Description

GTS is a managed care provider in Puerto Rico. Its business is mostly Medicare, Medicaid and a small commercial business, with about 1 million members and a 25% market share in PR. The company has the exclusive right to the Blue Cross and Blue Shield name. The company also has a life insurance and P&C business that is small compared to the managed care business.

Currently at about $15.60 the company is trading at 44 percent of book value. I believe that despite all the uncertainty surrounding managed care and the Puerto Rico BK, the valuation compensates us for the risk we are taking. Or as a friend of mine likes to say, “You make way more money when things go from truly awful to merely bad, then when things go from good to better”. With all the noise surround the Puerto Rico BK and Obama care there is a lot of leeway for things to go from awful to merely bad.

There seem to be a limited number of outcomes.

A.      For whatever reason GTS loses the contract with PR government. This would likely lead to a run off scenario in which I find it hard to see that we would get less than 80% of book. I believe the book value per share is real and would be realized over time. In that scenario, the company could still increase its book value per share by just buying back stock at a discount. And if no discount to book exists, I will likely already have sold the stock.

B.      Another scenario could be that GTS continues to contract as a managed care business with the PR government. It is my belief that somehow PR will do whatever it can to make sure its population maintains access to health care. Part of it is subsidized by the US government, the rest the PR government will have to come up with. The main issue for us then becomes how profitable that business would be for GTS. Currently GTS is mostly struggling with controlling the claims side of the business. Over the last few years they have brought down operating cost as a percentage of operating revenues, but on the claims side of the business GTS has had a rougher time controlling costs. There is only so much GTS can do to control costs, but that is why we are currently renegotiating the contract with the Puerto Rico government. GTS’ Triple S-Salud just got price increases of 7% to 10% for about a third of its covered lives. In the past the net margin tended to be in the area of 2% a year. If we can return to that number then GTS should be able to make in the region of $50 million after tax. Except if claims cost accelerate markedly, if GTS can achieve a 7% increase in pricing overall it should be able to achieve a 2% net margin again.

C.      And the last scenario would be to have something in the middle, meaning that GTS contracts with the PR government but without getting enough of a price increase. This is an unlikely scenario to continue for a long time. Management’s incentive are clearly aligned with shareholders as a large part of their annual remuneration is in restricted or performance stock. On the 2016 award, management is already $2.75 million under water. It is my feeling that management is too conservative when it comes to its balance sheet, but still very much incented to make money for shareholders, which includes management. In short, if the PR government does not allow the industry to be profitable, it will soon have a lack of parties willing to do the work. I do not see GTS management voluntarily draining BV with no expectation of returning to profitability.

Anyway, despite that the Puerto Rico economy is going to continue to suffer for a while longer. I believe that at this valuation we are sufficiently compensated for the risk we are taking. I do not see some scenario where the equity will be wiped out because of excess leverage or huge and persistent losses and a decrease in the level of uncertainty would allow for a significant change in valuation of the GTS stock. In short, if things improve, then we would likely see a higher multiple on an increasing BV per share. If GTS returns to a 2% net margin then I find it hard to see the stock not being worth between 0.8 to 1 times book value per share.

Some more stuff about GTS:

Book Value

Here is the book value growth per share since 2008. Not an amazing growth rate, but not bad either. As you can see the last few years the growth rate has slowed down and most of the BV per share growth over that time has come from buying back shares. A 10% compound growth rate since 2008 is pretty decent, especially since the PR economy has been in recession pretty much since 2006.

Excess Capital

GTS has to my estimates between $50 and $100 million that realistically could be available to buy back stock now. The $50 million number I got from management. Myself I think that $100 million is a more realistic number. The RBC requirement for Blue Cross Blue Shield is 200%, but in order not to be monitored GTS need to hold 375%. If I take the 2016 Capital and Surplus of $638 million and deduct the 375% RBC number of $521 million I get $117 million in excess capital management they could use to buy back shares right now. I assume they won’t want to get too close to the 375% number so $100 million seems like a decent number to use. If management would tender for $100 million at $18 per share it would increase book value per share to $40.5 per share. And if the company could get back to making about $50 million a year we would have more money to buy back stock with and I think management would do so. Actually the moment GTS can start making $50 million a year again, management will likely be more aggressive in buying back stock.

I know that some think there is significantly more excess capital available based on the 200% RBC requirement, and I agree with them there. Actually most people on this board would agree with that and find better ways to use the excess. Still I do not believe management will go there. Management will buy back stock as one can see above, but they are very conservative with their balance sheet and I do not think that will change soon. So I am not going to rely on it.

