| 2016 | 2017 | ||||||
| Price: | 61.00 | EPS | 3.93 | 4.50 | |||
| Shares Out. (in M): | 78 | P/E | 15.5x | 13.5x | |||
| Market Cap (in $M): | 4,727 | P/FCF | 0 | 0 | |||
| Net Debt (in $M): | 2 | EBIT | 0 | 0 | |||
| TEV (in $M): | 7 | TEV/EBIT | 0 | 0 | |||
| Borrow Cost: | General Collateral | ||||||
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“And I guess just to ask given going back quite long ago but there was a history of unexpected obstacles, the approval process at least to some degree, is there a reason to anticipate that we might have some special issues to resolve with respect to California approval?” – Matthew Richard Borsch, Goldman Sachs, CNC/HNT M&A Call, July, 2 2015 (Final Bloomberg Transcript)
“Do any of your organizations absolutely oppose the merger?...Do any of your organizations absolutely, you know, basically, have a bottom line, that this merger should under no circumstances be approved?” – John Finston, CDI General Counsel, CNC/HNT Administrative Hearing Under “Form A,” January 22, 2016 (Court Transcript)
"In July 2014, Strategic Party A decided to end discussions regarding a possible transaction with HNT, noting significant concerns with state regulatory approval requirements” Background Section, CNC/HNT Joint Proxy Statement on Form S-4, August 18, 2015
Thesis: Short HNT Spread, Risking $1 to Make $10+
The current HNT gross dollar spread of approximately $1 (1 HNT = $28.25 cash + 0.6220 CNC shares, no net dividends) presently imputes just a 5% probability of the California Department of Insurance ("CDI"), the state's most aggressive and politically-charged insurance regulator, blocking or materially delaying the deal (as it did with ANTM/WLP in 2004) or demanding such onerous conditions that CNC elects to walk “for free.” An analysis of the facts and situational dynamic suggests a striking parallel between CNC/HNT and the ANTM/WLP precedent. Indeed, one official at California’s Department of Managed Health Care (“DMHC”), the less political and more “by the book” of the state’s two independent health insurance regulators, recently characterized the probability of CDI action on the deal as a difficult-to-read “toss-up” in part due to elected CDI Commissioner Dave Jones’ likely political ambitions. Jones, a career Democratic politician in his second and final four-year term at CDI, recently announced his candidacy for California Attorney General in a crowded 2018 field, an office that has been a stepping stone to Governor and the US Senate. On January 22nd Jones held an unprecedented 6.5-hour administrative hearing on the CNC/HNT deal (CNC CEO Michael Neidorff was conspicuously absent which seemed to irk Jones) during which CDI General Counsel John Finston asked witnesses: “Do any of your organizations absolutely oppose the merger?...Do any of your organizations absolutely, you know, basically, have a bottom line, that this merger should under no circumstances be approved?” Finston suggested he was “concerned” whether CNC’s abrupt exit from the unprofitable Kentucky Medicaid market in 2012 in breach of its contract evidenced a lack of “integrity” such that CNC could not be trusted (“[O]ne of the basic assumptions in your testimony is that you’re willing…to provide service once you acquire HNT, and make certain commitments to California”). It was not completely clear from the proceedings whether Jones wanted to legitimately attempt to find common ground with CNC/HNT or whether he had already made up his mind to oppose the deal before setting foot in the room (“I’m unable to find any enforceable guarantee to make sure CNC remains in the individual and small group market in California”). Jones has broad, unilateral statutory authority to block CNC/HNT under Insurance Code 1215.2(d)(1)-(5) if he deems the deal not in the best interests of California consumer policyholders and if challenged the Trial Court has, precedentially, given the elected CDI Commissioner’s Office the benefit of the doubt. Significantly, due to a subtle but black-and-white turn of insurance law, of the “Big Three” managed care deals announced in July 2015 (CNC/HNT, AET/HUM, ANTM/CI), Jones only has power to block CNC/HNT because HNT alone owns a California-domiciled (rather than simply California-licensed) insurance corporation (Health Net Life Insurance Company, NAIC#66141). Jones may hold toothless informational hearings on the other deals but he only has formal “Form A” approval over CNC/HNT (AET/HUM and ANTM/CI will confirm that they have not filed for Form A approval from CDI, as they just need consent from DMHC). The background section of the CNC/HNT merger proxy indicates muted strategic interest in HNT in part due to California regulatory issues ("In July 2014, Strategic Party A decided to end discussions regarding a possible transaction with HNT, noting significant concerns with state regulatory approval requirements").
