Here is one of the Motley Fool stock picks for 2007: if folks are interested i will post more.
Healthy Growth at a Value Price
By Tom Gardner (tomg@fool.com) With writing and research assistance from Bill Barker (bbarker@fool.com)
Inv est ment Summary
Earlier this year, I concluded that the health-care insurance industry was being
unfairly beaten down. One great company after another had seen its stock
shaved back 10% to 30% in a matter of weeks. These are the kinds of situations
that make the investor in me salivate.
And so I’ve decided to recommend Coventry Health Care
(NYSE: CVH). I
believe it’s the most promising stock in what looks to me to be a very promising
industry for the next decade or more. The stock is attractively priced,
having tumbled more than 20% so far this year, and is now trailing the
market’s returns by about 30%. If I didn’t love the business, if I didn’t believe
in the management team, and if the company’s financial foundation were not
strong, I wouldn’t be recommending this stock when the market seems to fear
it. I oppose investing in companies that are truly struggling, have shady managers,
or sport suspect financials. This company has none of those and I think it’s
poised to deliver substantial returns.
Corporat e Facts
A national managed health-care company, Coventry Health Care was founded in
1986. It operates health plans under the names Coventry Health Care, Coventry
Health and Life, Carelink Health Plans, Group Health Plan, HealthAmerica,
HealthAssurance, HealthCare USA, Southern Health, and WellPath.
At the helm of this business is an outstanding leadership group built largely
by promotions from within. In 2005, longstanding CEO Allen Wise turned the
reins over to Dale Wolf, who previously served as the company’s CFO. COO
Thomas McDonough (formerly the CEO of a UnitedHealth (NYSE: UNH)
subsidiary) took responsibility for First Health. I have the utmost confidence in
this team.
For the past 20 years, the company has built its business in 17 small- to mid-size
metropolitan areas, mostly in the mid-Atlantic and Southeast, specializing in
serving mid-sized employers. In October 2004, Coventry made its biggest acquisition
by far, paying $1.8 billion in cash and stock for First Health Group, which
immediately made the company a national player. Wall Street hated the idea,
and the stock fell 11% on news of the deal. That’s not entirely without reason
— mergers of this size usually don’t work out as smoothly as the two partners to
the dance hope. In this case, however, the integration has gone quite smoothly
and in the two years since the merger announcement, shares are up 60%.
Let’s look at the business, starting with the health-plans group. This unit generates
a little more than $5.8 billion in revenue, primarily by serving 1.5 million
commercial risk members, including ambulatory and inpatient physician services,
hospitalization, pharmacy, mental health, and ancillary diagnostic and
therapeutic services. The second unit, First Health, concentrates on administrative-
only services, and generated around $812 million in sales last year
by providing coverage for state and federal employees and
offering workers’ compensation insurance.
Additional future growth will come in part from expanded
Medicare payments as the Part D Prescription Drug Plan
rolls out additional payments. Coventry is one of only
10 national providers currently authorized under the
program, though that list will expand to 17 for 2007. As
of September, Coventry had more than 650,000 members,
making it the sixth-largest in the country in terms of
members signed up to Part D. While this is certainly promising,
Coventry is competing against some very big players.
Inv est ment Thesis
Over the past three years, Coventry Health Care has compounded
23% sales growth and 43% earnings per share
growth through organic growth and acquisitions. How does
it generate such profits and what does management do
with all that cash? The answer lies in a single passage in its
last 10-K filing, which says so much about why I love this
organization:
We generate cash through operations. As a profitable
company in an industry that is not capital-equipment
intensive, we have not needed to use financing
methods to fund operations. While we did incur debt
in 2005 ... the entire proceeds were used to finance an
acquisition and were not used to fund operations. Our
primary use of cash is to pay medical claims. Any excess
cash has historically been used for acquisitions and for
repurchases of our common stock.
