Description

This has been bandied about on VIC before but now it looks like a pretty good entry point. If they hadn't flubbed the call last week, the stock would have been at +$12 but it fell instead...

Description:

eHealth Inc is a digital health insurance broker that has an online marketplace platform that assists with consumer engagement, education, and ultimately health insurance enrollment for major carriers in the US. The business focuses on Medicare, IFP and Small Business plans but the largest tailwind across the industry is the 10k seniors aging into the eligible cohort for Medicare Advantage on a daily basis that is expected to continue to 2040. One of the value propositions the business focuses on for the Medicare Advantage plans is their large online presence (compared to SLQT/GOCO two other listed peers) at online submission rates at 60% and +20% unassisted; however, the industry is broadly commoditized with largely still being tele-sales driven given the customer cohorts are seniors. Long term proposition is that aging seniors will be more digitally proficient for newer cohorts as time passes and EHTH has a lead.

Synopsis:

EHTH was classified as an un-investable stock in an un-investable industry on top of a Muddy Waters short report calling out the low-quality earnings due to the combination of ASC606 adoption (mandatory) and abusing its constraints with aggressive growth tactics given the business model. The business is now in process of turning around with new management, reversing bad growth policies, and industry players behaving more disciplined which will lead to the stock stabilizing back to normalized churn levels that could imply +100% upside opportunity protected by a floor valuation driven simply by the commissions receivables liquidation value higher than current market cap and fair at current prices with further conservatism applied.

Why is it cheap:

EHTH and industry peers (SLQT/GOCO) engaged in a lose-lose prisoners' dilemma of competing aggressively with Direct TV advertisements for Medicare Advantage plans with no consideration of plan matching for seniors along with doubling of external and internal contact centers post-2018 ASC606 adoption to drive an aggressive growth at all cost strategy to promote the stock to a high of $150/share vs current price at $9/share.

To keep it succinct, Muddy Waters came out with a short report in April 2020 calling out the industry bad practice across digital brokers competing to the death on growth at all costs post-ASC606 adoption along with the promotional nature of old management for the stock that led to the stock crashing down as the report came in conjunction with subsequent churn numbers at +50% which proved MW correct and crashed the stock down to a low of ~$2.70/share from a high of ~$150/share as this implies the business model is broken.

Context:

Single sentence to summarize the problem is realized churn way higher than implied churn used by actuarial models based on historical pre-ASC606 for industry players (EHTH/SLQT/GOCO) as aggressively acquired new member cohorts had implicitly higher churn than assumed by ASC606 adopted revenue models.

ASC606 adoption requires revenue needs to be booked for the services provided with an estimate of commissions to be collected, which in the case for digital brokers is the service of sale of the plan which is completed as soon as the plan is approved; however, they receive commissions for each year they stay on the plan that leads to digital brokers needing to estimate policy life of the plan which they sold they intend to receive commissions for. (Approximately $510 first year and $255 each subsequent year a member stays on plan -> we'll come back to this for valuation.)

Pre-ASC606, churn was at mid-30% implying a policy life of 3 years. Hence, post-ASC606 adoption, revenue is recognized for each member plan sale to be 3 years' worth of commissions. However, the aggressive direct TV ads and final-sale incentivized + aggressively expanded telesales teams drove MA plan growth at all cost that led to pulled forward revenue stack growth that led to a sky-high revenue growth along with sales multiples driven rerate that shot the stock to the moon. Once churn caught up as these were super low quality member sales given they were low-income seniors watching TV jumping on board for free dental checks only to realize they're not covered in the local network, out-of-pocket expenses blow out for them more than expected due to plan-mismatch led to supercharged churn that was +50% which implies policy life is less than 2 years. This creates a cash collection/earnings quality problem that derailed the whole growth train.

Once market caught onto this reality, the LTV/CAC completely broke down as the ratio implied less than <1 which makes the flywheel un-investable. It's similar to asking for a capital raise on an asset with negative NPV or ROIC

What is it the opportunity:

Given the disaster above, why is this an opportunity?

