Evolent Health, Inc. (EVH) Earnings Call Transcript & Summary

Good afternoon. This is Kevin Caliendo, health care service and distribution and IT analyst from UBS. Thanks for our last session of the day with Evolent Health, with John Johnson, Chief Financial Officer. John, thank you so much for coming.

Great to be here.

I know this was not an easy week to travel. So...

I made it...

I hope you make it home. I hope you all make it home. Maybe they'll vote tomorrow and miraculously all the FAA workers will be back. But again, all sincerity, thank you for coming.

Let's start out. Your stock did react favorably to the report -- to your third quarter results despite a meaningful new business win, a better quarter and better guide. I mean I think the issue is the lack of visibility into '26 due to potential membership losses and HICS and potentially Medicaid. And the question we've been getting a lot is how do we frame this? I know you've probably been asked this 100 times today, but let's just talk through it a little bit more. How do we think about -- do you think about it in terms of loss of numbers in HICS? Does it matter which customer it is? Let's just talk broadly about it. Let's try to dive a little bit as we try to maybe streamline our model a little bit.

Yes, of course. So let's talk about the building blocks for next year, right? So we think of 4, there's organic growth where we feel very good, both on the Performance Suite side and on the Tech and Services side. So adding new customers there, launching new business at the beginning of the year, which relative to the Performance Suite, of course, Tech and Services brings with it new EBITDA right away instead of having a maturation curve. So good on the growth side. Second thing is on the cost structure side. So we've talked about a $20 million year-over-year benefit leading into next year from reductions on the cost of revenue line driven through efficiencies. We feel really good about that as well. The third thing is medical trend and its position relative to our pricing where we feel quite good as we go into next year. Trend feels very much under control in our world and the pricing feels strong relative to the risk that we're taking next year. That then leaves membership. And it's -- what we laid out in the call is, while there is a wide range of potential outcomes for both MA membership and exchange membership, if you take the downside of the public commentary by some of our customers, then we would find it despite strong performance on items 1, 2 and 3, we would find it difficult to grow EBITDA meaningfully next year from this year's pro forma baseline. So then let's dig into a little bit what that looks like in the exchanges and what that looks like in MA because to your point, individual carrier dynamics certainly matters a lot. In the -- our HICS business, is about $360 million of revenue today, split about 50-50 between Tech and Services and the Performance Suites. In the Performance Suite, we're most levered to Molina. And so their commentary on membership can be read through to us. In the Tech and Services suite, we're most levered to Centene. And so their commentary on their exchange membership can be read through to us as well. We've heard public commentary from both of those players of as little as the high teens and as much as 2/3 of membership dropping. What can we then do about that, right? How can we mitigate that issue? The first, I'll talk both about cost reductions and about pricing in the risk business. On the cost reduction side, as you can imagine, we are today, from a planning perspective, ensuring that we're taking the appropriate actions to set up cost actions in the event that we end up at the more extreme side of that scenario, right, so that we are able to react very nimbly when we get final membership information. And you've seen us do that in the past, be highly disciplined on the cost structure and on the SG&A, and we're prepared to do that again. On the Performance Suite side, there, it's about matching our price with the changes in the population that might result from such a significant downdraft in membership. And our aim there is to ensure consistent MLR in the exchanges from this year to next year. So our pricing targets for next year in that part of the business, we're not seeking to drive EBITDA expansion right now in that area. But we do believe that we will be able to preserve our company average care margin, which is about 7%. That equates to an MLR of 93%, preserve that level of profitability in the exchanges next year based on rate.

So how -- you say you act nimbly. What does that mean? Because I guess the question is when will you know? And how quick -- what does nimbly mean? I'm not -- obviously, this is a sensitive topic. You don't want to -- but from an investor perspective, how do -- how and when will we understand this little better?

Yes. Look, I think open enrollment is going on right now. And we have good dialogue with our planned partners in terms of what they're seeing, and that informs our planning as well. And that should enable us as we come into the beginning of January and have a clear sense for their expectations of their membership that should allow us to kind of take action to rightsize what we need to based on those changes.

And I know this is an obvious question, but what is the greater sensitivity in which part of the business when it comes to the HICS side of the business?

For sure. So look, the relative margin between the Performance Suite and the Tech and Services is pretty different. So average margin -- care margin in the Performance Suite of 7% across the company right now. Average gross margin in the Tech and Services Suite and the exchanges would be between 40% and 50%. And so that's where the SG&A cuts will come into play.

I have to be more on that side.

