Analysis of HealthSpring IPO, Comments on AGP, CNC, MOH, WCG (HS)

Includes: CI, CNC, MOH, WCG
by: Bill Simpson

HealthSpring, Inc. (HS) plans on offering 19.55 million shares (assuming over- allotment) at a range of $16- $18.The company is selling 12 million shares, insiders are selling 7.55 million.

Goldman Sachs, UBS and Citigroup are lead managing the offering. Post- offering HS will have 60.6 million shares outstanding for a market cap mid- range of 1.03 billion. IPO proceeds will be going to pay off all outstanding debt. GTCR Funds are selling 5+ million shares on offering and post- offering GTCR will own 30% of HS. GTCR is a private equity group that has been involved in a number of IPOs the past year or so. Portfolio companies of GTCR coming public recently include PB Holdings/ Coinmach/ Syniverse/ Verifone. PB Holdings was one of the worst performing IPOs of 2005, while Verifone was one of the best.

From the S-1:

"We believe we are one of the largest managed care organizations in the United States whose primary focus is the Medicare Advantage market."

Medicare is a Federally funded health insurance program for those age 65 and over and those qualifying as disabled. Due to the aging US population, The Henry J. Kaiser Family Foundation estimates that the number of Medicare enrollees will increase from 41.7 million in 2005 to 43.1 million in 2006, 46 million by 2010, 61 million by 2020, and 78 million by 2030. The Congressional Budget Office expects Medicare expenditures, without taking into account the new prescription drug benefit, will rise at a compounded annual growth rate of 9.3% the next 10 years.

Medicare Advantage is a Managed Medicare program, a Medicare HMO. HS was formed in Tennessee in September 2000 and currently has Medicare Advantage plans available in Tennessee, Texas, Alabama, and has recently entered Illinois and Mississippi. Their largest markets currently are Nashville, Memphis and Houston and they expect large 2006 growth in the Chicago area.

HS had 102,000 Medicare Advantage members as of December 2005, up from 64,000 members the end of 2004. As only 12- 13% of Medicare recipients are in a Medicare Advantage plans, HS has been able to establish swift growth in their target areas. 80% of growth has been organic and HS feels there is plenty of organic growth possibilities currently in existing states in which they operate.

Medicare Advantage works along the same lines of Medicaid HMOs and traditional HMOs: HS, by covering a large number of people in a geographic area can build cost effective relationships with providers and create efficient use of resources. The idea is to be able to do more for less, utilizing expertise and numbers to create efficiencies and profit margins from finite Medicare premiums. Medicare premiums are fixed annually, so creating cost effective coverage efficiencies is THE key to profitability for a Medicare Advantage plan. By doing so, Medicare Advantage plans can also offer additional benefits to members, thus making them a more enticing choice for Medicare recipients than 'fee based' services. Also HS believes the new Medicare Prescription plan will help drive more fee based beneficiaries to the Medicare Advantage plans.

That's the business model. This is a very similar plan as a number of public companies undertook in the Medicaid space: AMERIGROUP Corporation (AGP), Centene Corporation (CNC), Molina Healthcare, Inc. (MOH), and WellCare Health Plans, Inc. (WCG). There is no current Medicare Advantage public pure- play. WellCare Group, Humana, United Health and PacificCare all have burgeoning Medicare Advantage programs and enrollment. Pretty much all the public HMOs had a very strong bull run from roughly the technology top in 2000 and lasting into 2005. Since than to varying degrees, they have pulled back somewhat. With the aging US population however, longer term trends should remain favorable.

HS believes the 2003 Medicare Modernization Act created a very favorable climate for Medicare Advantage providers by 1) increasing payments for MA plans and 2) changing payments to risk adjustment basis instead of a pure demographic basis. The former resulted in direct payments increases while the latter created potential efficiencies for operators of Medicare Advantage plans. Note that this act has will continue to bring in more competitors into HS sector. Also HS believes this act was the first step in privatizing Medicare plans, meaning the Federal government is steering beneficiaries toward Medicare Advantage plans. Why? In theory Medicare Advantage plans save the Federal Government overall dollars by creating efficiencies in covering more people/ services for the same federal dollars. The profit margins these plans make are sort of their 'bonus' for creating these efficiencies and saving the Federal Government overall dollars. That is in theory and there is not a lack of pundits and experts willing to argue both the pros and cons of privatized Medicare/ Medicaid HMOs.

HS also has a commercial HMO business in Tennessee and Alabama. The commercial business is not a focus going forward however as HS feels growth trends are more appealing in the Medicare Advantage space. HS believes their commercial business will constitute less than 10% of 2006 revenue and a decreasing percentage thereafter.

HS Medicare MLR (medical loss ratio) has been under 79% annually since 2003. This compares very favorably with other public HMOs with Medicare Advantage plans as Humana/ PacificCare/ WellCare all have a higher Medicare loss ratio than HS.

