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Bull of the Day: Centene (CNC)

Kevin Cook
HCA Healthcare (HCA) first-quarter earnings gain from solid revenues.

Managed care provider Centene (CNC) was already in the upper realms of the Zacks Rank after delivering a strong Q4 report and guidance in early February. Analysts responded by raising 2019 revenue estimates to nearly $71 billion for 18% growth and projected EPS of $4.25 for 20% growth.

 

Then we learned on March 27 that the company intends to acquire WellCare (WCG) in a cash and stock deal worth $17.3 billion. So it's time to review the investor and analyst reactions to see if it's still a good time to put money into CNC.

 

Shares had already drifted back below $60 in March, and Wednesday the 27th (deal news came before the open, though Bloomberg got a leak Tuesday night) saw a plunge to $50 on heavy volume of 34 million shares.

 

The transaction is obviously dilutive for CNC shares and thus the drop. Under the terms of the merger agreement, WellCare (WCG) shareholders will receive a fixed exchange ratio of 3.38 shares of Centene (CNC) common stock and $120 in cash for each share of WellCare common stock. Based on Centene's closing stock price on March 26, 2019, the implied cash and stock consideration to be received by WellCare shareholders is $305.39 per share.

 

The cash and stock consideration represents an approximately 21.0% premium to WellCare shareholders based on the 30-day volume weighted average closing stock price, or VWAP, of WellCare prior to signing and an approximately 32.1% premium based on the closing stock price of WellCare on March 26, 2019. Upon completion of the transaction, Centene shareholders will own approximately 71% of the combined entity, with WellCare shareholders owning approximately 29%.

 

The good news is that the stock didn't fall further and recovered quickly back to $53 to close the quarter. And since we've had plenty of positive investor and analyst reaction since the deal announcement, CNC shares have climbed back to $57-58 on good volume.

 

The bad news is that things were looking so good again for new highs in CNC before this deal, as the stock made a strong run back to $68 from the Dec lows at $54.

 

Why Buy WCG?

 

This is obviously part of the company's long-term growth strategy to compete with bigger players like UnitedHealth Group (UNH), Cigna, and Anthem (ANTM) in the vastly complex $9 trillion healthcare sector. On the surface, the new company would have strengths in Medicare Advantage (MA) and Medicaid, both of which are growing markets.

 

As consolidation continues in the industry, so that economies of scale can handle the turbulent waters of healthcare reform, I had thought the sub-$25 billion Centene would be an acquisition target for one of the larger players mentioned above. 

 

In the short-run, investors face plenty of "uncertainty volatility" that could keep shares below $60.

 

As we saw in Bristol-Meyers (BMY) $74 billion cash and stock bid for Celgene (CELG) this year, BMY shares fell immediately and that day marked the low, with the stock recovering to fill the down gap and then some. By the end of March, we saw CELG pop and BMY fidget as a key shareholder who had been blocking the deal fell in line.

 

This anecdote doesn't, of course, guarantee anything. And classic "merger arbitrage" will be buffeting the shares of both companies until their shareholders, and the regulators, chime in with "yea" or "nay." But so far, so good.

 

Centene Strategy Amidst ACA Turbulence

 

The day before the deal announcement we learned that the DOJ shifted its stance, backing full invalidation of the Affordable Care Act. In a legal filing March 25 with the U.S. Court of Appeals for the 5th Circuit in New Orleans, the Department of Justice revealed a significant shift in its stance and said it now backs a full invalidation of the Affordable Care Act. The DOJ previously has said there were grounds only to strike down the ACA's consumer protections.

 

So Centene's acquisition of WellCare comes just as the White House and Congress seem to be renewing a long-running feud over the Affordable Care Act. While ACA survived a 2017 repeal effort by Republicans, 20 conservative-leaning states sued last year to have it repealed, saying that changes in tax law invalidated it. This week, the Department of Justice backed the effort for a complete repeal. 

 

Of course, Centene and WellCare had to have been planning and negotiating this deal for months prior to the DOJ move. And it might be coincidence they announced the same week. But the spotlight is certainly on them about whether this was the right move for long-term growth given the legislative turbulence.

 

In an interview on CNBC's Mad Money on the evening of March 27, Centene CEO Michael Neidorff said "The time was right to buy WellCare... When there is uncertainty, that is the time to act... There are a lot of things that need to be strengthened with the ACA... There is an opportunity to make it more affordable. WellCare acquisition made more sense than I've seen in a long time."

 

And in formal comments that morning in the press release, here's how he described the deal...

 

This transformational combination creates a leading healthcare enterprise that is committed to helping people live healthier lives through a localized approach and provides access to high-quality healthcare through a wide range of affordable health solutions. With the addition of WellCare, we expect to bolster and diversify our product offerings, increase our scale and have access to new markets, which will in turn, enable us to continue investing in technology and better serve members with innovative programs designed to meet their needs.

 

Centene has grown significantly by adding capabilities that have increased revenues and enabled margin expansion. The addition of WellCare is the next logical step in our growth strategy and to drive value for our collective shareholders. We have long admired the WellCare organization and together look forward to building on our mission of transforming the health of our communities, one person at a time.

