Description

Ehealth (“EHTH”) is a great business for sale at a great price.

What do they do?

The Company operates a health insurance comparison shopping engine under the URLs www.ehealth.com and www.ehealthinsurance.com that is targeted primarily towards purchasers of individual and family health insurance plans. EHTH acts as a broker in these transactions, selling health insurance plans offered by all of the major managed care companies. The target market for EHTH is the 18 million people covered under individual and family plans (“IFPs”), the 47 million uninsured and to a much lesser extent through small business offerings the 51 million people covered by their small business employer. The business model is the same as any other broker of health insurance: compensation to EHTH is 25% of the premium in year 1 and 15% of the premium thereafter. The Company currently has 488,300 IFP members, representing a tiny portion of the addressable market. The basic service the Company provides is a faster, easier way to purchase health insurance: the comparison shopping engine allows customers to very easily compare premiums and other key terms of various health plans and then streamlines the purchasing process. The traditional purchasing process would involve comparing health plans on your own by contacting the managed care companies directly or by buying through a traditional broker. This purchase process is extremely unpleasant for the customer because it is cumbersome to collect the relevant information to compare plans and then the manual process of applying for health care and getting approved is slow and laborious. Further, brokers are incented to sell you the highest premium plans in order to maximize their compensation. EHTH simplifies the process by collecting all of the relevant information for you, presenting it in an efficent manner and then streamlining the application process. Because the purchasing process is so much easier with EHTH, the Company believes that it can expand the market for IFPs from the current 18mm market size to at least some portion of the 47 million uninsured, who have the economic resources but are turned off by the byzantine process of purchasing health insurance. EHTH believes that the standard process of getting approved for health insurance takes about 50 days from start to finish. EHTH reduced this process down to 17 days through its online application process and beginning in Q1 2008, the company launched an instant approval process whereby a customer can literally be approved and receive health insurance coverage instantly online. Only a small portion of the health plans currently have the instant approval feature, but this is growing rapidly which will be a nice catalyst for accelerating submitted applications and conversion rates.

Why is this an attractive business?

• Wide moat business: I describe EHTH as a comparison shopping engine, but what makes EHTH really special is the years of work and capital they have invested in tying themselves into the IT infrastructure of the managed care companies. Since being founded in 1997, EHTH has spent years developing the capability to complete health insurance applications online – if you think about the complexity of this process, mapping application fields into the literally thousands of plans offered by various managed care companies independently in each state, so that the systems work and the managed care companies are comfortable approving applicants online, it is an enormous task. That is why EHTH to this day is one of two companies (but the largest by far) that is able to sell health insurance plans online. There are numerous lead generators that compete with EHTH, but these competitors ultimately merely collect your contact information and then forward it on to traditional brokers who pay for the leads and then leave you daily voice mail messages for 6 months (note: do not give out your cell phone numbers to these folks when conducting due dili unless you want 6 months of daily solicitation). EHTHs IT capabilities are so unique that the Company also has a small but growing business in licensing the IT platform out to managed care companies. Hence, if you want to buy a policy online direct from Aetna, it is EHTH’s platform that is powering the application process. The platform has been further extended throughout the broker channel so that human brokers can electronically submit their clients’ applications to managed care companies without having to go through the manual process of filling out paper forms. The advantages of EHTH’s technology platform continue to be extended, especially since launching the instant approval product noted above which allows a customer to be approved immediately for health insurance through an electronic application and approval process. Further contributing to EHTH’s moat is that the Company is a licensed health insurance broker in all 50 states, a characteristic the lead generators do not possess.
• Does not compete on price: One of the quirks of the regulatory landscape for health insurance products is that prices are fixed – once a plan is approved to be offered in a particular state, all brokers must offer that plan at the same price. So, price competition is not part of the picture here as it is in the case of a seemingly similar business model such as Expedia where you are constantly in a price war with your competitors and your suppliers (the airline in the case of Expedia, the managed care company in the case of EHTH). So the Company really competes solely on the basis of quality of service, which is highly differentiated and there is nobody out there that is capable of offering the same customer service experience as EHTH.
• Enormous addressable market: The market size, defined most narrowly as the 18mm current IFP members in the US and most broadly at 115 million including uninsured and small business, is enormous. With 488,000 members currently, the Company has barely scratched the surface on this opportunity. Buying health care online remains a somewhat complicated process (as compared to buying auto insurance for instance), hence it has taken longer to achieve penetration in this market than other web based financial services. Over time, however, I think that the services provided by EHTH will continue to penetrate the enormous market opportunity. The instant approval process that was launched in Q1 2008 will be a catalyst over time for higher penetration and conversion rates. The small business market is an excellent opporunity for EHTH as well; there is no competitor in this market and EHTH has excellent products poised to capture this opportunity.
• Massive cash flow generation: This business has minimal capex and is not a taxpayer this year or next; hence the free cash flow generation here is fantastic. On $113 million of revenues this year, the company will generate free cash flow in the high $20s – this model is hugely profitable. I also think mgmt. is probably overspending and trying to keep margins lower than they would otherwise be in order to manage street expectations and not show too much margin too early. Regardless, cash continues to pile up on the balance sheet, now at $5.31 cash per diluted share and no debt. The scalability of the model is obvious, with incremental margins close to 100%.

