Description

In the age of Obamacare (aka the Affordable Care Act or ACA), it is not uncommon for a healthy 35-year old to be paying $300 per month for medical insurance having a deductible of $5000 and a highly restrictive network of doctors and hospitals. Imagine for a moment that in this environment you could somehow sell insurance policies for $80 a month, with a deductible of only $1000, and an unrestricted network of doctors and hospitals. How many policies do you think you could sell? Health Insurance Innovations (HIIQ) is doing just that. By exploiting a loophole in the Affordable Care Act, which exempts short term medical policies (STMs) from the requirements imposed on most individual and family plans under the ACA, they are able to offer policies as low as $32 per month with an unrestricted network of doctors and hospitals and deductibles as low as $500. While STMs do not cover pre-existing conditions, these policies are 50% to 80% less expensive than policies regulated under the ACA and provide a substantial, if not irresistible savings to healthy consumers, combined with quality coverage.  Health Insurance Innovations is capitalizing on this significant difference in cost, and the concomitant rush by healthy consumers from ACA plans to STMs (see WSJ article below), by offering a simple web-based means to instantaneously purchase short-term policies from a variety of vendors, and to seamlessly renew these policies when they expire. HIIQ takes no underwriting risk.  Instead, they have longstanding relationships with a large number of nationwide insurance carriers (Q1 presentation, p. 13) and have the ability to construct their own products to match consumers’ needs.  In the first quarter of 2016, policies in force grew 154% year over year and revenues grew 89%. For the full year, management anticipates revenue growth of 30% to 40% ($138 to $144 million), and net income growth of 40% to 55% (0.38 to 0.42 per share). The stock is not very liquid, but at least one well-known hedge fund manager with 25 years of solid returns investing in the microcap space has accumulated a 13.9% position.

Short Term Medical Policies and the ACA

With the passage of the ACA, most health insurance policies were required to conform to certain standards of care, many of them controversial.  One of these requires insurance companies to issue all new policies without regard to pre-existing conditions. The idea was to spread the risk and cost of caring for people with pre-existing conditions among the entire population, including such pre-existing conditions as pregnancy and drug addiction, with an increasing burden for these costs being felt by young, healthy individuals for whom coverage would otherwise have been very inexpensive.

Short term medical policies by contrast are exempt from the ACA. They were historically designed to fill short term coverage gaps for people in transition, but have now begun to take on a new purpose, allowing young and healthy individuals to find low-cost medical insurance at a price that reflects their true risk profile. STM policies require applicants to disclose their previous medical history and they exclude coverage for pre-existing conditions, which yields a low-risk pool of applicants and results in dramatically lower premiums, particularly now that most high-risk applicants are being directed to ACA plans. The maximum term for these policies varies by state, however they can be renewed once they expire simply by filling out a new application.  The policies are available in 43 states excluding NY, MI, MA, RI, VT, NJ and MD.

The cost advantage of short term plans over conventional ACA plans is substantial.  For a given deductible and out-of-pocket maximum, the policy premiums can be 50% to 80% less than an ACA policy. On the other hand, since STM policies do not conform to ACA requirements, the holder of the policy is not considered “covered” for health insurance purposes under federal law and must pay a fine to the IRS at year’s end. Even taking these fines into account however, there is still a significant cost advantage to healthy consumers who do not have pre-existing conditions.

In order to determine the actual savings that each age and income group would realize by choosing an STM policy over an ACA policy, and to verify the value proposition to consumers, we put together a matrix comparing the cost of STM insurance vs ACA insurance in various states at various deductible levels, and then subtracted the IRS penalty that would be paid by each group, both family and individual, at each income level. Below are the results for Washington state, in the Seattle area, for deductible levels of $1000 and $5000. They illustrate the dramatic difference in price for both families and individuals between STM and ACA policies:

From the data in the above tables we see that for individual plans, persons with an income between $40,000 and $90,000 will generally benefit significantly, even after paying the IRS penalty, by selecting an STM policy over an ACA policy. We also see that families with incomes between $65,000 and $250,000 also see a significant benefit. Below $40,000 for individuals, and below $65,000 for a family of four, the subsidies generally make the ACA plan more appealing. While at the high end, above $90,000 for individuals and above $250,000 for a family of four, the penalty also makes the ACA plan a better choice in most cases. There is little risk to an individual who forgoes an Obamacare policy in favor of an STM policy. In the event that he becomes seriously ill while covered by his STM policy, he can simply jump into an Obamacare plan during the next open-enrollment period thereby circumventing the problem of being left without coverage due to a pre-existing condition. Obamacare policies must accept ALL applicants regardless of their health status so they cannot deny coverage to anyone during open enrollment. One small risk to consumers using this strategy is that the expiration date of their STM policy might be several months away from the next open enrollment period (roughly Nov 1 to Jan 31), which ends up costing them some out-of-pocket expenses while they wait. However, the risk-adjusted cost of this possibility is still dwarfed by the savings in premiums.

