Description

I am recommending a long position in Universal American Corp.

Stock is currently trading for what seems to be a reasonable/expensive multiple on GAAP earnings.  Elevated cost structure and company is investing in a number of opportunities that currently produce little to no revenue.  Acquired APS Healthcare last year and hasn’t performed in line with expectations.  Medicare Advantage (MA) is facing premium headwinds.  UAM did not provide earnings guidance for 2013.  Investors looking for exposure to Managed Care Organizations (MCOs) have a number of larger, cleaner names from which to pick.

So what is there to like?

1)    It's cheap on an asset basis.  MA, Traditional Insurance and excess capital support current valuation.  Not paying anything for growth opportunities.

2)    Shareholder focused management team/board/private equity owners with a proven track record of adapting to opportunities in healthcare.  Created a Medicare Part D business in 2006 and sold it to CVS for $1.25 bn in 2011.  UAM distributed $14/share in cash and shares in Newco following the deal.  Company also paid a $2 special dividend in fall of 2010 and a $1 special dividend at the end of last year.  UAM cares about its shareholders.

3)    Healthcare landscape changing dramatically with implementation of the Affordable Care Act (ACA); ACOs, state Medicaid expansion, focus on dual eligibles, etc.  Reducing cost while maintaining or improving quality of care is the goal.  Change breeds opportunity.  UAM is positioning itself to capitalize on the change.

No one has the ability to predict the future and past success in no way guarantees future success.  However I am confident there will be significant value creation and I like to be aligned with management teams/boards who have the flexibility to adapt and who are focused on creating shareholder value.  Most importantly, I can buy into this opportunity without paying much if anything for potential upside.

Company Overview 

1.  Medicare Advantage (MA)

Approximately 25% of the 51 mm Americans currently eligible for Medicare are enrolled in MA plans; CMS estimates the total Medicare population will be close to 65 mm by 2021.  MA is offered and administered by private insurers.  They receive a flat per month per member fee from Medicare and design/offer plans with varying amounts of copay, out of pocket maximums, coverage, etc.  The plans are required to cover everything Medicare covers but they are not required to cover everything in exactly the same way.  Medicare Advantage participants still pay their Part B premiums and, depending on the offering, might also pay a premium to the Medicare Advantage plan sponsor.  In an effort to encourage private participation in MA, the per member per month fee was and continues to be more than the traditional Medicare cost of those members.  As an example, in 2012 the federal government spent ~12% more on Medicare Advantage than it did for traditional Medicare.  As part of the ACA, CMS initiated a star rating program whereby the quality of the MA plans will be assessed and future per member per month fees will adjust depending on those ratings.  Additionally, MA rates are scheduled to decline in 2014 and will most likely decline over time until they are on par with traditional Medicare.  Earlier this year CMS published a 45-day Notice outlining potential cuts to MA reimbursements.  The proposal was worse than anyone could have imagined and MA related stocks (including UAM) traded accordingly.  Following significant lobby group and bi-partisan reaction opposing the draconian cuts, CMS published final changes in early April that were more in line with initial expecations.  At the time I was suprised that the Administration would do something to upset ~25% of Medicare recipients because at the revised rates plan sponsors would have been forced to dramatically change their product offerings.  Government action clearly presents a near/medium term headwind, but sponsors will adjust their programs and service provider agreements to adapt to the new reality.  Sponsors like UAM are incented to partner with service providers to lower cost and increase quality of care.  Further, the tremendous growth in the addressable market given the aging of the baby boomers should largely overwhelm reimbursement pressures. 

UAM currently has 134,000 Medicare Advantage members generating ~$1.6 bn in annualized revenue, approximately $1,000 per member per month.  The members are split between HMO (56,000), PPO (16,700) and PFFS (61,500) and are concentrated in the Southwest, Northeast and Southeast.  Total membership has been relatively flat recently while the make-up is shifting more towards HMOs from PFFS.  MA PFFS opportunity will decline over time for all providers - I'll spare you the details.  Total membership seems to have finally reached a floor after a few years of steady decline.  There is no guarantee that we won't see further decline but management has suggested that we should start actually seeing some growth.  MA profitability is a function of premiums, medical loss ratio (MLR) and an ability to control operating expenses.  Due to the weak economy, almost all health insurance providers have experienced reduced MLRs.  Generally speaking, utilization has been low as the insured have been delaying procedures to avoid any out of pocket expenses.  You can see the flip side to this phenomenon in Hospital admission trends.  UAM's MLR has recently been in the low 80% range.  A more typical level is ~mid-80% and the government is mandating a minimum MLR of 85% beginning in 2014.  Operating costs have been ~10% - 12%, but should trend lower over time.  Operating costs are too high largely as a result of the company being too slow to cut overhead as membership has declined over the last several years.  Assuming $1.6 bn in revenue, an 85% MLR, operating costs of 10%, tax rate of 35% and 89 mm shares generates $0.58 in EPS.  Applying a 10x – 12x multiple suggests the Medicare Advantage business is worth ~$6.50 per share.  This implies ~$4,300 per member.  If you exclude the 61,500 of PFFS, this implies ~$7,900 per combined HMO and PPO member.

