Description

HEALTH NET (HNT)

Introduction

We last wrote up HNT a year and half ago in the midst of Armageddon, when the stock was beaten down to $11 - I recommend readers read that post as well (12/31/2008) to get the basic background information.  At the time, HNT was going through a number of issues (both company-specific and industry-wide), most of which have been or are being resolved favorably.  Currently the stock is at $25, but we think it remains a compelling investment.  We believe HNT is worth at least $35 as a standalone company or in a takeout.  Let me explain what happened and why we still like it here.

What Happened Since 12/31/2008

Business Improvements - In Q1-Q3 of 2008, HNT went through 3 consecutive guidance takedowns.  EPS began the year at a projected $4.14-4.17 ended up being an actual $1.85.  The street had lost all faith in management's estimates and some brokers took FY2008 #s down to $1.00-1.50 even as late as Q4 of that same year.  But in hindsight the 2008-2009 downturn was clearly an industry-wide cyclical problem, and since then the entire industry has re-learned pricing discipline and margins have stabilized for everyone.

Northeast Sale - In mid-2009, HNT reached an agreement with UNH to sell its Northeast business for book value + renewal fee for the members.  While the $600mm (most likely) price tag was on the lower end of what we hoped for, the structure of the deal highlights a very important point - that even though HNT is an underachiever that consistently has lower margins than its peers, its members can sometimes be worth more to someone else.  HNT's Northeast operations were $-losing on a standalone basis, but it was still worth a significant amount of $.  It had a statutory surplus which HNT could've recovered had they put the business in run-off mode.  And in addition, its $-losing members could become $-making members for someone else with more scale.  This deal was a win-win for both HNT and UNH because HNT was able to get significantly more value for this business than the street gave them credit for, and UNH was able to acquire new members cheaply and took no risk for it.

Healthcare Reform - After a long year, we're likely to see a final resolution of the healthcare debate within the next few weeks.  Whereas back in late 2008 the industry faced a high level of uncertainty, today the healthcare reform issue has only two realistic outcomes left.  We will either see no reform at all, or we will see a bill that's largely defined, and not all that harmful to managed care.  Specifically, to the extent the current reform proposal passes (ie. Senate bill + a sidecar reconciliation bill), HNT will stand to gain a significant number of new members (i.e. the "carrots"), while its below-market margins are unlikely to be negatively impacted by the profit-capping provisions of the reform bill (i.e. the "sticks").  In fact, we expect HNT to be a net beneficiary of whatever reform bill, if any, that may come out of Congress over the next few weeks.

TRICARE - The one negative event for HNT over the past year was the negative decision regarding the TRICARE contract.  In mid-2009, the TMA (TRICARE Management Activity) announced that Aetna had wrestled the TRICARE North contract away from HNT.  Since then, however, more details have emerged about AET's bid.  We now believe AET will be disqualified and that HNT will retain its TRICARE contract for another 5 years beyond the current renewal.  (See below for more)

Investment Thesis

Well positioned business model - HNT is unique among the publicly-traded managed care companies in that it focuses on an all-HMO (ie. very little PPO) business model.  For those of you who aren't familiar with the difference between an HMO and a PPO, think of the former as a lower-cost but narrow-network model, whereas the latter is more costly but you can see a much larger group of doctors and don't need a primary care physician's approval to see a specialist.  Back in the 1980's, HMOs got a bad reputation for having restrictive networks and difficult pre-approvals, so they started losing members who didn't mind paying a little more to have more freedom.  From the 1990's onward, PPOs have come to dominate 60% of the market vs HMOs at 20%.  PPO networks have become so large and non-discriminating, however, that they're becoming less and less useful in "managing care" or controlling costs.  The MCOs lose negotiating leverage against providers when they must include everyone in their network anyway; and not being able to pre-approve specialist procedures means anyone with a sore arm can call up an orthopedist and request an MRI.  For years, our system tolerated the prices increases, but now that healthcare spending is 17% of GDP, and the public is inundated with headlines of 39% premium increases, we believe the country is going to accept the HMO business model again.  Kaiser Permanente, which has perhaps the strictest network of them all, is also one of the best organic member-grower of the past 5 years.  Anecdotally we're hearing that narrow-networks, the sweet spot of HNT's business, are gaining market share across the country.

