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‘We're inherently suspicious’ when companies are able to use mark-to-model accounting for their revenue: Carson Block

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Shares of eHealth fell on Wednesday after Founder & CIO at Muddy Waters Capital Carson Block announced his company has taken a short position in the online health marketplace during the coronavirus pandemic. He joins us on Yahoo Finance’s On The Move panel to discuss.

Video Transcript

JULIE HYMAN: One stock that is not higher today is eHealth. EHTH is the ticker for that one. It is an online provider of various health insurance providers and exchanges. The stock is down 13 and 1/2% today, and that's after Carson Block of Muddy Waters said he was selling the stock short. He is joining us on the phone now. He's the founder and CIO at Muddy Waters. Carson, it's good to talk to you. Thanks for phoning in.

So when you look at eHealth, what is it-- first of all, I'm always curious about your process, right? What sort of stood out to you about eHealth that caught your eye, that led you to believe that perhaps all was not as it appeared here?

CARSON BLOCK: Sure. Well, when we see companies that are able to use mark-to-model accounting for their revenue or profits and that it comprises a significant portion of those revenues' profits, we're inherently suspicious, especially if we see the gains growing and the stock ripping. So that's what the deal was with eHealth. There's a new-- relatively new-- accounting standard that went into effect in 2018. And we think that that demarcate the old eHealth, which was, like, a marginally-profitable, unexciting, slow-growth business primarily focusing on Medicare, from the new eHealth-- which, when you look at the numbers, looks like it's growing both revenues and profits tremendously.

But because all of its revenue-- or substantially all of its revenue-- is mark-to-model revenue now under this accounting standard, you have to scratch the surface. And what eHealth does in this mark-to-model format is they say, OK. We've sold so and so a policy for one of these carriers. Now we're going to assume that, you know, Ms. Jones is going to be a member, or is going to have that plan for, I don't know, how many years? Let's make an assumption here.

And let's just say-- let's just book all of the commission revenue we'll receive from the insurer today as revenue. And so the problem is, you know, first of all, it's very hard to forecast the future. But the problem is, it's really tempting if you have management that is going to sell stock. And they have sold a lot of stock, sold about $35 million worth of stock in the past year and change.

So what we see them as having done is, they've greatly grown enrollments, but we believe they're sacrificing the quality. So they're jamming a lot of high-churn customers into the pipeline through late-night advertising on TV. And that and they're using the old churn assumptions, meaning, you know, Medicare Advantage enrollees will typically stay for three years. They're keeping that assumption constant, even though when you look at churn numbers from the 2018 and 2019 cohorts, they're massively up.

I mean, in 2017, they churned that year, 37% according to our calculations. Well by last year, it's 47%. So it's clear that the stickiness of the enrollees they're getting now is different from 2017, but 2017 still factors prominently into their model. So the net net of this is, we think they're actually losing substantial money on every Medicare Advantage enrollee. And most of their-- the vast majority of their business is Medicare Advantage. We think they lose about 400 million, or $400 per enrollee. So we adjust the 2019 revenue down by 25% versus-- so that's down $128 million versus the $500 million reported.

And we also adjust the operating profit down by $263 million. So they reported roughly $100 million operating profit. I mean, in our adjusted model, they really lost about $180 million. And that, again, is the result of what we see them very aggressively pursuing, low-value high-churn enrollees.

ADAM SHAPIRO: You know, you do this for a living. I have a very basic question. If the stock closed yesterday at $116 a share, trading at $100 right now, what do you think it's really valued at? What should it be?

CARSON BLOCK: I mean, it's-- this always a difficult-- you know, this is a surprisingly difficult question to answer when you're in our business because, you know, there's just so much information asymmetry when we're dealing with a management that's not really that forthcoming about what goes into the model and is misleading in other ways. But our back of the envelope, we think the stock's worth about $20. Now there are different scenarios. These guys are burning cash at a high rate, so the more they continue to pursue this growth path, you know, air quotes, "growth," the more value they're destroying.

So if they continue to do this for a while, then, you know, they could-- you could see debt on the balance sheet as well, and that would certainly be an issue for the equity holders.

JARED BLIKRE: All right, Jared Blikre here. My question is regarding the environment in which we are in. And so many companies are struggling, they're getting loans from the government, they're getting bailed out. Are they-- can they paper over-- and now assuming your thesis is correct, can they paper over these problems by blaming it on coronavirus and getting loans or whatever assistance they need from federal government, the Fed, whatever? What does this do to your thesis and your trajectory for the stock?

CARSON BLOCK: So they-- OK, so they did a sizable equity raise last year, which again, is a function of how much cash they're burning. I mean, I assume that their plan is to continue to finance through equity financing. Now you know, they've-- one of things you pointed out in the report is, they've been consistently moving the goalposts as to when they should cash flow. So, you know, I don't think they're ever going to cash flow on this growth trajectory, but they haven't discussed how they would finance.

In terms of availability of financing from the government, I mean, that's not something we'd consider or that we've really been able to understand yet. Many of their employees are really only seasonal, because they ramp up these call center agents during the annual enrollment period. So I don't know that they would get a lot of government assistance for, you know, for employees given that number, so many of these employees are not really full-time, and I don't think they would actually be deemed employees as opposed to contractors.

JULIE HYMAN: Carson, I want to kind of broaden out Jared's question and ask generally, if you're someone who is a short seller or a short sale-- a researcher, in a time like this when we're seeing an increased volatility in the markets, does that make your job easier or harder? Does it make it easier to convince people that a certain company is sort of an emperor wearing no clothes situation? How does it affect what you do?

CARSON BLOCK: Well, one of the-- one of the results of this-- at least in the short term-- you know, I guess, backing up, I've been really amazed at how anesthetized investors have become to risk. And it's now, I think, that that spills over beyond the capital markets. I mean, there's been so much short-termism throughout societies, especially since the financial crisis. So risk is real, and that's one of the things that gets under my skin when you hear these highly-levered companies saying, well, who could have known, you know? And it's like, well yeah, man. I mean, that's the point about risk. You don't know what the risk is going to be, but you know that you're increasing your fragility when you pile debt onto the balance sheet.

So we're-- you know, on one hand, investors are being reminded that yeah, unexpected things can happen. Fragility is bad, avoid it. But on the other hand, you know, we might be in another situation where no bad decision goes unpunished, at least for large companies. And so, I don't know how this will shake out, but I think that, you know, obviously, coming out of this, we need massive fiscal and monetary stimulus-- well, fiscal stimulus. I would love to see hand-- the money go directly into the hands of people in small businesses. But, you know, we're just-- unfortunately, we're just not geared up as an economy to do that, or as a government.

But the coming out of this, I think we need to rethink this roughly 35-year-old economic playbook that depends on stimulating asset prices to the moon and understand that there's a point at which you're distorting markets, you're dampening people's risk receptors, so to speak, and, you know, let the markets be markets and let people be more attuned to risk. But we'll see. I have no idea over the medium to long-term, how the dust will settle on that.

JULIE HYMAN: Yeah, predicting anything is tough right now, let alone big structural change like you're talking about. Carson Block, thank you so much for joining us. He's the founder and CIO at Muddy Waters Capital. I do want to mention we did reach out to eHealth for comment on Carson's thesis. We have not yet heard back from them, so we'll keep you posted if we do get a statement.