Centene's Narrow Moat Intact Despite Recent Contract Uncertainty

Senior Equity Analyst

Julie Utterback

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Centene aims to be the top provider of government-sponsored health plans. Although it has grown at a solid clip organically, the company also has made significant acquisitions—most notably WellCare—to meet that goal. Technology investments to boost efficiency have helped Centene prosper in this relatively low-margin managed-care sector, as well.

Centene leads the Medicaid managed-care business; those plans account for about two thirds of its medical membership. The Medicaid program is jointly funded by federal and state governments and primarily serves low-income individuals of any age and people with disabilities. The Affordable Care Act expanded the Medicaid population starting in 2014, and we think this program may be used in the future to expand insured rates further.

Centene boasts the leading franchise, Ambetter, on the individual exchanges. With its technology investments and scale-related advantages in local markets, Centene aims to remain the low-cost leader in this market. This business accounts for about 10% of Centene's medical membership and enjoys higher profit margin prospects than its other businesses. Also, demand for Centene's exchange-related plans could rise, as enhanced tax credits increase affordability on the exchanges and free plans may be offered to eligible Medicaid recipients in nonexpansion states.

Through the acquisition of WellCare in early 2020, Centene added to its Medicare-related capabilities, particularly in the fast-growing Medicare Advantage program. With positive demographic trends and increasing popularity relative to traditional Medicare plans, we see the Medicare Advantage program as one of the most attractive growth opportunities in health insurance in the long run. This opportunity largely explains the appeal of the WellCare deal, although WellCare also added to Centene's Medicaid footprint, too.

Business Strategy & Outlook

We believe Centene has dug a narrow economic moat around its government-sponsored health plan offerings. Quantitatively, we expect returns on invested capital including goodwill (in the midteens in 2020) to remain well above capital costs throughout our explicit 10-year forecast period. Qualitatively, we believe Centene enjoys cost advantages and switching costs as its moat sources for the entire company, although we recognize that it benefits from intangible assets in some businesses, too. These differentiated moat sources from the other major health insurers (where sources are typically cost advantage and network effect) relate to Centene’s focus on government-sponsored plans, particularly Medicaid, versus a focus on employer-based plans for most of the other insurers where there are different dynamics at work.

Centene is the leading provider of Medicaid managed-care plans, which serve low-income individuals and people with disabilities. We estimate that over half of Centene’s profits are generated from its Medicaid business, making that business the primary determinant of its moat rating and moat sources. 

Medicaid acts as a safety net for some of the most vulnerable populations in the U.S., and there are no preset limits associated with the Medicaid outflows for the government sponsors—the federal government and the relevant state government. Outflows can vary based on the number of enrollees and how those enrollees access care, so Medicaid spending can fluctuate year to year based on the utilization of this program, which is typically countercyclical. Funding of Medicaid is shared by the federal government and the states. In exchange for the states meeting some basic requirements with their Medicaid programs, the federal government has agreed to fund at least $1 for every $1 a state spends on Medicaid, with federal funding percentages (50% minimum to 78% maximum) dependent on incomes per capita in each state. 

However, while the federal government is the top source of funding for this program, the states actually dictate many aspects of their respective Medicaid programs, and each state's Medicaid program is relatively unique. For example, each state must decide who is allowed to enroll, eligible benefits, and how to pay providers in Medicaid. On the subject of payment, Medicaid was originally enacted as a program to directly pay care providers on a fee-for-service basis in 1965, but in the 1990s, states were granted the option of offering Medicaid through a capitated payment structure per Medicaid member, like the managed-care plans Centene provides. Most states now use a combination of these payment methods, and when managed-care plans are included in a state's Medicaid plan options, at least two managed-care plans are required in each state and typically a handful of insurance companies are awarded contracts to serve each state's Medicaid population. 

The vast majority of states outsource at least part of their Medicaid population management to private insurers like Centene, which can reduce the variability and magnitude of Medicaid spending for the states along with improving the quality of care according to recent studies. Overall, we believe most states outsource to managed-care providers to gain their expertise in reducing state costs while better serving end users relative to traditional Medicaid fee-for-service plans. Fee-for-service plans often provide less oversight and few incentives for the end users to control health-related expenditures, which can lead to higher spending per member than in managed-care plans. End users in fee-for-service plans typically have fewer limits and higher medical costs than end users in managed-care plans, the latter in which private insurers seek to control outflows by encouraging end-user behavior to improve health and lower costs. Overall, managed-care plans help states lower the cost and risk associated with serving its Medicaid population, which is why a state would choose to outsource at least part of its Medicaid program to a company like Centene. Additionally, on the cost advantage front, we believe Centene's significant scale, efficient operations, and effective programs for the Medicaid population give it a cost advantage over other private health insurers that offer Medicaid plans, too, which contributes to its market-leading position in the Medicaid managed-care business, in our opinion. 

Also, while regulated actuarial soundness requirements help ensure that Medicaid rates are high enough for a company like Centene to generate economic profits in most years, we believe switching costs—contractual obligations and entrenched relationships—are key to maintaining adequate returns for the long run. The strength of those switching costs make the Medicaid business relatively unique within the health insurance industry. For example, employers typically only contract for an annual period with their health insurance providers. In contrast, while contract terms vary by state, initial Medicaid contract lengths with managed-care companies typically last between three and five years. Additional renewal periods can lengthen those initial contract periods by several years as well, especially if the relationship is deemed satisfactory between a state and its managed-care plan providers. Beyond these contractually stipulated arrangements, the relationships between a state and its managed-care plan providers can last much longer than one RFP cycle. For example, the length of Centene and its predecessor firms’ relationships with state Medicaid plans currently averages about 15 years, by our calculations. 

