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Greg Hollander

CVH AT A GLANCE

P/E ► 13.3 HIGH EV/EBITDA ► 10.2 AVG ROA ► 4.1% AVG ROE ► 6.4% LOW Debt to Equity ► 1.27 AVG Interest Coverage Ratio ► 5.46 AVG

 

 

 

 

 

 

Coventry Health Care, Inc. (NYSE: CVH) is a health insurance company. CVH provides both risk-based (CVH assumes all costs and risks in exchange for monthly premiums) and administrative only services (billing and processing for self-insuring companies).

Historically, the company has focused on providing risk based health insurance policies to individuals and smaller-midsized corporation's. However, in 2005, the company departed from this strategy when it acquired First Health, a provider of administrative only services to large corporations. While the acquisition diversified CVH's business and transformed the company from a regional player to a national franchise, it also comes with considerable risk. The administrative services only business is largely one of scale, where high fixed costs and thin margins make large volumes necessary for profitability. As a smaller player in the industry, CVH is at a decided disadvantage to its larger competitors. Meanwhile, in 2007, 33% of CVH's revenue came from Medicare and Medicaid, and the company plans to increase this by over 50% in next few years. This goal seems to be at odds with the 2006 Deficit Reduction Act which aims to cut Medicaid funding by over $4.8 billion before 2011.

Company Overview

Coventry Health Care operates in four major business segments:

• The Commercial Division primarily provides benefits through health maintenance organizations (HMOs), preferred provider organizations (PPOs), and point of service (POS) products to employer groups in a variety of geographical markets. Under these plans, Coventry risks all medical and administrative costs in exchange for a monthly premium fee. The division also offers administrative services only (ASO) plans, in which the customer pays a smaller fee in exchange for Coventry taking on all administrative costs, but the customer incurs their own medical costs. In 2007, this segment generated 53% of Coventry’s revenue.^[1]

• The Individual Consumer and Government Division primarily provides health benefits to individuals participating in the Government’s Medicare and Medicaid programs. Under these services, Coventry assumes medical and administrative risk for individuals in exchange for premium payments from state and federal governments. The division also provides fee-for-service activities to governments, such as pharmacy and clinical management. In 2007, this segment generated 41% of Coventry’s revenue.^[2]

• The remaining 6% of Coventry’s 2007 revenue came from its Specialty Business Division, which provides workers’ compensation services such as access to a provider network, bill review services, and independent medical exams on a fee-for-service basis.^[3]

Coventry Health 2007 Annual Report^[5]

Coventry’s revenue stream has increased by approximately 49% from $6.611 billion in 2005 to $9.880 billion in 2007. This is due primarily to the change in enrollment of Medicare customers, which increased by almost 400,000 people (34%) from 2006 to 2007, and drew an additional $1.629 billion in revenue over this same period.^[6]

Operating income has increased from 2005 to 2007, albeit just over 17% from $792 million in 2005 to $933 million in 2007.^[7] This significantly smaller increase is reflects a decrease in its profit margin (which changed from 12.0% to 9.4%), which can be attributed to the acquisition of several firms - including First Health Group and Concentra - who have historically operated under smaller margins than Coventry.^[8]

Trends and Forces

Reduced government funding for Medicare and Medicaid threatens Coventry’s profit margins

Revenue from Medicare and Medicaid premiums, all paid by state and federal governments, accounted for over 33% of Coventry’s managed care premium revenue in 2007, and Coventry has announced that their goal is to increase this proportion to over 50%.^[9] However, the 2006 Deficit Reduction Act included a plan to cut Medicaid funding by over $4.8 billion before 2011.^[10] Additional legislature of this form would either hurt Coventry’s profit margins, or force them to cut benefits, which would potentially decrease enrollment in the long-term.

Current credit crisis threatens competitors’ investments, giving Coventry a competitive advantage

Given the current credit market turmoil in the United States, companies with a large proportion of their income invested in risky assets are facing lesser cash availability for infrastructure growth and subsidiary acquisitions. Cigna, a competitor of Coventry in the commercial market, invested over 75% of its first and second quarter 2007 revenue in investments that may be at risk for write-downs. Other competitors, such as Aetna, Sierra, and Humana, all invested over 30% of their income over this same period.^[11] However, investment income represented under 16% of Coventry's pretax income, allowing them to continue to use cash and cash equivalents to acquire new subsidiaries, expand their sales force, and diversify their customer base, even when the market forces competitors to limit their expenditures.

Acquisitions of firms offering ASO plans threaten Coventry's overall margins

The acquisition of First Health in 2005 allowed Coventry to expand its offering of Administrative Services Only (ASO) plans with its subsidiary's membership. However, due to the economies of scale associated with administrative infrastructure, the administrative services industry is generally dominated by larger companies than Coventry. Without these same economies of scale, Coventry's overall profit margins are being hurt by ASO plans. From 2004 to 2005 (the year of the First Health acquisition), for example, Coventry's administrative expense ratio - the percent of their costs associated with administrative expenses - increased from 11.5% to 17.9%, and reached 18.1% in 2007.^[12]

Competition

Coventry’s Commercial Division faces a highly competitive industry that competes on the prices and comprehensiveness of benefits, location and choice of health care providers, quality of customer service, and reputation.^[13] Its greatest competition comes from geographically diverse, national account companies such as Aetna (AET) and UnitedHealth Group (UNH). It also faces competition from such companies as CIGNA Corporation (CI) and Sierra Health Services (SIE).

As Medicare and Medicaid are sponsored by government funding, companies insuring these individuals generally compete primarily on the comprehensiveness, quality, and availability of their benefits and customer service. Top competitors to Coventry’s Individual and Government division include Humana (HUM), WellPoint Health Networks (WLP), and Aetna.

Note: Medical Loss Ratio (MLR) essentially represents the proportion of premiums received that is used towards paying for customers' medical services. It is sometimes referred to as Medical Benefit Ratio (MBR) when communicating with consumers.

References

1. ↑ CVH 2007 10-K, Item 1: Business, pg 1
2. ↑ CVH 2007 10-K, Item 1: Business, pg 2
3. ↑ CVH 2007 10-K, Item 1: Business, pg 2
4. ↑ CVH 2007 10-K, Consolidated Statement of Operations, pg 47
5. ↑ CVH 2007 10-K, Segment Information, pg 69
6. ↑ CVH 2007 10-K, Segment Information, pg 69
7. ↑ CVH 2007 10-K, Consolidated Statement of Operations, pg 47
8. ↑ Morningstar Report, CVH, 10/6/07
9. ↑ CVH 2007 10-K, Risk Factors, pg 24
10. ↑ CVH 2007 10-K, Risk Factors, pg 20
11. ↑ Stiffel Nicolaus Report, CVH, 08/16/2007
12. ↑ CVH 2007 10-K, Item 6: Selection Financial Data, Operating Data, pg 25
13. ↑ CVH 2007 10-K, Risk Factors, pg 20
14. ↑ CVH 2007 10-K
15. ↑ AET 2007 Annual Report, Financial Report to Shareholders
16. ↑ CI 2007 10-K
17. ↑ HUM 2007 10-K