Valuation

I won’t bore you with a DCF model, the valuation metrics here I think are pretty obvious. The market cap is $340mm, no debt and $140mm of cash gets you to an enterprise value of $200mm. The business will do $25-28mm of EBITDA this year, so about 8x EBITDA and will also generate about the same in free cash flow because of no cash taxes, minimal capex and interest income. So, you have an unlevered FCF yield north of 10% for what I consider to be an excellent business that will grow (debatable at what rate, but lets just say >10%). Yes, that’s based on no taxes which obviously will not last forever, but the business is growing so the cash flow is going in one direction, up. DCF and comps not necessary, this is common sense cheap.

Why is it cheap?

I think its important to understand the bear case, so I’ll offer up a few theories on why the stock has capitulated to these sub IPO levels:

• The Company missed expectations recently, though business fundamentals continue to quite strong. The key metric that the market keys on is submitted IFP applications. The growth rate in submitted IFPs slowed to 17.6% in Q2 from a mid 20s rate that was experienced in the last few quarters. The economy has impacted the business and consumers appetite for paying for health insurance. Regardless, the model is still generating excellent results as margins continue to expand significantly even at the lower growth rates. The investor base for this Company consists of uber-growth managers who probably bought at a much higher price. For the uber-growth crowd, this looks like a slowing growth story (though its probably just hitting a bump with the economy) and we’re probably in the process of transitioning the investor base to those who like wide moats, lots of cash flow and good long term business prospects.
• Sentiment has been weak on anything related to the managed care companies, whose stocks have gotten pummelled
• The stock is technically considered a “financial”, because it is an insurance broker.
• During Q2, there was a ton of speculation about ComScore data that showed web visits to EHTH slowing dramatically. This sentiment caused the stock to decline significantly going into earnings. The Company has said numerous times that the ComScore data is just flat out wrong and it has no correlation to what the Company is experiencing. I’m not an expert on this topic but anecdotal conversations I’ve had with others in the Internet world suggests the ComScore data isn’t viewed as being particularly important or accurate.

Potential Catalysts

• I think the most surefire catalyst is that the business is just generating so much cash flow relative to its enterprise value, which will eventually result in appreciation or at least not much more downside.
• I know this sounds very “2007”, but I do think a big buyback – dutch tender or ASR, would create a lot of value here. I think mgmt. is getting a lot of pressure in this direction; I personally don’t understand why they haven’t already done it. But it seems like it would be a pretty decent idea to take $50 of the $140 in cash and buy back 15% of the equity. I realize that begs the question what are they doing with the other $90mm of cash, but I guess that is kind of a high end problem to have these days.
• I think operating results at some point will start to get a tailwind from the launch of instant approval platform.
• Though I am not betting on this by any means, I think EHTH is potentially a very valuable strategic asset to a lot of different folks - could be a traditional broker like an Aon or Willis, another online financial player, a health care IT services company, or an underwriter that already has an online presence such as Progressive. Seems like there are a lot of people out there with cash right now looking to pick up great franchises at bargain prices.

Risk Factors

The biggest risk factor in this business is changes in the regulatory landscape. I don’t think this is a good venue or I’m necessarily qualified to write an intelligent treatise on the myriad of potential regulatory developments, which would impact all of the players in health insurance in addition to EHTH. You can read any of the many initiation of coverage reports or listen to an EHTH investor conference for an update on the regulatory landscape as it relates to the Company and which presidential candidate might impact the business more favorably (I bet you can guess which candidate is more favorable for this business, like a lot of businesses out there). Anyhow, I don’t pretend to maintain any unique insight on how regulatory processes might play out. My take on all of the regulatory discussion is there are tons of different proposals, some of them are positive with respect to EHTH and some are negative. The pace of change is very slow and it has been proven time and again that it is difficult to implement any kind of health care reform both at the state and federal levels. The most likely scenario is the status quo.

• The economic environment may continue to impact IFP membership growth – this will potentially come in the form of lower submitted applications and higher churn rates, both of which have been experienced already. Its nice to know the Company continues to grow and expand margins despite the economic challenges. At the current valuation I don’t think you need that much to go right to make this a success though. Further, the Company has a nice opportunity it is targeting to go after the COBRA market as unemployment rises. Employees will typically go onto a high cost COBRA plan and EHTH thinks there is a big opportunity to communicate to this market that there are more affordable plans out there and signing up for one is easy if you do it through EHTH.
• A further risk factor is use of cash/capital allocation. Management has talked about acquisitions but has also expressed a clear knowledge about the risks of doing acquisitions and the mixed history of deals done in the space. They have also talked about buying back stock. I guess we’ll see which path they take. I’m not expecting that they do anything really dumb as the board seems pretty solid. They could probably use an activist to bang on their heads a little bit though as the cash needs to be put to work.

Hope you enjoyed the writeup and I look forward to your questions and discussion….

Catalyst