GTS is a recent IPO of the Blue Shield HMO (part of Blue-Cross/Blue-Shield) in Puerto Rico.  Historically, GTS was structured as a non-profit, and was owned by the doctors who provided medical service to the members.  It has been a sleepy, under-managed company with no incentive to focus on profitability.  As a result, it has probably the worst commercial medical loss ratio (MLR) of any public player in its space.

 

GTS went public last week in a very underwhelming IPO.  Instead of pricing in the deal range of $16 - $18, the IPO priced at $14.50.  The deal was weak because of general market conditions, distractions for industry analysts (UNH and CVH, two large HMOs, both had their Investor Days only 1-3 days before this IPO priced), headline risk of Medicare Advantage reform, and perhaps because of the small-cap size of the company (~$500mm).

 

We think this was a classic management conspiracy story.  Prior to the IPO, the CEO and CFO owned no stock.  Upon the IPO they received approximately 1mm options struck at the IPO price.  While they have been at the helm for the last few years, the ownership structure remained the same as the non-profit days, and the management team had no incentive to improve profitability.  After the IPO last week, however, their incentives are clear.

 

We believe that GTS is currently earning ~ $1.60 - $1.80 per share.  As we will describe below, with reasonable margin improvement assumptions we believe EPS can grow to the $2.50 - $3.50 zone over the next few years.  More importantly, 6 years ago there were 6 publicly traded Blue-Cross/Blue-Shield companies, and today they have all consolidated under WellPoint.  There are significant scale advantages inherent in the HMO business model that motivate consolidation.  We believe GTS will ultimately be acquired.  Acquisitions of blues have occurred at an average forward P/E multiple of 18x.  That would suggest a $45 - $63 price for GTS, or 150% - 250% upside over a 2 – 3 year time frame.

 

 

Triple-S (GTS) is the exclusive Blue Shield licensee and the largest managed care company in Puerto Rico.  With just under 1mm members, GTS provides health insurance to about 25% of the territory’s population.  GTS just went public at $14.50 on 12/7/2007, and currently trades ~ $18, which is the high end of the original IPO range.  GTS has significant upside over the next 2 years because of its:

 

 

 

As the largest managed care company in Puerto Rico, GTS offers a broad portfolio of products in the Commercial, Medicare and Reform (similar to Medicaid) markets.  GTS is also the largest provider of life insurance and the 4^th largest provider of P&C insurance in Puerto Rico.

 

Commercial –                                    Historically, commercial health insurance has been GTS’s main business segment.  With 575k members, GTS has a 25%+ market share in this segment.  Since this business had been run as a non-profit for over 40 years, we suspect there is significant room for improvement.  Specifically, we believe GTS is currently underwriting commercial business at around 90% medical loss ratio (MLR) and 13% SG&A ratio, making this business unprofitable even after investment income.  For comparison purposes, a typical for-profit commercial plan in the U.S. operates at an MLR closer to 80%.

 

Medicare –                                        While GTS is a relative newcomer to the Medicare business (it has a market share of <10% in Puerto Rico), this business segment is fast growing and very profitable.  Of the 50k members, around 75% have medical coverage while 25% are standalone drug plans.  GTS expects to grow its Medicare Advantage program quickly (15%+ per year), through continued conversion from standalone PDPs, and as a result of operating issues as 2 of its largest competitors.  While we expect their Medicare MLR to increase from the current 79%, they should stabilize at or below the national average in the low 80’s.

 

Reform –                                            GTS currently has the exclusive fully-insured contract to 2 of Puerto Rico’s 8 Reform regions.  This program is both mature and low-margin.  MLR is currently running close to 90% and we expect that to continue going forward.  A year ago, there was some uncertainty in this business when Puerto Rico took 1 of GTS’s regions (it had 3 at the time) and gave it to Humana on a self-insured, or Administrative Services Only (ASO) basis.  That experiment ended up being a disaster and we don’t expect any more changes to the Reform program in the near future.

 

Life and P&C –                                 These two business segments combine for just under 25% of GTS’s operating income.  While we view both businesses as mature and stable, there may be cross-selling opportunities with the managed care business.  On the P&C side GTS tends to reinsure all exposure over $5mm.

 

 

Unmatched Brand Name and Provider Network – Blue-Cross/Blue-Shield (BCBS) is one of the most trusted brand names in health care.  According to the BCBS Association, 90mm Americans (or 35% of the insured population) get their coverage from a BCBS franchisee.  As with most other BCBS franchisees, GTS enjoys significant local market share (over 25%) and a large provider network (50% larger than the next biggest competitor).  This is extremely important because health insurance is essentially a local business.  When a payer tries to contract with a local provider (hospital, doctors, radiation centers, etc), the payer’s negotiating leverage is only as good as its local market share.  Typically, a BCBS franchisee can leverage its local scale to get the lowest possible rates from these providers.  Due to its former non-profit status and the fact that GTS was owned by the providers themselves, GTS has not negotiated aggressively with its provider network and we see this as a significant opportunity going forward.

