The following write-up is from my colleague, Matt Miller, on one of our favorite investment ideas right now (also available in PDF format: HERE).
The Clear Choice
By
One of the particular areas of the market that offers opportunity for enterprising stewards of small amounts of capital is the small and micro-cap arena. Although potentially rewarding, such activity requires a high degree of discrimination when it comes to one’s choices in allocating capital. It is particularly important to understand fairly precisely the earnings power of such companies, as in many cases stated earnings may be unpleasantly fleeting.
Keeping in mind that we are looking for obscure, small and micro-caps that offer sustainable earnings power, the potential for large a reward, and limited possibility of permanent capital loss, we point your attention to Clear Choice Health Plans (Ticker: CCHN.OB). Stated simply, the Clear Choice thesis is that an investment in its common stock at recent prices amounts to acquiring, for next to nothing (after consideration of excess capital), a health insurance business whose operating earnings power is approximately $14 million. Such an investment would be made at less than half of liquidation value.
Clear Choice, a Bulletin Board company which is not registered with the SEC (the company came public via an intrastate stock offering), is headquartered in
| | 2006 | 2007 | 2008 |
Medicare | 128,549 | 135,568 | 135,980 |
| % of Total | 27.11% | 25.45% | 24.92% |
| Growth | | 5.46% | 0.30% |
| Medicaid | 229,841 | 233,032 | 256,377 |
| % of Total | 48.47% | 43.75% | 46.98% |
| Growth | | 1.39% | 10.02% |
| Commercial | 65,488 | 113,484 | 127,535 |
| % of Total | 13.81% | 21.31% | 23.37% |
| Growth | | 73.29% | 12.38% |
| TPA | 50,338 | 50,542 | 25,793 |
| % of Total | 10.61% | 9.49% | 4.73% |
| Growth | | 0.41% | -48.97% |
| | ------------ | ------------ | ------------ |
| Total | 474,216 | 532,626 | 545,685 |
| Growth | | 12.32% | 2.45% |
A very substantial portion of the Company’s business is done in eastern
Believing that many of the best competitive advantages are local competitive advantages, we are particularly intrigued by Clear Choice. The company’s share of Medicare Advantage and Medicaid in its services territories is approximately 97% and 80% respectively. What is more, there is a significant likelihood that Clear Choice will become the sole provider of Medicaid in eastern
Though typically not attracted to health insurers, especially at a point in
| Price / Share | | $8.65 | |
Shares Outstanding | 1,701,048 | | |
Market Capitalization | $14,714,065 | | |
BV of Shareholders Equity | $49,278,945 | ||
Price / BV | | | 0.299 |
LTM Net Earnings | | $3,264,000 | |
Price / LTM Earnings | | 4.508 | |
Though intriguing, the picture presented above does little to impart on one the true earnings power of Clear Choice. Over the last several years, as management has grown the business, it became quite apparent that a new claims paying system was necessary. The cost of developing its own system being prohibitive, the company looked to an independent provider. After several months of work by the provider, it became obvious in 2006 that the provider would not be able to deliver the system the company was looking for. It wrote off nearly $2.4 million that year to reflect the disappointment. Since then, the company found a new provider and by the end of 2008 was substantially finished with the implementation of a new claims paying system. Unfortunately for the income statement, approximately $3.6 million was run through it in additional expenses related to this implementation in 2008. The new system has allowed the company to trim its fixed investment (including people) in this area which should provide significant savings going forward. This thesis has started to prove itself by virtue of the Q4 administrative expense ratio improvement.
Two additional items have obscured the company’s earning power over the last 24 months: a temporary rise in medial claims expenses and the construction of a new corporate headquarters building. In 2007 and early 2008, the company began to experience increased medical utilization and a compression in its medical loss ratio. By the end of 2008 the medical loss ratio has declined to a level commensurate with a steady-state, as rate increases have begun to work their way through the company’s business. Also in 2008, Clear Choice completed the construction of a new corporate headquarters building on company owned land. In 2001, the company acquired the property and towards the end of the company’s most recent office lease made the decision to build on its land. It completed a nearly $14 million build in mid-2008. The company occupies about half of the building and is currently seeking a tenant to lease the remainder of the space. Shown below are the company’s key ratios which show the impact of the investment in the new claims-paying system, the brief rise in the medical loss ratio and the construction and later move-in of the company’s new home office.
| | | 2004 | 2005 | 2006 | 2007 | 2008 |
Medical Loss Ratio | | 80.24% | 81.67% | 86.60% | 91.20% | 87.00% |
| Administrative Expense Ratio | | 8.03% | 7.44% | 8.30% | 11.00% | 10.60% |
We expect the business of Clear Choice to produce an 86% medical loss ratio and a 7.5% administrative expense ratio over time (if the future of health insurance is similar to what it is today). Given those parameters and the 2008 scope of business, we adjust the valuation to the following:
| LTM Adj Operating Income | $14,071,000 | ||
Price / LTM Adj Operating Earnings | 1.046 | ||
This exhibit would give the company very little credit for the earnings potential of its significant investment portfolio. Below is the summary of the portfolio at the end of 2008.
View PDF for table [too large to paste on site]
Based on company indications and state regulatory filings, we believe that the company’s allocation to common stocks (which is unusual for a health insurer) represents excess capital not needed for the current scope of the company’s business. This figure of $14 million at cost, approximates the entire current market cap of the company, hence our assertion that you are nearly getting the current business for free.
At an approximate industry average and median of about 5.5 times operating income, the valuation seems to be quite off, as illustrated below:
| LTM Adj Operating Income | $14,071,000 | ||
Price / LTM Adj Operating Earnings | 5.500 | ||
| | | | ----------------- |
| Implied Value of Op Earnings | $77,390,500 | ||
Plus: Non-Operating Capital | $11,800,000 | ||
| | | | ----------------- |
| Total Company Value | | $89,190,500 | |
| Value / Share | | | $52.43 |
What is most attractive is that the company currently trades at a 70% discount to book value in addition to the earnings power discrepancy. We believe that book value is fairly indicative approximation for liquidation value, given its component parts. A substantial portion of book value is freely-traded investments (stated at market value on the balance sheet), receivables, and real estate. Though one could argue about the exact price of the company’s new headquarters, given the current real estate market and high relative unemployment in
Three additional points are worth a mention. At the end of December, Clear Choice acquired a small TPA business, Trusteed Plans Service Corporation, which covers approximately 55,000 lives in
Additionally, the company is currently battling a hostile takeover. A smaller, private company in
And finally, the company is currently rewarding shareholders with a substantial buyback. During 2008, Clear Choice spent over $1.9 million repurchasing shares at very attractive prices below book value. The total authorization of $5 million means approximately $3.1 million can still be repurchased. This would represent a further reduction of approximately 21% in the shares outstanding.
In short, we believe Clear Choice Health Plans to be a “clear choice” for those seeking to allocate capital to a micro cap with little downside and substantial upside. There appears to be such a discrepancy in the company’s earnings power and liquidating values that it is worth moving into a health care company despite uncertain future legislation. If the future of health insurance in the
*This is not a recommendation to buy or sell a security. Please do your own research before making an investment decision. The author and poster of this article both have an indirect interest in the stock of Clear Choice Health Plans (CCHN.OB).