For sure.

Is it region by region? Like how do you think about this? Or is it nationally run given the HICS -- like -- and I should probably know this, but I don't, which is when you think about it internally, is it market by market that you know? Or is it just big picture...

So we will think about it as a region-by-region membership change. And that's, I think, where we have to estimate together with our partners, what are the actions that they're taking in a particular geography that might result in changes in membership in that geography, that then flows into our overall calculation. But our actual staffing is not geographic specific, right? Actual staffing is nationwide. And so we can titrate based on the aggregate membership decline.

Let me -- I'll ask this in a way, but -- does the HICS business for you guys make sense going forward? Obviously, we've seen CVS exit HICS. People are just saying, I can't make money in this business now. Do you guys look at that as sort of, hey, maybe we shouldn't -- we're basically at the whim of our customers here and it's incredibly volatile. But you make money doing it and it's high margin. So how do you -- I know your new role strategically isn't necessarily -- but this is a C-suite question of, hey, where do we invest our resources in terms of our new business wins? How do you view HICS? How do you view Medicaid? How do you view MA? How do you view some of the other opportunities that you have going forward, just given -- or is this like it's never going to get worse and this is the most disruptive it's going to be. But it's a legitimate question. I'm sure you've had it 100% internally.

Look, here's how we would approach that question, which is 100% through the lens of what's best for the customer, right? Because ultimately, the success for us comes from success for our customers, right? And if we can be their preferred partner across both lines of business, geographies and specialties, then that to us feels like the most durable position to occupy. And that to us is worth the potential volatility of seeing membership up and down in one of their lines of business.

It's a part of the offering. It's going to exist. If they want it, they can have it. I guess just from a question of your own operating leverage, like is it -- do you want it to be the first piece of the business that will last...

For sure. Look, I think it's true -- the best answer to that question is it is the smallest part of our business today, right? It's only about 20% of our revenue, and it's a vanishingly small percentage of the new growth that we've announced for next year, right? So it's not where we're growing right now.

Well, that's a good thing. Let's talk about this revenue guide, the $2.5 billion plus. There's obviously -- you have visibility into this. You wouldn't have guided to regardless of what happens with this membership presumably.

That's right.

How much variability was in that. Is this the baseline now -- is $2.5 billion the baseline when we think about long term? Or is there more above and beyond that, like, okay, that's the new baseline and then we attach some kind of LRP or growth rate to that? How should we think about it beyond this year?

For sure. So I'd say a couple of things. We view $2.5 billion as the current forecast for next year that is contracted, right? And so we haven't sent the sales team home. They're still selling business, and we would aim to sign up more business for next year. And that would then mean both through new business wins and through the timing of go-lives, we'd be exiting next year probably meaningfully north of that $2.5 billion number. That then tees us up for a strong growth into '27 and the size of our pipeline, which we referenced on last week's call is $650 million on a weighted basis, that's probability weighted based on the probability of close. That should set us up for multiple years here of very attractive growth. Generally, what we have indicated is 15% plus on the top line, obviously set up next year to meaningfully outperform that. And while we haven't given updated sort of long-term outlook beyond that 15%, you could see scenarios where it's meaningfully in excess of 15% for several years to come. I'd say one more thing on the growth side because it's important. At the same time as we're growing very significantly, one of the greatest things about having a pipeline this deep is we can be very disciplined on the underwriting. And so the construct of both the Tech and Services deals that we're announcing and the Performance Suite deals that we're announcing are very tightly constrained risk contracts to Evolent. They're still risk contracts, right? And we can't minimize that. But if you look at the protections that are contained in these enhanced risk contracts for Evolent that match our rate to things like changes in prevalence, changes in case mix and contractual protections that have corridors that cap our losses, things like that. It allows us to feel very comfortable in those underwriting standards given the pipeline that we have, we can demand those kind of terms.

That's great. Obviously, it's important because the risk metrics and margins are -- have been an issue, have been a controversy. You said that some of the new business that you've won, we should think about the margins peaking at around 10%. Is that the go forward? Like when we think about your business in '27 and '28 and the like, obviously, the mix of Performance Suite versus Tech-enabled. But how should we think about margins for your company starting -- if we want to start with this year as a baseline, but next year as a baseline? How should we think about the longer-term margin opportunity here, too, because, again, this has been a [indiscernible] controversy. I don't think you're winning new businesses. I think it's...

