** Draft: This will go through several iterations of updates.
Why I like Managed Care Organizations (MCO)
The secular growth story of healthcare sector is not hard to understand. Aging population and Obamacare expands the size of the pie; while government budget constraints means private sector gets a larger share of that pie. This applies not only to PBMs (which I have written about in another article), but also helps MCOs. For MCO’s specifically, the exchanges mandated by ACA also provide opportunities to lure some of the Administrative Services Only (ASO) business to full risk business, which has higher profit per member (by 4x in some estimates).
These are good businesses that are relatively simple. Compared to say, a life insurance company where you have all kinds of derivative exposures and quality of earning concerns, health insurance is much simpler because these are annual contracts. Furthermore, MCO’s are not pure risk businesses. In general there’s a large service component which is less capital intensive and high return (Nice ROE in the mid/high teens). Low capex also means strong cash flows and thus optionality to deploy capital.
Industry structure is fairly attractive. This is a fairly concentrated industry with several established national players (will discuss later). Other than the government, customers are fragmented and have low bargaining power. While some parts of the supply chain have consolidated (PBMs, distributors for example), providers (hospitals, physicians…etc) will likely remain fragmented. As large customers MCO will exert power to push prices lower for the benefit of consumer. Keep in mind that health plans are essentially commodity products so brand recognition is important. When you’re selling what’s basically a financial service, there’s just not much differentiation. How many customers can really tell the difference between UNH, CIG, AET? In my old company, where it comes time to pick health plans, most people just ask their friends (blind leading the blind) or randomly choose one. Despite being a commodity, barrier to entry is extremely high due to state level regulations, capital requirements, and the need for a provider network.
1. Valuation. Managed care is one of the few sectors that are still reasonably priced. The chart below shows that valuation has increased but still not high by historical standards
2. Mitigate risks in portfolios. People always need healthcare. In the past health plans do get hurt by unemployment in a down cycle, but I’m guessing demand should be more constant in the future due to individual mandates. Although I don’t know where rates will be headed, higher rate is a general risk factor, and Managed Care is one of the few sectors where rising rates would help (through higher investment income)
UnitedHealth Group Inc (UNH)
- Large & diversified business: UnitedHealthcare + Optum Health Services
- Exposure to NY where competition is intensifying according to management. Bad star ratings hurt its MA business.
- Amazing streak of beating estimates all the way back to 2009. Aggressively retuned capital to shareholders 2010-2013
- Has its own PBM
Wellpoint Inc. (WLP)
- Largest provider of Blue Plans. About 20% of members from government business (12% from Medicaid)
- Management levers
- Uniquely positioned to consolidate other Blue plans
- PBM “optionality”. WLP currently uses Express Scripts. However there’s a good chance they that WLP will either renegotiate better terms or otherwise extract another payment from ESRX.
- Consistently the lowest margins and ROE among big 4.
- Has hedging value if you own ESRX
Aetna Inc. (AET)
- EBITDA Mix: 39% large group insured, 24% commercial fee business, 22% government; 15% small group/individual/group insurance. Membership mix: ~15% government (7% Medicare)
- Sensible goals and strategies in my view. AET aspires to double revenue by 2020 and achieve double digit EPS growth with 5% organic and 5% capital deployment. To that end, management plans to increase government profit substantially over next few years.
- Grow Medicare Advantage (MA) & dual eligible. AET is well positioned in MA to do this as they have strongest STAR scores. AET is also aggressively getting into the public exchange business where clients are more likely to be full risk, which has higher margins.
- PBM relationship with CVS.
- Traditionally has the least risk business (more of ASO)
- “Go Deep. Go Global. Go Individual” strategy. Low commercial member growth but go for deeper product penetration.
- Has Catamaran as its PBM
- Medicare focused, roughly 35/35/25 in retail/employer/healthcare services
- 68% government business almost 90% risk). Particularly Retail MA & Medicare-PD. Not much Medicaid
- Looking to sell its PBM
At this point, I favor Aetna.
· Actually, I’d buy all of the above. So it’s a matter of maximizing value by buying at the best prices.
· I particularly like Aetna. It has a coherent strategy to increase earnings matched with action. For example management wanted to get more Medicare business, so they bought Coventry and have a high percentage of members in high STAR rating plans. I also like how they’re aggressively getting into exchanges.
· Good operator. AET consistently has one of the higher margins in the group. Both AET and UNH aggressively bought back stocks over the past few years which in retrospect were greatly accretive. Compare to UNH however, AET trades at a lower multiple and is more of a pure play MCO.
· Key things to watch out for in 2014 are how they manage to offset MA rate pressure & ACA fees; progress in Coventry integration.