HNT currently trades approximately $62 against downside risk on deal break to $40, which means an appropriately risk-adjusted spread (assuming a 25-50% probability of deal block or material delay) should be trading at least $4 wider than current levels for an “all-in” gross dollar spread of $5.50 to $11. In fact, the market’s mispricing of standalone downside at HNT may be even more striking than its complacency in the face of an aggressive California regulator (interestingly, current CDI Deputy Commissioner Nettie Hoge, the bureau’s senior health policy specialist, held the same role when CDI impeded ANTM/WLP in 2004; her LinkedIn lists the ANTM/WLP deal among her “key projects”). Consensus currently models over $4.50 of standalone EPS power at HNT for 2017. However, Street estimates wrongly flow through the full $150 million of cost reduction benefits from the Cognizant contract which has since been scaled back and which would not accrete to standalone HNT. This mis-modeling may overstate true standalone HNT EPS by up to $1 ($150 million less EBIT at 54% tax rate on 78 million HNT shares). This math puts aside the CNC/HNT transaction’s overhang on HNT organic growth and the company’s history of subpar execution. A California regulator blocking CNC/HNT would also strip, perhaps irreparably due to no clear M&A path, the “takeover speculation” premium that HNT has historically enjoyed which has fluffed its standalone multiple. Applying 10x to $4 to $4.50 suggests 25% to 35% downside from current levels, in the context of an already poor healthcare tape. Further, if the deal breaks HNT will not receive a break fee: per the definitive merger agreement HNT only gets a break fee in the event it fails to obtain HSR clearance. Equally under-appreciated, CNC’s stock stands to appreciate substantially if the HNT deal breaks. CNC has fallen from over $80 to $55 since deal announcement because the market wanted CNC to either sell itself like HUM or focus on growing its core, high-growth, high-multiple Medicaid business (CNC is basically a Medicaid pure-play levered to a category growing +20-30% year-over-year). The market penalized CNC for instead acquiring a diversified managed care player in HNT which will saddle CNC with a growth-dilutive Commercial/Exchanges business that CNC itself admits is non-core to its big picture strategy as a “government services healthcare company.” CNC shares, which currently trade 15x consensus standalone 2017 EPS (12x pro forma EPS including HNT), would likely re-rate towards their pre-deal multiple of 25x consensus standalone on continued Medicaid focus plus potentially revived takeout prospects.
Ultimately, Jones has absolute yes/no authority over CNC/HNT. He has enough ammunition to credibly argue that the deal is not in the best interests of California consumer policyholders, as well as ample political and personal motivation. And next week he has the podium at the 2016 California Democrats State Convention which runs February 26th to 28th in San Diego (in 2012 he used the podium alongside Senator Dianne Feinstein to bash health insurers and call for more authority to accrue to his office). Shorting the HNT spread (shorting 1,000 HNT shares and longing 622 CNC shares) offers an attractive asymmetric risk/reward (risking $1 to make $10+) with the opportunity to make a positive return on both sides of the trade over the next 1-3 months, all ahead of a key catalyst in the Democrats State Convention. Shorting the HNT spread is also a compelling way to hedge long exposure to the AET/HUM and ANTM/CI spreads as, if CNC/HNT is blocked, the market may initially mistakenly impute CDI risk to those deals, even though those deals are simply subject to the tamer DMHC.