Cigna purchased Healthspring in the fall of 2011 for ~$10,000 per MA member.  United Health purchased XL Health for a reported $2 bn in November 2011, or ~1x revenue.  At the time of the sale it was reported that XL Health had 117,000 MA members, but was growing rapidly.  Humana acquired a small MA HMO in 2012 (terms not disclosed) and WellPoint purchased CareMore in 2011 for $800 mm or ~$14,800 per member.  While none of these transactions are purely apples to apples, they do suggest that there is interest by the large players in expanding their respective MA businesses and that a valuation of ~$4,300 (~$7,900) per member is, at least, reasonable.  At the time of the Part D sale to CVS UAM stated in SEC filings that there were companies interested in purchasing UAM in its entirety.  UAM's MA business is an attractive asset.

2.  Traditional Insurance

Consists of three major lines of business: 1) Senior Market - Medicare supplement, senior dental, and hospital indemnity, 2) Specialty Health - disability, specified disease, hospital, surgical and long-term care and 3) Life Insurance and Annuities - whole life, universal life and annuity.  UAM stopped selling a number of products (long-term care, major medical, disability, term, universal and whole life and certain annuities) several years ago and discontinued marketing and selling the remaining traditional insurance products as of June 1, 2012.  This business remains profitable, but is in run-off.  Total net premiums were $242 mm in 2012, roughly equal to policyholder benefits and operating expenses.  Operating profit was $18 mm, more or less equal to net investment income. 

The company does not split out the capital required for the traditional business.  However as of 1Q2013 UAM had $640 mm in unregulated cash and statutory capital.  Unregulated cash was $42 mm and excess capital (above 350% RBC) was ~$318 mm, so capital necessary to support MA and traditional was $280 mm.  Let’s assume that the capital for each is proportionate to relative premium share.  In 1Q2013, traditional represented ~12% of net premiums so ~$34 mm in capital or $0.38 per share.  Not a major component, but does represent some value.

3.  Excess Capital

As of the first quarter, UAM had ~$360 mm of unregulated cash and excess capital (in excess of 350% RBC) or >$4 per share; ~$318 mm is at its wholly owned subsidiaries.  Management has stated that it will have $59 mm available to dividend to the parent this year.  I would be surprised if UAM doesn’t dividend something to shareholders but management/board has not committed to anything as of yet.  The unknown is when the company will take action so that shareholders can benefit from the excess capital. 

Richard Barasch, Chairman and CEO, said the follow at a recent investor conference, "we have too much capital at this point...we understand that frankly it's not our money and we have to do something about it for the benefit of our shareholders."  A great thing to hear as a shareholder.

Valuation sidebar

There is ~$10.90 per share of value between MA, Traditional Insurance and excess capital.  To be fair, we should subtract debt of $128 mm and $40 mm of preferred from excess capital or ~$1.90 per share.  This implies net to shareholders of $9.00 – equal to the current share price for just the current businesses and net excess capital.  A lower level of support is tangible book value of $7.58 per share.  Subtracting net excess capital from tangible book puts a value of $5.48 on the remaining businesses, which is roughly 9x my MA target EPS.

What about the other businesses? 

4.  Accountable Care Organizations (ACOs)

The ACA established ACOs as a tool to improve quality of care and lower costs by encouraging care coordination among various service providers in the fee for service population, or the 75% of Medicare recipients who are not part of MA programs.  CMS facilitates this through the Shared Savings Program.  Taken directly from UAM's most recent 10-K:

"The Shared Savings Program is designed to improve beneficiary outcomes and increase value of care by (1) promoting accountability for the care of Medicare FFS beneficiaries; (2) requiring coordinated care for all services provided under Medicare FFS; and (3) encouraging investment in infrastructure and redesigned care processes. The Shared Savings Program will reward ACOs that lower their growth in health care costs while meeting performance standards on quality of care and putting patients first. Under the final Medicare Shared Savings Program, or MSSP, rules, Medicare will continue to pay individual providers and suppliers for specific items and services as it currently does under the FFS payment methodologies. The Shared Savings Program rules require CMS to develop a benchmark for savings to be achieved by each ACO if the ACO is to receive shared savings or for ACOs that have elected to accept responsibility for losses. An ACO that meets the program's quality performance standards will be eligible to receive a share of the savings to the extent its assigned beneficiary medical expenditures are below its own medical expenditure benchmark provided by CMS."