First Health was the company’s biggest acquisition, but
Coventry didn’t stop there. It acquired Provider Synergies,
an Ohio-based manager of preferred drug lists that negotiates
drug rebates on behalf of both commercial and governmental
clients, in a deal that closed on Jan. 1, 2006.
After repurchasing 3 million shares in 2004, Coventry
bought back virtually no shares in 2005, but stepped back
up to take advantage of this year’s lower prices. Thus far
this year the company has bought back about 4 million
shares, reducing share count by about 2%. The board has
cleared the executive team to purchase an additional 6.2
million shares — or 4% of the company — at its discretion.
But what about that debt from the First Health acquisition?
Well today, Coventry has $2.4 billion in cash and investments
alongside $750 million of debt (again, all from its
acquisition). And over the past 12 months, Coventry generated
around $530 million of owner earnings (excess cash
not needed in the operations of the business). Present debt
levels are no problem at all as operating income is well in
excess of interest expense. This is a business with a strong
financial position, backed by a commitment to serving
outside shareholders through stock buybacks.
Valuati on
Analysts are expecting 15% profit growth per year over
the next five years. I believe that’s a bit optimistic, even
considering the company’s strong historical results, and
I’d encourage you to keep your expectations a bit lower. I
expect annual growth of 13% to 14%, which would yield a
total valuation of around $20 billion by the close of 2011,
assuming the company keeps its share count more or less
even over those five years. Currently, the company is valued
at about $7.2 billion, so if I’m correct, we’ll enjoy 22%
annual returns from here. This is made possible by the fact
that the company is valued at less than 12 times next year’s
earnings, a surprisingly low multiple for a business that has
been growing its earnings as rapidly as this one.
It is possible that at today’s prices, Coventry could continue
to sink a lot of money into share repurchases, which would
keep the total market cap lower, but would produce the
same type of rewards to shareholders. I do not foresee the
company starting any dividend payments.
Ris ks
In this industry, there is always the risk of new government
regulations. But I feel this fear is overblown. Coventry generates
less than $0.08 in profit on every dollar of sales. The
much more likely target has always been the pharmaceuticals
business, where the major players routinely earn $0.15
to $0.20 on every dollar of sales.
Beyond the hypothetical political troubles, the company
faces some existing legal troubles. Coventry, along with
plenty of other players in the field, has been named in a
class action suit brought by doctors. Other major players,
Cigna and Aetna (NYSE: AET), have settled out of the case
to the tune of more than $500 million each. Coventry is
only about half the size of Cigna and one-third the size of
Aetna, so its ultimate liability will likely be less.
The other primary risk I see is further consolidation in this
industry. As a smaller player, Coventry could certainly be
acquired in the next five years. If so, I hope it comes at a
price very rewarding for outside shareholders.
Cata lysts
Catalysts for the stock include successful integration of First
Health leading to higher margins and increased earnings
guidance, further share buybacks, successful completion of
the litigation pending against the company, and continued
expansion of the Medicare Part D program.
The acquisition of First Health made Coventry a truly
national company, and with that reach, the company has
begun to realize some economy of scale. However, successfully
implementing a merger of this size is not easy. Witness the troubles that Legg Mason (NYSE: LM) has had since
acquiring the asset management assets of Citigroup (NYSE:
C) and the ongoing destruction that it has wrought on
Legg Mason’s share price. Large mergers are more often
value destroyers than value producers, and I believe that
Coventry’s price is being held down by lingering worry over
the First Health acquisition. So far, all seems to be going
well and if that continues, the value of the company should
become more apparent.
I don’t think that providing earnings guidance is a good
use of management’s time, as it sets up a short-term framework
for looking at the success or failure of the company.
Nevertheless, management of Coventry does provide earnings
guidance, and if it increases that guidance, the stock
price will likely see a boost.
The stock price could also benefit from increased share
repurchases. In the second quarter of the year, Coventry
spent $207 million to reacquire 3.6 million of its shares.