Further margin improvements - despite the recent margin stabilization, HNT continues to have one of the lowest underwriting margins in the country.  For full year 2009, HNT's operating margin was 2.4% vs 5.5%-6.5% for its larger peers (AET, UNH and WLP).  While some of this is attributable to business mix differences and the high level of capitation contracts between HNT and its providers, we believe there is still plenty of room for improvement.  HNT has identified another $80-100mm of annual G&A expenses that it expects to cut by year-end 2011.  On a share count of just over 100mm, that could translate into $0.50-0.60/share per year.

Significant cash deployment opportunities - one of the issues that HNT did not clear up at its recent Investor Day was what it plans to do with its cash position.  At the end of 2009, HNT had $450mm of cash at the parent and expected cash flow of $300-325mm in 2010.  Even assuming they boost their regulatory subsidiaries by another $90mm of capital, spend $90mm on share buybacks (most of which were already done in Q1), pay down $140mm of debt and $80mm of capex/severance, they will still have $350mm of cash at the parent at the end of 2010, with another $200mm of proceeds from the Northeast sale still to come.  At the same time, their debt-to-cap ratio would've fallen to an industry-low 20%.  Clearly HNT needs to do something to deploy its excess cash.  In fact, if we assume HNT intends to keep its debt-to-cap ratio in the range of 25-30% (industry average and where HNT was in 2008-2009), they need to ramp their share repurchases up to $400-500 per YEAR for a few years vs a market cap of only $2.5bn.  Yet the company is guiding to only $90mm of buybacks in 2010 and many analysts assume no buybacks beyond that.  This cash deployment opportunity represents a very significant upside to EPS since every $100mm of share repurchase at the current level adds about 8c to annual EPS.

TRICARE Upside - on 7/13/2009, HNT received a significant setback when it was announced that the TMA had awarded the TRICARE North Region contract to Aetna.  HNT quickly filed a protest, however, that was sustained by a subsequent GAO finding that TMA's bid evaluation process had 6 flaws.  Specifically, TMA gave Aetna credit for past performances that aren't applicable to TRICARE, for proposed staff that wasn't realistic; TMA didn't consider HNT's existing network discounts; and most importantly, TMA didn't protest Aetna's hiring of a former TMA official.  We spoke to a consultant that worked with Aetna on its bid, and he calls that last point "fatal" for Aetna's bid.  The former TMA official was an ex-Chief of Staff who attended meetings and had email access to confidential information, including details of HNT's bid.  The GAO recommended that Aetna be excluded from the competition and thus HNT is the only viable bidder.  This finding is deeply embarrassing to TMA, which is already under Congressional pressure because the transition has taken much longer than expected and the current TRICARE contract is already operating under its final allowable extension.  While TMA needs to make a final decision on where to go from here, our consultant believes Aetna has already started laying off its TRICARE staff and that there's a 90%+ chance that TMA will have to follow GAO's recommendation and disqualify Aetna from the process.  We believe Aetna has also filed a protest that HNT also hired two ex-TMA employees, but we were told that they were lower level clinicians with no access to confidential bidding information, were "ring-fenced" within HNT away from the bidding team, and in any case this was fully disclosed to TMA during the bidding process.  The current TRICARE contract runs through March of 2011, and since some sell-side analysts are still modeling HNT assuming they lose TRICARE after that, we believe an announcement here would be a positive catalyst.  In addition, HNT has been telling folks that their new TRICARE bid assumes a much lower margin than the current contract (which contributes $1 in earnings).  We are told that HNT's new bid also includes numerous incentive kickers that can make the final payout much higher than what they're telling people, and that's why Aetna was able to bid $500mm lower than HNT over 5 years (which translates into 60c/share for HNT) and still make $ doing it.  Thus, we know HNT is making at least $100mm/year on its new TRICARE contract (assuming Aetna's bid was only break even).

Attractive Valuation - using the midpoint of HNT's 2010 guidance, the stock is currently trading at 10.5x earnings, at the low end of its commercial peer group (10.5-12x).  Such a straight comparison, however, doesn't account for the fact that HNT is sitting on a much stronger balance sheet with a debt-to-cap ratio of only 23% (which will get even lower once HNT gets its remaining $200mm from UNH), compared to WLP at 25%, AET at 30% and UNH at 34%.  If we adjusted these four companies to use the same leverage of 30% debt-to-cap, and assuming 4% cost of cash, the "adjusted P/E" of WLP and HNT drop to only 9x while UNH and AET are at 12x.  This is another way of saying, you should not pay the same multiple for two businesses when one of them has an overcapitalized balance sheet that they intend to deploy accretively.  Another way to look at this:

