Friday, May 15, 2009

The Clear Choice

The following write-up is from my colleague, Matt Miller, on one of our favorite investment ideas right now (also available in PDF format: HERE).

The Clear Choice

By Matthew Miller

One of the particular areas of the market that offers opportunity for enterprising stewards of small amounts of capital is the small and micro-cap arena. Although potentially rewarding, such activity requires a high degree of discrimination when it comes to one’s choices in allocating capital. It is particularly important to understand fairly precisely the earnings power of such companies, as in many cases stated earnings may be unpleasantly fleeting.

Keeping in mind that we are looking for obscure, small and micro-caps that offer sustainable earnings power, the potential for large a reward, and limited possibility of permanent capital loss, we point your attention to Clear Choice Health Plans (Ticker: CCHN.OB). Stated simply, the Clear Choice thesis is that an investment in its common stock at recent prices amounts to acquiring, for next to nothing (after consideration of excess capital), a health insurance business whose operating earnings power is approximately $14 million. Such an investment would be made at less than half of liquidation value.

Clear Choice, a Bulletin Board company which is not registered with the SEC (the company came public via an intrastate stock offering), is headquartered in Bend, Oregon and provides health insurance and services for mostly rural individuals and businesses. Clear Choice offers Medicare, Medicade and commercial plans, as well as third party administration (TPA) services. Their business, in terms of membership months, over the last three years is presented below:








% of Total











% of Total











% of Total











% of Total

















A very substantial portion of the Company’s business is done in eastern Oregon, specifically the area that falls east of the Cascade Mountains. Though holding licenses for the states of Oregon, Washington, Idaho, and Montana, the company only recently (2008) moved into its first non-native state, Montana. A recent acquisition, which will be discussed later, expands the company’s TPA business into several additional states.

Believing that many of the best competitive advantages are local competitive advantages, we are particularly intrigued by Clear Choice. The company’s share of Medicare Advantage and Medicaid in its services territories is approximately 97% and 80% respectively. What is more, there is a significant likelihood that Clear Choice will become the sole provider of Medicaid in eastern Oregon at some point in the near future. Potential state initiatives calling for a single provider of Medicaid in a particular service territory is being contemplated. Clear Choice would seem to be the natural sole provider given its local market share and ownership profile. Nearly 23% of the company’s shares are owned by CONET, a consortium of hospitals in Oregon which is the largest in the state. Additionally, the company was formed by a number of physicians in the state which remain a large shareholder contingency.

Though typically not attracted to health insurers, especially at a point in US history where the future business model may not look precisely like the historical business model, the valuation of Clear Choice allows one to be relatively indifferent about the future direction of health care in the United States. Below is a brief overview of the company’s valuation:

Price / Share


Shares Outstanding


Market Capitalization


BV of Shareholders Equity


Price / BV


LTM Net Earnings


Price / LTM Earnings


Though intriguing, the picture presented above does little to impart on one the true earnings power of Clear Choice. Over the last several years, as management has grown the business, it became quite apparent that a new claims paying system was necessary. The cost of developing its own system being prohibitive, the company looked to an independent provider. After several months of work by the provider, it became obvious in 2006 that the provider would not be able to deliver the system the company was looking for. It wrote off nearly $2.4 million that year to reflect the disappointment. Since then, the company found a new provider and by the end of 2008 was substantially finished with the implementation of a new claims paying system. Unfortunately for the income statement, approximately $3.6 million was run through it in additional expenses related to this implementation in 2008. The new system has allowed the company to trim its fixed investment (including people) in this area which should provide significant savings going forward. This thesis has started to prove itself by virtue of the Q4 administrative expense ratio improvement.

Two additional items have obscured the company’s earning power over the last 24 months: a temporary rise in medial claims expenses and the construction of a new corporate headquarters building. In 2007 and early 2008, the company began to experience increased medical utilization and a compression in its medical loss ratio. By the end of 2008 the medical loss ratio has declined to a level commensurate with a steady-state, as rate increases have begun to work their way through the company’s business. Also in 2008, Clear Choice completed the construction of a new corporate headquarters building on company owned land. In 2001, the company acquired the property and towards the end of the company’s most recent office lease made the decision to build on its land. It completed a nearly $14 million build in mid-2008. The company occupies about half of the building and is currently seeking a tenant to lease the remainder of the space. Shown below are the company’s key ratios which show the impact of the investment in the new claims-paying system, the brief rise in the medical loss ratio and the construction and later move-in of the company’s new home office.






