Description

Situation Overview:

Magellan is a managed care provider focused on specialty populations, which also has a smaller in-house PBM segment. Given its relatively small size and niche businesses, it tends to be underfollowed by investors and analysts. While the stock had a strong run over the last 12 months, the stock price has not kept up with the underlying improvement in earnings. We estimate the company’s run-rate earnings power is more than double 2015 reported earnings and initial expectations for 2016, driven by an improvement in the core business, an accretive acquisition, and a large contract win.  Initial start-up expenses and losses for new business have masked part of the earnings step-up during 2017.

As a result, Magellan trades at one of the lowest multiples in sector despite having one of the most compelling growth profiles. Magellan is currently trading at 12x our estimate of run-rate earnings versus peers now trading at mid to high teens multiples. We see 30-40% upside in a standalone case as the company re-rates to a peer multiple over the next couple years.

We also think Magellan would present an attractive acquisition target for a larger peer. With several of the largest managed care M&A deals finally dissolved after facing anti-trust opposition, we would expect M&A activity in the sector to reaccelerate and present incremental upside optionality for the company over the next couple years.

Company Overview:

Attempted Diversification Outside Behavioral Health (2006-2012):

Magellan historically operated in the managed behavioral healthcare business before starting a “diversification” strategy in 2006. This strategy entailed acquiring an assortment of PBM and specialty healthcare businesses outside the legacy behavior area, such as radiology management. Perhaps not surprisingly, results from the acquisitions were somewhat inconsistent. Combined with contract losses in the core behavioral business, Magellan effectively had a lost decade, particularly when compared to peers’ growth. The company reported EPS of $3.55 in 2015 versus $3.46 in 2005.

New CEO Refocuses Business (2013-2016):

In 2013, Magellan hired a new CEO Barry Smith who kicked off what the company has subsequently called the “repositioning” phase. Following this three year repositioning, Magellan now operates in two segments: healthcare and pharmacy management. The healthcare segment is a full-service managed care organization focused on complex populations particularly within Medicaid. Healthcare also contains the legacy behavioral assets which continue to represent a large portion of segment earnings. The pharmacy management segment contains a full service in-house PBM that is focused on clients with complex needs, particularly around specialty drugs. For example, a large focus is on medical pharmacy management, specialty drugs covered under the medical benefit rather than the pharmacy carve-out.

Return to Growth (2017+):

Earlier this year, the company held its first investor day in 3 years to unveil what they are now calling the “growth” phase. While the title is a little silly (they were always trying to grow), the main point is the company has reached its final form and will now focus on driving organic growth, with acquisitions pursued only opportunistically.  The two main drivers of growth will be state Medicaid contract wins for specialty populations in the healthcare segment and picking up lives for medical pharmacy management on the PBM side. The company is targeting 10-15% organic revenue growth for each segment and 10% segment profit growth, allowing for any potential margin compression, and we think these targets are achievable.

Valuation:

Over the last year, Magellan has experienced a material step-up in earnings power, resulting in run-rate earnings more than double historical levels. This increase has largely been due to three drivers: (1) improved results from the core business, particularly an inflection in their Florida Medicaid contract, (2) new contract awards including a Virginia Medicaid contract which went live in August, and (3) an acquisition of Senior Whole Health (Medicare and Medicaid in New York and Massachusetts) that is approximately 20% accretive. As a result, we now see run-rate earnings power of roughly $7 as these new business wins reach steady-state profitability and the Senior Whole Health business is integrated. Given upfront start-up expenses, these new business wins have actually had a negative impact on 2017 EPS (see below), further obscuring the improvement in earnings power over the last couple quarters.  Our numbers are ahead of Street estimates in the out years. To be clear, we do not expect the company to guide to $7 of EPS for 2018, but instead for $7 to be run-rate earnings including integration of Senior Whole Health and fully ramped-up new business.

Note: Profit forecast excludes reinstatement of health insurer fee which would increase EBITDA but be relatively neutral to EPS

Based on $7 of run-rate earnings, Magellan is currently trading at 12x, compared to Medicaid peers trading in the high teens, Medicare players over 20x, and general MCOs >15x.  If management hits their growth targets, Magellan will have one of the fastest growth rates in the sector. We think Magellan should rerate to at least in line with group, equating to a target price $115-$120 (35-40% upside).

We also think Magellan could be an attractive M&A target to a larger managed care player that either already has some in-house PBM capabilities or is looking to grow internal PBM capabilities, particularly for specialty drugs.  We see a wide range of potential buyers who would have interest in the asset, particularly as some of the larger players have built up capital and, as a result of recent antitrust rulings, are likely confined to looking at smaller targets.  Looking at past M&A transactions and potential synergies, we think an acquirer could reasonably pay 20x earnings or >$140 (60%+ upside).

Probability weighting these two cases, we reach a price target of $126 (48% upside), with catalysts as underlying earnings potential shows through and industry consolidation accelerates.

Risks:

Potential 2017 Earnings Miss: Magellan significantly missed Q2 earnings estimates, in part due to the cadence of quarterly earnings this year but also due to some one-time issues with new business on-boarding. Management maintained the guidance range but pointed to the lower-end. We think it is likely that they miss the lower end of the range, and consensus now sits below the low end as well. We embedded a modest miss in our earnings bridge above, roughly in line with consensus estimates for segment profit. While we think a miss is well flagged, we wanted to make sure to point it out with Q3 results coming up in a few weeks.

Florida Contract RFP: Magellan has a large Medicaid contract with Florida that is coming up for rebid. While management has generally framed the RFP as an opportunity to potentially expand their footprint in the state, there is always some risk in these re-bids. Florida is roughly $600 million of revenue and likely above-average segment margin. The current contract expires at the end of 2018.

Virginia Contract Start-up: Magellan’s new contract with Virginia went live on August 1st. While state Medicaid contracts typically end up earning relatively consistent profit margins, it’s not atypical for there to be some start-up losses as a managed care provider ramps up the new population. This could push out the timing of hitting our earnings estimates by a couple quarters, but shouldn’t change the overall level.

Healthcare Reform: Although latest reform efforts appear dead (and Magellan does not have direct exposure to the exchanges), the company derives a large portion of its revenue either directly or indirectly from Medicaid, which could be exposed to future reform. Given the niche nature of its business lines and limited exposure to expansion states, Magellan is more insulated than most of the larger Medicaid peers which trade at significantly higher multiples. The company also provides services across both segments to numerous regional health plans, effectively an outsourced manager of specialty coverage areas. While a lot of these capabilities are critical and cost effective for their MCO customers, Magellan would be at risk of any reform that reduced the viability of regional insurers.

Catalyst

• New contract wins 
• Earnings step-up 
• Potential acquisition