Description

Jaws Acquisition (JWS) is a SPAC that will become Cano Health (CANO), a value based primary care provider serving Medicare patients. The typical Cano member is lower income and non-native English speaker. 85% of employees are bilingual. In exchange for a monthly premium (~$1,000) from insurance, Cano assumes the risk of its members’ care, and profits by keeping them healthy and out of expensive 3rd party settings. This seems simple, but requires a care approach that is fundamentally different from the prevailing fee-for-service model.

First, it’s important to understand some of the key differences between value based care and fee for service (FFS).

Cano is a value-based provider, and the US government is increasingly promoting this model as it seeks to rein in Medicare/Medicaid costs while improving beneficiaries’ experience and health.

Business model

Cano contracts with health plans to provide care to their members, mostly in Medicare. It accepts risk for medical costs, and has leeway in how to treat patients. By spending more time and money on primary care, or simply providing rides to appointments, Cano improves patient health and happiness, and avoids more expensive specialist care. The savings are its profit.

Despite Cano and other peers’ rapid growth under value-based reimbursement, assuming real risk of patients’ cost of care is still in its early stages.

Value-based care, however, is expanding rapidly, driven by the government’s bipartisan focus on containing health costs. The main initiative is Direct Contracting, where instead of paying a health insurer to administer coverage, CMS (Centers for Medicare and Medicaid Services) directly pays providers to care for non-Medicare Advantage patients. 

Direct Contracting is important because it addresses the 60% of Medicare beneficiaries not in MA plans. The program went live 4/1/21 and Cano expects to start off with 11,000 members representing $130m annual revenue. Despite already earning revenue from Direct Contracting, there is no revenue from this program included in Cano forecasts.

Cano’s business model has been successful since Day 1. Unlike many startup peers, Cano was founded as a self-funded clinic by newly minted doctor Marlow Hernandez, who immigrated to the US from Cuba as a child. He did not have the luxury of running losses in exchange for growth. While the first facility opened in 2010 took a few years to become profitable (it charged $30/mo), the second location opened in 2014 was profitable within months. 

In 2014, [founder Dr. Marlow] Hernandez decided the time was right to open a second location. He brought on a partner, Dr. Richard Aguilar, to build a new medical center in Miami to prove their concept. "It was 30 miles away--different demographic, different dynamics--but within three months it was full and it was profitable," Hernandez says. "And then we decided, well, this should not be the best-kept secret in South Florida. We should expand it significantly." https://www.inc.com/brit-morse/cano-health-health-insurance-marlow-hernandez-2019-inc5000.html

Value proposition

The value proposition to patients is in exchange for a more restricted network, they receive free rides, exercise, pain management and in some cases food. Cano provides these benefits, and more, in order to prevent far more costly hospitalizations.

The value proposition to health plans is Cano helps them grow members, limit costs and improve quality of care in their patient rolls. It also provides cost certainty, as Cano takes financial risk for members’ care.

Peers

Cano trades at a significant discount to direct competitor Oak Street Health (OSH), which operates a very similar business in different geographies. Cano is more attractive on nearly every measure. 

[note: @ 3/2/21]

Cano is also much more conservative (perhaps to a fault), as highlighted by its accounting for the Direct Contracting opportunity. The program, which launched and began generating revenue in April 2021 is not at all in Cano’s guidance, despite comprising nearly 10% of PF revenue. Oak Street includes direct contracting in its forecasts.

Risks

Execution. Cano was bought for $30m five years ago and is currently valued at >$6B. While there is a reasonable line of sight into growing into valuation, if the quality of care and cost control falter amid rapid growth, there is plenty of room for near-term multiples to contract.

Payor concentration. To date, Cano receives an outsized portion of its revenue from Humana. It is unlikely they would do anything to damage Cano, as 1) it has done an excellent job serving their members, 2) Humana owns equity in the business, including right of first refusal on sale of Cano 3) Humana has agreed to fund 50 new centers from 2020-24. Over time, concentration could become a positive catalyst as Cano signs new payor contracts, diversifying its revenue base. On my visit to Cano centers, they mentioned plans to add new insurers over time.

Capitation unprofitable. Primary care providers have had bad experience with capitation in the past. During the HMO boom of the 1990s, several practices went bankrupt from taking on patients in capitated contracts that cost more than the reimbursement attached to them. This was my initial concern when learning of Cano’s business model, but advances in computing have enabled better tracking of risk and more appropriate reimbursement.