California Insurance Code 1215.2(d)(1)-(5)
“The commissioner may disapprove the transaction if the commissioner finds any of the following: (1) After the change of control the domestic insurer referred to in subdivision (a) could not satisfy the requirements for the issuance of a license to write the line or lines of insurance for which it is presently licensed. (2) The purchases, exchanges, mergers, or other acquisitions of control would substantially lessen competition in insurance in this state or create a monopoly therein. (3) The financial condition of an acquiring person might jeopardize the financial stability of the insurer, or prejudice the interests of its policyholders. (4) The plans or proposals which the acquiring person has to liquidate the insurer, to sell its assets, or to merge it with any person, or to make any other major change in its business or corporate structure or management, are not fair and reasonable to policyholders. (5) The competence, experience, and integrity of those persons who would control the operation of the insurer indicate that it would not be in the interest of policyholders or the public to permit them to do so.”
ANTM/WLP Precedent
In 2004 CDI Commissioner John Garamendi, a Democrat who had recently announced his campaign for Lieutenant Governor, blocked ANTM/WLP on the grounds that the deal was not in the best interest of California consumer policyholders citing California Insurance Code 1215.2(d)(3) and S 1215.2(d)(4). ANTM sued CDI in Los Angeles Superior Court and CDI filed a motion to dismiss, setting the stage for what The Wall Street Journal called on August 4, 2004 “an extended and, possibly, uphill legal battle.” On August 21, 2004 CitiGroup ascribed a <50% probability to ANTM succeeding in the upcoming court hearing scheduled to begin February 25, 2005: “We think it is unlikely that a judge rules against the elected CDI Commissioner because the law is vague.” Garamendi parlayed the political points into victory in 2006 and later Congress where he now sits. ANTM/WLP eventually closed but only after a painful six-month delay during which the parties narrowly avoided a protracted legal standoff. Jones' Deputy Commissioner, Nettie Hoge, was Garamendi's health policy specialist at the time.
Regulatory Process
There are two state regulatory entites of consequence in California managed care: CDI and DMHC. CDI, whose Commissioner is elected through a statewide contest making the body much more political and prone to grandstanding (e.g., ANTM/WLP), has statutory purview where the transaction entails a change in control (>10% ownership) of a California-domiciled insurance corporation. CDI has no authority to review the change in control of insurers that are licensed but not legally domiciled in California. Acquirers must petition CDI for what is called “Form A” approval in order to consummate the change in control of the California-domiciled insurance corporation. Due to this subtle but black-and-white turn of insurance law, of the “Big Three” managed care deals announced in July (CNC/HNT, AET/HUM, ANTM/CI), Jones only has formal statutory ability to block CNC/HNT. HNT alone among the “Big Three” targets owns an insurance company, called Health Net Life Insurance Company, that is legally domiciled and not simply licensed in California. AET/HUM and ANTM/CI will confirm that they have not filed for Form A approval with CDI. This is important because CDI has been an outspoken opponent of all “Big Three” transactions with the view that M&A begets higher premiums and less consumer choice. If CDI wants to throw a wrench into the industry’s M&A plans, versus passively lobbing verbal barbs, then its single most actionable target of size is CNC/HNT. The Commissioner has unilateral yes/no approval of this petition and may hold, but is not required to hold, an administrative hearing as part of his diligence process (Jones held a hearing on CNC/HNT January 22nd). Following the hearing the Commissioner will proclaim the public record closed which begins a 30-day “shot clock” for his final decision (the clock in CNC/HNT currently remains open, according to CDI). In any case, this clock is not a hard-and-fast deadline as it may be mutually waived or extended by the parties. During the “shot clock” period the CDI Staff will generally work with the target and acquirer to see if they can come up with a set of mutually acceptable transaction conditions or “undertakings” which are then brought to the Commissioner as a “fix.” Generally the Commissioner has limited contact with the Staff and the companies during this time. The Commissioner can attempt to press the parties for further undertakings or block the deal outright. If he blocks the deal, then the parties have recourse to the Trial Court. The Trial Court has, precedentially, given the elected Commissioner’s Office the benefit of the doubt, making challenging the ruling an uphill battle. If the acquirer views the conditions as overly onerous, then he may walk. In contrast to CDI, DMHC is less political and more “by the book.” DMHC, whose Commissioner is appointed by the Governor, has regulatory purview where a deal entails a material modification (e.g., trasnfer) in the underlying license of a California-domiciled health maintenance organization (“HMO”). DMHC’s purview applies to all “Big Three” transactions. DMHC recently said that is does not believe it has ever before blocked a material modification of a HMO license in the context of a change in control (e.g., DMHC blocking any of the “Big Three” would be unprecedented). DMHC held a hearing on CNC/HNT on December 7th. Its regulatory process is independent of CDI’s and it is expected to make a decision in the next 1-2 months. With two regulators yet to decide on CNC/HNT, the companies’ guided close of March 1st – already pushed back from the overly optimistic February 1st date tabled January 11th at the JP Morgan Healthcare Conference – seems ambitious.
