Centene Corporation: An Undervalued Growth Stock

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About: Centene Corporation (CNC)
by: Kurt Pollet
Summary

Centene Corporation is an expanding company with sustainable growth expected for 2019.

The company is undervalued based on its earnings potential.

Centene Corporation has the potential for significant capital gains.

Introduction

Centene Corporation (CNC) is a growth company which primarily focuses on government-backed health insurance plans.

The company has a history of growth with a slower but more sustainable growth expected for 2019. The stock is undervalued after the recent market decline, but there are some risks investors need to consider.

Earnings growth has slowed and the company does operate with a fairly low operating margin (profit to sales ratio). Also Centene Corporation's earnings would be reduced if the currently suspended ObamaCare Affordable Care Act is reinstated.

Financials

Centene Corporation has reported financial results for the third quarter of 2018 (data from Seeking Alpha and Yahoo).

The company's earnings were up 54 percent and its revenue up 36 percent from the third quarter of 2017. Historically, from 2013 to 2017 Centene Corporation's revenue has grown 41 percent per year and its earnings have increased by 47 percent per year.

The return on equity is fair at 10 percent and the operating margin (profit to sales ratio) is quite low at 1.7 percent.

The company's book value is currently around $52 and with a stock price of $112 Centene Corporation is trading at 2.2x book value.

The analysts' consensus forecast for 2019 is $60.0 billion in revenue and earnings of $8.38 per share (up 17 percent and 19 percent respectively). The 2019 PE ratio is 13x.

Centene Corporation does have a solid history of growth; however this growth is expected to slow through 2019.

According to Bloomberg, Michael Frederic Neidorff, Chairman & Chief Executive Officer has stated that the company will continue to seek out and make acquisitions of any size.

In my opinion this may well be an attempt by the company to bolster it's earnings as growth seems to be slowing. To see how effective this strategy is I will have to wait for the 2019 earnings results. Over the last year Centene Corporation has successfully integrated its last acquisition - Fidelis Care - as evident with a rise in third quarter earnings of 54 percent.

The Affordable Care Act

The Trump administration has suspended the ObamaCare Affordable Care Act. This program plays a key role in the health insurance market, a move that will affect the earnings of insurers depending on the health of their clients.

The Affordable Care Act's risk adjustment program tells insurers with relatively healthy clients to hand over some of their premiums to health plans with relatively unhealthy clients.

The basic idea under the Affordable Care Act was that people with pre-existing conditions could obtain affordable health insurance. This in effect meant that insurers who offered health coverage to people with pre-existing conditions would receive a payment from the premiums of health coverage plans from healthy people.

Now since most large insurers were more reluctant to insure pre-existing conditions, under the Affordable Care Act this enticed the smaller insurers to take on these pre-existing conditions as they would be effectively compensated.

The suspension of the Affordable Care Act will tend to benefit the larger companies and put pressure on the smaller companies as they will no longer be effectively compensated for taking on the pre-existing conditions clients.

Centene Corporation is a large-cap $23 billion dollar company that is on a mission to acquire any company it can find. In my opinion the suspension of the Affordable Care Act will benefit Centene Corporation. The smaller insurers will find it more difficult to operate profitably, which means that their valuation drops and thereby making a takeover bid from Centene Corporation more attractive.

Earnings Risks

Suspension of the Affordable Care Act does pose some risk to Centene Corporation.

While the suspension is profitable to the company, the suspension is just that - a suspension. If the Trump administration lifts the suspension and resumes the Affordable Care Act then Centene Corporation will take an earnings hit (due to the additional costs of having to pay over a percentage of their health care premiums).

According to Investors Business Daily, the risk-adjustment for 2018 was $1.1 billion and considering its forecast profit is around $1.7 billion in 2019, the company's profit could take a decent hit.

As earnings are already forecast for slower growth, any further decline in earnings is not something that I would want to see. Slower growth means that the stock's valuation would fall.

Another risk is highlighted in the financials. Centene Corporation's operating margin (profit to sales ratio) is quite low at only 1.7 percent. This means that the company's operating costs are 98.3 percent of its revenue. There's not much room for operating costs to increase before the company becomes unprofitable.

Given that revenue is forecast at a lower growth rate for 2019, if operating costs increase then earnings could become negative.

Stock Valuation

Having established that Centene Corporation is a growth stock I will now take a look at what those shares are worth. I will use the PEG (PE divided by the earnings growth rate) as this is an accepted method for valuing growth stocks.

The historical earnings growth using reported data from 2013 to 2017 is 47 percent per year, and the forward annual earnings growth using forecast data is 19 percent for 2019.

Given that earnings growth may be slowing, using the lower 2019 annual earnings growth of 19 percent will lead to a more conservative valuation and this lower growth rate is more likely to be sustained into the future. This gives a forward PEG of 0.7 with a 2019 PE of 13x.

A forward PEG of 0.7 means that Centene Corporation is undervalued with a current stock price of $112. It is commonly accepted that a stock is fairly valued when its forward PEG is 1.0 which gives Centene Corporation a fair value stock price of around $160.

Stock Price Target

As an active investor I personally like to determine some likely price targets.

As a growth company the stock price could increase at the rate of its earnings growth rate. Given that the 2019 earnings growth rate is 19 percent the stock price could increase by that amount over the next year. The current stock price is $112 and in 12 months the stock price could be around $130.

However, the stock has pulled back with the PEG valuation currently at 0.7 and with a fair value PEG of 1.0 the stock price could be 19 percent above the current fair value of $160. This gives a 12 month price target of $190.

Stock Price Risks

The stock price has pulled back 23 percent from its record high of $146 down to $112 over the last two months. This pullback coincides with the pullback in the broader market indices.

While the stock is undervalued at present, this can change if future earnings growth slows or stops. The forecast earnings growth is less than its five year historical growth rate and if future earnings fall short of forecasts this will increase the PEG valuation. This can potentially make Centene Corporation expensive.

The broader market also poses a risk. The market indices have been trending upwards with a bull market that began in 2009. These market indices have currently pulled back from their highs and it's always possible that this is the start a bear market.

Also, the stock's pullback may not yet have bottomed and the stock price could fall some more. Investors would need to be prepared as the stock price could fall some more before bottoming out. Over the longer term I would expect the stock price to fully recover and continue higher in line with Centene Corporation's future growth potential.

Conclusion

Centene Corporation is a growth company that's undervalued based on its earnings potential. While the 2019 growth rate is less than its historical growth rate, this lower growth rate is more likely to be sustained into the future.

Even with the lower growth rate Centene Corporation is still undervalued, but there are some risks to its earnings. The company does operate with a fairly low operating margin (profit to sales ratio). Also earnings would be reduced if the Affordable Care Act suspension is lifted.

While Centene Corporation does pose a higher level of risk I still think the stock would make a sound long-term investment with potential for significant capital gains.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.