The successful MA business feeds right into what it takes to develop a successful and profitable ACO business.  Working with providers to coordinate care in an effort to lower cost and maintain or improve outcomes.  Fee for service Medicare participants won't notice any meaningful differences in the mechanics of the program and won't need to enroll in anything.  Providers will work against cost and outcome benchmarks.  How they do against both will determine how much they share in any savings.

UAM has partnered with primary care and multi-specialty provider groups to form 31 ACOs with ~324,000 assigned fee for service lives.  These ACOs were approved by CMS for participation in the Shared Savings Program.  The company has not recorded any revenue (but has incurred start-up costs of ~$20 mm) from the ACOs as of yet but expects to by the end of the year.  UAM recently provided the following as a rough framework of how to think about the ACO opportunity:

The above framework implies 324,000 members could generate $22 mm in operating profit, $15 mm in net income and ~$0.20 in EPS.  Applying a 12x – 15x multiple suggests ~$2.75 in per share value.  UAM is in the process of applying for more ACOs.  By the time UAM is realizing the economics of the ACOs, the business will most likely be bigger and cost efficiencies greater.  We will learn much more throughout the year as the company begins to report revenue from the ACOs.

5.  Medicaid and Dual Eligibles
Medicaid is the largest publicly funded program in the US and provides health insurance to low income families and people with disabilities.  The program is jointly funded by the federal government and the states.  The ACA significantly expanded the Medicaid program; according to CMS, Medicaid should grow from $450 bn in 2012 to $900 bn by 2020.  Further, approximately 20 mm more people will qualify to receive Medicaid by 2014.  A subset of Medicaid beneficiaries are considered dual eligibles, that is they qualify for and receive benefits from Medicaid and Medicare.  As it states in the 10-K:

"Based on CMS and Kaiser Family Foundation data, we estimate there are approximately 9 million dual eligible enrollees with annual spending of approximately $320 billion.  Only a small portion of the total spending on dual eligibles is administered by managed care organizations."

This opportunity/strategy is much less defined by management.  UAM acquired APS Healthcare from GTCR in 2012 for $222.3 mm; $147.8 mm in cash and ~$74.5 mm in UAM stock.  APS provides specialty healthcare solutions to Medicaid agencies; these solutions include case management, care coordination, clinical quality and utilization review and behavioral health services.  Services are intended to improve quality and reduce cost in the Medicaid system.  This is a service business, not a risk based business.  Similar to the ACO opportunity, this is capital light.  APS' results are reported in "Corporate"; revenues were ~$300 mm in 2011 and currently appear to be at the same run rate.  Barasch has stated that the acquisition hasn't progressed to their liking but they are still encouraged that it will play a role in their Medicaid/dual eligible plans.  Management has said we should learn more about UAM's Medicaid plans over the next several quarters.  Difficult to build a model given lack of disclosure.  In an attempt to put some value on the business, I’ll apply a discount to the APS acquisition price.  Maybe a 25% discount, 50% discount?  So Medicaid/dual eligible/APS business is worth ~$1.90 per share, $1.25 per share?

Ownership/Board
As of the latest proxy, list of top holders:

Capital Z Partners (PE)              18.6%
Perry Corp                                12.4%
Welsh, Carson (PE)                   8.0%
GTCR (PE)                                 6.7%
Dimensional                             6.0%
Lee Equity Partners (PE)          6.0%
Richard Barasch, CEO               3.3%

Four of the top six holders are private equity firms.  Further 60% of the stock is held by the top six plus Barasch.  Key Directors: 1) Robert A. Spass – Chairman, CEO, Partner and co-founder of Capital Z Partners.  Capital Z initially invested in UAM in July 1999 and made a second investment in 2007, and; 2) Thomas Scully – General Partner of Welsh, Carson and Senior Counsel at Alston & Bird LLP, a law and lobbying firm where he focuses on health care regulatory and legislative matters.  Formerly (2001 to 2004) Administrator (head) of CMS.  He was appointed by President Bush.  The 13 member Board also includes five other Directors representing the four PE investors.

Positive:  pretty clear.  Significant PE ownership and Board representation suggests the company is being run for the shareholders, not the management team.

Negative: if you view it as a negative.  PE firms are generally not concerned with the day-to-day stock price.  This stock does not work for the catalyst/short term trading/upside surprise driven investor.  It can be left for dead for long periods.  Ownership is concerned with creating businesses where they realize value over time – years, not weeks and months.  UAM is a publicly traded PE investment.

Summary
MA, traditional and excess capital support current valuation.  Management team/board has demonstrated ability of creating and distributing shareholder value.  Currently investing in high growth areas within the ever changing healthcare landscape.  Rough/high level analysis suggests $4 – $5 of upside, without including the potential for special dividends, capital return, etc.  No easily identifiable catalysts (probably explains the opportunity) so investors will need patience.

Catalyst