For sure. I'd highlight maybe 3 things. The first is on the Performance Suite. Last year, care margin was 3%. The historical average was 10%. This year, we've got 400 basis points of recovery already delivered. We're at 7% this year and on our way back up to that 10%. That is the right long-term target as we see it today for that part of the business. On the Tech and Services side, average gross margins there today are around 50%, 5-0. We see an opportunity there through these automation and AI activities to increase that gross margin over time while also bringing costs down for our customers. I think we can have both of those 2 things. That's a win-win. Let me give you an example of what this sort of cost work looks like. In April, we deployed some machine learning technology on a broad swath of codes in one part of the business. And between April and over the summer, iterated more than 50x tuning those models to best approximate what our case reviewers were doing when they were reviewing those particular codes. At the end of that fine-tuning, we saw more than double the rate of auto approvals of those codes than we had seen prior to that work. And so that's the kind of AI automation that we're talking about that then directly translates into improvements in our staffing ratios and turnaround times for our customers.

Have you quantified it?

So that is -- you add that up across a lot of different projects, and that's what gets you to the $20 million improvement for next year. And then thinking longer term, we see that as a $50 million EBITDA opportunity.

I mean that's a huge number.

It's a giant number.

What are the KPIs? Like how do we know that this is working and how do we just see it in the results like this $20 million, I'll just -- will you be able to call that out as what's -- incremental?

Yes, for sure. But you'll see it show up in the cost of revenue line is where it will show up because these are direct staff. And as we are rolling this out further across the organization and adjusting the staffing ratios at the end of this year during Q1, we'll be able to call those out and what changes those have translated into from the cost structure perspective.

Got it. The other debate, obviously, the margin for next year and the loss of membership and that was an overhang. But it's also brought in affect the balance sheet a little bit. So let's talk a little bit about that. You've done some things to mitigate your near-term capital structure risk, if there's such a thing as capital structure risk. Tell us sort of where we are now and what's the plan to delever going forward? How should we be modeling that '26, '27, how should we be thinking about what's the company's plan? What have you -- I don't know if you've had to talk to the banks, covenants, any other issues you did an offering. But just talk through -- let's understand a little bit.

Yes. So a few things to note there. So let's go to the numbers first. We would expect to end this year after paying down about $100 million of the senior term loan with the proceeds from our Evolent Care Partners divestiture, we would expect to end the year with about $800 million in net debt that would translate to about 5.5 turns on our 2025 EBITDA. From there, between EBITDA growth and cash flow, we would expect to be able to delever by about 1 turn per year, getting us below our target, which is 4x in, call it, mid- to late 2027. So that's the plan and the goal. I'd note a couple of other things. Just in terms of bank covenants because you mentioned that, it's very covenant-light debt. We only really have one, which is 8.5x the senior secured portion. We have a very significant amount of cushion to that covenant, not something that we're concerned about.

Okay. And after you did the offering last year, you don't have any maturities coming due for at least 3 years...

The end of 2029.

So 4 years.

That's right.

4 years. Okay. So -- and I'm presuming free cash flow is basically going to be devoted entirely to this.

Correct. That's right.

No other -- there's not going to be any M&A. There's not going to be any -- this is like we're in a deleveraging...

That's right.

Okay. I think that's pretty clear. I do understand why investors are concerned. And getting back to the EBITDA question, I guess this is a place to ask it. You said you can mitigate, but it will be hard to grow significantly. Does that mean that like what -- I'm not going to hold you this guidance, but is a worst-case scenario flat? Like regardless of what happens if these -- the worst-case scenario with membership is -- happens, you can still at least be flat.

Yes. Based on everything that we know today and looking at some of those extreme scenarios that have been put out by some of our customers, if we run that through the model, add it to it, all the growth, add to it the actions that we know we can take, then we see that as our baseline for next year. So flat to a pro forma number this year.

Okay. All right. So that's not formal guidance.

Not formal guidance for sure.

Fair enough. The oncology costs, you mentioned that they're running a little bit below the sort of target they have been. We track it pretty closely. We have a whole oncology script model that we built that Andrea, my colleague was able to uncover. It's fantastic. We get more requests for that than we get almost any...

I believe it's a good model.

But you mentioned you saw a spike in cardiology utilization, specifically September into October. How much impact does cardiology utilization actually have on your model? Like that's a harder one for us to track because that's more procedure than it is on drug. The drug correlation to in oncology is higher, cardiology is more procedure driven. It's harder for us to track that. So maybe tell us the impact that has on your total cost trend, how much is cardiology as a percentage of your total cost?

