Kerrisdale Capital Buys CNC; Reiterates UNIS, PLUG, BOFI Short CallsVW Staff
Kerrisdale Capital was down 1.2% in the quarter ended 3/31/2014 net of fees, comprised of monthly returns of (5.9%), 3.4% and 1.7% for January, February and March, respectively. In comparison, the S&P 500 was up 1.8% over the quarter, comprised of monthly returns of (3.5%), 4.6% and 0.8%. The Barclay Hedge Fund Index was up 1.5% over the quarter, comprised of monthly returns of (0.4%), 1.9% and 0.0%.
Since inception, the fund is up 876.4% net of fees. In comparison, the S&P 500 is up 125.18% and the Barclay Hedge Fund Index is up 43.5% during that time.
Below are more details from Kerrisdale Capital’s Q1 letter to investors
Our top five positive contributors were Short A, JLL (Jones Lang LaSalle Inc.), CALL (MagicJack Vocaltec Ltd), NUS (Nu Skin Enterprises Inc.), and FL (Foot Locker Inc.) . Our top five negative contributors were NOW (ServiceNow Inc.), SBER:RU (Sberbank), Short B, HLF (Herbalife Ltd.), and CHS (Chico’s FAS Inc).
Kerrisdale Capital on Centene Corp (NYSE:CNC)
We are long Medicaid managed care provider Centene Corp (“CNC”). In order to relieve costs and improve efficiencies, state governments increasingly contract health management of their Medicaid populations to managed care operators like Centene. In return, the state pays Centene an annual fee that is negotiated each year to adjust for changes in patient acuity. Over the next 2 to 3 years, we expect $50-75bn of Managed Medicaid RFPs to become available for bid. If Centene can win 15% of this new business at a 1.5% margin, we think CNC can earn $5.50-6.00/share by 2016, or roughly double what they earned in 2013. Furthermore, we believe there’s room for margin expansion once patient growth slows and Centene further integrates its in- house provider services (CNC has its own pharmacy benefit manager). CNC currently trades at 6.5x EBITDA and 18x forward earnings. In a market still beset with triple- digit earnings multiples on high-growth businesses, we believe CNC is a rare case: a 20-30% grower trading at a reasonable valuation.
A well-run managed care operator (“MCO”) provides benefits across the healthcare system. When managing Medicaid populations on their own, states pay a fee-for-service expense as provider costs are incurred. Managed care providers, on the other hand, are paid a fixed fee per patient that’s aligned to health outcome goals. Transitioning to a managed care model improves state budgetary predictability, enhances patient outcomes due to more preventative care, and aligns providers more closely to health outcomes. A combination of state budgetary pressures and mounting evidence for managed care cost-efficacy positions Centene at the forefront of a multi-year growth opportunity. The Congressional Budget Office predicts that Medicaid spending will grow from $297bn in 2014 to $536bn in 2022. Today, just 26% of Medicaid spend is contracted under managed care contracts. With hard-to-treat patients now transitioning to managed care, the Affordable Care Act increasing patient populations, and the continued escalation in overall Medicaid spending, Centene enjoys an enviable market opportunity.
Managed Medicaid earnings can be variable quarter -to-quarter. A mispriced contract or a regional flu outbreak can temporarily devastate the bottom line, as CNC experienced in 2012. However, the ability to renegotiate fee rates at year-end allows operators to retroactively claw back extraordinary costs and reset rates for changes in acuity levels. The power of this model was put on display in 2013 – Centene was able to exit an unprofitable contract, recover from the 2012 flu season, and generate a 150bps increase in net margins. This year, a fresh batch of short-term concerns has emerged: the Affordable Care Act Insurer Tax and Gilead’s newly introduced $84,000 Hepatitis C drug. Additionally, the sellside worries about the tendency of new patient populations to temporarily depress margins – acuity levels are higher if a patient hasn’t seen a doctor in years – and how this could cause an earnings miss. These myopic concerns obscure the secular growth opportunity. Judging by recent events, we believe that states will reimburse Centene for the insurer tax, CNC can manage its extraordinary drug costs, and that the rapid onboarding of new populations is a positive for the company, not a negative.
The substantial market opportunity in Managed Medicaid has not gone unnoticed by the large diversified insurers. In July 2012, the $27bn market capitalization WellPoint paid 31x LTM earnings for Amerigroup, the largest Managed Medicaid provider at the time. Today, Centene has replaced
Amerigroup as the largest independent Managed Medicaid operator on the market. At a comparable earnings multiple, we think Centene would fetch $90-100/share from a bidder, or 40% above its current price. Even without this M&A optionality, we’re thrilled to own this well- managed, cash-generative compounder. CNC generates nearly twice the cash flow as it reports in net income. This capital is redeployed into capitalizing new contracts and growing the business. Returns on equity average 20% over the past eight years. Centene is a value-creating machine, and compounders like this are rarely priced near market multiples.