One of the unintended consequences that designers of value-based payment models need to guard against is inadvertently creating incentives that encourage providers to cherry-pick only the healthiest patients. Effective value-based payment systems include robust risk adjustment in order to account for patient mix, eliminate adverse selection, and set prices that are fair to all providers, including those managing the most complex and expensive-to-treat cases. Although risk adjustment has historically been prohibitively complex, it is now more accurate and easier to implement, given the advances in computing power, the increasing availability of large data sets, and improvements in predictive analytics.  https://www.bcg.com/publications/2019/paying-value-health-care

A population-based payment system would differ from the capitated method most insurance companies use in significant ways. With PBP [population based payments], care provider organizations would receive a risk-adjusted monthly payment that covers all necessary health services for each person. Eliminating the gatekeeper and the third-party authorization for care that made HMOs so unpopular, PBP would put responsibility for considering the cost of treatment options in the hands of physicians as they consult with patients. Finally, unlike HMOs of the 1990s, PBP would include quality measures and standards. A care delivery group would pay independent physicians using existing fee-for-service mechanisms but would adjust payments quarterly according to the levels of clinical quality and patient satisfaction achieved as well as total cost to care for the covered population. The advantage of this approach is that it would build on a system physicians already understand while rewarding them for improvements in quality and cost, which would compensate them for income lost if total care volumes decline as a result of waste elimination.  https://hbr.org/2016/07/the-case-for-capitation

Competitive new entrants. Given the growth potential and margins at maturity, value-based providers will likely attract competition. While the capital barriers to entry are low, it is difficult for an organization built on FFS to re-create its business model for a value-based environment. This is likely why many of the existing players are new businesses. Regardless of competition, there is a massive runway of untapped growth, due to underlying Medicare growth, rapid shift toward value based models, consolidation potential and the need to contain health care costs without sacrificing care. Cano and its peers combined serve a low single digit % of Medicare beneficiaries, and CMS is working to make value-based care a norm in the years ahead.

Reimbursement pressure. There is always a possibility that reimbursement cuts will provide a negative surprise. However, it seems unlikely in this case, as value-based payments save the government money, and Direct Contracting has been advanced by both Democrat and Republican administrations. Cutting reimbursement would impair providers like Cano, but likely result in more patients in emergency rooms or other high cost settings that will end up raising the government’s health care bill.

Valuation

As a typically cheap value investor, this is my area of biggest pause. ~$6B for a company barely a decade old that was acquired for $30m 5yrs ago seems very rich. 

I became comfortable with valuation by understanding the fundamentals of Medicare growth, which is a near certainty, and also learning that it’s hard for FFS incumbents to change their business model to value-based arrangements. Cano has a real behavioral first mover advantage that should enable it to offer superior value-based service and drive growth.

Cano clearly lays out unit level economics, so we valued the business by determining what level of steady state membership generates enough EBITDA to justify Cano’s $6B EV. From March 2021 investor presentation:

If the business executes according to guidance (300k members by 2023), I assume it could be valued at least 15-20x EBITDA. Using the above unit level metrics and making an assumption for overhead ($122m FY20) results in implied steady state membership at various multiples. 

The 377-445k membership implied by ~15-20x steady state EV/EBITDA seems reasonable. Based on projected growth rates, these could be reached by 2025. DC is not included in management targets of 370k members by 2024, so these levels are even more plausible. If the thesis plays out to plan, Cano will grow far beyond 2025, generating upside to the current enterprise value.

Another way to think about the opportunity is potential membership by Medicare penetration. I conservatively assume their addressable market as the lower income range, <400% of federal poverty limit (FPL for family of 4 in 2020 is ~$26,000). This is roughly 60% of total Medicare membership. If we assume a range of penetration, valuation seems very reasonable above 1.2%. For reference, Cano has 3% penetration of total Medicare in its core Florida market. 

The current share price implies ~1.2% penetration of Medicare lives <400% of FPL.

A final potential source of upside is management’s conservatism. If they are cautious enough to exclude $130m of certain FY21 Direct Contracting revenue from forecasts, their unit level profit estimates or long-term market estimations could also be low.

Other

• 71 NPS score appears very good. Adds credence to the notion that they can continue to grow by word of mouth.

• SPAC sponsored by Barry Sternlicht. Although founder and CEO Dr. Marlow Hernandez is a relatively young entrepreneur, Board oversight consists of well regarded financial investors. Seems to be a good balance of long-term alignment.

• Having visited Cano’s Nevada locations, the company investor pitch aligns with what you see in person--caring health advocates devoting individual attention to low income patients. Centers have more of a community feel than a doctor’s office, and you can see room for growth with minimal capital investment. I could not take pictures inside, but they tend to be located near big box shopping areas with steady traffic. As noted, Cano has drivers constantly shuttling patients from home to appointments. By ensuring people get regular preventative care regardless of personal logistic challenges, Cano avoids costly episodes that end up with sick patients in a hospital. 

Catalyst

Conversion to CANO

Direct Contracting revenue included in forecasts