As alluded to above, HS plans to grow through a) organic growth as much of their current covered area still consists of predominantly fee based Medicare beneficiaries; b) expansion to new geographic areas c) providing prescription drug plan coverage and d) acquisitions. A lot of growth engines here and growth has indeed been quite strong for HS: Medicare membership growth percentages are actually accelerating with a 56% membership base growth rate in 2005, coming on the heels of 40% in each of '04 and '03.


We've seen the CMS look to freeze specific Medicare payment rates here recently, this has been in part due to reigning in Federal spending especially in the face of future aging trends. By freezing certain payment levels the CMS is trying to cap payments overall growth rates at the 8- 10% natural newly covered levels going forward. Medicare premium per patient was up 10% for HS in each of '04 and '05. However in December 21, 2005, the U.S. Senate passed legislation that reduces federal funding for Medicare Advantage plans by approximately $6.2 billion over five years. The House has passed similar legislation, it can be assumed that a version will be signed into law at some point in 2006. While it appears the huge number is a bit misleading due to the new Medicare prescription plan, I would definitely not expect HS to experience 10% growth in their Medicare premium per patient in 2006 and beyond. HS is in a good spot to benefit from overall trends and growth should be strong here based on growing enrollments. However operating and net margins may contract a bit due to Medicare Advantage payment freezes. It appears CMS and Congress feel that 10% annual growth in payments per patient to Medicare Advantage plans was just too much. Going forward I would not be surprised at all to see HS Medicare Expense Ratio blip up a bit from the 78% number of past 3 years.


$2 1/2 in cash per share, no debt post- offering.

As mentioned above HS has done a nice job managing expenses and creating efficiencies. Their Medicare MLR (medical loss ratio) of 78- 79% each of the past 3 years is better than competitors in the states HS operates.

HS had a very strong 4th quarter as they've been adding new members at a rapid pace. New Medicare member growth grew over 50% in 2005 and revenue increased 42% from '04 to an estimated $850-$860. SGA has been steady in the 11%-12 1/2% range and in '05 operating profit margin was an estimated 9%.

Net margins after paid off debt and non- recurring expenses were both removed was an estimated 6% in 2005. Earnings per share (with non-recurring expenses removed) should be 80-85 cents for 2005. At mid- range HS will be trading at 21 X's trailing earnings.

Looking at the strong 4th quarter 2005 and factoring in continued strong enrollment growth for HS, I think we'll see HS increase revenue strongly again in 2006: Quite possibly by another 40% to 1.2 billion. With some of the latest Medicare payment freezes, I think we'll see an impact on gross and net margins. Assuming a bit weaker operating and net margins in 2006, HS could do $1 - $1.10 per share in 2006.

They mention quite often throughout prospectus and presentation that they manage business with an eye towards 80% Medicare ratios. If they are able to continue ratios in a tougher Medicare reimbursement climate it is possible earnings could be higher. I'm being conservative on the $1 - $1.10 number as we've seen the Federal Government talk tough lately on Medicare payment increases freezes. Mid-range than HS will be coming public at 16 X's 2006 earnings.

While no pure play public comparable exists, HS reminds me more of WCG than anything else. WCG came public just as they were hitting their stride profitability and while Managed Medicaid plans are WCG's primary revenue source they're really focusing on growing their Medicare Advantage plans. The Medicare Advantage focus has helped them maintain their multiple/ earnings while other Medicaid focused public companies MOH/ AGP/ CNC got hit pretty hard. Also Humana runs a large Medicare Advantage plan in, a growth target of HS. While not direct 'apples to apples' comparisons WCG trades 17 X's 2006 expected earnings with a stronger projected growth rate than HS, while HUM trades at 21 X's '06 earnings with a slower projected growth rate than HS. HS would seem on pricing to be coming in the neighborhood valuation wise to publicly traded HMOs.


HS is in a sector with both very favorable mid and longer term trends, while at the same time some short term clouds due to the Federal Govt. attempts to reign in spending. Growth should be very strong for HS as they've a number of solid growth engines. I would expect a 40% top- line growth rate in 2006 and most likely similar 30%+ top- line growth in 2007 and even into 2008. At the same time HS expense ratio could move up a bit and gross and net margins may also contract.

The key to HS success as a public company will be their ability to manage costs as they grow in enrollment and deal with a tighter Federal Medicare spending program-- by tighter I mean slower Federal payment growth per covered member. I like the longer term trends here quite a bit as well as HS projected growth. I do like this offering around pricing as a potential longer term winner. However one must keep an eye on quarterly operating and net margins here as HS ability to manage growth in this challenging environment will be the key to their success. A tricky offering in that rapid growth and revenue should continue on one hand, while margins may contract a bit on the other.

I would like this deal much more were it not coming quite as bulky-- many of the successful similar IPOs of the past 5 years came public early in their growth curve and much more attractively valued initially. At a billion plus market cap HS is coming public anticipating strong 2006 growth which will probably limit any shorter term upside from pricing.

Solid offering, a potential longer term winner assuming growth is well managed.