Yes. Yes. So cardiology represents about 40% of our Performance Suite revenue. And I want to be explicit about where we're seeing this trend because it's not broad-based. It is in the exchanges. And we believe that it is likely driven by what's been called a benefits rush, where people who are currently covered with an Affordable Care Act plan who see the possibility of, boy, my premium might go up by 50%, I might not stay covered. Before I make that decision, I'm going to go see a doctor and get a clean bill of health and maybe that visit uncovers something. And that is what in our hypothesis leads then to this spike in care. We did see that in cardiology in the exchanges in September a little bit, in October, a little bit more. And so then our guide contemplates $3 million of increased cardiology expenses in the third quarter -- or sorry, in the fourth quarter. That is effectively -- if you look at the midpoint of our guide, it went from 52.5 -- $152.5 million to $149 million, and that's basically all this cardio benefits rush.

And if that were to continue, so you basically -- your working assumption is this is going to run out at the end of the year.

It feels transient to us. That's right, because of the way that it's coming about.

And there wasn't a similar spike in oncology probably because...

Not particularly. You could imagine a little bit, maybe somebody similarly goes to the doctor and they catch something, right? They get screened for cancer. But obviously, oncology treatment is a little less elective. And so it's more likely that somebody would have gotten that checkout.

There's been a lot of debate here at this conference around what happens when biosimilars come to oncology drugs in the context of the distributors, in the context of PBMs, in the context of payer models and all these -- it's -- what happens if the IRA price comes down, what happens to ASP? Like it's a debate going on. But I'm interested what happens to Evolent when you contemplate in 3 or 4 years when, say, KEYTRUDA goes biosimilar, maybe the price comes down by 30% in year 1. How do we think about that? How do you guys model that? Is it a tailwind for a year? Or is it automatically readjusting your rates because it's so huge, that particular drug is massive. So how do we think about that? Is it a good thing for 1 year and bad thing after that because everything reprices lower, how do we think about it?

Yes. Let me say a couple of things. The first note I would make is our experience in navigating the introduction of biosimilars in oncology is we can position Evolent as a change agent to our key customer, which is the health plan, right? Because biosimilar adoption doesn't just happen, right? It is physician behavior change. And that is an area that we can support. And so we can make that adoption happen where it's clinically indicated, we can make it happen faster. So we can create more value. We then get to capture some of that value in our Performance Suite, and we would share some of that value with our customers as well. So we would see this as a tailwind. The other note that I would make is the -- as I look at drivers of cancer trend over the next 2 to 3, 4 years, while checkpoint inhibitors will continue to be an important piece of the trend, you've got antibody drug conjugates right behind them, right? I think drugs like ENHERTU and things like that, that we are -- have longer time horizons on this biosimilar issue. So I don't think that we're going to wake up in '29 and see a dramatically lower cancer trend. I think these elevated levels persist for some time.

So you can help move patients to the biosimilar regardless of like a PDM decision and the like. And do they get -- is the cost base on the biosimilar list? Or is there -- if they use the brand, but the brand gets a bigger rebate, like how does your cost? Is it the rebate because they're the GPO negotiated price? How does that work for you guys?

So generally for us, in the Performance Suites, we don't control the fee schedule, right? That's controlled by the plan. And generally, it's going to be indexed on ASP. And so it's going to move with the average selling price.

Okay. And if they throw the whole ASP model out, how does that work? I mean it's something that CMS is talking about doing and that's why I'm not joking.

No. Look, so let's do that real example. Let's say that in a couple of years, there's a wholesale update to unit costs in oncology. What would happen in that context in the Performance Suite is our rates would update based on those changes. And if it was a significant change, it would happen in that same year.

Okay. I got it. You're now -- it was a year ago this quarter, the third quarter, a year ago when everything changed, right? And the world turned upside down a little bit for you guys and you had to go and recontract new risk corridors. We've talked about the limit to -- now we talk about 10% margin and things like that. You've won some business as well now with these new quarters. And that was a concern going in like, hey, if Evolent is not willing to take the same amount of risk, will people still pay for their services? They are. What has the sales pitch? How has the sales pitch changed? Who's coming to you? What are they asking for differently than may have been 16 months ago?

Yes. So look, I think there's been this wholesale change in how MCOs approach this kind of contract because of the realization that a company like Evolent can create a ton of value in a specialty where we're very deep, but we can only do that if it is sustainable for both parties. And so that's the context of these conversations. And we have now a number of reps, both recontracting the book between last November and February and now a significant number of new wins with these enhanced protections that I think we have proven that there's significant appetite and belief in the value that we're creating independent of some of these protections. And so we're pretty excited about that.

