Shares of Elevance Health Inc. (NYSE:ELV) have performed quite well over the last year, returning 21% over this time frame.
For comparison purposes, the S&P 500 Index has gained 22.5%, so Elevance has underperformed the market by a small margin over this period.
However, there are several reasons to believe that Elevance will continue to provide steady returns for shareholders. This article will examine why I believe that investors looking for exposure to the healthcare sector should consider adding the name to their portfolio.
Takeaways From Recent Earnings Results
Elevance reported second quarter earning results in mid-July that topped what analysts had projected. Revenue did fall 0.4% to $43.2 billion, but this was $321 million ahead of estimates. Adjusted earnings-per-share of $10.12 was $0.11 more than expected and up 12.2% from $9.02 in the prior year.
Health Benefits, which contributed 86% of total revenue, was lower by 2% to $37.2 billion. This decrease was caused by medical memberships falling by 2.2 million to 45.8 million.
On the surface, a decline in the most important aspect of the company is troubling, but the drop in memberships was primarily due to eligibility redeterminations for the company’s Medicaid business. As a reminder, states were not allowed to terminate Medicaid coverage during the height of the Covid-19 pandemic. Starting on April 1st, 2023, states began to remove those that were no longer eligible to receive Medicaid from its rolls.
As such, Elevance has seen its membership figures drop each of the last four quarters. The company is now largely lapping the removal of people from its memberships due to eligibility requirements, so this is likely less of a headwind moving forward.
Despite a 5% drop in its membership, revenue totals were down a low single-digit figure. This was driven by gains in Elevance’s Affordable Care Act health plans and commercial Employer Group fee-based memberships.
At the same time, medical costs are rising and thus cause premiums to increase, which tells us that the company’s products remain in high demand even as they are becoming more expensive.
Elevance’s benefit expense ratio, which simply compares the amount of money the company spends on claims to its net premiums, improved 10 basis points to 86.3%. The company used higher premium yields to offset fewer members and higher medical costs, pointing to a very efficient business.
Digging deeper into the company’s membership pool, individual, federal employee, and commercial risk-based all showed growth while Medicare was lower. Excluding Medicaid, total medical membership grew 1.5% to 36.7 million, so the company is still seeing incremental growth in most areas of its business.
While the Health Benefits business is responsible for the bulk of revenue, Elevance’s real area of growth is in the Carelon segment. This segment, which is composed of the healthcare services segment and the PBM business, grew nearly 10% on both a year-over-year and sequential basis.
This segment benefits from cost savings associated with medical members choosing the company’s healthcare services instead of a third-party service. The real success comes when members outside Elevance’s customer pool choose its healthcare services. This is referred to as unaffiliated or external revenue, something that has lifted recent results. This business has seen steady growth.
Elevance has often raised its guidance at each issuance of its quarterly report. The most recent quarter was no exception, with the company now expecting adjusted earnings-per-share of at least $37.20, up from $37.10 previously. This would be an increase of more than 12% from last year.
Earnings Growth Expected to be Robust
While the most recent quarter highlighted some of the strengths of the company, this has been very much the story of Elevance over the last decade. Since 2014, earnings-per-share have a compound annual growth rate of nearly 16% as the company has benefited from an increase in customers.
Growth has slowed somewhat in the medium term as the company’s CAGR is 13.9% over the last five years, but is still very close to the long-term result.
Elevance has been a model of consistency over the long term. The company has missed earnings estimates just once in the last 20 quarters, while revenue has failed to beat expectations just five times during this period.
Importantly, Elevance is expected to continue to see double-digit growth moving forward. Given the penchant for management to raise guidance, it would not be surprising if their forecast is increased following the next quarterly report.
The market projects double-digit growth for the next few years as well. At $37.26, analysts are projecting slightly more adjusted EPS for the current year than the company’s guidance.
Elevance’s long-term track record, recent reports, and estimates for the near-term all point to strong results. Even reducing future earnings growth projections to 10%, which is well below what the company has generated over the last five- and 10-year periods of time, is still a solid return.
And this is the worst-case scenario in my opinion. Elevance, along with the rest of the industry, was hit with a sizeable decline in its membership pool because of Medicaid eligibility requirements and still managed to improve its profitability. For example, the operating margin increased 30 basis points to 6.4% from the prior year, speaking to the overall strength and efficiency of the company.
Dividend Analysis
This business model has long supported Elevance’s dividend, as the company has increased its dividend for 14 consecutive years.
Elevance has never been much of an income story. Shares of the company yield just 1.2% currently, which is lower than the 1.3% yield for both the S&P 500 Index and that of the company’s peers. However, the current yield is running ahead of Elevance’s five-year average yield of 0.9%.
Where Elevance really shines is in its dividend growth. Over the last decade, the dividend has a CAGR of 14.5%. Looking at just the last five years, the growth has accelerated to just under 15%. These types of raises are made possible by the company’s earnings growth.
Despite these aggressive raises over the long term, the payout ratios are still very reasonable. With projected dividends of $6.52, Elevance has an expected payout ratio of less than 18%. This is below the average payout ratio of 21% since 2014.
The free cash flow payout ratio shows that the company’s dividends are well covered, with one exception.
The free cash flow payout ratio for the last year is 180%, which is obviously unsustainable. Free cash flow can be volatile in this industry, but this figure is an outlier as the prior four years produced tremendous free cash flow to the point that the average payout ratio was just 15%.
While the yield might not be enticing to some, I find that the company’s mid-teens growth rate and the very healthy payout ratio make for a compelling case from a dividend growth perspective.
Risks to Investment Thesis
The primary potential pitfall to my investment thesis is that rising medical costs will not be offset by higher premiums. One way to combat this would be to grow the membership base, something that Elevance had done prior to the pandemic and the resulting reimplementation of eligibility requirements. If the company’s customer base returns to growth, then its premium pool should also become larger. Disciplined underwriting will be key to maintaining the company’s benefit expense ratio.
Another potential headwind would be a material decrease in earnings growth, as this will contribute the majority of my projected returns in the coming years. This seems unlikely as earnings growth has accelerated over the five years compared to the prior 10 years. The law of large numbers has not caught up to the company yet and, if future estimates can be believed, Elevance should continue to grow at a high rate.
Buybacks will also aid earnings growth. The company also has retired more than 30 million shares over the last decade, leading to an annual reduction of 1.4% in the share count during this period. Elevance repurchased $900,000 worth of stock last quarter. The company had $3.6 billion, or almost 3% of its current market capitalization, remaining on its share repurchase authorization as of the end of the quarter.
Valuation and Total Return Potential
Shares of Elevance are trading at 14.6 times forward earnings estimates, which is a slight discount to the five-year average price-to-earnings ratio of 15.6 and the 10-year average price-to-earnings ratio of 15.1.
Typically, I use the medium- and long-term average valuations to help establish a target range for a stock. Within this estimate is this is the possibility of growth in the future.
Double-digit earnings growth is what the company is expecting and analysts are anticipating. Therefore, I believe that growth will continue and the average valuation multiples are a solid way to value the stock.
I believe a price-to-earnings range of 15 to 16 times earnings estimates is appropriate at this moment. An expanding multiple could act as a tailwind for Elevance, but much of the total returns will come from expected earnings growth.
Coupled with the current yield and a small amount of multiple expansion, EPS growth could drive low double-digit returns for those purchasing shares of Elevance today. As a result, I have a buy rating on shares of Elevance.
Read the full article here