Centene Corporation — Q3 2016 Form 10-Q
Reporting period: Quarter and nine months ended September 30, 2016. Amounts are in millions of dollars unless otherwise noted. Results include Health Net from its March 24, 2016 acquisition, so year-over-year comparisons are materially affected by the enlarged business.
Business context
Centene operates Managed Care and Specialty Services businesses, with most revenue tied to government-sponsored health programs. The Health Net acquisition expanded its Medicaid, Medicare, commercial, and government-contract operations. At quarter-end, managed care membership was 11.4 million, up 137% year over year; this included 2.8 million TRICARE eligibles.
Financial and operating metrics
| Metric | Q3 2016 | Q3 2015 | Nine months 2016 | Nine months 2015 |
|---|---|---|---|---|
| Total revenue | $10,846 | $5,821 | $28,696 | $16,458 |
| Earnings from operations | $342 | $183 | $739 | $485 |
| Net earnings attributable to Centene | $145 | $93 | $297 | $244 |
| Diluted EPS, continuing operations | $0.84 | $0.75 | $1.89 | $1.99 |
| Total diluted EPS | $0.83 | $0.76 | $1.87 | $1.99 |
| Health benefits ratio (HBR) | 87.0% | 89.0% | 87.2% | 89.3% |
| G&A expense ratio | 9.2% | 8.4% | 9.7% | 8.4% |
Revenue grew 86% in Q3 and 74% for the nine-month period, primarily from Health Net and program growth. Management attributed the lower HBR mainly to Health Net’s greater commercial and Medicare mix and, for the nine-month period, growth in lower-HBR businesses and improved medical expense in higher-acuity populations. G&A ratios rose, reflecting Health Net’s business mix and acquisition, integration, and expansion costs.
- Adjusted results: Q3 adjusted net earnings from continuing operations were $194 and adjusted diluted EPS was $1.11, versus $107 and $0.87 a year earlier. For nine months, adjusted net earnings were $513 and adjusted diluted EPS was $3.23, versus $268 and $2.18. These non-GAAP measures exclude Health Net acquisition expenses and acquired-intangible amortization.
- Cash flow: Operating cash flow was $255 for nine months, down from $457. Investing used $1,632, including $848 net cash for acquisitions; financing provided $2,598. Cash and cash equivalents ended at $2,982.
- Liquidity and debt: Current assets were $7,755 and current liabilities $9,023, producing negative working capital of $1,268, primarily due to current debt. Total debt was $4,589, versus $1,221 at December 31, 2015; debt-to-capital was 44.5%, versus 36.0%. Centene reported compliance with debt covenants and no revolver availability limitation from its leverage ratio.
- Medical and other liabilities: Medical claims liability was $3,767. Premium and related receivables were $3,445. Management said the $513 annual 2016 health insurer fee payment, not yet reimbursed by most state customers, weighed on cash flow.
Material changes and unusual items
- Centene acquired Health Net for approximately $6.0 billion, including assumed debt. The transaction involved $2,247 cash and Centene shares valued at $3,038; acquisition accounting and acquired asset valuations remained preliminary. Health Net contributed $3,981 of Q3 revenue and $8,604 from acquisition through September 30.
- Q3 included a $19 pre-tax reduction tied to revised information on the ACA Arizona risk-adjustment program. This followed a $70 pre-tax benefit recognized in Q2 from reconciliation of 2015 risk-adjustment and reinsurance programs.
- Nine-month Health Net acquisition-related expenses were $224, reducing diluted EPS by $0.98; Q3 expenses were $10. Acquisition-related restructuring and stock-compensation charges were also recorded. The company expected further termination costs through 2016 and early 2017.
- Acquisition financing increased interest expense: $142 for the nine months versus $32 a year earlier. The company had $2,350 of interest-rate swaps, exposing part of its debt to floating rates.
- California regulatory undertakings include investment, service-center, and health-system commitments. The present value of $61 of specified contributions was expensed in the nine months.
Outlook, risks, and contingencies
Centene expected approximately $300 of net capital contributions to insurance subsidiaries and about $140 of additional capital expenditures during the remainder of 2016. Management stated that available cash, investments, operating cash flow, and revolver capacity were expected to fund general operations and capital expenditures for at least 12 months. It also cited expected growth from Health Net and new or expanded contracts; several contract starts remained subject to regulatory approval or bid protests. The filing did not provide a clear full-year EPS guidance figure.
- Key operating risks: Medical-cost estimation and claims reserves, premium adequacy, government funding and payment timing, regulatory and contract changes, Marketplace pricing and ACA risk-sharing programs, and the ability to maintain quality ratings.
- Acquisition risks: Integration costs, realization and timing of synergies, disruption to business relationships, and increased leverage. The acquisition’s final purchase-price allocation was not complete.
- Legal matters: Kentucky litigation over the early termination of a state contract remained unresolved; damages were pending, with trial expected in the latter half of 2017 if not settled. A California taxpayer action seeks gross-premiums tax, interest, and penalties against Health Net California. The company said legal and regulatory accruals overall were not material, but could not estimate possible exposure for these matters clearly.
- Market risk: Management estimated that an immediate 1% interest-rate increase would reduce fixed-income investment fair value by about $148 and debt fair value by about $114.
Important facts for investors to verify
- How much of reported growth and margin change reflects Health Net versus organic enrollment, rate, and business-mix trends.
- Whether HBR, Marketplace performance, and medical claims reserves develop as expected, including the final effect of ACA risk-adjustment settlements.
- Health Net integration costs, realized synergies, and final purchase-price allocation, including goodwill and intangible-asset estimates.
- Cash conversion and receivable collections, particularly reimbursement of the health insurer fee and timing of state payments.
- Debt maturities, covenant headroom, refinancing needs, and the financial impact of California commitments and the Kentucky and California legal proceedings.