On April 23, eHealth Inc. (EHTH) reported first-quarter earnings after the market closed. The company, which provides online health insurance agency services, announced that it beat analyst consensus estimates.
Calling out aggressive accounting
In the weeks leading up to its latest earnings announcement, eHealth faced public scrutiny from Muddy Waters Research, a short-side research and investment firm renowned for rigorous financial analysis and forensic accounting. On April 8, Muddy Waters published a scathing report on eHealth, in which it claimed a number of questionable accounting practices that may have served to give investors an inaccurate impression of eHealth’s true financial health.
According to Muddy Waters, eHealth has used aggressive accounting and relied on unreasonable expectations to mask persistent losses. The digital insurer’s stated methodology allows it to recognize future revenues based on long-term member contracts. However, the company has reported significant member churn for years. Indeed, churn has actually increased steadily since late 2017, while the recapture rate for churned members has remained stubbornly below 10%. Despite this, the company has continually adopted assumptions of higher persistence, and built these into its revenue recognition formula. In Muddy Waters’ view, such practices do not comport with reality:
“EHTH’s highly aggressive accounting masks what we believe is a significantly unprofitable business…We conclude that EHTH is pursuing low quality, lossmaking growth while its LTVs are based on lower churn, pre-growth cohorts…In addition to using aggressive modeling assumptions, they misleadingly downplay the need for ongoing service and retention. This is the crux of how they justify booking multiple years of revenue at one time…EHTH appears to be booking multi-year ‘tail’ revenue at the end of each cohort’s estimated life, which is extremely aggressive in light of the significantly elevated churn.”
An unsustainable growth model
By embracing an extremely aggressive revenue recognition methodology, eHealth has managed to juice up its reported earnings. Indeed, the company has booked profits in quarters when more conventional accounting would have resulted in steep losses. Analyzing eHealth’s business strategy, Muddy Waters found that reported growth, which has been driven by low quality and usually money-losing consumer segments and population cohorts, to be largely illusory:
“EHTH is pursuing low quality, lossmaking growth while its LTVs are based on lower churn, pre-growth cohorts. We conclude that the key driver of growth since 2018 has been EHTH’s reliance on Direct Response television advertising, which attracts an unprofitable, high churn enrollee. To generate this unprofitable growth, EHTH has been incinerating cash, which we expect it to continue to do until this value destruction slows down or stops.”
Company management has consistently downplayed the importance of spending on member management and retention, despite the evident high churn rate. Booking multiple years of revenue immediately upon signing new members is hard to justify, based on eHealth’s low retention rate. Moreover, as CVC Research pointed out on April 23, eHealth’s reported revenue growth appears to have been driven more by increasingly ambitious assumptions about membership lifetimes than actual top line expansion:
“Beat and raise, but cut [cash flow] guidance. it appears extending customer lifetime assumptions may be driving most of the revenue ‘growth.’ Note the huge growth in noncurrent commissions receivable. Very sus.”
In the first quarter, eHealth claimed $3.5 million in net income on $106.4 million in revenue. The company also raised its full-year guidance. Yet, at the same time, eHealth cut its cash flow guidance. That makes sense in the context of a company burning cash to fuel a growth narrative, but it does not comport with the performance of a genuinely profitable operation.
While eHealth can justify its revenue recognition and accounting practices up to a point, no amount of financial gamesmanship can distract from its unsustainable cash burn. Ultimately, cash is king.
I recommend that investors approach this name with extreme caution. A healthy dose of skepticism seems warranted, based on eHealth’s reported results and guidance. The company is burning cash unsustainably. In my view, eHealth’s short-termist strategy will not benefit its shareholders.
Disclosure: No positions.
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This article first appeared on GuruFocus.