Firstly, the old management that drove the growth bonanza have left and is replaced by new CEO Fran Soistman who was an ex-EVP at CVS Health, President at Aetna, founding Jessamine Healthcare and four decades experience in the industry. A boots-on-floor guy with goal of fixing the broken flywheel with profitability, earnings quality, and fixing churn as key focus.

Ever since Frans has joined in November 2021, churn has changed direction and given the seasonality of AEP/OEP being 4Q/1Q weighted, the proof of the business model being fixed has been only most recently shown in the latest 4Q22 although the direction of churn has changed from 4Q21.

Chart below shows TTM churn calculated using MW's method which is simply how you would calculate a SaaS business customer churn which is logical than company provided calculation which cushions the churn by having a beginning period-weighted cushioned denominator. Clearly, the TTM churn is fixing and the red-line being 1-year moving average both trending down back below 50% and with goal to bring it back down to sub-40% which would imply a policy life back to 3 years. Implied policy life = 1/TTM_churn. Top right chart shows MA policy margin where (MA LTV - MA TTM CAC)/MA LTV)) is the formula clearly inflecting back to pre-2018 which is proving the business model is fixing itself in conjunction with churn. Most recent AEP season and EHTH's plan approval rating improvement, conversion improvement, policy margin improvement along with churn improvement GIVEN cost-base reduction is showing that the business model is fixing back to the right direction.

Calculation method below:

TTM churn is calculated by TTM churn divided by AVERAGE 4 QUARTER MA member.

TTM churn is calculated by Ending – Start – New = Churn (now add the last 4 quarters of this).

Using implied policy life of 1/TTM_Churn simplifies everything and we calculate our own LTV by the following (more details in valuation section):

LTV = $510 + $255 * (implied_policy_life - 1)

Where, implied_policy_life = 1/TTM_Churn

Business model is fixing up:

• TTM CAC in top right chart above is now below 2018 levels with trend continuing down. Medicare variable marketing costs for 4Q22 and FY22 is $67.5m and 162.8m respectively which is 37.4% and 45% of Medicare revenue. This is a significant improvement from 4Q21 and FY21 where the Medicare variable marketing costs as % of Medicare revenue is 53.4% and 49.9% of Medicare revenue. Pre-2018 was at mid to high 20s % hence there are some more improvements to go.
• Fixed marketing costs kept broadly flat at low to mid $20m since 2019 hence no further expansions here.
• Ultimately, churn is what ultimately needs to fix itself and this is shown in the bottom left chart above trending down at TTM levels of 48.2% as at 4Q22 vs 52.4% in 4Q21 and 58.7% in 4Q20. This has more room to improve to sub-40%. Pre-2018, 4Q17 TTM churn for Medicare Advantage was 36.9% pre-ASC606 adoption.
• Bottom right chart above shows the MA policy margin improving back to pre-2018 levels showing that the flywheel is on its way to work again. This will fix if churn is back down below 40% and CAC is kept flat.
• 4Q22 was an impressive result given EHTH reduced approved member growth by 26% yet achieved policy margin improvement to 30% vs (3%) in 4Q21.

Additional support to the opportunity:

• CEO bought 80k shares at $3.05 in November showing further confidence and they have an investor day in May 2023 to further outline strategic direction of company.
• Two other listed industry players who faced same issues, SLQT and GOCO, are also plugging their costs and have messaged markets with a focus on plan-matching and profitability which normalizes the post-ASC606 environment back to reasonable competition given the industry itself is an expanding pie.
• Last earnings call for 4Q22, a comment by the CEO on a leading question on liquidity got misinterpreted as needing a capital raise when the business obviously has sufficient liquidity where their commissions receivable balance at +$884m alone covers +3x the market cap led to an instant stock drop of 14% during the day. It has since recovered but this now leaves a solid opportunity to jump in given the stock opened 9% up as a nice trading cushion.

