Centene Corporation — Q2 2016 Form 10-Q
Reporting period: Three and six months ended June 30, 2016. Figures are unaudited and in U.S. dollars. Centene completed its Health Net acquisition on March 24, 2016; reported results include Health Net only from that date, limiting comparability with 2015.
Financial performance
- Revenue: Q2 total revenue was $10.897 billion, up 98% year over year; premium and service revenue was $10.276 billion. First-half total revenue was $17.850 billion, up 68%.
- Earnings: Q2 operating earnings were $377 million, up 118%; net earnings attributable to Centene were $169 million versus $88 million. Diluted EPS from continuing operations was $0.98 versus $0.72. First-half net earnings attributable to Centene were $152 million, approximately flat, while diluted EPS from continuing operations fell to $1.02 from $1.24.
- Adjusted results: Management reported Q2 adjusted diluted EPS of $1.29 versus $0.76, excluding Health Net acquisition costs and acquired-intangible amortization. First-half adjusted diluted EPS was $2.11 versus $1.31. Q2 included a $70 million pretax ACA risk-adjustment and reinsurance reconciliation benefit, equivalent to about $0.19 per diluted share.
- Margins and costs: Q2 health benefits ratio (HBR) was 86.6%, down from 89.1%; first-half HBR was 87.4%, down from 89.4%. Management attributed the improvement largely to Health Net’s higher commercial and Medicare mix, marketplace and Medicaid expansion growth, and improved medical expense in higher-acuity populations. Q2 G&A ratio was 9.2% (9.0% excluding acquisition costs), versus 8.4%; first-half ratio was 10.0% (8.7% excluding acquisition costs), versus 8.4%.
- Cash flow: Operating cash flow was negative $225 million for the first half, compared with positive $395 million in 2015. Management cited the timing of state capitation and health-insurer-fee payments; substantially all of the cited June capitation-payment delay was collected in July. Q2 operating cash flow was negative $420 million.
- Liquidity and debt: Cash and cash equivalents were $2.710 billion at June 30. Total debt was $4.494 billion, versus $1.221 billion at year-end 2015; $845 million was classified as current. Working capital was negative $961 million, primarily because of current debt maturities. Debt-to-capital was 44.8%, up from 36.0%. Centene reported compliance with debt covenants and no revolver availability limitations from its leverage test.
- Other balance-sheet measures: Total assets were $19.496 billion, versus $7.339 billion at year-end; goodwill was $4.707 billion and acquired intangible assets were $1.609 billion. The scale-up primarily reflects Health Net.
Material changes and business developments
- Health Net was acquired for approximately $5.986 billion, including assumed debt; consideration included about $3.038 billion in Centene shares and $2.243 billion in cash. Centene issued approximately 48.4 million shares. The purchase-price allocation remained preliminary, with $3.85 billion of goodwill initially allocated and subject to measurement-period updates.
- Managed-care membership reached 11.43 million, up from 4.61 million a year earlier. This includes 2.82 million TRICARE eligibles; at-risk membership was 8.62 million. California membership increased substantially following Health Net.
- Q2 revenue growth reflected Health Net and expansions, acquisitions, and new programs. Managed Care Q2 operating earnings were $336 million versus $125 million; Specialty Services operating earnings were $41 million versus $48 million.
- First-half acquisition-related expense was $214 million, including $25 million in Q2. Integration restructuring charges included $32 million of employee termination costs and $38 million of stock compensation through June. Management expected approximately $50 million of termination costs and $43 million of stock compensation in total, with most expected through 2016 and early 2017.
Outlook, risks, and contingencies
- Centene did not provide a specific full-year earnings or EPS forecast in the supplied filing text. It expected approximately $473 million of net capital contributions to insurance subsidiaries and $256 million of additional capital expenditures during the remainder of 2016. Management expected available cash, investments, operating cash flow, and revolver capacity to fund operations and capital expenditures for at least 12 months from the filing date.
- Management cited potential growth from Health Net, new and expanded contracts, and the July 2016 award of the TRICARE West Region contract, with care delivery expected to begin in mid-2017. Contract awards and anticipated starts remain subject to approvals and execution.
- California regulatory undertakings associated with the acquisition include a $200 million service-center investment over ten years, $65 million in specified health and community contributions, $30 million of additional investment over five years, and a $75 million investment-portfolio commitment. The present value of $62 million of the $65 million contribution commitment was expensed in the first half.
- Legal matters: The Kentucky Spirit contract dispute remains unresolved; a state appellate ruling that early termination breached the contract became final after the Kentucky Supreme Court declined review, while damages and Centene’s counterclaims remain pending. A California taxpayer lawsuit alleges Health Net of California should have paid gross-premium tax rather than corporate franchise tax and seeks retroactive tax, interest, and penalties. Accrued legal and regulatory amounts were described as not material, but adverse outcomes could be material.
- Key risks: Government funding, rate-setting and contract renewals; medical-cost and claims-reserve estimation; marketplace pricing and ACA risk-sharing programs; integration and realization of Health Net synergies; increased leverage; regulatory and capital requirements; and investment interest-rate exposure. Management estimated a 1% immediate interest-rate increase would reduce fixed-income investment fair value by about $143 million.
- Disclosure controls were assessed as effective at June 30. Health Net control integration was ongoing, with completion expected during 2016.
Most important facts for investors to verify
- How much reported growth and margin improvement reflects Health Net and membership mix versus underlying organic performance, and how comparable segment results are after integration.
- Whether the lower HBR and the $70 million ACA reconciliation benefit are sustainable; review subsequent claims development and marketplace risk-sharing settlements.
- Whether state payment timing normalizes and operating cash flow improves, given negative first-half operating cash flow and substantial premium receivables.
- Debt maturity and refinancing needs, leverage covenant headroom, and the effect of acquisition debt and variable-rate swaps on interest expense.
- Final Health Net purchase accounting, goodwill and intangible valuations, integration costs, expected synergies, and progress against California commitments.
- Developments in the Kentucky damages proceedings and California tax litigation, including any change in estimated exposure or accruals.