 

Significant Margin Expansion Opportunities – While GTS formally converted from a non-profit to a for-profit corporation in 2004, it continued to operate as if it were a non-profit.  The shareholders remained the same, and the underwriting standards stayed the same.  Significantly, before the IPO the ownership was 100% former and current doctors/providers, and the management team had no shares in the company.  In 2005 and 2006, GTS management did a decent job establishing a profitable beachhead in Medicare Advantage, but going forward we expect them to take significant costs out of the commercial business.  Specifically, management understands that as a publicly traded company, commercial MLR of 90% is simply not acceptable.  They have highlighted a few areas to target over the next few years, including

As we did our due diligence we became convinced that the margin expansion opportunity here is even greater than we expected.  Competitors confirmed that GTS was still writing business as if it were a non-profit.  We spoke to one competitor who is currently getting around 80% commercial MLR in Puerto Rico (similar to U.S. national average for commercial plans), and they believe that GTS can fairly easily reduce its MLR by 400-500bps.  As the local market share leader, we believe there is no reason why GTS can’t bring its commercial MLR down by nearly 1000bps, even though that will take a few years.

 

Growth Opportunities – Despite having significant market share in Puerto Rico (25%, if you assume that everyone has insurance), GTS is a fairly small player in Medicare Advantage (<10% share) and expects to grow this segment rapidly.  In the past two years, some of GTS’s competitors (Aveta, MCS and Humana) expanded aggressively into MA and ran into more than a few hiccups.  GTS, on the other hand, grew slowly but very profitably.  Going forward, we expect GTS to gain market share at the expense of its competitors.  Even though we believe GTS’s current Medicare MLR of 79% is unsustainable and will move inline with the competitors in the low 80’s, GTS will gain scale and be able to lower its SG&A ratio for this business segment.  In addition, GTS plans to increase cross-selling efforts between its medical business and life/P&C business.  While we believe this opportunity sounds reasonable, we can’t quantify it and therefore did not incorporate it explicitly into our model.

 

Attractive Valuation – At $18, GTS is trading at 10x our 2008 earnings, 8.1x 2009 earnings and 6.8x 2010 earnings.  We believe our estimates are fairly conservative, and will explain more in the next section.  Currently the industry is trading at 14x 2008 earnings.  We believe GTS can grow its earnings at a 20% CAGR without any share repurchases, while the industry can grow only half of that without repurchases.  The main difference lies in GTS’s significant commercial MLR improvement opportunities.  In addition, GTS is trading at about $500/member and 33% of revenues, all on the very low end of industry averages.  Historpically, HMO acquisitions have been done at >$1,000/member, and many of the large diversified HMOs (WLP, CI, AET, UNH) trade at close to 1x revenues.

 

Attractive Take-Out Candidate – In the past 6 years, there have been 6 publicly traded BCBS companies, and only 1 remains independent today.  WellPoint (formerly Anthem) has acquired WellChoice, WellPoint Health Networks, Cobalt, Trigon and RightCHOICE at an average forward P/E of 17.9x.  Simply put, we do not expect GTS to remain independent for more than a few years.  We have spent a lot of time thinking about why WellPoint didn’t take out GTS pre-IPO, and after going through all the risk factors (see below), we believe the primary reason is that GTS was not a willing seller.  Before the IPO, the management team had no ownership stake and had significant margin expansion opportunities.  Had they sold the company, their best-case-scenario outcome would have been to keep their existing jobs.  With an IPO, they now have over 1mm shares, mostly in options struck at the IPO price ($14.50).  If they can grow earnings to $2.63 by 2010, they can sell the business for $40 (15x) to $48 (18x) and pocket $25-35mm for themselves.  This is a no-brainer for them.

 

 

Membership Growth – We assume minimal (1-2%) membership growth through 2010, primarily in self-insured (2%) and Medicare (10-12%).

 

Premium Growth – We assume 5% annual premium growth for commercial and Reform segments, flat PDP premiums, and Medicare Advantage premium declines of 2% in 2008, and 5% for each of 2009 and 2010.  Premiums growth is primarily a function of health care cost inflation, which has been running in the 6 – 8% range for many years.  We believe our assumptions for GTS are conservative relative to industry expectations.

 

MLR Assumptions – We assume commercial MLR declines from 90% in 2007 to 86% in 2010.  Even with this improvement, GTS would have one of the highest MLR’s in the industry.  We believe 400bps of improvement over 3 years is very conservative.  We assume Reform MLR stays flat at 90%, and Medicare MLR increases from 79% in 2007, to 81.5% in 2008 and 83.5% in 2010.