Political Motivations & 2016 California Democrats State Convention
CDI’s Jones, a career politician with aspirations of Governor, has already announced his plans to run for California Attorney General in 2018 in a crowded field. The stakes in 2018 are, objectively, enormous for 54-year-old Jones who is in his final four-year term at CDI after being reelected in 2014. Victory in the California Attorney General race would catapult his career in state and national politics (e.g., incumbent Kamala Harris is expected to claim Barbara Boxer's US Senate Seat in 2016) while defeat would consign him to local obscurity during his prime. His challenge for the next two years, which will amount to a marathon campaign, is to stand out among the three Democrats and two Republicans who have already announced their candidacy. Jones recently stated that he is starting his campaign early due to "the reality of the cost of campaigning in California and the amount of Super PAC money likely to be spent against me by special interests." Prominent among these "special interests" are California's managed care companies. Concurrent with his CDI reelection campaign in 2014 Jones publicly pushed for Proposition 45 which would have granted the CDI Commissioner veto power over health insurance rate hikes for six million Californians with individual and small-business policies (CDI has this authority for automotive, home owners, and property/casualty insurance). Proposition 45 was defeated because, Jones told The Los Angeles Times on November 5, 2014: "Health insurers flooded Californians with $57 million worth of false television commercials, radio ads, and slick mailers. Our consumer coalition [which raised less than $4 million] simply could not compete with that." HNT contributed $5.5 million of the $57 million. Jones won re-election in 2014 but couldn't have liked the headlines: "Proposition 45's Resounding Defeat is a Boon for Health Insurers." There is no love lost between Jones and health insurers. At the January 22nd hearing, it took ten tense minutes of questioning from CDI’s team to parse from CNC’s General Counsel that HNT’s CEO and CFO, both larger stock holders of HNT, would make a combined $75 million from the deal. Jones is likely to use the podium at the upcoming 2016 California Democrats State Convention which runs from February 26th through February 28th to further his agenda of health insurance reform – and potentially publicly challenged the CNC/HNT deal. At the 2012 meeting Jones joined with Senator Dianne Feinstein to scold the California legislature for failing over the preceding five years to pass a bill requiring health insurers to publicly justify their rate increases and to make such increases subject to CDI Commissioner approval (California is one of the few states where Jones’ analogue lacks this power). Jones lamented at the time: "My only authority for health insurance is, get this, to sentence the health insurer to my website if I think their rate is unreasonable. They're [the health insurers] laughing too." Will Jones get the last laugh?
CNC is a Medicaid Pure Play
Missouri-based CNC is a Medicaid pure-play (83% of premium and service revenue; #3 player behind ANTM and UNH) with a small Specialty/Government business (11%) and minimal exposure to Commercial/Exchanges (2%) that serves 4.8 million members across 23 states. Since 2009 CNC has grown premium revenue at a CAGR of over 30% and EPS at nearly 20% as states and the federal government have increasingly shifted from fee-for-service ("FFS") to managed care products aided in part by Medicaid expansion under the Affordable Care Act ("ACA"). CNC has been acquisitive with a focus on small Medicaid and Specialty/Government plans. CNC's Y+2 (2017 equivalent) P/E multiple peaked at 25x in 1H15 as CNC and HUM were considered among the most prized M&A targets in managed care due to their scale and strong market positions in faster-growing government end markets (CNC in Medicaid, HUM in Medicare Advantage).
