Description

Earlier this month, Molina Healthcare (MOH) fired their CEO and CFO, Mario and John Molina (the Molina bros) who were the sons of the company’s namesake / founder. Shares popped on the news which is attributable to (a) renewed optimism around a potential sale of the company previously thought to be opposed by the Molina bros and (2) optimism that the yet-to-be-named new management will bring about operational improvement, namely an increase in industry lagging margins which has been the persistent ‘knock’ on the company. These indeed remain the two largest risks to the short thesis. However, I don’t think a sale of the company is imminent and I also think it’s overly optimistic to believe that a new CEO, for which the search is only commencing, will be able to quickly improve margins that have stubbornly low for years.

Given that (a) the valuation has now risen to well above many peer companies (b) an analysis of the profit pool shows MOH is heavily reliant on Medicaid Expansion, which has been one of the Republicans’ largest chopping block targets in healthcare reform and (c) my belief that the current lack of full-time leadership could be a weakness during a period of large re-bids, I believe MOH shares are an attractive short opportunity.

First, in further addressing the bull case, I will say I don’t think the company will be sold in the near-term because (a) the newly named Chairman has stated the Board’s intention is not to put the company up for sale but to find new management to improve performance and (b) I don’t think a buyer would wish to pay a premium on top of the current share price given the current state of extreme flux around Medicaid policy. Secondly, while there isn’t any smoking gun obstacle that prevents MOH from achieving a 1.5 – 2% net margin on its Medicaid business (peers have achieved this level), I also don’t see how the yet-to-be-named new CEO will be so successful where the Molina bros and the company’s prior efforts have fallen short. I also don’t regard the current lack of management stability as helpful in attaining the company’s margin goals. Having followed the company for several quarters, there seem to be various issues that have hampered results including systems failures and contract adjustments that don’t speak well of the operations and don’t suggest a quick repair is coming. Even the manner of the CEO change, occurring shortly after an investor day, and with no replacement lined up doesn’t speak well of the company and could suggest a couple more skeletons in the closet. The chief accounting officer seems to be well-liked by the Street but assuming the CEO + CFO roles (as he is doing) is a large task. Further, the company’s accounting / finances have been far from perfect over the last year with mis-estimates of ACA marketplace transfer payments cratering the marketplace business’s profitability while 4Q 2016 results had to be re-adjusted by 79 cents (a large positive benefit) weeks after the company’s conference call.

As far as valuation, there is a wide range in peer company valuations with larger, somewhat slower growth insurers such as Anthem priced at 14x 2018 EPS (after a re-rating upwards), Centene at 14x, while Wellcare trades at 22x (considered by many to be a peak multiple). After the recent run-up, MOH shares trade at 20.5x 2018 EPS, near the top of the group. This illustrates the M&A premium and margin improvement premium already baked in to the share price. If MOH does deliver on its margin improvement over time, the multiple will likely decline as that particular growth lever can only be realized once.

