2023-09-13 09:29:33 ET
Summary
- eHealth uses its platform & technology to improve access to health insurance, especially Medicare Advantage policies.
- The large-scale brokerage industry has been constrained on cash flows in the past by very high customer acquisition costs versus the long tail of commissions receivable in the future.
- eHealth has aggressively addressed its marketing spend, sacrificing some growth in order to get on track to create positive operating cash flow, and looks to be slightly ahead of schedule.
Here in the United States, we're just about a month away from the start of the annual enroll period for Medicare, a window from mid-October until the first of December during which Americans with the eligibility for Medicare can choose their plans for the following calendar year. eHealth ( EHTH ), a national broker for insurance products, especially Medicare Advantage plans but with other insurance offerings available as well, has really seen a dramatic improvement in the market's perception of its equity value since I last wrote about it in November 2022, as some of the operational headwinds have been addressed and management has communicated fairly well about its plans. Though I missed the opportunity on this 10 months ago by rating it as a hold due to the tough industry dynamics, it is time to take a fresh peek and evaluate it once again.
For anyone not already familiar with eHealth and its peers like GoHealth ( GOCO ) and SelectQuote ( SLQT ), the basic business model works like this, in very broad strokes:
- Insurers need to sell their policies to consumers, which they may do directly in some cases, but will also sell through third-party brokers like eHealth. For eHealth specifically, its largest carrier partners include Humana ( HUM ), UnitedHealth ( UNH ), and Aetna ( CVS ).
- Brokers such as eHealth then make the upfront cash outlay for customer acquisition to bring people to its platform, as well as investing in the operational infrastructure for the staffing and technology necessary to convert leads into as many sales as possible. For the consumer, the benefit of the eHealth platform is the ease of comparing multiple policies from different insurers, and having help in enrolling in a plan that is appropriate (the enrollment can be completed entirely online, or with the help of an agent who can guide a consumer through the process).
- When a consumer purchases a policy through eHealth, the insurer pays a commission to back to eHealth, and so long as the policy continues to be renewed, eHealth continues to receive commissions for the life of the policy.
As I attempted to note in my previous review of this broker sector, the industry economics have historically been challenging because of the mismatch in cash flows and timing. On the front end, the brokers are required to put up a lot of cash into demand generation (ie. advertising), and to develop the technology tools and human resource pool to handle the enrollment. Yet the cash flows back to them on the back end relatively slowly as the commissions are paid back to the brokers incrementally, potentially far out into the future.
In spite of the difficulties as evidenced in a lot of value destruction, there has been a bit of a perking up in the market over last year or so for both eHealth and GoHealth, while SelectQuote has not really participated in the upswing.
While the overwhelming story of the chart is steep loss in value since January 2022 (and the chart would show greater losses if it were to be extended further back), I set the chart to these particular date parameters to try and capture both the sense of heavy losses as well see the uptrend that started in the back half of 2022. Over the last twelve months, eHealth and GoHealth have generously outperformed the market, but from a base point that was already highly depleted. The question for investors now is whether or not the uptrend has fully run its course, or if there is still a likelihood for strong returns from here.
Behind the Recent Results of eHealth
eHealth released its Q2 results in early August, and with half of the year behind us, there are some definite trends that are emerging in terms of management's ability to deliver on its plans. eHealth brought in a new CEO in late 2021, Fran Soistman , who came from CVS Health [Aetna], and he quickly identified that rationalizing the spending for customer acquisition was a necessary step even if that sacrificed growth, and the company has successfully cut costs at rate greater than the loss of growth (as measured by revenue).
The spikes in both sales and marketing expense and revenues is due to the seasonal cycle related to open enrollment for Medicare that occurs in the 4th quarter each year. For eHealth, whose main business driver is Medicare Advantage plans, revenues and expenses will always peak in any calendar year during the 4th quarter. In raw numbers, marketing spend has historically been the single largest expenditure; for H1 of 2022, marketing spend alone accounted for 57% of revenues, but has dropped to 40% so far in 2023. Overall losses from operations fell to ($49.0 million) from ($85.2 million) in H1 of 2022 on the back this expense management.
This ability to rein in spending has been a major contributing factor to making eHealth a more palatable investment, as the path towards operating profit, and free cash flows is coming into focus. In fact, cash flow from operations is positive through the first 6 months of 2023, at $51.4 million, much stronger than the $21.3 million over the same period from 2022.
Examining Claims on the Cash Flows
Given the major cash expenses that arise in Q4 each year, management's expectation is still that operating cash flow will be slightly negative for the calendar year 2023, though the base is building towards a case for 2024 being the year in which eHealth turns the corner on positive free cash flow. The company's CFO, John Stelben, provided the following guidance on the recent Q2 earnings call in terms of cash flow:
for the 12-month period ending June 30, 2023, operating cash flows was a positive $3.2 million ahead of our original goal to become operating cash flow positive on a trailing 12-month basis in March of next year. We expect for operating cash flow to be negative for the calendar year 2023 as reflected in guidance as we invest for AEP [annual enrollment period] execution. We expect to return to breakeven to slightly positive operating cash flow for the trailing 12-months ended March 2024 and plan to build on that foundation going forward.
The possible turn in operating cash flow has been a long-time coming, but is not the end of the story, as there are other claims on that cash flow that need to be addressed.