Are they asking for anything different or in return?

Yes, there's a clear trade, which is we share more of the upside, right? And so how does that typically manifest? Often, it manifests as beyond a certain MLR for Evolent, we start sharing 50% of the savings back to the plan. And that's what results in our target margin for that business moving from the mid- to upper teens, which it was 2 years ago, down to 10%. Now that's -- it's still a very aligning structure, right? It's not like we're capped. We're still motivated to go out and continue to create value. And the plan is aligned with us if they're sharing in that value.

Got it. It makes sense. Is there any -- I'm just trying to think of like the new contracts that you have -- that you've won, CVS and this Blues plan. How do we think about onboarding and margin progression? You talked a little bit about this on the earnings call. We talked about a little bit afterwards. But -- if we were just to bridge core business and then layering on these new contracts, how do we layer on revenue progression versus adjusted EBITDA or EBIT margin? How do we get there?

For sure. So in the Performance Suites, revenue comes on day 1. And we think of it as a 2-year ramp to target profitability. So in year 1, we will generally expect minimal EBITDA contribution. We're building the reserves. We're driving change through the network that takes some time. Year 2, during the actual year 2, we would expect margins of between 5% and 7%. And then exiting year 2 is when you start to get to that 10% target.

And then year 3.

Then year at steady state.

Right. And these contracts are 3 years. So you're going to get at least 1 year full margin benefit. The extension beyond 3 years, is that -- how does that -- how many contracts have you not renewed past 3 years? I'm sure there's been some, but like...

Very few.

Very few?

Yes. Our retention rate on the specialty side has been very, very strong. And I think it speaks to the value that we've been able to create for our customers. If you think of Evolent generating 10% margin at maturity, the plan is usually also capturing 10% savings relative to that benchmark or better, right? And so it's a situation that can really work for both parties.

The -- if I'm thinking about just the new contracts and when they onboard because the Blues Plan doesn't onboard 1/1, right? It's 5/1. So there's not going to be a ton of EBITDA contribution in '26 from either contract...

That's right. But very nice tailwind as we move into '27.

Right. So when we're bridging your earnings and the like, it's really take the '25 baseline, adjust the normal growth and there's some maturity in margin in some of the business there.

That's right.

Right? So there's some business that's moving to the peak margin for 2026, you have this membership headwind, whatever it might be. And then you should be getting, in essence, the start of margin, 5% to 7% for a full year in CVS and half -- roughly half a year the Blues plan.

That's right.

That's the way to model. And then whatever other core growth you have because there's other things -- okay...

That's right.

It's not an easy model to build, and it's fair. The free cash flow in the quarter was negative...

The free cash flow was because of the $40 million share buyback.

So you had this $40 million it's receivable. Is that...

So we had -- so 2 things. We had -- the free cash flow is negative because we bought back $40 million of shares in August as a part of the refinancing of the '25 convertible notes. We also -- CMS had planned to pay us the $42 million shared savings payments for MSSP in September. That was delayed until October. So we've now collected that money, but that did result in operating cash flow for the quarter being $15 million instead of quite a bit higher, which is the initial expectation.

How should we think about it for the full year?

Yes, for the full year...

Operating and free cash flow.

Yes. So as we move through Q4 here, we've collected that $40-plus million from CMS. We don't have any significant outflows other than normal course stuff for Q4. So we would expect to end the year, the number that we've put out there is an expectation of net debt at the end of the year of between $805 million and $840 million. And that variability is largely driven just by timing of customer collections. Somebody pays us on December 27 or January 3.

Free cash flow again next year, we understand these new contracts aren't going to be onboarding. There's probably CapEx associated with them as well.

A little bit.

Does CapEx go higher? I'm getting to -- let's just say adjusted EBITDA is flat, the worst-case scenario, you mitigate [ Europe ] flat. CapEx goes up like in free cash flow -- free cash flow positive next year, presumably in that scenario, but maybe less than what it was this year or...

Yes. So free cash flow positive next year for sure. I would expect software CapEx this year is $35 million. I would expect that to come down a little bit next year because some of the CapEx this year was -- you could think of it as onetime in service of some of these AI acceleration initiatives.

Okay. Got it. Is there anything else we haven't covered?

No.

We're sort of out of time, but I want to make sure I didn't miss anything.

Yes. Good set of questions.

Great. Well, sir, thank you very much. We appreciate the time.

Thank you. Thanks.