Elevance Health Q4: Undervalued Despite Risks To Core Business (NYSE:ELV)

Elevance Health, Inc. (NYSE:ELV) reported earnings on January 24th with a favorable reception.

Elevance Health is the largest commercial insurance company in the United States. Its comprehensive business model centers on ‘whole health’.

Elevance Health’s services extend across various domains of healthcare. These include medical, pharmaceutical, dental, behavioral health, long-term care, and disability plans through affiliated companies. Their competitive advantage comes from both their scale and their integration of business models (i.e., they are the largest insurance company and can use their own pharmacy benefit management company to lower the cost of care).

Normalized EPS of $5.62 beat by $0.03, and revenue of $42 billion beat by $250 million. The stock price was largely unchanged following that announcement and has essentially been flat across the last year.

Despite the earnings beat, I was initially pessimistic on the stock after reviewing the earnings release and listening to management’s commentary and Q&A. Here is what I noted:

• Cash flow went backward from $8.1 billion to 7.8 billion despite growing margins and an improved claim ratio.
• Challenges with competitive environment and STAR rating with Medicaid advantage programs resulting in higher attrition and lower bonuses.
• Heavy exposure to potential legislation around pharmacy benefit managers (PBMs).
• Growth rate from guidance falling below industry.
• Operating margin deteriorated despite high single-digit growth in revenue.

Much to my surprise, DCF analysis generated a price target of $559, 16% upside from today. Even more surprising, Elevance could lose $5 billion in revenue with no change in fixed cost structure and still support today’s pricing.

Given the sizeable margin of safety against business risk and industry headwinds, in addition to growing dividend payments, I rate Elevance Health a buy.

Q4 Earnings Recap

Q4 earnings were solid, beating analyst expectations for both EPS and revenue. GAAP EPS was off due to a swing in losses on financial instruments that do not materially impact the company going forward.

While revenue has performed consistently well throughout the year, the operating margin actually deteriorated despite an improved loss ratio.

Despite the margin and cash flow challenges, Elevance still exceeded all of its 2023 guidance due to the solid performance across all four quarters.

2024 guidance is disappointing, in my opinion, specifically the flat to low-single-digit growth for revenue, minimal change in operating expense ratio (which means they are not scaling well), and flat operating cash flow. The overall market is expected to grow by 7% from 2023 to 2024, so Elevance is planning to lose market share.

Growing Risks To Business Model

One of Elevance’s growth businesses is working as a Pharmacy Benefit Manager to lower cost of care. This business model is broken down in the following chart from Avalere health.

Unfortunately for Elevance, PBMs are the target of legislation to increase transparency and regulation on the space. A draft package recently advanced from the Senate Finance Committee by a unanimous vote. The industry group that supports PBMs has more than doubled its lobbying spend to counteract.

The potential for bipartisan reform of PBMs poses a risk to Elevance’s cost of care. In the current text of the bill, PBMs would be prohibited from charging the health plan a different amount than the PBM charges the pharmacy, essentially reducing Elevance’s profit as the intermediary.

Elevance is also at risk from tightening standards on Medicare star ratings. Elevance health is losing $500 million in bonuses based on a decrease in its rating from Health and Human Services. Across the industry, a new statistical methodology lowered ratings. The average star rating fell from a high of 3.7 in 2022 to 3.11 in 2024 with Elevance being hit particularly hard.

Lower star ratings have an immediate impact on bonus payments and a long-term impact on customer retention. Management also discussed in the earnings call that they have to increase customer service expenses and related investments to improve the rating in 2024.

Five Billion Dollar Margin Of Safety

Up to this point in my research, I fully expected to rate Elevance a hold. But it’s hard to argue with hard numbers.

I ran a DCF analysis using the following assumptions:

• Management guidance delivered in the near term with 1% revenue growth, margin maintained, and loss of bonus revenue in 2025.
• 10% discount rate with low-risk premium as a large-cap, high cash-flow company.
• 3% long-run growth, balancing management’s expectations against the industry growth forecast of 7%.

I am comfortable with management guidance for a few reasons. First, management has significantly overdelivered in 2023 as discussed above. Second, Elevance has a solid history of beating consensus (which guidance weighs heavily on) with 7 EPS beats out of 8 quarters. Lastly, as we will discuss in a bit, there is plenty of headroom in the analysis to absorb a variance to guidance.

This DCF yields a price target of $559 or 16% upside.

Given the Q4 performance and risks outlined above, I assumed I would be well out of bounds. But Wall Street actually has a higher price target at $567 or 17% upside.

The quant rating is a hold; however, it is being weighed down by the one-time hit to GAAP EPS from financing losses. Absent this adjustment, I believe it would weigh upwards to a buy.

Given the significant upside against a backdrop of risk, I wanted to test the impact of lower revenue on the share price. I ran a scenario reducing revenue by $1 billion to $10 billion with no change to the fixed cost base.

With all other DCF assumptions above held equal, Elevance Health can support its current pricing with an overnight revenue loss of $5 billion. Combined with the largely favorable valuations, this makes it a solid buy.

Verdict

Elevance’s Q4 earnings beat analyst expectations for both EPS and revenue, and the company managed to exceed its 2023 guidance. However, the 2024 guidance, predicting flat to low single-digit growth for revenue and minimal change in the operating expense ratio, is disappointing.

Potential risks to Elevance’s business model include legislation targeting pharmacy benefit managers (PBMs) and tightening standards on Medicare star ratings. The Star Ratings have already resulted in Elevance losing $500 million in bonuses impacting 2025. To improve this rating, management plans to increase customer service expenses and related investments in 2024.

Going forward, I expect Elevance’s Medicare business to continue to struggle between higher costs to improve customer service and lower retention. A growing market is likely to partially mitigate this. I will be looking out for signs of a miss on revenue expectations as PBM legislation moves forward and Medicare plans renew. I will also be looking closely for changes to margin with an improvement offsetting risk or further deterioration risking cash flow. With such significant headroom, I will be looking for more substantial impacts to the business.

Despite these risks, my DCF analysis generated a price target of $559, indicating a potential upside of 16%. Elevance could lose $5 billion in revenue with no change in fixed cost structure and still support today’s pricing. This indicates a substantial margin of safety against business risk and industry headwinds, making Elevance a solid buy.