Next, and perhaps the crux of my thesis is the company’s profit exposure to Medicaid Expansion. This is important because a key provision of the recently passed AHCA House Bill is the rollback of Expansion (there is a great deal of information about this online but the general idea is that the bill would no longer provide funding to the Expansion population after 2020. For those that remain enrolled from prior to 2020, funding will continue. However, this is a high churn population and so many people would eventually lose coverage and the bill would amount to a significant gutting of the Expansion population). Now, there are some that believe when the Senate finishes with the bill, they’ll end up preserving more of the Expansion benefits as compared to the House draft. Or, some believe no bill will pass and the ACA will mostly remain in place, providing a status quo (bullish) outcome for MOH. I think perhaps the truth will turn out to be somewhere in the middle but it’s hard not to be bearish about Expansion given it’s been a primary focus of the Republicans reform efforts. The reason this is all relevant here is because, as I’ll show next, Medicaid Expansion has been MOH’s golden goose. Some analyst reports have quantified Medicaid Expansion vulnerability across the various insurers and MOH routinely scores the worse. However, these analyses actually understate the impact to MOH as they tend to apply a firmwide margin to MOH’s Expansion revenue. In actuality, the impact of Expansion needs to be viewed more granularly. I’d refer you to page 15 of the company’s 2016 10-K. There, you’ll see nearly 30% of MOH’s “medical margin” (a gross profit measure of premiums less healthcare costs, but before G&A) came from Expansion. However, because of operating leverage in the Expansion business, I believe the Expansion business has a far greater EPS impact. What you’ll also see on page 15 of the 10-K is that the premiums per member month (PMPM) for the expansion business is much higher than typical TANF members and so MOH makes a high margin per member for the Expansion population. Using the same page, we can calculate that while Expansion is 30% of medical margin, it’s only 18% of premiums, and 15% of member months. This is important because, if we are to attempt to derive an EPS by business-line for MOH, we need to allocate MOH’s ~8% G&A ratio across the premiums of each business-line (i.e., for Medicaid Expansion, take 2,952 of premiums and multiply by 8% and do the same for all other business lines to arrive at G&A, which is then subtracted from the medical margin, and tax-affected). This won’t be exact but I believe this gives a rough-but-accurate sense for EPS by business-line). After completing this exercise, which effectively takes into account the operational leverage in the business, I derive that MOH earns >$2.50 of EPS from the Expansion business and Expansion is by far the single largest EPS lever of the company. For reference, MOH is expected to earn ~$2.40 of EPS in 2017 and ~$3.25 in 2018 and so Medicaid Expansion, the “bullseye” cost-cutting target of healthcare reform efforts, comprises nearly all of MOH’s EPS. This is not an enviable place for MOH to be in and not a business that I think is likely to be acquired until some more certainty evolves as to Medicaid Expansion policy. As mentioned, this profit pool won’t go away immediately even if the House proposal passes the Senate but I believe the potential negative impact is being understated / ignored by the market currently.

To gain an intuitive sense for why Medicaid expansion might be such a large profit driver, consider for a minute that the ACA grants states a 90% reimbursement rate on expenditures pertaining to Expansion populations (which could include the able-bodied but low-income working age population, but also many high-risk previously out-of-the-system sickly people) compared to a ~50% reimbursement rate on expenditures pertaining to the normal pre-ACA Medicaid population (e.g., women and children). This created a lax spending environment around the Expansion population that appears to have been a boon for MOH’s profits.

The above discussion of Expansion is probably the crux of my argument and together with the high valuation, makes the company a viable short in my view, despite of the acquisition / turnaround speculation. However, beyond this, I’d also note that MOH has up to 25% of premiums in contracts up for re-bid over the next year or so (CS estimate) and I believe the in-flux management could pose a problem in renewing contracts. In general, MOH has a mixed record in terms of serving / pleasing government customers as evidenced by Illinois dropping MOH from a few counties in central Illinois in early April in favor of a return to traditional government-run fee-for service Medicaid (anecdotal, but relevant) and so I wouldn’t be entirely surprised if we see further operational problems develop.

So, if this plays out according to the thesis, over the course of the remainder of the year the market will (a) realize that MOH isn’t going to be sold immediately (because they don’t want to sell and because a buyer is going to want more policy certainty before writing a large check), (b) realize MOH has a larger than realized vulnerability to Medicaid Expansion that puts long-term EPS in jeopardy and (c) (perhaps) MOH will stumble further operationally as a potentially already stretched chief accounting officer now serves as CFO / CEO. Combined, these factors should remove the M&A premium that has recently crept into shares and valuation should return to the sub-$50 level (which still wouldn’t be cheap at 15x 2018’s consensus).

Catalyst

CEO decision, healthcare reform developments, contract re-bids will all be potential catalysts.

I'd also note that tax reform is also a bullish risk here, as the company pays a full tax rate.