Value Investors Club / Amerigroup (AGP)

Description

How about a long-idea with positive industry trends in 2009? Amerigroup is an opportunity to invest in the leading Medicaid managed care company with significant long-term and short-term tailwinds at a very attractive price.

INDUSTRY BACKGROUND: MEDICAID MANAGED CARE

Medicaid managed care saves states money now and in the future:

Medicaid is the state-run healthcare system in the U.S. for the poor and disabled which represents approximately 16% of national health spending ($380 billion expected in FY09). Medicaid programs are administered on a state-by-state basis under broad Federal guidelines, and are funded by state governments with a federal match, which ranges from 1:1 to 3:1 (depending on the wealth of the state’s residents). Medicaid managed care plans get paid on a monthly basis (“per member, per month”, or “PMPM”) and are then responsible for managing the health of those members. Details vary by state and by program, and complexity rules the day, which creates barriers to entry.

Managed care has become an increasingly acceptable method for bringing health benefits to the poorest members of the community. Over the past 20 years, states have been experimenting with managed care programs for various Medicaid populations (such as pregnant women, people with disabilities, children in foster care, etc.), and third-party studies have verified managed care’s ability to save states money. (See appendix B-1 of http://www.ahipresearch.com/pdfs/MedicaidCostSavings.pdf) Savings come from proactive approaches to preventative care and tightly managed networks to limit overutilization. For example, a managed care company might help a poor pregnant women to stay healthy during a pregnancy, reducing potentially higher costs later on from an unhealthy baby.

Across the country, approximately 65% of the Medicaid eligible population is enrolled in managed care plans, and in anticipation of tough budget times, states are increasing their managed care initiatives. The Kaiser Family Foundation reports that in FY2009, 18 states are going to increase their managed care service areas or expand populations. In addition, Obama’s stimulus plan will undoubtedly include (a) expansion of Medicaid eligibility, (b) expansion of SCHIP (a children’s health insurance program for children who don’t qualify for Medicaid), and/or (c) increases in the federal match (potentially up to $40 billion), which will help solve states’ funding issues. This represents the near-term opportunity for Amerigroup and the industry. Keep in mind that existing Medicaid programs are one of the fastest ways for the federal government to get money to the states.

While 65% of the Medicaid-eligible population is enrolled in managed care, only about 15% of the costs are associated with managed care plans. This is because states have been more aggressive in moving the healthier populations like adults and children to managed care while continuing to treat the aged, blind, and disabled population (ABD) on a fee-for-service (or unmanaged) basis. The ABD population accounts for ~24% of all Medicaid enrollees but 70% of the costs, largely because of long-term care needs (which Medicare does not pay for). The medium and long-term opportunity for Amerigroup and its competitors lies here in slowing the long-term care expenses for an aging society.

Medicaid managed care is highly fragmented, with the top 10 companies representing less than 40% of the enrolled lives. Much of the competition is from community-based non-profits, which have an obvious cost advantage, but my sources tell me that Medicaid directors like having for-profits in the program due to their creative approaches and efficient operations. One former Medicaid director told me that it’s the for-profits that “keep the not-for-profits honest.”

INVESTMENT THESIS

	Enrollment as % of AGP Total	Party: Governor/ Lower/ Upper House	Expected program expansion in 2009	State Mgd Care % as of 6/30/06	Medicaid Budget (FY06) $B	Relations since
Texas	27%	R/R/R		69%	$18.1	1996
Tennessee	21%	D/D/R		100%	$6.1	2007
Georgia	12%	R/R/R		98%	$6.8	2006
Florida	13%	R/R/R	x	66%	$12.8	2003
Maryland	9%	D/D/D	x	70%	$5.0	1999
New York	6%	D/D/D	x	61%	$44.7	2005
New Jersey	6%	D/D/D	x	69%	$9.1	1996
Ohio	3%	D/R/R		40%	$12.3	2005
Virginia	1%	D/R/D		63%	$4.7	2005
South Carolina	1%	R/R/R		20%	$4.1	2007
New Mexico	0%	D/D/D	x	65%	$2.5	2008

Amerigroup can grow the top line in three ways:

(a) Increased eligibility in the short-term: As unemployment rises, Medicaid enrollment will rise as well. In the last downturn from 2001-2003, Medicaid enrollment increased 7.9%, 9.5%, and 5.6% in those three years. Amerigroup doesn’t need to do any incremental work to capture these members due to the fact that in many states, individuals are assigned to the managed care organization: they will get their pro-rata share of the increase without much additional work.

(b) Continued increase in managed care penetration within existing states in the medium-term: In 2009, five of Amerigroup’s 11 state clients are expanding their managed care programs with Amerigroup. On a weighted-average basis, the managed care penetration in Amerigrioup’s states is only 64%, so there is additional room to grow.

(c) Addition of new programs in new states, especially long-term care in the long-term (no pun intended): Since 2005, Amerigroup has entered seven new states, and they expect to enter Nevada in 2009. In 2008, they began a new initiative with New Mexico (a new state) for an innovative long-term care program, which is largely designed to keep the elderly poor out of nursing homes by helping them manage their health and healthcare in the home setting.

Long-term care represents the largest opportunity for Amerigroup, since approximately 25% of all Medicaid spending is for long-term care, and 75% of that is for nursing homes. Given the demographic tidal wave of elderly, states need to get ahead of this problem or they will become insolvent (unlike the Feds, most states require balanced budgets each year). However, currently less than 3% of the elderly eligible for Medicaid are enrolled in managed care plans. States are increasingly open to working with managed care plans to help their states save money and predict their budgets. Managed long-term care can result in a win-win-win scenario: the state has lower and more predictable costs; the managed care company can make a profit, and the beneficiary can stay in their home longer than otherwise possible.