1. In our base case, which we believe is very conservative (see section below for details on our assumptions), we see earnings of $2.37 in 2010, $2.91 in 2011, $3.36 in 2012 and $3.75 in 2013.  Keep in mind, however, we are assuming share buybacks of only $200mm/year, which means HNT's debt-to-cap ratio will continue to decline from 23% today down to 15% by 2013.  Most HMOs target a debt-to-cap ratio of 25-30%.
2. If we push the share buybacks up to $450mm/year, HNT can maintain its debt-to-cap ratio around 22-24% but its EPS would grow to $2.45 (2010), $3.25 (2011), $4.18 (2012) and $5.38 (2013). Of course, this scenario becomes highly hypothetical because HNT would need to buyback 15-20% of its stock per year (aggressive, but has been done before in this industry), and HNT may have to be more aggressive about dividending cash from its subsidiaries to do it.  But this scenario illustrates just how much accretion HNT can get by deploying its excess capital.
3. Another metric we look at is valuation/member.  HNT is currently trading at about $850/member, if we assume TRICARE is worth 10x earnings, and that Medicare lives are worth 3.5x and Medicaid lives worth 0.5x a commercial life.  This compares favorably with peers that trade at closer to $2000/member.
4. Using a multiple of 12x 2011, we arrive at a price target of $35, which we think is conservative given the EPS growth profile of this company.

Takeout Candidate - HNT is widely believed to be the next acquisition candidate.  When HNT ran a "strategic review process" last year, its board decided that a sale of non-core divisions was the best way to maximize shareholder value.  In hindsight, that was the right decision, as HNT was able to realize $600mm of proceeds for a business segment (Northeast) that they would've never made money on, while retaining its core business (West Coast/TRICARE) that benefited from a stabilization in the industry.  At this point, however, HNT is a sub-scale regional player that will never achieve margin parity with its peers.  In the long run (ie. after reform is done), we believe HNT will be sold to a competitor that is looking to beef up its presence on the West Coast.  Here are some issues to consider in a takeout, but the important thing to remember is that HNT is worth much more to a competitor than as a standalone company.

1. Anti-Trust - we don't believe anti-trust will be an issue because the California market is very fragmented.  The 2 large Blues (Blue Shield and WLP's Anthem Blue Cross) and Kaiser combine for 13mm members out of a state with 36mm people.  HNT is 4^th with just over 2mm members, but 850k of that is Medi-Cal, which contribute little to earnings.  After that, UNH has 1mm members, AET has 450k, CI has 200k.  Even if we assume the political atmosphere remain hostile to HMOs, AET and CI (at 2% and 1% of the market, respectively), should have no problems buying HNT.  Even UNH may be able to, since combined they'd have only 3mm members, and that's including almost 1mm members under the Medi-Cal contract.
2. Price - we believe an acquirer would find HNT's narrower network product very attractive, and can probably bring in most of HNT's business with little additional overhead, much like what UNH did with HNT's Northeast business.  If an acquirer can even improve HNT's 2010-2011 pretax earnings by 100bps, they can improve HNT's standalone earnings to $3.13 and $3.75.  Thus we believe an acquirer can easily pay $35.  HNT's board would have a hard time turning down a 40% premium.

Base Case Model Assumptions

Membership Growth - we assume flat 2010 (inline with guidance), and 2% growth in 2011+ to account for an end of the recession and the attractiveness of HNT's narrower networks.

PMPM Assumptions - modest low-to-mid single digit growth until 2013, when Medicare gets hammered with a 17% cut due to competitive bidding under healthcare reform.

MLR Assumptions - we take the guidance for 2010, and assume no more improvements.  We believe this will be conservative since current MLRs are still exacerbated by COBRA subsidies, which led to adverse selection and higher MLRs.

SG&A Ratio - we take the guidance for 2010, and assume only 50bps of improvements in 2011 and no more beyond that.  Company believes there's a total of 80-100bps to be achieved by end of 2011.

TRICARE Assumptions - we assume $100mm/year in contribution, which assumes that Aetna's bid was at break-even levels.

Share Repurchases - we assume $200mm/year.

Catalysts and Summary

1.                    Deploy excess cash accretively (buybacks or dividend)

2.                    TRICARE contract announcement over the next few months

3.                    Sale of the remaining business after the conclusion of healthcare reform debate.

Catalyst

1.                    Deploy excess cash accretively (buybacks or dividend)

2.                    TRICARE contract announcement over the next few months

3.                    Sale of the remaining business after the conclusion of healthcare reform debate.