Anthem (NYSE: ANTM), perhaps best known for its aggressive strategy with the Affordable Care Act's healthcare exchanges, has been focused on growing in other ways too -- most notably by latching on to the growth in government healthcare. The evidence is compelling: Last quarter, for the first time, Anthem's Government Business segment (which represents Medicaid and Medicare) brought in more than half of the company's operating revenue: $9.5 billion compared to the Commercial & Specialty segment's $9.4 billion.
There's a surprising reason this could pay off in a big way for Anthem.
Overall trends weigh in favor...
The general argument for insurers focusing on government healthcare is simple and straightforward: It's a huge underlying growth trend in American healthcare, which will lead to more patients served, more revenue, and -- with economies of scale -- hopefully more profitability for companies that seize a greater portion of the market share. For example, take Medicaid expansion under the Affordable Care Act. Despite uneven and incomplete implementation -- only 29 states and the District of Columbia have taken the federal money to expand Medicaid thus far -- it has still resulted in over 12 million new Medicaid/CHIP enrollees to date. Or, consider the opportunities in Medicare Advantage. With 10,000 baby boomers turning 65 every day through 2032, Medicare -- and presumably the privately operated Medicare Advantage plans, which serve about 30% of Medicare patients -- will have a nice growth ramp for the foreseeable future. That means there's serious money at stake: Anthem CFO Wayne DeVeydt anticipates $65 billion in incoming contract activity for services in this space, including for the aged, blind, and disabled program; foster care; and re-procurements. Even a slice of that means big potential money for an insurer that already brought in $19 billion in quarterly operating revenue last quarter. Of course, there's a big problem with the government business.
But it weighs on profitability
Government insurance is tightly regulated, and there are caps on profitability. Medicare Advantage and Part D plans must meet a minimum 85% medical loss ratio, or MLR (MLR is the percentage of premiums collected that must be spent on medical care, and a higher number is less profitable). CMS recently announced a proposed rule requiring that Medicaid plans also abide by an 85% MLR starting in 2017.
Let's face it: Critics have a point. Government healthcare is a lower margin business for Anthem, as demonstrated by a 3.4% operating margin in Q1 2015 versus the Commercial & Specialty segment's 13.5%.
So, why hitch your wagon to a lower margin business? Part of the reason is the demographic trends I mentioned above. But I think Anthem's playing an even smarter long game with this shift.
A virtuous feedback loop
Here's where things get interesting. Anthem is taking the growth and scale it's gained from government healthcare and leveraging that to win new (presumably higher margin) commercial business.
DeVeydt makes the case more eloquently than I could, courtesy of an S&P Capital IQ transcript from the Goldman Sachs Healthcare conference held in June (emphasis mine):
We're finding the scale play that we have now between our Medicaid, our commercial book, even our local Medicare in certain markets is giving us a unique opportunity to play the proper balance between price and overall value that the consumer wants. And so our large groups are actually holding in not only well, but we expect to maybe see some growth in large group as well next year...scale matters, and our investments are being pushed over a broader scale.
And how exactly are they leveraging that scale? DeVeydt again, this time from the first quarter 2015 earnings call: "our cost of goods sold advantage on a national basis is so meaningful that anybody that switches to us that [sic] we can generally show them in year 1 that they will actually have their cost go backwards...and it gives us a real unique advantage as we go after National Accounts."
Anthem has pursued lots of patients and related contracts across the board (particularly in Medicaid, but also in the exchanges built by Obamacare), built economies of scale, and turned those around to up their game on the commercial side by helping client companies better control their healthcare costs. It's a smart example of playing on the long-term demographic trend (toward government healthcare) while using it to shore up the more profitable business -- or, put another way, management is having its cake and eating it too.
It's not all coming up roses...
Scale should generate better margins for the business -- if you can spread fixed costs over a greater number of revenue-producing members, then you should make more on a per-member basis. Yet, while the 2014 benefit expense ratio was 83.1% -- a two percentage point decline year-over-year -- Anthem's SG&A (selling, general and administrative) expense ratio climbed from 14.2% of operating revenue in 2013 to 16.1% in 2014. So why is that number going up instead of down, as we'd expect if Anthem was properly wringing out synergies from its scale?
Management blames fees tied to the Affordable Care Act and also claims that the company is investing in additional opportunities, such as provider collaboration and better cost management. Other national insurers have reported similar expense bumps from the ACA, so I buy the argument -- for now. The key thing to watch, then, will be whether Anthem is able to bring those expense ratios down over time.
...but Anthem's still in a good spot
While I'm overall very bullish on the strategy of using the scale gained from the government business to strengthen the commercial side, there just isn't enough data yet to prove that management's gambit will work. Nonetheless, it's a smart move on Anthem's part -- even if the government business fails to help the commercial side grow substantially, Anthem will still benefit from the overall demographic trend toward government healthcare. That's a great position to be in.