January 04, 2011 - 11:25am EST by
2011 2012
Price: 14.25 EPS $0.66 $0.44
Shares Out. (in M): 22 P/E 21.6x 32.4x
Market Cap (in $M): 316 P/FCF 19.8x 35.1x
Net Debt (in $M): -153 EBIT 28 16
TEV ($): 163 TEV/EBIT 5.8x 10.2x
Borrow Cost: NA

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EHTH is facing a severe crisis that began on January 1, 2011.  The company is the nations largest broker of individual health insurance policies.  Over the trailing four quarters, approximately 80% of its revenue base has come from commissions on the sale of individual health insurance policies. As a consequence of the stipulations of The Patient Protection and Affordable Care Act, the commission rate for these policies will drop by 35-50% starting on January 1st, 2011.  After several months of uncertainty, the magnitude of these cuts is no longer in doubt.  Over the last few weeks major insurance carriers have sent out communications to brokers describing these new commissions.  This will have an immediate and severe negative impact on the core business of EHTH.   Analysts have significantly underestimated the magnitude of the cuts.  The company has remained oddly silent on the topic.  We project that shares should drop from $14 to $10 when the impact becomes clearly known.

  2009 2010E 2011E 2012E
Commission Revenue 119 129 102 95
Other Revenue 16 24 32 38
Total Revenue 135 151 134 133
EBITDA 29 28 16 10
Analyst Mean Est: Revs     162 167
Analyst Mean Est: EBITDA     33 31

The Business: EHealthInsurance is the largest online health insurance broker, matching individuals seeking health insurance with insurers (in many ways they are analogous to an online travel agent such as Expedia).  Commissions are earned for as long as a policy is in effect, often multiple years.  Commission rates for the first year are approximately 16% of premium collected (this occurs on a monthly basis) and then drop to roughly 6% for the remaining duration of the policy.  Churn rates are high for EHTH, with 10-12% of the customers leaving each quarter.  This is because many individuals seek this coverage as a short-term alternative when they are between jobs.  The company acquires customers in three primary ways.  The first is "direct", or individuals that arrive at the website through non-paid search.  The second is through "partners", third-party companies that EHTH pays for qualified leads.  The third is through paid search, where customers end up at the site via a paid search recommendation from Google and similar.

The MLR Problem: One major stipulation of the government legislation is the establishment of Medical Loss Ratio levels (MLR's) for the individual health insurance market.  Insurers must, by law, maintain an 80% MLR, paying out 80% of all premiums earned towards the provision of health care.  This leaves 20% of premiums for insurers to pay ALL other expenses, including broker commissions, and for profit.  Clearly, this makes it economically impossible to give 15-20% of first year premiums  to brokers.  Throughout much of 2010, the brokerage community and lobbyists attempted to avert this severe problem by having commissions treated as a pass-thru.  A special committee, made up of a number of state insurance commissioners was assembled to convene on the topic.  On November 22, 2010, the committee rejected this proposal. The following week, major health insurance carriers began sending communications to their brokers, describing the upcoming drastic cuts in commissions.  Here are some examples (for EHTH's three largest customers):

  Cut in 1st yr Cut in 2nd yr % of EHTH 2009
Carrier Commissions Commissions Revenue
Aetna -50% -43% 16%
Anthem (Wellpoint) -30% -40% 14%
United Health Care -50% -40% 15%
Sources: conversations with multiple brokers, insurers, and online forums such as

These cuts began January 1, 2011.  This is an immediate and massive hit to what constitutes 80% of the company's revenue base. Essentially prices for the company's product are suddenly being sliced by 30%-50%.  In some cases the cuts also apply retroactively to policies signed as of July 1, 2010.  Other existing policies will be 'grandfathered' under old commission rates, which will phase in the impact to EHTH over 2 fiscal years.  When asked about the potential for commission cuts on their October 26, 2010 Q3 conference call, the company replied with the following:

"The discussions we've had ... are not highly definitive because the regulations haven't been released yet. ... until we see those regulations, it's unknown."

While this is clearly no longer the case, neither the company, nor the majority of sell side analysts have updated their commentary on this critical issue.