Valuation:

The valuation will be conservative hence the assumptions are dialed down and no growth is assumed from here. Two methods to be considered -> When the business flywheel is fixed and liquidation value of commissions receivable. Medicare Advantage (MA) drivers will only be considered for LTV hence we can assume IFP/Small Business/Medicare D business to be free for additional conservatism although management will focus on driving these businesses for growth as well.

Method below assumes the valuation given LTV/CAC flywheel works and assuming no member growth from here what the business should be worth given the existing unit economics. Given new management was able to plug costs already as at 4Q22 by 38% YoY, the valuation will use TTM marketing + customer care and enrollment (cc&e) expense per Average TTM MA member hence [a] will use this figure consistently across bear, base bull case.

[b] is the LTV calculated using input churn % to arrive at an implied policy life to determine our own LTV calculation instead of company provided numbers. The calculation is simple. The commissions received for an approved MA member that stays on for first year is approximately $510 then $255 subsequently each year the member stays on policy. Hence, the calculation for LTV becomes LTV = $510 + $255*(1/churn-1).

The key input driver here is CHURN.

Bear assumes 60% which was the worst of the bad acting period when low-income, poorly plan-matched, high-churn seniors were the majority of the incoming member cohorts.

Base assumes current TTM churn using MW method.

Bull assumes pre-2018 churn levels before ASC606 adoption and aggressive advertising.

Multiples are kept flat at 3x but given the industry's continued growth and assuming industry players act disciplined, it could rate higher although a discount is warranted given the commoditized nature of the business.

Assuming above, the upside looks attractive with +70% upside for base and ~400% upside for bull case if multiples rerate and churn is fixed. Very squishy numbers here but these are the numbers given we assume no value for Supplements and IFP business along with no growth assumed. If they can fix churn back to pre-2018 levels, grow Supplements and IFP whilst keeping costs reasonably flat, then this could definitely be a multi-bagger. 3-5x EBIT multiples is already a significant discount for a profitable unit economics business.

Current share price is protected by a liquidation value of the business given the commissions receivable itself has a book value of $884m which is +1.8x the current market cap at $248m or in share price terms, the book value of commissions receivables is $25.38/share after net debt and preferred.

However, given the commissions receivables are booked with company's LTV calculations and churn models we can give it additional discount adjustment on top of this figure for margin of safety.

Another reason why these numbers are very conservative is that most of the bad cohorts have churned out. Usually, members find out that the plan is not a match for them within the first year given out-of-pocket expenses blowing out more than expected, network not available in their locality, and benefits not applicable given their locality. Hence, given the discipline in plan-matching seniors put into practice since late 2021, it is less likely to see churn spike back to 60% which means that it is more likely the churn numbers revert to the bull case than stay at base or relapse to the bear case churn.

Conclusion:

Business turnaround with new management fixing a broken flywheel previously driven by aggressive but destructive growth practices post-ASC606 adoption by industry players. The drivers of these bad practices have been reverted now with focus on reducing churn, keeping costs low, and keeping disciplined across industry peers to continue growing in a structurally growing Medicare Advantage industry growth trend to last next two decades.

Given churn is fixing up in the right direction, EHTH has an upside of 70% assuming no growth and no value to IFP/Supplements business and a bull case that can be a multi-bagger opportunity assuming the current turnaround trend continues. The risk profile of this business is usually high given the commoditized competitive environment; however, the current stock price is well insulated by a liquidation value of commissions receivable in the books of EHTH that is still fair at current prices assuming further churn adjustment applied to the book value which is highly conservative given the persistency curve of members' retention. This is a multi-bagger opportunity if it flips heads; and it's fair if it flips tails.

Risks:

Industry peers (SLQT/GOCO) along with EHTH reengage in hyper aggressive growth practices incentivizing growth at all costs strategy again which would lead to bad plan-matching and spiking churn again which would derail the business model as before leading the stock price collapse as the business flywheel completely derails in a hyper competitive industry.

Catalyst

Catalysts:

• Management has indicated an investor day mid-2023 to provide further longer-term strategic guidance which will give clearer roadmap to future unit economics.
• 2Q23-3Q23 OEP numbers showing proof of further churn improvement