 

SG&A Ratio – We assume modest leverage of SG&A going forward.  We expect SG&A as % of sales to gradually decline from 11.0% in 2007 (10.7% in the last quarter) to 10.5% by 2010.

 

Other Assumptions – We’re keeping most other items (investment income, life and P&C) flattish, assuming cash flow reinvested at 5% (instead of debt pay-down), no share repurchases, and tax rate increasing from 24% to 30% as more income is generated from insurance business instead of investment income.

 

EPS Estimates – Based on the above assumptions, which we believe to be very conservative, we are estimating EPS of $1.81 in 2008, $2.21 in 2009 and $2.63 in 2010.  Had we assumed 2010 commercial MLR can reach 80% (similar to U.S. national average), EPS would be $3.58.  Clearly, there’s still significant upside to our $2.63 2010 EPS.

 

 

Commercial Execution Risk – The biggest question for GTS is: can management execute the game plan?  GTS is well positioned in its market, has a lot of fat to cut, but you need a sharp management team to drill down.  We were concerned that this management team has been in place for a few years now, and yet there had no been improvements to date.  But again, one must keep in mind that this was a non-profit until recently.  Prior to the IPO, the management team had no incentive to run it like a for-profit.  Management has begun to introduce reforms at the board level, and begun to lay the groundwork for changing its underwriting standards and actively improving its commercial MLR.

 

Medicare Advantage Risks – Currently Puerto Rico receives favorable rates for its Medicare Advantage plans.  CMS estimates that Puerto Rico’s benchmark is 175% of the traditional fee-for-service costs.  The Puerto Rican insurance industry disputes this figure, claiming that CMS underestimates fee-for-service costs because it omitted certain items.  In any case, we have spent a significant amount of time handicapping MA benchmark cut risk for GTS.  First of all, GTS has no private fee-for-service (PFFS) plans and currently we expect any MA cut to be concentrated in PFFS plans.  Second, Charlie Rangel (Chairman of the House Ways and Means Committee) has been a great friend of Puerto Rico (partly due to his NY constituency), and will likely protect Puerto Rico from unfair cuts.  Third, even if Puerto Rico’s benchmark is cut, it will likely start in 2009-2010 with a 3 year phase-in, and GTS firmly believes that it can maintain a low 80’s MLR by paring back extra benefits that it is currently providing.  Ultimately, we believe that even if MA cuts are implemented, they will be significantly outweighed by improvements on the commercial MLR side.

 

Reform Risks – About a year ago there was fear that Puerto Rico would turn all 8 of its regions into ASO (self-insured) contracts.  After running a trial in the Metro-North region with Humana, we do not expect the government to continue down that path.  We believe cost of care has risen significantly for the government under the ASO contract, and given balanced-budget requirements, we do not expect the Puerto Rican government to take on more risk going forward.  In any case, the entire Reform business has very thin margins (3% pretax) and despite the large membership, contributes fairly little to operating income.

 

Litigation Risk – There are some outstanding claims primarily from heirs of previous doctors who were given an option to buy shares in the non-profit (but didn’t).  GTS believes that those claims are no longer valid, and thus, has not sold/issued stock to these claimants.  So as to protect public shareholders from any adverse outcome on this issue, GTS set up a dual class stock structure.  The doctor/providers own Class A shares, and the public owns Class B.  Both calluses are identical except that Class B shares enjoy dilution protection.  In the event the company loses the litigation with the heirs of former doctors and needs to issue stock to them, GTS will issue Class A stock that will only dilute the Class A holders.  Mechanisms exist to convert all of the Class A stock to Class B over the next five years or upon the resolution of these claims.

 

Other – WellPoint is currently a junior JV partner in GTS’s biggest competitor, MCS.  MCS is majority-owned by JLL, a private equity firm, and ran into significant problems in 2006.  WellPoint had the opportunity to buy the entire JV but decided against it.  We don’t know if the reason is because WellPoint prefer to buy only BCBS plans (as they have done in the past), or because of MCS-specific problems.  Nonetheless, we expect WellPoint would need to divest its MCS stake (12%?) before pursuing GTS.  In addition, we expect GTS to use its IPO proceeds to pursue the Blue Cross franchisee in Puerto Rico, La Cruz Azul (owned by Independence Blue Cross of Philadelphia).  La Cruz Azul is very small and bleeding money.  The BCBS Association also prefers all Blue Cross and Blue Shield plans in the same territory to merge (in order to minimize blue-on-blue competition).  We believe it would be a positive for GTS to take out La Cruz Azul, because they can swap the members onto their network more profitably, and it would prevent WellPoint from gaining a BCBS foothold in Puerto Rico.  We don’t expect the acquisition to be very big (under $50mm).

 

 

1.                    Seasoning of new IPO.

2.                    Earnings growth through commercial MLR improvement.

3.                    Eventual takeout by WellPoint.