Fully implementing the current authorization to buy back
another 6.2 million shares would boost earnings per share
and signal management’s confidence in the company to
the market. With the share price below where it was for
most of the second quarter, the opportunity for a major
share buyback remains.
If the litigation mentioned above is resolved without a
major payout by Coventry, that would also add a little juice
to the stock. Finally, there is the Mediare Part D program.
It’s still too soon to predict how much it will benefit
Coventry and the other national providers in the program.
Certainly, the lower margins that come from the Part D
business make it a bit of a risk. Still, if the benefits exceed
current expectations, that will be good for the stock.
Sellin g Crit eria
Coventry is well positioned in an industry that has very
favorable long-term demographic trends to support it.
Earnings growth has been very strong and consistent,
achieved through growing the business internally as well
as making smart acquisitions. But earnings growth has
outpaced even revenue growth in recent years, as the
company has seen a very favorable pricing environment.
Management has taken full advantage of all of this to
create a resounding business success.
At the core of all of that is one crucial factor that has made
the company a success in its field — discipline. This is a
business that has grown revenues more than 20% annually
for the past five years, but attempting to keep up that
pace could tempt the company to enter policies that it
shouldn’t. As Warren Buffett has written many times about
his company’s efforts in the insurance business, anyone can
come in and collect a lot of business simply by undercutting the competition, but that will ultimately lead to disaster.
When the competition is selling policies at prices that
are sure to produce losses, you have to have the discipline
to pull back the reins and let others damage themselves.
So if you see Coventry pursuing revenue growth and enrollment
numbers to the exclusion of commensurate earnings
growth, look out. This could take the form of a too pricey
acquisition or a sector-wide loss of discipline in underwriting.
Keep an eye on margins at all times.
If you suspect accounting irregularities or other actions
that put management’s interests above shareholders’,
tread carefully. Fellow managed health-care company
UnitedHealth was forced to get rid of its CEO recently
because of his role in backdating options. While Coventry’s
management is extremely well compensated (CEO Dale
Wolf pulled down more than $6 million last year) and
options compensation does form a chunk of his package,
there is no hint of any problems with the way the options
have been handled.
Additionally, the current political and legal environment is
favorable for Coventry. However, with a new mix of power in
Congress following the 2006 elections, and changes in the
administrative branch certain to occur in 2008, there could
well be a negative effect on the profitability of health-care
companies. That’s a threat that has more often led to temporary
investment opportunities than actual catastrophe,
but it is something to note. It would take a dramatic change
in the political landscape to make me consider selling.
Finally, the integration of First Health into Coventry’s operations
continues. Should we find out down the road that
the company is simply not able to integrate the operations
appropriately, I would consider selling.
For the most part though, I recommend making this a buy
and hold stock, one to follow for decades to come.
The Foolis h Bott om Lin e
Coventry has successfully grown from a regional insurer
to a national one while rewarding long-term shareholders
many times over. It operates in an industry that has
a tremendous future as long as political movements do
not interfere. Though it has been a fast grower of late,
Coventry still has tremendous opportunities in front of
it. A potential triple over the next five years, it’s currently
trading for less than 12 times next year’s expected earnings.
I think the stock is going to be very rewarding to
shareholders in the future, just as it has been in the past.
Tom Gardner does not own shares of any company mentioned in
this article. Bill Barker owns shares of Legg Mason, but no other
company mentioned.
Coventry H ealth Ca re
Ticker: NYSE: CVH
www.cvty.com
Address: 6705 Rockledge Drive, Suite 900
Bethesda, MD 20817
Phone: 301-581-0600
financial s naps hot
(All figures in millions, except share price)
Share Price: . . . . . . . . . . . . . . . . . . . . . . . $45.96
Shares Outstanding: . . . . . . . . . . . . . . . . . . . 159.4
Market Cap: . . . . . . . . . . . . . . . . . . . . $7,300
Cash: . . . . . . . . . . . . $1,410
Debt: . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $760.5
Enterprise Value: . . . . . . . . . $6,490
(Current as of 11/08/06)