While we cannot guarantee that Centene’s future relationships with served states will last that long, we see several factors that reduce incentive for plan sponsors (whether they are government entities or employers) to switch managed-care plans, and this reluctance to switch influences the moat sources in the Medicaid market, in our opinion. For any covered population, the switching of healthcare plans can create event risk for end users. For example, one major event risk relates to how the covered population receives care, since each health plan may have a different network of care providers even in the same geographic area. So if a plan sponsor chooses to switch to a new insurance plan, its care provider networks could change substantially, creating potential care gaps that cause both frustration and poor health outcomes for end users. Poor outcomes like that can ultimately drive up the tangible and intangible switching costs for plan sponsors. The various qualitative programs provided by each insurer's plan can differ as well, creating the potential for differing quality and cost outcomes for stakeholders when switching insurance providers. In Medicaid in particular, the negative effects of these switches for taxpayers (typically higher costs associated with poorly controlled medical conditions) and the vulnerable population covered by Medicaid (including low-income individuals with a high percentage of children, the elderly, and people with disabilities) create significant headline risk for state administrators, which we believe amplifies the risk of switching providers in Medicaid plans somewhat even relative to other insurance plans, such as employer-based plans. Overall, many states appear reluctant to switch managed-care providers, especially if a managed-care plan already has effective programs and provider networks for its Medicaid population, which are evident at Centene. 

In summary on the Medicaid business, we see the potential for Centene to generate economic profits for a relatively long period related to two primary moat sources—cost advantage and switching costs—and the regulated actuarial soundness requirement (a supportive intangible asset) in this business. Overall, we see incentive on both sides—the states and the managed-care plans—to work cooperatively to achieve their respective goals in Medicaid. Specifically, states are trying to reduce the cost and risk associated with serving Medicaid enrollees, so they try to outsource those plans to managed-care organizations that take on some risk in this particular population and, of course, save them money. Centene’s extensive experience with this population, which has unique challenges, and its related set of programs to encourage health-improving and often cost-reducing activities are in demand, and nearly 80% of all Medicaid members were enrolled in managed-care plans as of early 2021. As a reward for accessing Centene's Medicaid plans that can reduce costs and risks for the states, we think states will continue giving Centene the opportunity to generate adequate returns over capital costs for a relatively long period by determining appropriate rates per Medicaid enrollee. Considering those factors and the inherent switching costs related to the contractually supported and entrenched relationships with each state, we believe Centene is more likely than not able to generate economic profits for at least the next 10 years, which informs our narrow moat rating. 

We see positive characteristics in Centene’s other major business segments—commercial (primarily plans for the individual exchanges) and Medicare—too. Both businesses enjoy higher margins than the firm’s Medicaid business, which helps the company generate excess economic profits. Centene typically caters to lower-income individuals in these businesses as well, which is strategically aligned with the firm’s Medicaid focus. However, we think intangible assets—specifically brand and reputation—play a key role in these end markets where end users actively choose their insurance plans. 

On the exchanges, Centene claims the top position in the U.S. while operating in only a limited number of states, which we believe creates decent local scale in its target markets. On the individual exchanges, Centene aims to be the cost leader in the geographies it serves, and like in other insurance markets, we think price will remain the key determinant of market share, especially in this price-sensitive population that includes the recently unemployed. Centene also strives to maintain continuity of services for seasonal employees that often shift between Medicaid and the exchanges throughout the year, depending on seasonal income levels. Brand recognition in this population along with a low-priced offering has helped Centene build the leading market share on the individual exchanges. Given the cost advantage and intangible assets inherent in the individual exchange business, we believe Centene’s individual exchange business contributes to its consolidated narrow moat. 

In Medicare, though, we believe Centene probably has not dug an economic moat yet. In this business that was primarily acquired through the WellCare merger in early 2020, Centene remains a second-tier player in Medicare Advantage plans, and we think it may have a difficult time competing with larger peers in this niche for a variety of reasons. For example, the organization may remain constrained by weaker star ratings than many of its peers, which affects value-based payments. With lower value-based payments, Centene may have trouble expanding the breadth and depth of its service offerings, which can limit the attractiveness of the plan for end users relative to Centene’s peers. Also, with those lower star ratings, Centene may have less profits to share with its provider networks, which can influence incentives for that key constituent group as well. We also think brand awareness may be lower than key peers in this niche, too, where intangible assets make a difference for end users, who are the decision-makers on these plans. So while we see Medicare as a good growth and margin opportunity for Centene, we think the company probably hasn’t dug a moat in this business yet.

Narrow

Economic Moat

Centene

Centene Corp. operates as a healthcare enterprise, which engages in the provision of programs and services to government sponsored healthcare programs. It operates through the following segments: Managed Care and Specialty Services. The Medicaid Managed Care segment provides health plan coverage to individuals through government subsidized programs through Medicaid. The Specialty Services segment offers healthcare services and products to state programs, correctional facilities, healthcare organizations, employer groups, and other commercial organizations. The company was founded in 1984 and is headquartered in St. Louis, MO.

Earnings data Q2 2023

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Centene Corp. operates as a healthcare enterprise, which engages in the provision of programs and services to government sponsored healthcare programs. It operates through the following segments: Medicaid, Medicare, Commercial, and Other. The company was founded in 1984 and is headquartered in St. Louis, MO.

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