Molina Healthcare Stock: Has The Rally Finished? (NYSE:MOH)

Investment Summary

The secular persistence of inflation and strong nominal economic activity continues to be a systemic headwind for pricing across risk assets. So much so, that US markets continued their descent into chaos into the new year, providing cause for a reversal in the broad indices to test the October 2022 lows. The new paradigm of higher policy rates and bond yields is a major turning point for broad equity markets, accompanied by a similar regime change in the macro-investing landscape.

It is for these reasons, and more, that individual equity selection has made a major comeback for tactical asset allocations. I’d even go so far to suggest it has become an essential component of allocating from the equity risk budget, especially considering the breakdown in passives/ETF’s that occurred last year, notwithstanding the fact that many valuations still don’t make sense. The S&P 500 for instance has yet to pull back to its historical range of ~16x trailing earnings, currently priced at 19.8x trailing EPS. The size factor, covering the various mega caps in the benchmark, has also demonstrated to be a poor hedge against the downside in bear market positioning. Hence, we opine those names within the small-mid (“SMID”) and attractively priced large caps are set to offer valuation upside down the line.

In this vein, we immediately turned to Molina Healthcare, Inc (NYSE:MOH) following its latest selloff. As a reminder, investors were net sellers of MOH in H2 FY22′, with the pace of downside creeping up in the final weeks of the year [Exhibit 1]. However, this opens up an interesting investment debate for the company, and whether this represents a buying opportunity or not. Looking at the chart below [Exhibit 1], you’ll note that MOH held up well in the latter parts of 2022, creating an upside divergence against the S&P 500. At the same time, its covariance structure has shifted down rapidly, meaning any upside form here could be idiosyncratic in nature, by estimation. Here I’ll cover our examination findings for MOH, linking back to the broad economic spectrum and the company’s capital budgeting, capital intensity and propensity to fund its future growth down the line. Net-net, we rate MOH a buy on a $335 starting price objective, looking for the stock to re-rate higher beyond this point if taking this target out.

Exhibit 1. Divergence in MOH equity vs. S&P 500 in back end of 2022, despite selloff increasing in pace during December. At the same time, equity beta vs. the benchmark has shifted down to meaningful lows

Review of macroeconomic pressures

Arguably the peak of January 2022 marked the secular top in growth and tech stocks, the former darling-children of the U.S. equity market. In fact, many agree the reason the U.S. outperformed for so long was due to its heavy tech exposure, precisely the reason why Eurozone and Australian stocks caught a bid last year, given their weighting toward energy, resources and utilities.

We see this most specifically as the yields on long-dated bonds have shifted to the upside, with the 2/10 year inversion at its widest point in more than a decade. The result has seen a rapid unwind of the growth and high-beta trade of the past decade, with inflation drivers also compressing bond prices at all portions of the corporate and treasury curves.

Starting yields on high quality corporate credit now sits at ~400-500bps, rivalling the yields on most high-quality dividend paying stocks. You’ll see in Exhibit 2 that the 10-year yield has held its place at a similar range, currently at 3.725% at the time of writing. This, as the stock/bond correlation pushes back to 2021 levels, but this is still well above historical range.

Exhibit 2. Yields at the short and long-end of the curve continue to shift higher, further compressing asset prices

As a result, the growth/value axis has continued to widen in favour of value-oriented stocks [Exhibit 3]. This sets up companies producing stable, predictable cash flows in prime position to catch a further bid in FY23′.

Moreover, the concepts surrounding valuation are exquisitely important in the coming 12 months. Not only for the prospects of valuation upside, but to offer downside protection via a margin of safety. We feel it’s essential for investors to consider these points in equity positioning this year, and equally as important in the MOH investment debate.

Exhibit 3. Growth/value axis favoring value meaning predictability of future cash flows, starting valuations and downside protection are all essential to equity positioning in FY23

MOH fair view of fundamentals

It’s important to look beyond pure quarterly/annual earnings and cash flow movements for MOH in order to get a true understanding of its financial performance. As a reminder, the company booked $7.6Bn in revenue for Q3 FY22, with medical care costs of $6.75Bn pulling down to quarterly operating income of $335mm and net earnings of $3.95 per share. Each of these figures represented a YoY growth 12.4%, 11.6%, 51.6% and 61% respectively.