 

Analyst Reaction to Deal

 

Centene might internalize WellCare PBM business, says Wells Fargo

 

Analyst Peter Costa expects Centene to eventually internalize WellCare's pharmacy benefit management (PBM) business, which would likely be another blow to CVS (CVS), WellCare's current PBM. Centene currently has some of its PBM business with CVS and is bringing that business in-house to its own internal PBM, while WellCare is planning to rebid its PBM contract this year. He added that this merger would likely mean that contract rebid may not occur and that WellCare would more likely move its estimated $15B-$20B in pharmacy spend away from CVS to Centene for 2021.

 

Costa told investors that he does not believe the government would find the overlapping Medicaid markets as problematic from an anti-trust point of view, since he believes the government views Medicaid market as a more national market of bidders for state contracts. 

 

Stephens: "Excellent strategic combination"

 

In a research note before the companies confirmed the deal (based on the early Bloomberg reporting), Stephens analyst Scott Fidel told investors that he would view a Centene/WellCare deal as an "excellent strategic combination." While he acknowledged that the transaction could face some political hurdles, the analyst noted that the direct business overlap is "actually less than one might initially suspect." Both companies are in a position of strength as they are each poised to deliver top-tier revenue and earnings growth performance in 2019 Fidel concluded. He kept an Overweight rating on both names.

 

Leerink analysts see strong "offensive" play in CNC-WCG deal

 

While WCG earnings won't become accretive until year 2 of the merger, some cost synergies will start right away. Leerink analysts attended a reception after the deal was announced with managements from both companies and came away more optimistic about changes in managed care, reiterating their $78 PT...

 

The net upshot for us is that fears that this deal has been inked to offset secular headwinds are unfounded. The combined almost ~$100 B entity is poised to be a Government powerhouse across Medicare Advantage, Managed Medicaid & Part D. Regulatory risk remains, but unlike MA, the Medicaid plans are price takers and there is no 35% market share ceiling.

 

SunTrust: "Powerful combination with opportunity on several fronts"

 

The analysts view the proposed combination as compelling as it further increases scale, expands the Medicaid footprint, accelerates MA growth and provides an attractive opportunity in pharmacy. They noted that "synergies look quite doable" as the deal brings incremental diversification, is expected to be accretive in year 2 and CNC's integration track record provides comfort. They reiterated their Buy rating and $90 PT based on about 21.5X 2019E EPS.

 

Oppenheimer analysts wrote a preliminary note on the morning of March 27 with these thoughts: The deal would expand Centene's leading Medicaid platform and provide a large boost in Medicare Advantage (MA), a business it has targeted. Although the price and equity-heavy deal terms represent a hefty premium to Centene's own valuation, the company has done a good job with M&A in the past. Since then, the Oppenheimer team has reiterated their Outperform rating and $83 PT.

 

Are any i-bank analysts not so enthusiastic about this deal?

 

Yes. Jefferies analysts are far less sanguine, with this title on their report after the deal...

 

CNC for WCG: Strategically Logical, but not Catalytic

 

Jefferies analysts see the logic of the deal in a strong strategic rationale (enhances Medicaid and overall scale, accelerates MA growth agenda, and diversifies HIX exposure), but they see only modest financial benefit. They also think that cost synergies and earnings accretion contemplate divestitures.

 

And regarding the probability of the deal actually getting done, they cite as many as 5 markets likely to be scrutinized by anti-trust regulators. The Jefferies analysis of Medicaid market share  focuses on key states where CNC and WCG will have significant share of > 30%: MO, NE, IL and GA. These are likely to be most problematic since combined share is 60%-75% and the states only have 3-4 MCOs in the market. Combined share in IL would be 54%, but the market would still have 5 players after the deal closes. Here's how the Jefferies team described the impacts of potential divestitures...

 

If CNC was required to divest the smaller contract in each of those 4 states, they estimate pro forma EPS impact of -15c, lowering year 2 accretion by 2.5 points. FL and NY have many more players, perhaps lowering the divestiture risk in those markets. That said, divesting the smaller contract in FL/NY would lower EPS by 11c. Thus, the worst case is 26c of EPS risk across all 6 states. If that happened, the deal would still be accretive by 1.5% in year 2.

 

Another issue is competitive bidders. Other big managed care players may want WCG more than CNC does. Deal "break-up" fees increase after May 10, which suggests to the Jefferies team that both parties may be willing to entertain other offers.

 

Bottom line: I remain a buyer of CNC in the low $50s and wait to see where large shareholders, regulators, and potential competitive bidders, stand on the deal. The recent ACA political rumblings are seen by many as mere posturing ahead of the 2020 elections. So the real test of this deal is how compelling it is for an unpredictable landscape. The bias leans toward "size wins" to compete on this bigger, more turbulent field.

 

I should add that I wrote most of this report during the final weekend of March for my subscribers in Healthcare Innovators where we've been long-time CNC shareholders. So it does not include the impacts of April 1 proposals by the Centers for Medicare & Medicaid Services (CMS) in their 2020 Medicare Advantage and Part D Rate Announcement.

 

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