The CapEx needs for cash are historically not that great - less than $0.5 million in all of 2022 for property, equipment, etc. and just $0.3 million YTD in 2023. The capitalization of software is the big line, around $15 to $17 million annually from 2020 through 2022, but this is running at about 50% of that rate so far in 2023, with $4.2 million recorded through the first six months. While it could be a potential concern if the company is under-investing in its own platform improvements, I believe it is rather a sign that eHealth is making more targeted investments, and perhaps now reaping some of the benefits of the higher investments made in prior years and able to step back modestly for the moment.
eHealth has borrowed on a relatively limited basis, taking on a $70 million term loan from Blue Torch Finance in February 2022 secured by its contract assets (commissions receivable). The rate is floating, and as of June 30, 2023, it was over 13%. Interest expense has been rising quickly, doubling from $2.2 million in H1 of 2022 to $4.4 million in H1 of 2023. The loan has two covenants, one for liquidity, and a second regarding the ratio of balance of the debt relative to the company's contract assets, and both covenants were compliant as of Q2. The debt matures in February 2025, but I expect it to be refinanced at potentially better terms (that is, at least at a lower margin relative to the base rate, or possibly on fixed rate terms) assuming the operating cash flow trajectory holds up.
Lastly, eHealth did sell $225 million in 8% convertible preferred equity to H.I.G. Capital in 2021, and there are dividend payments required on those shares. The 8% dividends are partially payable in kind [PIK] and partially cash, and the cash portion of the dividends came to $0.9 million for the first half of the year (the June 30 payment was the first cash distribution due). That cash payment will grow over time (unless the shares convert to common shares) due to PIK payments. As disclosed on the earnings call, the minimum asset coverage ratio covenant on the preferred shares failed to meet the criteria, due to the intention slowdown in growth efforts, and thus there is a correlated decline in commissions receivable which directly impacts the covenant ratio. So in spite of much improved operations, investors should be aware that eHealth has breached a covenant on its preferred shares. As a result, the preferred shares have features that give H.I.G. Capital some additional governance control, including C-suite hiring power and budget setting. Furthermore, investors should be aware that the preferred shares having voting rights equal to the common shares (based on a conversion formula relative to the common shares).
Valuation Thoughts: Two Approaches
In spite of the competing claims on the cash flows from CapEx, debt, preferred shares, and common shares, if the operating cash flows can continue to stay in positive territory over a trailing 12-month basis, it would be a significant breakthrough for the company. Specifically, it has the potential for setting up an alternative framework for thinking about the value of the company's common equity. In the handful of times that I have covered eHealth and GoHealth, I have largely focused on something similar to the book value, but arguing that the book value needed to be discounted because so much of it was derived from commissions expected in the future. In a sense, this methodology is backwards-looking or static, not accounting for continuing operation's potential future growth (or change in any direction). It might be described as rather something like a hybrid between a straight-up price to book value ratio and a discounted cash flow model, and just like a DCF model, it largely depended on how you set the discount rate.
Ten months ago, I estimated from the book value at the time and using a 25% discount rate that the shares might be worth around $15, with the following caveat:
I do not think there is any justifiable reason that eHealth's shares should be near parity with their book value at this stage in the company's journey. The result of the calculation obviously depends entirely on the discount rate applied, as everything else is fixed, but the investor has to grapple with question honestly. Is 25% appropriate for the risk factors? There is little positive cash flow historically but rather consistent cash burn, whereas government bonds are paying north of 4%, inflation is high, and the reliability of these commissions receivable are of a somewhat uncertain nature.
The same calculation today, using the latest values for the current commissions receivable and discounting the long-term commissions receivable by 25% over three periods, comes to around $18.50 per share.
At the current market value, this results in a price to discounted book value of 0.42x, a definite improvement over where it stood last fall at around 0.26x (by my estimates at the time), but still well below even the discounted book value.
However, with the potential for measurable free cash flow on the horizon, a true discounted cash flow valuation strategy could be employed for comparison. Any DCF approach is only as good as its assumptions, which will necessarily be imperfect. I've started my model with the 2022 results and the midpoint for revenue guidance for 2023 of $449 million, with annual growth ranging from 8% to 3% over the following four years (conservative, I believe, based on overall Medicare growth projections and industry consolidation potential), backing out the dividends for the preferred shares, and a terminal growth rate of 1.5%. With expenses continuing to moderate as a percentage of revenue and discounting cash flows at a WACC of ~14% brings me to an estimate value per share of ~$14 range.
Under either model, the shares of eHealth do appear to be under-valued, which could represent an opportunity or a trap.
Conclusion
Saying it could be either one or the other isn't helpful. So which is it? In this case, I believe this is more of a bug than a feature of the models in terms of over-estimating the intrinsic value of what the common equity could or should be worth today by under-estimating the risk. Attempting to parse out the future results and reliability of the long-term commissions receivable is such guesswork that neither valuation approach is really getting at the core of what I think makes the market nervous - that is, will the cash flows really materialize? At a certain point cranking up the discount rate applied to account for the risk moves you into a twilight zone of not being reasonable, yet it feels like the big risk overhangs remain. However, that being said, I do believe the evidence is coming together credibly to argue that eHealth is succeeding at making the necessary changes in expenses to begin creating sustained shareholder value.
Based on management's impressive progress to date and proximity to ongoing positive cash flows from operations, I am tentatively willing to move from a "hold" rating to a speculative buy, with a price target in the $10 to $11 range based on the previous 52-week high along with the improving fundamentals that could point even higher if the trends continue.
For further details see:
eHealth: Ahead Of Schedule On Cash Flows