While net margins are just between 2-3%, Amerigroup has opportunities to improve its bottom line by expanding scalable processes and procedures. Given the difficult life circumstances of most Medicaid beneficiaries, this is a challenging population to serve, and Amerigroup has figured out the best ways to manage poor and disabled populations in a way that locally-based not-for-profits will not be able to. In addition, Amerigroup can leverage its member call center, claims processing system, and network contracting team across a broader number of states and members than other companies, especially the not-for-profits.

Outstanding performance:

Amerigroup’s ability to manage costs within these populations can be seen in their Medical Loss Ratio (MLR) (the term for COGS within health insurance) for their established and steady-state programs vs. their start-up programs. In expansion markets, their MLR is around 88-89% while their “core” markets have an MLR of 79-81%. This performance is what is most attractive to states that want to control healthcare costs. This is simply the natural result of having someone pay attention to medical costs – states simply pay claims.

Part of this performance is a result of Amerigroup’s sole focus on Medicaid, which allows it to negotiate more favorable terms with providers in its networks. Multi-line health insurers (like United or Wellpoint) have a more difficult time negotiating lower rates than Amerigroup since Medicaid reimbursement is almost always lower than commercial or Medicare reimbursement, even when a managed care company is involved. As a result, Amerigroup enjoys a 400-500 basis point MLR advantage vs. the multi-line health insurers.

Attractive returns on capital:

I contend that this is a good company in a good space, but is this a good business? Let me illustrate with a hypothetical example of how the business works. Let’s say Amerigroup signs up for a new program within a state, representing 10,000 members and a premium of $150 per member-per month. The state would require Amerigroup to put some capital upfront to ensure that it would be able to handle claims from the start. This ranges from 4-6% of annual premiums, or $720k to $1.08 million. Amerigrioup targets 2.5-3.5% net income margins, because it is unlikely that they will be able to “get away” with more than that given the political nature of Medicaid managed care. Nonetheless, the normalized returns on capital can range from 25% to 50% (see table)

Illustrative Incremental Returns on Capital
	Net income margins
Upfront capital requirement	1%	2%	3%
4%	25%	50%	75%
5%	20%	40%	60%
6%	17%	33%	50%

This is a simplistic illustration, and obviously there will be some set-up costs associated with getting the new program off the ground, but for an established company like Amerigroup, there are fewer set-up costs relative to others, and their experience gives them the ability to hit the higher net income margins faster than others. On the positive side, a cash-based view of returns would be even more attractive since managed care plans are paid well in advance of their claims. In many cases, these programs can become self-financing in about 3-6 months.

Attractive valuation and solid balance sheet:

Despite the positive trends, Amerigroup is trading at 11 P/E (2009) and 3.8x EV/EBITDA (for purposes of EV, I take a conservative approach by treating the “claims payable” as debt, since they have already collected the cash and are responsible for paying those claims). In addition, they have decent short-term visibility in 2009, since the reimbursement rates on 65% of their member-months have already been set – at a weighted-average rate increase of 4.7%.

I believe that with modest enrollment growth of 5% for the next couple of years and modest rate increases of 4%, Amerigroup can grow its bottom line by over 15% per year for the next few years, before stock buybacks. In addition, over the next few years, interest rates are likely to rise (even slightly) and as such we should see additional earnings growth.

Amerigroup has a conservative balance sheet. They have has $1.35 billion in cash and investments, of which $280m is unrestricted at the parent level – and only $310m of debt. Through Sept 30, they generated $170m of adjusted cash from operations, and they repurchased $4m of stock in Q3. Their portfolio consists of 52% money-market; 38% government-sponsored entities; 4% investment-grade corporate bonds; and 6% municipal student loan corporation auction-rate securities. The average duration is 8-9 months. As a result, their investment income will be tiny in 2009, but they will not have the write-offs that some other managed care companies have and will have.

In addition, last week Amerigroup modified its senior credit agreement to allow for increased stock repurchases, convertible debt repurchases, and larger acquisitions.

RISKS:

- Headline risk: Governors will make a lot of headlines (especially early in 2009) about how bad the fiscal conditions are in their states. However, if the federal government bails out Citi, they will bail out the states too. There is a concern that some of the states will cut across the board given the nature of their budget problems, but a 2002 law requires Medicaid managed care rates to be “actuarially sound”, and states know that plans will withdraw from states if rates are not economically viable.

- Group risk: At times, Amerigroup trades with the rest of the managed care space, even if there are issues that have nothing to do with Amerigroup. Sometimes it trades in sympathy with other Medicaid managed care companies, even if their issues are in states where Amerigroup doesn’t operate. Group balance sheet concerns have also impacted the stock, despite the fact that Amerigroup has the most conservative balance sheet of them all.

- Execution risk: Amerigroup has to manage health expenses well because with slim margins, it doesn’t have a lot of room for error.-

- Compliance risk: Medicaid managed care companies are scrutinized heavily by the states and have sometimes run into trouble. This happened to Amerigroup under previous management in 2002 in Illinois and Wellcare last year in Florida.

- Kucinich risk: Some people are under the impression that Democrats will move to a nationalized healthcare system, controlled by the government (proposed by Dennis Kucinich, Democratic Representative from Cleveland). I think there is as likely a chance of this happening as Kucinich’s standing in the New Hampshire Democratic primary: 1.4%.

Catalyst

• Obama stimulus package in early 2009.

• Additional state expansion of Medicaid managed care programs.

• Announcement of larger stock buyback or open-market convertible debt repurchases.

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			2008	2009
Price:	27.59	EPS
Shares Out. (in M):	0	P/E
Market Cap (in $M):	1,460	P/FCF
Net Debt (in $M):	0	EBIT	0	0
TEV (in $M):	0	TEV/EBIT