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Clover Health Folds: Q3 Update
Clover Health (NASDAQ:CLOV) shares rose 25% in the past two sessions, fueled by prospects of lower cash burn after management’s abrupt decision to axe (paywall) its Direct Contracting “DC” business in 2023. The segment has been a drag on profitability since CLOV joined the government-sponsored program in Q1 2021.
We have decided to significantly decrease the total number of participating physicians. We believe this will reduce total attributed live and revenue managed by our ACO by up to two-thirds. Andrew Toy, Q3 2022
In a prior piece, I noted that CLOV’s success depended on its ability to make a profit from the DC scheme. With last week’s announcement, investors now see this division, which has grown to become CLOV’s largest revenue contributor, as a crucial source of potential cost savings, fueling the stock’s rally in the past few days.
CLOV has long boasted its role as one of the largest DC companies in the US. Thus, this decision marks a major shift in strategy. It also marks a critical turning point in the fortunes of the company that has previously prided itself on aggressive expansion, citing the advantages of Big Data collection and analysis in developing its digital platform, Clover Assistant, in the belief that doing so will eventually lead to lower costs, and urging patience as its “artificial intelligence” program gets to speed.
This article downgrades CLOV’s rating from buy to hold based on lower revenue visibility and renewed execution risk. A rating upgrade is conditional on achieving sustainable profitability by the first half of 2023. On the other hand, a further rating downgrade is likely if the cash burn run rate puts pressure on liquidity to the point where CLOV is pushed to raise additional capital.
Direct Contracting: Profitless Growth
In my view, at its core, DC is quite similar to MA, but I understand the controversy behind this statement, given the technical differences between the two programs. From a financial perspective, one of the most notable differences between MA and DC is the risk/reward balance manifested in CLOV’s earnings potential, being free of the 15% – 20% gross margin limits imposed by the Affordable Care Act “ACA” on Medicare commercial contractors. The program belongs to a class of initiatives by the CMS to lower healthcare spending, giving the incentive to CLOV to control costs by allowing the insurer to keep all savings it achieves below the capitated fees it earns per enrollees, which from my understanding, hovers around the $12,000/p.a to $13,000/p.a per enrollee.
For CLOV, the most impactful difference between its MA and DC segments is its approach to the two. Management adopted an aggressive growth strategy inherent in its “Open Network” Preferred Provider Organization “PPO” plan, with minimum benefit constraints. These dynamics, from my understanding, are amplified in the case of DC, as one can conclude from management’s remarks on the segment.
Something like direct contracting, we’re able to much more easily work with physicians directly in any given state, and we don’t have to necessarily have all that overhead of building network. Andrew Toy Q4 2021
I guess, when you think about 2023, how are you thinking about benefit design kind of moving forward? You obviously have rich benefits already. Jonathan Yong Credit Suisse, Q4 2021
DC allowed CLOV to expand its operations significantly, adding over 160,000 enrollees in a span of eighteen months since joining the program in April 2021, with little or no network-building initiatives necessary to ensure cost controls. For this reason, the rapid increase in membership wasn’t accompanied by profit gains for CLOV. The Medical Cost Ratio “MCR” barely touched break even in Q1 2022 but has been declining since. Management has always preached patience, saying they expect profitability to increase once their AI-powered system gets up to speed, but this does not seem to be happening.
The company’s bet on Clover Assistant hasn’t yielded much that average investors can see. The MA segment delivered 86% MCR (14% gross margin) compared to 104% (-4% gross margin) for the DC segment despite that all DC enrollees being on Clover Assistant, compared to the MA segment with less than half of enrollees on the platform. Thus, one can’t attribute MA’s positive results to Clover Assistant. Management’s decision to cut its DC participation despite having enough liquidity to run the program for at least two more years is the clearest sign of structural and operational deficiencies, including Clover Assistant. For example, if the company saw encouraging data from its older cohort, i.e., the 60,000 DC enrollees on the Clover Assistant platform for nearly two years, it would have maintained its participation in the program.
Financial Position
CLOV reported $73 million in operating loss in Q3, an improvement from the previous quarter. These improvements are attributed to higher insurance premium revenue and lower MCR in both MA and DC segments compared to the previous quarter. Management cited seasonality and claims volatility, warning of more normalized (higher) medical expenses ahead.
SG&A expenses remain unchanged compared to last year, despite adding more than 120,000 new members in its insurance and DC segments. At this point, I’m not sure if this is an advantage of scale or an indication of inefficiency within the organization, namely a lack of medical auditing, fraud control, and reimbursement negotiation, which could explain the high MCR in its DC segment, which experienced the highest member growth in the past quarters.
The company ended the quarter with cash, cash equivalents, and marketable securities of approximately $782 million, up nearly $100 million sequentially after receiving a $96 million prepayment for its DC operations for October. On a normalized level, CLOV remains cash-flow negative.
The company expects about 93% MCR for its MA business. After running a quick back-of-the-envelope math based on a 15% MA segment growth rate, 2023 revenue is $1,072 million (2022 revenue run rate) * 1.15 (growth rate) * 0.07 (profit margin) = $86 million (gross profit). This is still below the approximately $370 million annual operating expense. The company states that its DC segment will scale to about $1 billion in 2023, down from $2.3 billion at the time of this writing. Management also gave an MCR guidance of below 100% but has yet to specify a number. Assuming a 95% MCR, the segment will add $50 million to gross profit, still needing more to cover operating losses.
Summary
After months of preaching patience to investors and Reddit followers, CLOV has reversed course on its DC segment and plans to axe enrollees by up to two-thirds this enrollment season (effective 2023.) The cutback comes on the heels of a mixed Q3 report in which the company reported a 2% increase in Medical Costs in its DC segment.
Shares rebounded in the past two trading sessions on speculative bets that the cuts will improve profitability. Nonetheless, the strategic shift highlights a potential structural weakness in CLOV’s operations: its inability to repeat its success beyond its core market segment in New Jersey. There is no clear benefit of Clover Assistant “CA,” and while there might be some correlation between low MCR and CA use, correlation doesn’t mean causation. The company will likely remain unprofitable for at least through 2023.
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