Description

HEALTH NET (HNT)

 

Introduction

 

HNT is a regional managed care company, with 3.7mm fully insured members primarily in CA, OR, AZ and the Northeast.  Product-wise, HNT has just over 2mm commercial, 300k Medicare Advantage, 540k Medicare PDP, and nearly 800k Medicaid members.  In addition, HNT services about 3mm members under the TRICARE contract for the North Region.

 

Over the past year, HNT stock has declined by nearly 80% due to earnings misses and a re-valuation of the entire managed care industry.  Specifically, HNT began 2008 with an outlook of $4.14-4.17.  On each of the 3 quarterly earnings, HNT has lowered its outlook, and now HNT is expected to do $1.85-1.89 (excluding charges) for 2008 and $2.25-2.40 for 2009.  Accordingly, HNT stock has traded down to $11.00, or 5.9x 2008 and 4.7x 2009 earnings.

 

We find HNT attractive for two reasons.  First of all, despite having taken down the earnings down dramatically to improve reserve levels, HNT is now trading at a significant discount to its peer group (AET, WLP, CVH and UNH), at 4.6x 2009 earnings versus the comps at 7.1x.  The street has this irrational tendency to apply lower multiples to more depressed earnings and higher multiples to inflated earnings.  Second, HNT is in the process of divesting its unprofitable non-core geographies.  We believe their asset sales can raise $5.00/share of cash without impacting 2009 earnings at all.  Depending on how HNT returns that money in a tax-efficient manner, HNT could be trading at an incredible 2.6 times a depressed 2009 earnings.

 

Business Summary

 

With $15.5bn in operating revenues, HNT is the 5^th largest publicly traded managed care company in the country.  Unique among large national players, HNT focuses almost exclusively on more valuable fully insured members, and has operations along the West Coast and the Northeast.

 

(Membership – 000s)	California	Connecticut	New York	New Jersey	Arizona	Oregon	PDP/Other	Total
Large Group	954	117	101	20	80	99	-	1,371
Small Group/Indiv	431	26	107	55	50	38	-	707
Commercial Risk	1,385	143	208	75	130	137	-	2,078
Medicare Advantage	131	57	6	-	67	22	10	293
Medicare PDP	-	-	-	-	-	-	538	538
Medicaid	742	-	-	46	-	-	-	788
ASO	5	25	11	4	-	-	-	45
Total Lives	2,263	225	225	125	197	159	548	3,742

 

Commercial Risk –                           Historically this is HNT’s core business.  Unlike some of its larger peers, HNT is focused on just a few states where it has achieved decent market share.  HNT is strongest in CA, CT and OR.  It is subscale and/or poorly positioned in NJ, NY and AZ.  Over the past year, HNT has done a poor job of identifying an accelerating cost trend, and its MLR worsened by 200bps from 2007 to 2008.  HNT is raising prices accordingly, and has guided to a 50bps improvement in commercial MLR for 2009.

 

Medicare –                                        After several years of stable membership, HNT expanded its Medicare Advantage program significantly over the past two years, growing from 199k members in Dec-06 to 293k today.  Like many of its peers, however, this explosive growth was accompanied by flawed product design, and HNT’s MLR exploded from 85.4% in 2007 to over 90% in 2008.  HNT has seen higher-than-expected utilization in both MA and PDP, and has re-priced for some of this in its 2009 bids.  HNT will also be exiting certain unprofitable geographies next year.  We expect a modest improvement in HNT’s Medicare margins next year.

 

Medicaid –                                        After exiting a loss-making contract in CT, HNT still has Medicaid contracts in CA and NJ.  Over this past summer, Medi-Cal announced provider cuts that also impacted HNT’s margins.  Going forward, our estimates already include lower profitability from Medi-Cal.  We have not given HNT credit for additional enrollment growth in Medicaid, either from new contracts or from significant same-state membership growth due to higher unemployment or some type of Universal Coverage.

