Larry Robbins on Heath Maintenance Organizations

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Feb 17, 2011
Before founding Glenview Institutional Partners in year 2000, Larry Robbins had worked for Leon Cooperman at Omega Advisors for 6 years. Currently, he manages about $7 billion, which is split between Glenview Funds, a short fund, and Little Arbor Funds, a multi-strategy fund. Robbins makes his returns making concentrated bets on large cap stocks. In addition, Robbins has been known to take a more activist approach to some of his large bets, voicing concerns about what management is doing and publicly demanding change.


Robbins was featured in the latest issue of Columbia Business School’s Graham & Doddsville. Here is an excerpt with Robbins taking about the his thesis on Heath Maintenance Organizations:

G&D: Could you talk us through a particular stock or industry you like?


LR: Let's talk about Heath Maintenance Organizations. We've owned HMOs on and off in the past. They were about 20% of our fund by the second quarter of '09 and then were reduced to as low as 2%. Today, they’re approximately 9% of our fund. We own three: Cigna, Aetna, and Well-Point. What do we look for? We look for businesses that have a good medium and long-term growth outlook and are cheap relative to the cash flows that they are currently generating. In general, we're looking for low-teens or better growth.


HMOs have been vilified by the press and by constituents in Washington and their business practices have come under intense scrutiny. If you look at the overall healthcare landscape, coming into 2008 the average healthcare traded at a 110% relative multiple, and coming into 2010 they traded at a 70% relative multiple. The market multiple went from 18x or 19x to 13x or 14x, and healthcare went from 10% to the right of that to 30% to the left.


So, healthcare multiples got crushed. Why? People were uncertain about what healthcare reform meant, and therefore the multiples of the stocks were hurt. Despite the uncertainty, healthcare stocks did what they are supposed to do: grow regardless of the economi environment. Lots of stocks went down, but the company earnings went up and that therefore created the double-whammy for valuation. Today, Cigna trades at 8x earnings, Aetna and WellPoint at 9x, so these stocks are exceedingly cheap.


There were three elements of healthcare reform that really affected HMOs. The first is that there is a profitability cap called “medical loss ratio” or “MLR” minimums that regulates the maximum gross margin that the industry is allowed to have. Any industry which has regulated profits is worth less than one without. The second thing is that there are new industry taxes, some of which may be passed onto the customers, but for the most part, it will hurt the companies. The third thing out of healthcare reform is that there are 37 million people who are now uninsured and who will be entering the market in 2014. The HMOs will get their fair share of these customers in 2014, which can only be positive for these companies. Margins may not be as great forthe companies as now, but nobody is arguing that this will make the economics worse. There is some concern that some existing customers in the high profit margin bracket might slip into the lower bracket. When we do the math, we find that in spite of that mix shift, profits should still improve in 2014.


So when you think about the profits of HMOs, you think about it as headwind offset by some tailwind. You should have earnings declining in 2011 and then two normal years of growth in 2012 and 2013, and an elbow upwards in 2014. So if you ignore the left side of the graph, and start with 2011, you start to think to yourself that with the accelerating tailwind in 2013 and 2014, that this is a pretty good investment. It's probably going to move faster than the overall market. Where’s the market trading? 14x. Where are these guys trading? 9x! Not to over-think it, but there are only two things that matter in investing. What are they going to earn, and what multiple are people going to put on that. Let's not make our business any more complicated than this. The headwinds from healthcare reform are going to be fully reflected, there are going to be many different cycles, but we should be back to the general trend of HMOs, which is a low single-digit population and membership growth. The price in general is proportional to the cost trend, so if the cost trend is up 7.5%, prices will also go up by about 7.5%.


Therefore, if you have 1.5% membership and 7.5% price growth, you have 9% topline growth and 9% COGS growth. Therefore, you have 9% gross profit growth, and you shouldn't have to grow your administrative costs by 9%, and therefore that should lever up to 12% EBIT growth. You have productive use of free cash flows because nearly all HMO earnings require no additional capital invested, and therefore, you should be able to get to a 15% earnings growth trajectory on a constant balance sheet. We know that the EBIT growth can't get too high because of these MLR caps, such that if costs go up only 6%, you can’t price it up 10% because that's above the allowable amount. It would literally have to be refunded under the new health plan.


Read the full text at www.grahamanddoddsville.net.