The Cost of Marketing Problem: Complicating matters further is the fact that under the new commission rates, customer acquisition via paid online search will no longer be profitable for EHTH unless keyword search rates decrease significantly.  This channel accounted for 28% of new EHTH customer applications in the most recent year.  It is possible that keyword rates will drop significantly, and the company believes they will, but our research suggests this is not certain.  For example, insurers could step-up their own online direct efforts.  Also, government-sponsored entities (such as have recently stepped up their paid search efforts.

The Inadequate Backup Plan: EHTH has very recently attempted to expand into two additional related areas.  The first is Medicare, through the acquisition of PlanPrescriber in 2010.  Currently this is not a broker commission-based business, but merely a lead generating program (though the company plans to shift it to become a brokerage business).  While this business will account for well under 10% of their 2010 revenues (even after extrapolating for the full year), the company has made very optimistic comments regarding its growth potential.  The second area is state exchanges, where EHTH will construct the websites for state and federal government entities to help consumers navigate health care options.  This is currently a straight pay-for-service fee model that appears to have limited profit margin potential.  It is an RFP business where contracts are awarded to the lowest cost bidder.  The company has discussed making this into a commission based business going forward but it is too early to tell whether this will be the case.

The Valuation: There is little doubt that the "business-as-usual" which EHTH has known since its inception will be abruptly and severely compromised starting January 1st, 2011.  The future profitability of the core business is unclear.   Somehow the Street is not accounting for this.  EBITDA forecasts for 2011 make absolutely no sense - they are higher for 2011 than for 2010.  At current prices, the stock is trading at roughly 8x 2010 EV/EBITDA but at over 10x our 2011 projections and 13x our 2012 EBITDA projections.

Conclusion: We believe that EHTH, on its Q4 2010 earnings call scheduled for January/February, will provide guidance for 2011 that is dramatically lower than analyst expectations due to the effects of commission rate changes from The Patient Protection and Affordable Care Act.

Short Term Mitigants

  • State waivers: Waivers are being filed in many states to try and put a temporary halt on the implementation of the MLR reforms. This could have the impact of delaying the commission cuts. One industry expert referred to this attempt as a "Hail Mary pass".
  • Cost cutting: It remains to be seen what potential the company has to reduce its cost structure given the new economics. It should be pointed out that while their revenues will drop substantially, the number of customers serviced and the work required to service them will not change.
  • Rise in customers: The commission cuts could put many smaller brokers out of business, increasing the policy growth rate for EHTH above its current trajectory.
  • Rise in premiums: Premium per policy growth for EHTH has typically been approximately 3% per year. (This is well below the growth rate in overall health care premiums because EHTH customers pay out of pocket and thus tend to 'trade down' to higher deductible plans when premiums increase.) The new MLR ratios enacted could spur carriers to try and increase the rate of premium growth in the near future.
  • Successful negotiation with carriers: EHTH management has recently said that, as the country's largest broker in the segment, they hope to negotiate a lower commission cut than the rest of the brokerage community. Industry experts expect any difference to be small.
  • Keyword search price drop: As discussed above, the price for keywords could drop significantly, as players like EHTH can no longer afford to pay historic rates.

 Long Term Mitigants

  • Medicare business growth: EHTH has articulated high hopes for its new Medicare Advantage business. While this is only likely to account for $10-12 million in revenues for 2011, it could grow rapidly.
  • 2014 mandatory coverage: The health care reform stipulates that by 2014 health care coverage will be mandatory for all Americans. This could lead to a significant opportunity for EHTH to gain meaningful numbers of new customers.
  • Online exchange business: Each state is currently setting up an online exchange where citizens can go to find health insurance options. EHTH is actively bidding on the contracts to construct these websites. This could grow into a meaningful revenue stream over the long run.
  • Legislative relief: There remains the possibility that legislative changes further modify the rules regarding individual health insurance and commissions, to the benefit of EHTH.
  • Cash balance: The company has approximately $140 million in cash ($5.78 per share). This should give it time to determine and implement a new course and the company could continue to use the cash to buy back stock, which could offset any weakness.


 January/February Q4 conference call announcement of guidance for 2011 that is dramatically lower than analyst expectations
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