 

TRICARE –                                       HNT’s TRICARE contract is essentially a cost-plus contract with profit/loss-sharing in case of cost over/under-runs.  HNT has performed very well under its contract as evidenced by its 7.8% margin in 2007.  All TRICARE contracts are up for rebid right now, and we suspect HNT is bidding in all 3 TRICARE regions.  As the incumbent in the North Region, HNT has performed well in the technical area (most important factor for the DoD in its evaluation of RFPs).  AET is the only other bidder in the North Region, and AET would not be able to use its larger network (AET’s only “advantage”) for the TRICARE contract.  Management is confident that they will at the minimum retain its current North Region, and we agree with their assessment.  Going forward, we are forecasting a lower 4.5% margin in this business segment.

 

Investment Thesis

 

Commercial loss ratio improvements – the main problem for HNT in 2008 here was not bad pricing, but a delayed recognition of accelerating costs.  HNT was able to push through commercial premium yields of 8.3% in 2008, inline with their expectations at the beginning of the year.  But commercial costs rose even faster at 10.9%, much higher than the expected 7.5%.  During its analyst day, HNT discussed at length what went wrong, and how they’re planning to fix it:

1. HNT’s primary cost problem was the near-double-digit unit cost inflation at its non-capitated inpatient and outpatient providers.  While some of the problem was unavoidable and possibly the result of provider fraud, HNT has put in a new operations team to review all provider contracts and enter into new negotiations for multi-year agreements.
2. HNT is putting into place new care management programs and better modeling/reporting.  These efforts are targeted to help manage utilization of specific high intensity care cases.
3. HNT realizes that it’s fundamentally disadvantaged in certain geographies and will be exiting those markets (see section below).

 

Medicare improvements – one advantage of being breakeven in Medicare is that there shouldn’t be much more downside from here.  Even if Obama pushes through onerous cuts to Medicare Advantage and make the business unprofitable, HNT will likely simply exit this business (as many carriers did earlier in the decade) instead of sustaining losses for multiple years.  CT Medicaid is another recent example of where HNT is willing to walk away from an unprofitable government business, instead of holding onto contracts for the sake of keeping revenues.  But in the near term, HNT has a good opportunity to improve this segment in 2009.  HNT’s problems in 2008 was the result of poor product design – HNT put in rich benefits and low member out-of-pocket costs in order to grow what should’ve been a nicely profitable segment.  Instead HNT got plenty of growth at the cost of adverse selection.  For 2009, HNT was able to price its bids to address MLR concerns across all its products.  We’re expecting a modest improvement in Medicare MLR, but still 300bps worse than 2007 levels in order to be appropriately conservative.

 

Cost cutting opportunities – over the past two years HNT has invested a significant amount of money into restructuring.  These initiatives will cost nearly another $100mm in charges over 2009-2010, but should start paying dividends soon.  HNT expects savings to start outpacing costs by next year, and will reach $150mm of annual savings by 2012, lowering its G&A ratio from 9.2% in 2008 to 7.7% in 2011.  Specifically these initiatives are:

1. Consolidating multiple systems and eliminating manual processes and workarounds.
2. Replacing aging and inefficient systems with best-in-class outsourcing partners.  This initiative alone accounts for 50% of total savings.
3. Eliminate high cost locations; reducing headcount; and shrinking management footprint.
4. Consolidate multiple data warehouses; moving onto internally consistent operational metrics; and eliminating redundant analytical functions.

 

Asset Sale and Strategic Review – see section below.

 

Attractive Valuation – assuming even a low-end scenario where HNT only gets its statutory capital back from its asset sales (which also happens to be roughly the business’s tax basis, so there would be no capital gains tax), HNT would realize about $5/share in proceeds without any impact to its EPS guidance.  What could HNT do with this money?  Let me lay out 3 scenarios:

1. If HNT could return this capital to shareholders tax-free, the “effective stock price” would be lowered to $6, or about 2.6x the midpoint of its 2009 guidance.
2. If HNT ends up buying back 33mm shares of stock at $15 (35% premium from the stock price today), EPS would increase from $2.325 (midpoint of guidance) to $3.39.  At the current price of $11, we’re looking at 3.2x next year’s new EPS.
3. Right now HNT has $645mm of debt and is running at 27.5% debt-to-cap.  (It should be noted that book equity has been unfairly punished due to HNT’s significant buybacks of the last few years).  Nonetheless, let’s say HNT uses some of the $500mm to pay down debt and maintain its debt-to-cap ratio.  HNT currently has $245mm of bank debt and $400mm of 6.375% Senior Notes outstanding.  HNT may either pay down the bank debt, or they could buyback some of the Senior Notes in the open-market, which last traded at 40c.  (Some investors may find the Senior Notes interesting as well.  At 40c it yields 22% to maturity in 9 years.  We’ll leave that discussion to another time, but do want to caution people that the Senior Notes have essentially no covenants, and HMOs have a tendency to return a significant amount of cash to shareholders.)  In any case, if HNT pays down $150mm of bank debt and buys back $350mm of stock at $15, its 2009 EPS goes to $3.05 (which at $11 is 3.6x).  If HNT buys back $200mm of the Senior Notes at 50c and $400mm of stock at $15, 2009 EPS goes to $3.22 (which at $11 is 3.4x).

Thus, while we aren’t exactly sure what course of action HNT will take, the resulting multiple after an asset sale (even assuming only $500mm of proceeds) leaves a stub company that’s trading at anywhere from 2.6-3.6x a depressed 2009 earnings, compared to peers in the 7.1x area.  The obvious risk is that HNT may guide down its 2009 estimates further.  We believe that is unlikely, given that HNT’s reserve levels seem appropriately conservative, its cost-cutting measures and focus on driving down commercial loss ratio, and the fact that it has rebid its 2009 Medicare plans to drive down cost at the expense of enrollment losses.

 

Asset Sale and Strategic Review

 

Last month HNT announced that CEO Jay Gellert was stepping away from day-to-day operations of the company to focus exclusively on a Strategic Review.  This is highly significant because we believe Gellert is the primary reason why HNT is still even an independent company today.  Over the past few years there were numerous rumors of takeout bids for HNT.  While we may never know the full details, we have enough information that lead us to believe that there were multiple bids for HNT, including an offer from AET in the $40-50/share range just over a year ago.  Gellert, however, was determined to keep his status as the CEO of an independent HMO and retain his chairmanship of a committee on AHIP (industry association).  HNT’s Board had followed Gellert’s advice to stay independent, until recent events and an 80% decline in the stock price finally forced their hands.  We believe the Board is now fully supportive of a transaction, and asked Gellert to undertake the review solely to determine if HNT is worth more to a buyer whole or in pieces.

 

During the Investor Day, HNT gave more details of what they’re thinking about: HNT has about $500-550mm of statutory surplus trapped at the insurance subsidiaries in “non-core locations” (Arizona and Northeast) that are not generating any income.  This represents the amount of money HNT would receive back if they shut off operations and put the subsidiaries in run-off mode.  In choosing to exit these markets, HNT has decided that it is fundamentally disadvantaged in those markets due to a lack of scale.  In fact, HNT believes that its unit health care cost is about 5% higher than those of larger competitors, and that its 12% G&A ratio is another 5% higher than the marginal G&A cost to a competitor.  In other words, these same members that are breakeven for HNT would yield a decent 10% margin to someone else.  With $3.7-3.8bn in expected revenues, they could provide $375mm of pretax income to a potential buyer.  Here are some metrics we use to figure out what someone may pay for these assets:

1. $1.6bn using Earnings Multiple – by applying peer group’s 7x to $230mm of net income ($375mm of pretax income at 38.5% tax rate).
2. $1.1bn using Revenue Multiple – by applying peer group’s 30% to $3.75bn of revenues.
3. $900mm using Members Multiple – this metric is tricky because it’s nearly impossible to adjust for mix differences (Medicare vs commercial vs Medicaid; fully-insured vs ASO; managed care vs non-managed care), but using $1,100/member for commercial, $1,900/member for Medicare and $500/member for Medicaid, we get just over $900mm of value.
4. $500-550mm using Statutory Surplus – this is the amount HNT can realize in a run-off, giving no value to the “on-going enterprise” (ie. the ability to sign new members at a positive NPV).