There are a number of factors which should continue to push consumers toward STM plans at ever increasing rates for the foreseeable future:

• ACA compatible premiums have been rising each year and are projected to rise again, by double digits, in 2017.
• Several insurance companies have stopped offering ACA compatible coverage, or have cut back the number of states in which they participate, making the already limited choices for consumers fewer and more expensive
• Networks of doctors and hospitals that participate in ACA plans are becoming more restrictive each year making STM plans, with often unrestricted access, look more attractive

For more news on the trend from ACA plans toward STMs see this April 10, 2016 article from the WSJ:

http://finance.yahoo.com/news/sales-short-term-health-policies-224900324.html

Agile Health Insurance

The company markets its health care insurance policies through three distinct channels: nationwide call centers, a nationwide broker network inherited from Assurant Health following its demise in June 2015, and the Agile Health Insurance website, which is owned and operated by HIIQ.  The call center network has significant operating leverage. The company pays a 30% commission on premium equivalents, representing about 50% or 60% of revenues, but a nearly unlimited number of new customers can be handled without investing in new infrastructure.

While Individual and Family Plan (IFP) applications sold through all three channels over the last 12 months grew at an impressive 211% clip, the fastest growth came from the company’s newly-launched website, AgileHealthInsurance.com, which was launched in the second quarter of 2015.  Agile Health is a unique-to-the-industry eCommerce site which allows consumers to purchase STM policies instantaneously, by filling out an application, making payment on the spot, and immediately printing their insurance cards, all within the space of a few minutes. By comparison, consumers who attempt to purchase a policy through eHealth.com, HealthMarkets.com, GoHealth.com or GetInsured.com, must fill out the application online, send the application to the insurance carrier along with payment instructions, wait for the application to be underwritten, and won’t receive their insurance cards until a week or so later. This results in a number of customers dropping out of the process before completing the purchase.  Meanwhile, visitors to the Agile site can complete the purchase entirely online in just a few minutes, resulting in a higher number of potential purchasers completing the transaction.

The Agile platform has several advantages to the insurance carriers as well. In the case of a policy purchased through HealthMarkets.com or eHealth.com for example, the carrier must contact the customer, review the application, manage the customer’s payment, and send out the insurance cards. If the same policy is purchased through Agile’s website, the carrier does not have to perform any of these functions and receives payment from Agile immediately when the transaction is completed. According to the company, the fact that carriers do not have the additional burden and expense of managing the transaction means that HIIQ is able to negotiate more attractive pricing with these carriers than other health insurance brokers, and that this allows them to offer STM policies to the general public at lower prices than their competitors.

The table below, taken from the company’s latest press release, shows the number of IFP applications submitted during the past five quarters to the Agile website compared with all other distribution channels combined:

Agile is clearly the company’s fastest growing distribution channel. IFP applications submitted through the call center and broker networks increased 25% sequentially from Q4 2015 to Q1 2016. However, during the same period, the number of IFP applications submitted through the Agile website grew by 104%.  Variable acquisition costs for Agile’s new customers are significantly lower than through either of the other two channels, however they must be accounted for as an up-front expense whereas the revenue from the associated policy is recorded over the life of the policy. Partly for this reason, and partly due to fixed overhead costs, Agile itself is not yet profitable on a stand-alone basis. However, management believes it will flip to profitability later this year or in early 2017.  When a purchase is completed on the Agile website there are no commission payments made to third parties.  By contrast, as mentioned earlier, both the call center and broker networks require the company to pay 30% commissions on premium equivalent sales, which equated to a whopping 60% of revenues in the last quarter. The elimination of this commission expense will dramatically improve the company’s gross margins over time as Agile becomes a greater and greater percentage of HIIQ’s distribution mix.  It will also allow them to further undercut their competitors’ prices who must still pay high commissions to third parties.

Can the company’s high growth rates be sustained?