New Management

In 2016 Bobby Garcia took over as the new CEO. I think he is an improvement over the old management. He has aggressively attacked the operating cost side of the business. When it comes to his excess capital I believe he will continue to be conservative.

Now what I like a lot is that management gets a large part of its compensation paid in restricted and performance stock. A few years ago management stopped handing out options and started handing out restricted and performance stock. Every year, management gets for 75% of its stock awards as performance awards which vest at the end of 3 years and are based on certain performance measures. The other 25% is handed out in restricted stock and vests 1/3^rd each year for 3 years. If you want to see the exact compensation tables for management look on page 60 of the latest proxy. Now if you look at 2016 you will see that 110,181 restricted shares were handed out with an average cost of 23.78 and 234,121 performance shares were handed out at $23.85. So the current stock price is more than $8 below the 2016 grant price. The 2015 grant price was in the low $20s and the 2014 was $16s. So in short, management is under water at this time on all of its grants since 2014.

In addition, management is expected to hold significant amount of stock. 5 times base salary for the CEO and 3 times for the CFO and subsidiary presidents. Management is not required to buy the stock on the open market, but can only sell 50% of its vested stock awards until it reaches the goal and cannot drop below that level once reached. Anyway, it feels to me that management is incented to get the stock price up, especially from the low valuation we are seeing now.

Future buybacks

Lately GTS has not been buying back shares. Given the incentives of management and the capital surplus I believe there is a good chance that that will reboot at some point in the future. Once a new contract is in place with the PR government management should be more willing to buyback more stock. But my thesis does not depend on it.

Operating expenses

Management has been addressing expenses. If you just look at operating expenses as a percentage of operating revenues ex investment income, we have gone from 22.1% in 2014 to 15.7% in Q1 2017. Sadly over the same period the claims side of the business has gone the other direction. The goal is to see that addressed in the new rates currently being negotiated with the PR government.

Current negotiations with PR government

Currently GTS is negotiating with the PR government for a new contract extension. Recently Triple S-Salud, a subsidiary that covers 390K Medicaid lives, got a contract extension for 3 months. What was interesting is that in the Metro North Region the monthly rate went from $165.93 to $183.38 (10.5%) and the monthly rate for the West region went from $138.37 to $148.99 (7%) per covered person. Also the release states that these rates will be maintained for the 2017-2018 fiscal year. So GTS is able to get price increases in the current environment. This does not cover all their insured lives, but it is a good signal. It is my expectation that health care coverage will continue on Puerto Rico. If GTS can get this kind of price increases overall, it should be able to return to a 2% net margin if it is able to keep the lid somewhat on the claims side of the business and keep the operating costs where they are now.

Just as a side note, GTS is allowed to discontinue coverage in case the PR government is 45 days late in paying. So it is unlikely we will end up in a situation where GTS is expected to cover people for an extended period of time while it is not getting paid.

PR economy

Putting in place Promesa seems to have been a decent solution to get PR moving in a positive direction again. Sadly as was the case in Greece, they are creating a lot of taxes and implementing budget cuts without structurally reforming the PR economy. It is my expectation that the PR economy will continue to struggle for some time. It could go from moderately bad to really bad. Now don’t forget that the PR economy has been in a recession since 2006 and from 2008 through now, GTS succeeded in increasing BV per share from $15.57 to $35.40.

One interesting element is that PR citizens are allowed to move to the US without limitations and in the US healthcare costs are significantly more expensive than in PR. So in case of a significant decline in the quality of healthcare in PR, the PR people will just move to the US if they are in need of healthcare. That is a strong incentive for congress to continue to help out PR on the healthcare side as it would end up costing a lot more to the US treasury if the people from PR decide to come en masse to the US. FYI. Alabama has about 1.5 million people more people than Puerto Rico, but it gets more than 10 times as much money from Washington for Medicaid than Puerto Rico does. In short, it makes a lot more sense for the US government to keep sick Puerto Ricans in PR.

Lastly a huge problem for PR has been tax collection. If the PR government could enforce the same kind of tax collection as the US does in general it would go a long way to fixing the debt servicing issue of PR. What is encouraging for PR is the Promesa allows for a debt reduction as part of the bankruptcy process.

Conclusion: Despite all the noise and uncertainty, I believe at the current valuation we are getting rewarded for the risk we are taking. Anything that gets the situation from truly awful to merely bad will likely result in a higher valuation.

Catalyst

Final agreement with the PR government on rate increases leading to a resumption of reasonable profitability and more buybacks of stocks driving EPS and BV per share growth.