 

Obviously, given that HNT’s market capitalization is only $1.1bn and can still earn well over $2/share in the core business in CA and OR, a price anywhere near the above would be incredibly accretive to the stock.  Thus we have spent a lot of time trying to figure out exactly how likely a deal is to happen.  We have confirmed that the Offering Memorandums went out to prospective buyers in late November, and that there will likely be multiple bidders on these assets.  The front-runner for the Northeast assets is Emblem Health, whose subsidiary HIP has numerous ex-HNT employees that are very familiar with HNT’s Northeast assets.  Emblem’s footprint also fits nicely with HNT’s assets and would realize immediate synergies.  We believe AET will also likely bid for HNT’s assets once again, and other possible bidders include UNH and Horizon in NJ.

 

Lastly, we also heard from some folks that Blue Shield of CA may also take a look at HNT’s remaining “core” business in CA.  As some in the sell-side have noticed, Shield and HNT both lack critical mass in CA and geographically would fit nicely together.  We recommend Carl McDonald of Oppenheimer’s 7/7/08 piece titled “Thinking Outside The Box – Why Blue Shield Could Buy Health Net” for details of this transaction.  We had initially dismissed this idea as a typical “investment banking pitch,” but upon reading it closely realized that it actually made a lot of sense.  In fact, we believe the most likely course of action is that HNT sells off Northeast and Arizona first, and use the proceeds to pay down debt and buy back stock.  The remaining business would just be the CA and (a small) OR businesses.  It makes no sense to run a publicly traded company based primarily in only a single state, so we believe the current asset sale is at prelude to HNT selling the remaining business to someone like Blue Shield of CA.  Thus, we were even further encouraged when we started picking up industry chatter about this possibility as well.

 

Model Assumptions and Valuation (Using Entire HNT as a Going Concern)

 

Membership Growth – we are assuming -4% in 2009 after -1.3% in 2008.  The 2008 figures include significant growth in Medicare offsetting higher churns in commercial and the loss of CT in Medicaid.  For 2009 we are assuming continued churn in commercial, with stable Medicare and Medicaid.

 

MLR Assumptions – we are assuming only a 50bps improvement in commercial, a 200bps improvement in Medicare, and 120bps deterioration in Medicaid to reflect worse reimbursements in CA.  For comparative purposes, our 2009/2010 MLR assumptions are still far higher than 2006-2007 levels (150bps higher in commercial, 300bps higher in Medicare and 340bps higher in Medicaid).

 

SG&A Ratio – we assume no improvements in SG&A ratio and holding it constant at 12.3% of premiums, despite HNT’s expectations of 150bps improvement by 2011.

 

EPS Estimates – based on the above assumptions, which we believe to be extremely conservative, we are estimating EPS of $1.90 in 2008, $2.34 in 2009 and $2.61 in 2010.  It should be noted that the above assumptions imply an underwriting margin of only 2% (85.7% combined MLR, 12.3% SG&A ratio), which is the lowest in the industry and arguably unsustainably low in the long run.

 

EPS Upside – how can HNT do even better than our model?  100bps improvement in either the MLR or the SG&A ratio is worth about $0.75/share to EPS, so if HNT can just hit their cost-cutting target of 150bps by 2011, that’s an incremental $1.14/share.  I’m also modeling in very minimal share repurchases ($30mm/year); but assuming $200mm/year in additional repurchases would add $0.21/share to 2009 earnings and $0.54/share to 2010 earnings (due to compounding effects).  Thus, very quickly we can paint a scenario where earnings are over $4/share instead of mid-$2’s.  Is that unlikely?  Let’s not forget that HNT’s original 2008 guidance was for $4.14-4.17 before it got hit for these unexpected cost trend issues.

 

Catalysts and Summary

 

1.                    Asset sales are underway will likely be announced in Q1 of 2009

2.                    Many earnings improvement opportunities (MLR, SG&A, share buybacks) that can potentially push earnings up from the mid-$2 range back up to over $4.

3.                    Price target of $25-30/share, assuming $5-10/share from asset sales and $20/share of residual value in the core business.

 

Catalyst

1. Asset sales are underway will likely be announced in Q1 of 2009


2. Many earnings improvement opportunities (MLR, SG&A, share buybacks) that can potentially push earnings up from the mid-$2 range back up to over $4.


3. Price target of $25-30/share, assuming $5-10/share from asset sales and $20/share of residual value in the core business.