Description

Hooper Holmes is the nation’s largest provider of health information services to the life insurance industry. They provide medical exams, personal interviews, record collection, and laboratory testing services that enable insurers to evaluate underwriting risk.

When an applicant applies for a term life insurance policy, they generally must undergo a physical examination, and data must be collected about their medical history. The exam is conducted wherever the applicant chooses, frequently in his or her home. It is a common practice in the industry for the insurer to contract out these types of services to companies like Hooper Holmes, because Hooper’s network of examiners can provide the service far more efficiently than the insurer. Hooper serves virtually all of the top 100 life insurers in the country, and over 700 overall.

There are four national companies that handle medical screening for the life insurance industry. Hooper is the largest of these, controlling approximately 35-40% of the market. ExamOne, a subsidiary of LabOne, is the only other publicly traded medical screening company; Hooper is over twice as large as ExamOne based on sales.

Barriers to competition in this industry are considerable. Hooper is over 100 years old and has established a reputation for reliable consistent service. They have over 700 life insurance customers, and a network of 8500 examiners that can conduct an exam anywhere in the country in three to five days. It is unlikely that insurers, especially the larger ones, would utilize the services of a company without such a reputation. Also, it would be difficult for a new competitor to organize a nationwide network of examiners, and establish relationships with all of the top insurers.

This business is extremely profitable. Since its most recent major acquisition in 1999, Hooper has generated $30.1 million of free cash flow per year ($0.45 per share) with minimal capital expenditures (6.3% of cash flow from operations). In other words, Hooper gets to reinvest over 93% of its cash flow from operations. Historically, they have reinvested excess cash in acquisitions and share repurchases. Hooper’s free cash flow to sales percent is 11.8%; 10% or greater is considered exceptional. Their FCF to invested capital percent (i.e., ROIC) is currently 18.4%; historically, this ratio has been in the upper 20% to lower 30% range. ROIC is lower now primarily due to the addition of their most recent acquisition, which hasn’t been fully integrated yet. Still, 18.4% is exceptional. In addition, Hooper’s balance sheet is stellar with $80.1 million ($1.20 per share) of net quick assets (quick assets minus total liabilities). Lastly, since 7500 of their 8500 examiners are contractors, Hooper can scale back its operations during difficult times without having to undergo expensive layoffs.

There are also a number of favorable trends. As the baby boomers age, more thorough exams will be required to assess the applicant’s risk, meaning more money for Hooper; however, this is offset somewhat by a reduction in demand for life insurance as people age. As insurers consolidate and become larger, to get more consistent reliable service, they are turning to the national exam companies, as opposed to regional companies. In addition, Hooper’s network is being used for other purposes outside of the insurance industry. For example, they recently signed an agreement with DNA Services to provide specimen collection and data management for pharmaceutical clinical trials. Management also believes there could be additional opportunities in workman’s compensation and long term care insurance.

At its current price, Hooper has an economic value to free cash flow ratio of 10.6, cheap for an industry leader that generates so much free cash flow with substantial barriers to competition.

So, if everything is so great about this company, why is the price so low? It’s primarily because of a slowdown in the life insurance industry due to “Triple X”, a new insurance regulation enacted as of January, 2000, that forced insurers to increase their reserve requirements for the term life policies they sell. This caused a boom – bust cycle, as insurers frantically issued policies prior to 2000 to get around the additional reserve requirements. As a result, Hooper realized extra business during late 1999 and early 2000, but has seen a falloff in revenues since (18.9% less for the first six months of 2001 vs. 2000). As of 2000, Standard & Poor’s, Moody’s, and Fitch predicted that the downturn would last at least two years. However, it is likely that policy underwriting will eventually stabilize, and that this is a short-term situation (i.e., a buying opportunity). Another issue with Hooper is that their acquisitions have generated a lot of goodwill which is being deducted from earnings. Because of this, Hooper is one of the rare companies that actually generates substantially more free cash flow than reported earnings.

In summary, Hooper Holmes is a very profitable business which is the leader in a long-term expanding industry with large barriers to competition. They are facing a temporary downturn in business due to a new insurance regulation and the slowing economy, which has led to a large drop in share price. In a nutshell, Hooper Holmes is a great company selling at a very reasonable price – a rarity in today’s market.

Catalyst

Catalyst: A new regulation requiring insurance companies to increase reserve requirements for term life policies has caused a temporary downturn in insurance underwriting. Once the insurance underwriting market stabilizes, which according to S&P, could happen some time in 2002, look for Hooper Holmes to resume the solid growth it had prior to enactment of the new regulation.