Was the HNT Deal Defensive? Why Dilute Medicaid?
California-domiciled HNT is a diversified MCO that derives 39% of premium and service revenue from Medicaid, 34% from Commercial/Exchanges, and 19% from Medicare. California comprises nearly 90% of its members, and it has 10% share of the California health insurance market. Pro forma for the deal CNC will become the nation's largest Medicaid player with 5.7 million members (Medi-Cal, California's Medicaid program, has the largest number of beneficiaries in the country). However, the deal is growth dilutive. Standalone CNC had 83% of its sales levered to a Medicaid stream growing 20-30% per year and only 2% exposure to a flat Commercial/Exchanges business. Pro forma CNC would have 64% of its sales tied to Medicaid and 16% linked to Commercial/Exchanges. Disappointed CNC shareholders, who had been expecting either a takeout or continued Medicaid-focused expansion, voted with their feet, sending the stock from an all-time high in the $80s down to $70 (currently CNC shares sit at $54, 15x consensus standalone 2017 EPS and 12x pro forma EPS). Asked on the M&A call whether CNC plans to grow Commercial, CEO Michael Neidorff's suggested no and seemed to consciously distance himself from the Commercial business: "We are basically a government services healthcare company." Neidorff hedged again at the Morgan Stanley Global Healthcare Conference on September 16th (“[W]e're not trying to be the typical Commercial player that you see in the other major carriers"). At CNC's December 18th Investor Day Neidorff was more diplomatic, saying vaguely that CNC was “committed” to HNT’s Commercial business but that CNC would not grow the business into other states: "No, I wouldn't say, we try to – I try to be sensitive and careful. Our commitment to Commercial is limited to California at this point...But that is not saying we want to take that and move it beyond that to other states.”
Why Didn’t HNT Divest Commercial Before? Why Didn’t HNT See More Strategic Interest?
Commercial has long been an EPS overhang and source of material EPS volatility for HNT. Street has long speculated that, if HNT were not to sell itself, then HNT would sell the Commercial business to an acquirer with greater scale in that line. One potential issue is that HNT might have surmised that CDI would never allow the change in control of just Commercial and so HNT had to try to sell the whole company. The background section of the CNC/HNT merger proxy indicates muted strategic interest in HNT in part due to California regulatory issues: "In July 2014, Strategic Party A decided to end discussions regarding a possible transaction with HNT, noting significant concerns with state regulatory approval requirements."
Jones Can Make a Compelling Legal Case to Block Deal
1. Under Under 1215.2(d)(5), CNC lacks the “competence, experience, and integrity” to run HNT and so the deal is “not in the interest of policyholders of the public.”
a. HNT is one of four California health insurers together controlling 85% of the market. HNT, with the smallest share at around 10%, has historically competed on the basis of lowest price and so represents an important “value check” on the three larger players (Kaiser Permanente with 40% share, Anthem Blue Cross with 20%, and Blue Shield of California with 15%).
b. CNC lacks the “competence” and “experience” to run a Commercial business. This will result in diminished market power for HNT’s Commercial business, thus depriving California consumers of their important market “value check.” This dynamic is
i. CNC is a Medicaid player, wanted HNT purely for Medicaid, and has vaguely said it will keep Commercial but not grow Commercial in other states, even though it describes itself as a “growth company”
ii. CNC’s lack of competence and experience in Commercial are exacerbated by CNC’s lack of incentives to care about and optimally allocate capital to HNT’s Commercial line. Under the CNC umbrella HNT’s Commercial business will be capital starved and neglected with most incremental capital going to higher-ROIC Medicaid. CNC will increase HNT’s rates to stabilize its top line and further narrow its provider network to cut costs
iii. CNC’s lack of competence and experience may catalyze it to exit HNT’s Commercial business
c. CNC lacks the “integrity” needed for CDI to take CNC at its word, should CDI and CNC negotiate mutually agreed upon undertakings. It is impossible for CDI to credibly propose undertakings purporting to protect California consumer policyholders when CNC, based on its history particularly in Kentucky, may attempt to breach and them perpetually litigate on the contract (CNC is still today going through Kentucky litigation from 2012 but it was able to weasel out when the business turned unprofitable).