Summary of Recent Short Ideas
During the first quarter, we published research for several of our favorite short ideas, three of which are summarized below. The full investment thesis for each of these names is available on our website: www.kerrisdalecap.com.
Kerrisdale Capital on Unilife Corp (NASDAQ:UNIS)
This purported syringe manufacturer has a 15- year track record of disappointing shareholders. The recent share spike of Unilife (“UNIS”) began in December 2013 after UNIS nearly doubled following the announcement of a supply agreement with a generic drug manufacturer. Yet even if this and other contracts deliver their milestones as indicated, Unilife should remain free cash flow negative through 2015. The company’s market capitalization reached $500m before the late March-April correction and we believe UNIS is an overhyped name that has reached unrealistic valuation levels.
By way of a promotional CEO and complicit sellside coverage, Unilife has managed to raise $200m of cash from equity investors since 2005. In return, Unilife has failed to deliver a semblance of credible product revenue ($9.4m cumulatively over the past five years). UNIS has followed a predictable life cycle over the past few years. To fund an annual cash burn that can reach $40m, management announces new partnerships or contract “wins”. These partnership announcements contain lofty revenue targets and colorful language, propelling a short-term spike in the stock. Unilife is then able to raise equity off this newly inflated price and can manage operations for the next 3-9 months. The strategy has seemed to serve Unilife’s management team well while diluting shareholders into oblivion. To us, it seems that Unilife isn’t in the syringe business; it’s in the business of selling stock.
Kerrisdale Capital on Plug Power Inc (NASDAQ:PLUG)
We are short Plug Power Inc (NASDAQ:PLUG). After two years of languishing as a penny stock, PLUG became the latest story stock to surge to a billion dollar market cap. Investors are frequently drawn to new technology companies like Plug Power Inc (NASDAQ:PLUG) that promise outlandish returns, such as the chance to triple or quadruple one’s money on a revolutionary innovation with little risk. But beneath twitter-fueled momentum day trading frenzy lies a company with a long road to profitability. PLUG has missed its revenue and unit guidance in 2010, 2011, and 2012 by an average range of 30 – 50%; in other words, PLUG’s actual results never came close to guidance. PLUG’s CEO Andy Marsh seems to have no qualms with this; he has continued the same cadence in 2014, the most recent insult to shareholders being a 22.6m $5.50 share offering that was priced 8% below the previous day’s close. This highly dilutive offering came just days after PLUG hosted a special business update call to announce a deal that won’t yield revenue until 2015.
After a minor Wal-Mart contract was announced in February, PLUG shares skyrocketed to an extraordinary $1.2bn market capitalization. Basic fundamental analysis using management projections and generous growth assumptions yields a valuation target of no more than a few hundred million dollars under a bull-case scenario. The weak underlying fundamentals are reflective of a niche fuel cell business that remains cost-prohibitive to all but a small subset of warehouse customers. Besides, PLUG does not own highly sought after technology; Plug Power Inc (NASDAQ:PLUG) is merely a value-added integrator that sources fuel cell stacks from a third-party. Any substantial increase in revenue would likely be paired with falling margins as the technological innovators capture incremental profits. Similar to story stocks like UNXL in 2013, we expect PLUG to rapidly deflate once the fundamentals come back into focus.
Kerrisdale Capital on BofI Holding, Inc. (NASDAQ:BOFI)
In early April we shared our investment thesis on BofI Holding, Inc. (“BOFI”), a company that we were originally long back in 2010. After several years of impressive results driven by opportunistic mortgage investments from 2009 to 2011 combined with BOFI’s competitive deposit rates, we now think BOFI is significantly overvalued at 3.8x tangible book value. This extraordinary valuation assumes not only a long -term continuation of its rapid balance-sheet growth but also the retention of an extraordinarily strong net interest margin (“NIM”) in perpetuity. We think BOFI will go from posting industry-leading margins to falling well behind its peers – a logical outcome given its business model’s inherent funding- cost disadvantage. We believe the main driver of BOFI’s recent earnings has been a large gamble on low interest rates and a once-in-a-lifetime opportunity in distressed mortgage-backed securities. As legacy securities roll off and interest rates rise, BOFI’s funding costs should increase far faster than its asset yields, compressing its NIM by as much as 40%.
While BOFI’s management has rapidly grown its deposits in a mature and commoditized industry by chasing fickle, price-sensitive depositors, these hot-money depositors do not come cheaply. To retain these deposits in the future, BOFI will need to pay up. And deposit growth could also become more difficult as online-only competitors replicate BOFI’s value proposition. We think BOFI’s hyper-growth phase will ultimately come to an end, and the company’s 3.8x TBV multiple will decline to more reasonable levels. Its shares should adjust accordingly.
We continue to be confident about the composition of the current portfolio. Regardless of how the overall market performs, we expect our portfolio to fare well over the long term.
Thank you and please don’t hesitate to contact me with any questions.