer in the company. He negotiated a pay package consisting almost entirely of options. With the stock at $14/share, Mr. Flanders received four equal tranches of options struck at $20, $24, $28, and $36. He further asked for his 2017 cash bonus to be paid in equity. Needless to say, we believe Mr. Flanders has incentive (and conviction) to drive the stock price higher.

Valuation: This is one of the most difficult parts to the investment case in its current state. However, it should get far easier over time as revenues grow and EBITDA/EPS turn positive. Right now, we are relegated to use EV/Sales or a DCF (which we won’t even bother given the amount of assumptions that need to be made). We would note that EHTH has typically traded in the 1-2x sales range (currently 1.5x 2018 using the old accounting standards). After speaking with several sell-side analysts who have a long history with the company, they said when the company was doing well prior to the ACA, investors often used a 2-3x target sales multiple. Eventually, we think the company will be valued off of EBITDA and EPS. Under the old accounting standards, we believe the company could do $50mm+ in EBITDA in 2-3 years but under the new accounting standards, this could happen next year. At 10x, the stock would be worth $30. Depending on growth and marketing spend, the numbers could get quite enormous for 2018.

A couple other anecdotes to think about for valuation:

1.       If the business went into runoff mode, the current book would produce around $220mm of pre-tax cash flow compared to its current EV of $290mm.

2.       M&A comps in the space have averaged around 3-4x LTM revenue and 10-20x LTM EBITDA.

3.       In February 2017, management forecasted 5-year revenue CAGR of 20%+ and EBITDA margins in the mid 20% range. This implies around $470mm of revenue and $120mm in EBITDA in 2022. Discounted that at a 15% rate back to 2018 and applying a 12x EBITDA multiple produces a $50 stock price. If the company comes close to hitting its targets, the stock will likely trade for a much higher multiple.

Risks. There are a plethora of risks for EHTH. Aside from executing the company’s strategy, other risks include:

1.       Political Risk: there is significant noise coming from D.C. regarding the future of the ACA. This will likely cause near term volatility in the stock as investors digest the daily news flow. However, our base case scenario assumes the ACA remains a competitor so we have factored this risk in.

2.       Trump Risk: this is the biggest risk in our opinion. We believe most pragmatic approaches to healthcare reform should benefit eHealth. However, the President has made remarks that if Congress will not repeal/replace, he would let Obamacare fail. A situation like this would likely cause significant disruption to eHealth and the healthcare system. We will leave it to the reader to ascribe odds to the President’s rhetoric.

3.       Insurance Companies Exit: the ACA has made the IFP market unprofitable for many insurance carriers. A continuation of the status quo could see fewer participants, which would decrease the company’s products to sell.

Catalyst

1. Growth and profitability in Medicare

2. Growth in IFP

3. New Partnerships

4. Accounting Change