SHARES OF MANAGED-CARE COMPANIES have fallen 18% in the past three months, about 50% more than the Standard & Poor's 500, amid uncertainty surrounding the implementation of health-care reform. The selloff could spell opportunity for intrepid investors, especially in shares of Coventry Health Care, a health insurer whose stock has declined by an even greater 30% since Congress passed the landmark legislation in March.
Behind Coventry's slide are some additional concerns, including the company's ill-advised expansion in recent years into several less profitable businesses, and fears that state regulators will seek to limit price increases in Pennsylvania, one of its largest markets. As a result, shares that fetched north of 60 apiece at the start of 2008 now can be had for 17, or 7.4 times analysts' estimated 2010 earnings of $2.31 a share. That's well below the industry's price/earnings ratio of 8.
Coventry raised its 2010 earnings guidance Friday to $2.75 to $2.90 a share from a prior range of $2.35 to $2.50. The new estimate doesn't include a pretax charge of $1.18 a share it announced the same day, related to its loss of an appeal in a workers'-compensation-insurance case. Using the midpoint of management's new estimate, the stock is selling for only six times earnings.
Dave Shove of BMO Capital Markets doesn't think Coventry's valuation will return to its once-lofty levels. But he rates the stock Outperform, in the belief that price hikes and a better business mix could boost the P/E to 10 to 11. His 32-a-share price target implies a gain of more than 80%.
Based in Bethesda, Md., Coventry operates in 23 regional markets; it served 3.24 million members as of March 31. Its largest business segments are commercial insurance, Medicare and Medicaid. After years of solid earnings growth, the company stumbled badly in 2008, prompting the board to recall long-time CEO Allen Wise, who retired in 2004 but returned early last year in the same capacity.
.Although some investors have criticized Wise's lush $17 million pay package, others applaud his leadership, in particular his knack for buying underperforming health plans and boosting their profitability. Coventry recently acquired Preferred Health Systems, which helped strengthen its Midwest footprint, and last week announced plans to buy Mercy Health Plans, with its strong presence in Missouri and Arkansas. Some have speculated the company itself could become a takeover target. Coventry "stands out because it is the last remaining non-national player that is publicly traded and well run," one money manager told Barron's.
Wise, 67, also has discontinued or sold noncore businesses. The company is dropping its private fee-for-service Medicare Advantage business this year, which will help free up cash for additional acquisitions, stock buybacks and debt reduction. Coventry expects to have $1 billion of "deployable" cash by the middle of 2011, equal to more than a third of its $2.5 billion market value.
Wise likewise is known for his strict attention to costs. Under his guidance, Coventry was able to reduce the medical-loss ratio, or MLR the percentage of premium revenue used for medical costs to 80.2% in this year's first quarter in its commercial group, a decline of 70 basis points, or 0.7%, from the year-ago period. Operating margins jumped to 5.4% in the quarter from 1.8% a year ago, while earnings of $97.3 million, or 66 cents a share, far outstripped analysts' expectations.
BMO's Shove says Coventry has been able to raise prices faster than peers because it had been underpricing policies. He also likes the fact that commercial health insurance represented about half of 2009 revenue of $13.9 billion. Commercial lines could hold up best in the new health-care environment. Regional rivals Humana and Health Net, he notes, are skewed more toward Medicaid and Medicare, especially in tough markets like California.
MEDICARE REPRESENTS ABOUT A THIRD of Coventry's revenue. Medicaid is 10%, and growing. John Stelben, the company's chief financial officer, told a Deutsche Bank conference in May that he sees membership in the commercial business growing by mid-single digits, with a loss ratio of around 82%. He noted Coventry is moving its Medicare business away from low-income regions, while Medicaid looks to be a growth business, with the company recently adding contracts in Pennsylvania and Nebraska.
Under health-care reform, medical-loss ratios are a key concern for companies like Coventry. The new legislation effectively caps profitability at 15% for individual and large group plans, and at 20% for small group plans. But state regulators have yet to identify which expenditures may be considered medical costs. Shove thinks they will soften some restrictions, and that portions of the law might be repealed if Republicans regain control of Congress.
"Managed-care stocks are valued as if the law will be implemented as written," he says. Instead, the shares could get a healthy lift as "reform gets reformed."
The Bottom Line
Price increases and profit growth could help Coventry Health Care earn a higher stock-market valuation, and a share price closer to 32 than today's 17.