Medical Loss Ratio






Administrative Expense Ratio






We expect the business of Clear Choice to produce an 86% medical loss ratio and a 7.5% administrative expense ratio over time (if the future of health insurance is similar to what it is today). Given those parameters and the 2008 scope of business, we adjust the valuation to the following:

LTM Adj Operating Income


Price / LTM Adj Operating Earnings


This exhibit would give the company very little credit for the earnings potential of its significant investment portfolio. Below is the summary of the portfolio at the end of 2008.

View PDF for table [too large to paste on site]

Based on company indications and state regulatory filings, we believe that the company’s allocation to common stocks (which is unusual for a health insurer) represents excess capital not needed for the current scope of the company’s business. This figure of $14 million at cost, approximates the entire current market cap of the company, hence our assertion that you are nearly getting the current business for free.

At an approximate industry average and median of about 5.5 times operating income, the valuation seems to be quite off, as illustrated below:

LTM Adj Operating Income


Price / LTM Adj Operating Earnings



Implied Value of Op Earnings


Plus: Non-Operating Capital



Total Company Value


Value / Share


What is most attractive is that the company currently trades at a 70% discount to book value in addition to the earnings power discrepancy. We believe that book value is fairly indicative approximation for liquidation value, given its component parts. A substantial portion of book value is freely-traded investments (stated at market value on the balance sheet), receivables, and real estate. Though one could argue about the exact price of the company’s new headquarters, given the current real estate market and high relative unemployment in Oregon, we believe its book value is at least its salable value. What gives us such confidence is that the company’s six acres of land was purchased for $4.50 per square foot in 2001 and that same land was appraised at the completion of the building at $18 per square foot. This would imply an approximate $3 million not recognized on the balance sheet.

Three additional points are worth a mention. At the end of December, Clear Choice acquired a small TPA business, Trusteed Plans Service Corporation, which covers approximately 55,000 lives in Alaska, Washington, Idaho, Montana, Oregon and Nevada. This new business, which substantially adds to TPA covered lives, also expands the state presence of the company into several adjoining states. This may assist the company in moving forward with its expansion of underwritten products in those new territories. Though financials, including the acquisition, have not been disclosed, we believe this complementary acquisition will prove to be of long-term strategic importance.

Additionally, the company is currently battling a hostile takeover. A smaller, private company in Oregon, Agate Resources, is attempting to buy Clear Choice at a 15% premium to the 120 day moving average, which at the time of the offer was $12.62. The stock is now at a 31% discount to what we and management believe was a grossly inadequate offer. We highly encourage those interested to review the “Shareholder Communications” on the company’s website in response to the offer.

And finally, the company is currently rewarding shareholders with a substantial buyback. During 2008, Clear Choice spent over $1.9 million repurchasing shares at very attractive prices below book value. The total authorization of $5 million means approximately $3.1 million can still be repurchased. This would represent a further reduction of approximately 21% in the shares outstanding.

In short, we believe Clear Choice Health Plans to be a “clear choice” for those seeking to allocate capital to a micro cap with little downside and substantial upside. There appears to be such a discrepancy in the company’s earnings power and liquidating values that it is worth moving into a health care company despite uncertain future legislation. If the future of health insurance in the US is even remotely similar to that which exists today, Clear Choice has the durable earnings power needed for investments in small and micro-caps to be successful. If the future looks nothing like the past, the liquidation value would seem to protect our downside. We believe the risk/reward at $8.65 is heavily skewed to the buyer of its shares.

*This is not a recommendation to buy or sell a security. Please do your own research before making an investment decision. The author and poster of this article both have an indirect interest in the stock of Clear Choice Health Plans (CCHN.OB).