According to research conducted by the company, the overall size of the individual and family ACA policy market is approximately $35 billion.  They also estimate that 40% of this market would be better off with an STM policy, which is a market size of about $14 billion (see Q1 presentation, p.5).  However, because of the importance of this estimate to the future of the business, and in particular, to how long their exponential growth rate in policies can be sustained, we decided to verify this number independently. Those of you not interested in the details of how we determined the size of the market and the company's market penetration can skip to the bottom of this section.

To calculate the number of people currently enrolled in an ACA policy who would benefit by transferring to an STM policy, we need to identify the following:

• What portion of individuals enrolled in ACA policies have no serious pre-existing conditions, or pre-existing conditions that are not serious enough to preclude them from getting the maximum benefit out of an STM policy
• What portion of these individuals receive subsidies significant enough to make an ACA policy the more cost-effective option
• What portion would pay a penalty large enough to offset any savings if they were to change

The number of people insured in the individual and family policy (IFP) marketplace both on and off the exchanges, was 15.6 million in 2014. 43% of these policies were purchased through the exchanges, and 85% of that 43% received subsidies (source KFF.org). Since those individuals who received subsidies are generally not likely to switch to an STM policy, that leaves (15.6 million x 57%) + (15.6 million x 43% x 15%), or 9.90 million who did not receive subsidies. We estimate that 80% of these individuals, or approximately 7.92 million, have minimal pre-existing conditions and would generally be good candidates for an STM policy. However, after accounting for the fines that many of these individuals must pay to the IRS should they transfer to an STM, this number will be lower. This is a good time to point out that many of these individuals (perhaps most?) may choose NOT to pay the fine and instead take the risk of an IRS audit, or perhaps don’t even know that a fine is due. If you prepare your taxes through H&R Block for example, the website asks if you had health insurance coverage for the entire year, NOT whether you had an ACA compatible plan for the entire year!  So, many people, whether through ignorance or strategic planning, will simply answer “yes” to this question and move on with their lives. Still, let’s adjust the size of the market assuming that all individuals are savvy enough to become familiar with the details of the IRS penalty and that they intend to pay it.

Continuing with our estimate, let’s assume the number of families applying for a policy represents 1/4 of all IFPs, which means 50% of the individuals who have coverage are covered under a single family policy (two applicants), and 50% are covered under individual policies (one applicant). Taking the 7.92 million people we calculated earlier who would see a savings if they didn’t pay a penalty, we can use our earlier research regarding the benefit to various age groups and income levels to estimate the theoretical size of the market. For single persons who opt to pay the penalty, the income levels for which an STM makes sense range from 40k, the level at which subsidies are negligible, to $90k, which is the point at which the fine becomes almost as large as the benefit. For family applicants who opt to pay the penalty, the income levels at which an STM makes sense are approximately $65k to $180k. According to 2010 US census data, 95% of US households make less than $180,000 per year and 75% of US households make less than $90,000 per year.  Since we have already subtracted the individual market policy holders who receive subsidies earlier in our calculation, we can finalize our estimate as follows:

Market size = (7.92 million individuals * 50% in family plans * 75%) + (7.92 million individuals * 50% in individual plans * 95%) = 6.73 million.

This is the number of individuals who would receive a significant cost savings by moving from an ACA plan to an STM plan assuming they know that a fine must be paid to the IRS, how to calculate that fine, and assuming that they actually intend to pay the fine.  At an average per-person premium of $275 per month, this represents a market size of $22 billion, which is 50% larger than the company’s estimate of $14 billion.

In Q1 of this year, the company had 115,300 individual and family policies in force after a year-over-year increase of 152%. A certain number of these policies represent traditional STM policy purchases by people who are bridging short term gaps in coverage, so they don’t really represent a penetration of the ACA market. Nevertheless, even if we include these policies, HIIQ’s market penetration is still only 1.5%.  And it is probably less than 1% if you assume, as I do, that half these people don’t even know a fine is owed.

Valuation and Upside

Management is forecasting net income for the year at 0.38 to 0.42 per share with revenues of $138 to $144 million. This implies a growth rate of 30% to 40% in revenues and 40% to 55% in net income. While I am generally averse to using company projections for valuation purposes, it is clear from conversations with management that they believe these estimates are on the very conservative side. In fact, management acknowledges that setting expectations too high was partly responsible for the stock’s decline in 2014, and they have stated repeatedly that they are making every effort to avoid that mistake again. In addition, forecasting revenues for upcoming periods in the insurance business is made easier by the fact that policies are underwritten for periods of several months or years, and the duration of these policies is well known, so there is good deal of visibility into the company’s future revenues and earnings, at least for that portion which represents policies in force.  Given management’s extreme caution in setting revenue and earnings guidance it seems likely that we could see at least one more upward revision in earnings estimates this year, similar to what happened in Q1 when the company raised guidance by 10%.