However, digging deeper into its financials we see some more curious data points to highlight. Specifically, the medical margin and medical care ratio [medical care costs as percentage of turnover] increased to $888mm and 88.4% respectively in Q3 FY22. This compares to $751mm and 88.9% in the prior year.

The way to interpret the medical care ratio is the lower the better. So the 50bps YoY improvement in the third quarter, combined with a lower medical margin, fed a greater deal of income to the bottom line. Moreover, the company recorded $49mm in investment income for the quarter, bringing the total for the 9 months to $82mm.

Looking at further details, it’s worth noting the company’s return on invested capital (“ROIC”) has remained at a steady state over the 12-months to Q3 FY22. For those observing Exhibit 4, one might be alarmed at the reduction in free cash inflows to ~$850mm [TTM basis], below the 2-year quarterly TTM average of $1.19Bn.

However, you’ll also note the ROIC level pushing higher at the same time, driven by an upshift in the level of net operating profit after tax (“NOPAT”) from the previous period’s invested capital. As such, it realized a TTM ROIC of 11.5% last quarter, well above its cost of capital of 7.13% for the same period. Aside from this, it repaid $723mm in long-term debt over the TTM, in-line with the prior 3 quarters.

Therefore, the free cash outflows are nigh a concern on our end, as the company is exhibiting substantially higher ROIC from this use of cash, well above the WACC hurdle.

Exhibit 4. Upside divergence between ROIC and free cash flows for MOH

However, it’s also worth pointing out the mammoth amount of cash MOH keeps on-balance sheet. This isn’t a form of capital that is used in operations, and therefore we believe there’s a degree of ‘excess cash’ that must be adjusted for in order to get a better reflection of MOH’s ROIC.

We’ve done the calculations for this below [Exhibit 5], and you can find the full breakdown in Appendix 1 at the end of this report. You’ll notice that of the $10.5Bn in current assets booked on the Q3 balance sheet, $4.24Bn was clipped as cash. Question is how to separate the ‘excess cash’ that’s been recorded, and what’s needed for MOH to run its business.

There’s quality research to suggest that for a company in its steady state cash at 2% of sales should be included into the calculation for invested capital. We’ve done just this to estimate the amount of cash required for operations and then stripped out the excess cash. Post adjustment, the cash at 2% sales came in to $154mm for Q3, leaving $4.09Bn in excess cash that shouldn’t be recorded as invested capital for the quarter. Doing this along a time series since Q1 FY20′, we note the company’s ROIC is statistically higher, and the capital intensity of the business is far lower.

Working capital requirements for instance slip to $2.78Bn from $6.87Bn post adjustment, whereas the overall invested capital drops to $4.46Bn from $8.45Bn. These are large reductions in the capital requirements for MOH than what’s seen on face value. Importantly, there’s no reduction to NOPAT seen following the adjustments. As such, the TTM ROIC has hovered around 22-25% sine Q3 FY21 for the company.

Exhibit 5. Adjusting for excess cash on the balance sheet, we see that MOH’s ROIC clicks higher to ~22%, with nil impact to NOPAT

Consequently we see the full aspects of MOH’s value creation for shareholders over the 12-month period to Q3. We benchmark this as economic value added (“EVA”), a reflection of the company’s profitability above the cost of capital required to produce that income.

In Q3, the company generated $668mm in EVA post-adjustments [$376.6mm pre-adjustment], up from $483.8mm the year prior. In any sense, these are impressive numbers on absolute and relative terms.

Moreover, the ROIC is ~15% above the hurdle rate, and has remained at these levels during the testing period. You can see a breakdown of these calculations in Exhibit 6 and Exhibit 6a below.

Exhibit 6. MOH EVA, Economic profit pre and post adjustments for excess cash

Exhibit 6a. Further breakdown of MOH’s quarterly EVA, Q3 FY21-22

In our opinion, these are factors that must be heavily considered in the MOH investment debate, and demonstrate the fact it can continue funding its future growth initiatives without additional financing.