i. During the January 22nd hearing CDI General Counsel John Finston specifically questioned CNC’s “integrity” and “its willingness to act responsibly with respect to providing health care it has contractually committed to provide.” CNC defended itself by saying the market has turned unprofitable and that it was still litigating. This seemed to irk Finston: “[I]sn’t it true that both the Trial Court and Appellate Court have concluded that you did breach that contract?” Finston wondered how CDI could negotiate undertaking with CNC if CNC were simply to try and evade them: “Well, I'm somewhat concerned about the situation in Kentucky. Throughout your testimony you explained why this transaction would be beneficial to people in California. But one of the basic assumptions in your testimony is that you're willing to continue and make – continue to provide service once you acquire Health Net, and make certain commitments to California. Yet when I look at the Kentucky Spirit situation – and correct me if I'm wrong – but from the Court proceeding, it appears that Centene, through Kentucky Spirit, had entered into a three-year commitment to provide certain services in Kentucky, and yet attempted to withdraw prior to the end of that time period.”
ii. CNC presented to CDI that it placed a high priority on IT/security. But four days later is said it lost hard drives containing the information of nearly 1 million people. It is unclear whether CNC was aware of this development during the hearing.
2. Under Under 1215.2(d)(2), CNC’s acquisition of HNT would “substantially lessen competition in insurance in this state.”
a. CNC could unintentionally run HTN’s Commercial business poorly and deprive Californians of a strong “value check” player.
b. CNC could consciously run HTN’s Commercial business poorly and try to wind down the business.
c. CNC could go back on its word and, like Kentucky, exit Commercial (individual, small group, commercial).
3. Under Under 1215.2(d)(4), CNC’s plans for HNT are “not fair and reasonable to policyholders.”
a. Under CNC, California consumers will see lower quality, higher costs, and less choice
If Jones’ Conditions Are Too Onerous, CNC May Balk and Walk…“For Free”
If Jones doesn’t block the deal outright, he will likely detail fairly onerous conditions. It is uncertain how far CNC would go before balking considering it would not owe a break fee.
1. CNC suggests it is willing to discuss with CDI the prospect of committing to the California Commercial market. But will CNC contractually commit to not exit the individual, small, and large group markets for 10-20 years irrespective of the business lines’ profitability? Recall in 2012 that HNT took a 50% EPS bath when the Commercial business disappointed. Is that a risk that CNC – not only as a fiduciary, but as a “government services healthcare company” whose bread-and-butter is Medicaid – wants to take?
2. Will CNC commit to publicly publishing its healthcare insurance rates and giving CDI yes/no power over these rates for 10-20 years?
3. Will CNC commit to scaling back job cuts?
4. Will CNC commit to a mandatory quality of care threshold that could eat into its $150 million synergy target?
CNC May Actually Want to Walk
With the managed care M&A frenzy now over and CNC’s stock trading on its lows amidst a growth-dilutive deal, CNC may jump at the opportunity to walk if Jones proposes overly onerous undertakings. CNC’s CEO did not even attend the CDI hearing which seemed to irk Jones. If this were a must-have asset, wouldn’t the CEO have attended to diffuse the state’s most aggressive regulator?
Links
· Jones at 2012 California Democrats State Convention
o https://www.youtube.com/watch?v=nSUCKgdhJFY
· CDI CNC Hearing and Documents (see in particular Jones at 03:17-03:45)
o http://www.insurance.ca.gov/0400-news/0100-press-releases/2016/Centene_Health_Net_Merger.cfm
· Consumer Watchdog Letter to CDI
· California Insurance Code
o http://www.leginfo.ca.gov/cgi-bin/displaycode?section=ins&group=01001-02000&file=1215-1215.18
· California Healthline
o http://californiahealthline.org/news/will-a-california-regulator-halt-the-centene-health-net-deal/
o http://californiahealthline.org/news/health-insurers-grilled-over-merger/
· Domicile Information: Health Net Life Insurance Company
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