So, if we use the company's guidance from their last press release, the stock is currently trading at a P/E multiple of about 15.8 and an EV/Revenue multiple of 0.6, which seems reasonable for a company growing new policies at greater than 150%, revenues by 30-40% and earnings by 40-55%, and which is based on guidance that will most likely be revised upward at least one more time this year. By contrast, the insurance brokerage industry trades at an average P/E multiple of 22.4 with substantially lower growth rates, although with an admittedly more established books of business.

To illustrate the operating leverage in this business and its effect on earnings and ultimately the share price, let’s imagine a time in the future when the number of policies in force average 300,000 per year.  Last quarter there were 258,000 policies in force at the end of the quarter so this isn’t a wild assumption. Furthermore, let’s assume that Agile, with its higher gross margins, represents 33% of the business by that time, or an average of about 100,000 policies in force. This too is not a wild assumption since there were approximately 25,000 Agile policies in force at the end of Q1, representing 10% of existing business, and policies in force at Agile have been growing in excess of 100% sequentially for the past few quarters. So the scenario of having an average of 300,000 policies in force over a one-year period, with Agile representing 33%, is not too hard to imagine. In fact, it might not be unreasonable to expect such a situation by the end of 2017.

Based on an average of 300,000 policies in force, adjusted earnings per share would be calculated as follows:

Total Revenue……………...........................$180.0 million  (300,000 policies x $150 average revenue/policy/quarter x 4 quarters)

Commissions……………………………………......$72.4 million   (2/3 of Total Revenue x 60%, which is the high end of the historical figure.  1/3 of business is done through the Agile website and no commissions are paid)

Processing Fees……………………………………….$3.6 million   (Total Revenue x 2%)

Core SG&A (fixed costs)……………………….…$35.3 million

Marketing & Advertising for Agile……….….$24.8 million    (Assumes submitted applications were 938,540 for the year, that 1/3 of these were attributable to Agile, and that the average variable cost per submitted application was $80)

Call center variable costs………………………....$4.2 million

Depreciation…………………………………………….$0.8 million

Adjusted Ebitda…………………………………......$38.9 million

Taxes…………………………………………...............$14.8 million    (38% tax bracket)

Adjusted Net Income…………………………....................$24.1 million

FD Share count (inc. Class A and B)………………….......14.611 million

EPS……………………………………………………………………..$1.65 per share

At a multiple of 15x earnings this would equate to a stock price of about $25 per share.  At a multiple of 20x, this would be about $33 per share. The stock is currently trading at $6.65.

Risks

1) Despite management’s belief that short-term medical insurance will not be affected by any currently-foreseeable political outcome, it is hard to see how the repeal of Obamacare by Trump would not throw the insurance market into temporary upheaval and force the company to dramatically alter their business strategy.  Likewise, if Hillary becomes president and is lucky enough to have a Democratic House and Senate, there could be an attempt to close some of the STM loopholes or add amendments to the health care law which make STM’s less attractive when compared to ACA plans.  Although there is currently no political appetite for any changes to the healthcare law and particularly not for any increases in the penalties charged for not having “minimum essential coverage”, this still looms as a risk worth bearing in mind. It is unlikely that any political event would force the company's business into permanent decline, but it might put a cap on the rapid growth in policies, which would be enough to upend the story.

2) The actual number of people who are willing to switch from an ACA policy to an STM policy might turn out to be much smaller than our model predicts. If this is the case, the rapid growth we have seen in the last three quarters may fizzle out sooner than expected.  It is important to mention here that HIIQ's business is cyclical and peaks during Q4 and Q1, corresponding to the Obamacare open enrollment period. Since STM policies have a short duration, it would be entirely reasonable to see a temporary drop in policies in force during Q2 and Q3 without it being a signal that growth rates have tapered.

Catalyst

• Further increases in insurance premiums for ACA compatible plans
• Continuation of the narrowing of doctor and hospital networks for ACA policies
• More insurance carriers dropping out of the Obamacare system
• Continuation of the company's double and triple digit growth in new policies, revenues and earnings
• Increase in web-based sales as a percentage of new business which will dramatically increase gross margins
• Gridlock in congress – desirable although not necessary