MOH technical indications

Equally as important here is what the market is telling us from the various chart studies seen below. Using the weekly chart first, you’ll see the uptrend has been maintained since FY20′. Since H2 FY22′, the stock has majorly traded sideways, with the latest down-leg gapping to the downside. At the same time, relative strength versus the benchmark is adequately strong.

Important to note, however, is that MOH faced heavy resistance at the 250DMA, testing that level twice as the tops of the upside move opened up and eventually broke the 50DMA. Question now is if there’s enough buyers to fill the downside gap from 2 weeks ago.

Exhibit 7. MOH weekly price evolution, breaking 250DMA support and gapping to the downside

Looking at a shorter-term daily chart, the downside can be seen on a more pronounced level. Shares now trade at a low point, and need to recover from here. Running a scenario where it has bottomed, we’d be looking for the next upside targets to be $311 then $319 to see prices normalize back to range.

Exhibit 8. If MOH has neared a bottom, needs to snap-back to $311 then $319 for prices to head back to range

Problem is there’s a lack of trend support to suggest this could happen. You’ll note in the cloud chart below that both the price line and lagging line are positioned beneath the cloud. Moreover, on-balance volume has drifted south with momentum along the same time frame.

This could be a risk that must be factored in. It tells us that buyers are absent at the moment, warranting further downside. Therefore, in the very near term, we believe MOH could face challenges for a reversal.

Exhibit 9. Trading below cloud base with lack of support from on-balance volume, momentum

Turning to the weekly chart, however, the picture is different and remains bullish. You’ll see that prices have tested the base and/or top of the cloud along the trend. MOH is currently testing the top of the cloud at present, along with the lagging line, meaning that if it bounces from here, we’re likely to remain in a continuation of the long-term trend.

Exhibit 10. Weekly cloud chart showing different picture. MOH needs to bounce from this level in order to stay on trend

Balancing this picture, we have decent breadth in the price targets shown in our point and figure studies. Specifically, there’s upside targets to $495, with downsides to $207. The mean of these two numbers is $351 which also gives more confidence on a potential reversal to this level.

Exhibit 11. Upside and downside targets present, with mean of $351

Valuation and conclusion

There’s some conflict in understanding the valuation debate for MOH. First, it should be noted that at its current market cap it trades at 6x book value. Using enterprise value [stripping out the cash, as mentioned] it still trades at 4.1x book value.

Question is, does this represent value or not. First, the ROIC and EVA discussed above are immediate drivers to corporate value. Both numbers are also high on absolute and relative terms.

Second, MOH’s increased its book value per share by 87.79% since Q1 FY20′, and its tangible book value per share by 22.1% over the same period. Each are ahead of the S&P 500’s total return.

The stock is also priced at 10.8x forward EBITDA, and 18.2x forward earnings [GAAP], 25.6% and 27.8% behind the sector median respectively. This comes in to a trailing PEG ratio of 0.49x. Moreover, consensus EPS estimates point to further sequential upsides into the coming 2-year period [Exhibit 12].

Exhibit 12. MOH Quarterly Consensus EPS estimates into FY24

Moreover, considering the forward EPS estimates, we see the stock trading fairly at 20.5x forward earnings.

Assigning this multiple to the $16.35 FY22 EPS estimate, we see valuation upside for MOH to $335, in line with the ranges described above. Hence, we value MOH at $335 with our first price objective.

Exhibit 13. Fair value estimate of $335

Net-net, we believe there is scope for MOH to re-rate to the upside on a medium-term basis. We are searching for an initial price objective of $335, and would be looking to the stock to break former highs of ~$350 afterwards. There are risks that investors will continue to sell MOH shares in FY23′, however, this could open up the value gap even further for patient investors. Current valuations make sense to us and are well backed by measures of corporate value in ROIC and EVA. Hence, on these points, rate MOH a buy.

Appendix 1. Adjustments to MOH’s financial statements to account for excess cash, used in calculations for ROIC, EVA