On April 25, 2017, health insurance player, Centene (NYSE:CNC), reported stellar 1Q 2017 results. The company reported revenues and EPS of around $11.7 billion and $0.79 in 1Q17, which is higher than those in the corresponding quarter of the previous year by approximately 68.6% and 758.3%, respectively. Despite consistently outperforming its peers in terms of revenue and EPS growth rates, Centene continues to trade at significant discount on risk adjusted basis. The good performance – low valuation dynamic presents a very good opportunity for retail investors in 2017.
Centene can survive the expected changes in the healthcare regulatory landscape
Centene’s excess exposure to Medicaid business has been recognized as the most important idiosyncratic risk for the company. The Affordable Care Act or ACA proved to be a definite boon for Centene, as the subsequent Medicaid expansion programs added multiple contracts to the company’s kitty.
But as clarified in the 1Q17 transcript, worries related to the company’s growth prospects due to impending Repeal and Replace bill may be exaggerated. The approval of the new bill is bound to face challenges, as the House stands largely divided on the issue. While a group of conservative Republicans wants to completely scrap the ACA, there is another group of Republicans who want to remove certain aspects of ACA and retain certain features such as maintaining coverage for people with pre-existing conditions and providing subsidies to low-income population groups. Democrats have been largely supporting the continuation of ACA with modest changes.
After passing through the House, the bill will be tested in Senate, where Republicans are a minority. Further, the bill will also be subject to Byrd Rule scrub, which may prove to be a significant challenge.
Even if the new bill manages to overcome these challenges, it is expected to remain conducive to both Medicaid and public exchange business. It should be noted that 20 Republican senators belong to states which have already expanded their Medicaid programs. Hence, the member balance looms largely in favor of a healthcare bill with significant Medicaid reforms and higher level of flexibility to states in terms of fund usage.
Since ACA has been implemented, Centene has managed to increase its annual revenues from $3.4 billion in 2008 to more than $40 billion in 2016. The company has also expanded geographic reach of its services from serving 1.2 million people in eight states in 2008 to offering services to 11 million members across 29 states and 900,000 members in two international markets in 2016. With proven capacity to perform cost-effectively in times of regulatory changes, Centene seems well placed to benefit from any changes in the healthcare landscape in 2017.
Centene has provided healthy financial guidance for 2017.
Centene expects its full year 2017 revenues to hover close to the range of $46 billion and $46.8 billion. This is projected year-over-year revenue growth of around 17%. Health benefit ratio is expected to remain at similar levels as seen in 2016, in the range of 87% to 87.5%, a tad higher than 86.5% reported in 2016. Despite the increased projections for medical costs, Centene expects adjusted diluted EPS in 2017 to fall in the range of $4.50 to $4.90, higher than $4.43 reported for full year 2016. The company’s performance in 1Q 2017 has further reiterated investor confidence in the company’s financial performance for full year 2017.
As can be seen in the diagram, Medicaid expenditure has remained unabated despite changes in economic cycles. Based on 2015 population survey data, it has been seen that out of 318 million people in USA, 60% people are at or below 400% of federal poverty line or FPL. Further, it was also seen that 76% of 118 million people on either Medicare or Medicaid subsidies were at or below 400% of FPL. Medicaid spending will continue unabated beyond 2017, as no government can significantly reduce healthcare benefits of the vulnerable segment of US population.
In such a market scenario, Centene has emerged as the largest Medicaid managed care organization in USA as well as dominant player in three prominent Medicaid states of California, Florida, and Texas. Further, Centene is also a leading provider of managed long-term support services in USA as well as a dominant player in federal services segment which involve TRICARE and Veteran Affairs programs.
Centene has successfully replicated its strategy to focus on low-income population in other product offerings.
Centene has been quite picky about the population segment it wishes to focus on, be it any product offering. The company is mainly focused on population at or below 400% FPL in USA.
In the health insurance marketplace segment, Centene has targeted an increase in enrollment for its silver plans, since these members receive 92% subsidy. The company is also expanding its medicare advantage footprint, but only restricted to its desired population segment. This strategy also involves creating provider networks that are most suitable for serving low income population groups.
The acquisition of Health net, completed in March 2016, has added California commercial business to Centene’s portfolio. However, Centene does not plan to expand in this area outside the state. This highlights the long term strategy of the company to mainly focus on areas with significant competitive advantage.
With these merits, Centene seems significantly undervalued
Centene is currently trading at EV/Sales LTM multiple of around 0.28x, much lower than the median health insurance industry multiple which is around 0.75x. However, the company’s excess reliance on high cost Medicaid business and subsequently lower than average two-year forecasted operating margins is majorly responsible for Centene’s depressed valuation multiples. Centene is projected to have average annual operating margins close to 3.1% in next two years.
If we run a regression with operating margins on independent axis and EV/Sales LTM on dependent axis, Centene’s risk adjusted EV/Sales multiple should be around 0.35x. Based on these values, Centene’s risk adjusted market capitalization comes to around $15.8 billion. The number of outstanding shares for Centene is around 172. 28 million. Hence, Centene’s risk adjusted target share price close to $90 to $91.5, which will be a return over current share price in the range of 18% to 21%. Hence, retail investors should consider adding this stock to their portfolio in 2017.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Medicaid Business Resilience Can Catapult Centene’s Share Prices In 2017 – Seeking Alpha