IB Equity Research

September 11, 2013

MOLINA HEALTHCARE, INC. Thesis Overview

As one of the leading Medicaid-focused HMOs, MOH enjoys a strong foothold in one of the healthcare sector's fastest-growing markets. MOH should directly benefit from healthcare reform, as states like California, Michigan, and Washington expand their Medicaid rolls. In addition, there is a robust pipeline of contract opportunities transitioning state Medicaid programs from traditional government fee-for-service mechanisms to managed care. In the near term, MOH should see upside to earnings versus current expectations driven by easing medical cost trends and conservative 2013 guidance. Over the medium and longer-term, the growth story is compelling, as the company has indicated a 2015 goal of doubling its revenue base while simultaneously improving margins. Based on industry trends, MOH could grow its topline 20% or more over the next 5 years or more. In addition, as margins are still recovering from higher medical costs experienced in 2012, further normalization of cost trends could lead to significant earnings growth. Given these opportunities, the company is undervalued, trading at just under 15x consensus 2014 estimates, which could be as much as 20% too low. Next week, the company is hosting an investor day, which should present a favorable update on the company's LT growth prospects.

Stock Rating Catalyst Category Price Target Price (9/11/2013): $36.69 Upside/(Downside): 23% Ticker: MOH Exchange: NYSE Industry: Healthcare Trading Stats ($USD millions) Market Cap: $1,680 Enterprise Value: $908 Price / Book: 2.0x PEG Ratio: 0.21x Dividend Yield: 0.0% Price / 2013E EPS: 23.2x Price / 2014E EPS: 13.9x EV / 2013E EBITDA: 3.4x EV / 2014E EBITDA: 2.6x

BUY 6 MONTHS $45.00

Source: Company filings, Wall Street Consensus

Price Performance 52 Week range: $21.62 - $40.90 Analyst Details IB Username: HCJK1718 Employer: Private Hedge Fund Job Title: Analyst Analyst Disclosure MOH Position Held: Yes

IB Equity Research
September 11, 2013

Company Overview
Molina Healthcare (MOH) is a Fortune 500 managed care organization focusing on providing health services to Medicaideligible families and individuals. The company also assists state agencies in their administration of the Medicaid program through its subsidiary Molina Medicaid Solutions. The company focuses exclusively on government-sponsored health care programs and operates health plans in ten states while its Molina Medicaid Solutions segment provides design, development, implementation, and business process outsourcing solutions to Medicaid agencies in an additional five states. Additionally, MOH operates primary care community clinics providing direct delivery of primary care constituting 17 primary care community clinics in California, two clinics in Washington, and three county-owned clinics in Fairfax County, Virginia. Medicaid sub-segments of TANF (Temporary Assistance for Needy Families), CHIP (Children's Health Insurance Program) & ABD (Aged Blind or Disabled) comprise the lions share of its 1.8M enrollees while Medicare Advantage only accounts for the remaining 2%. MOH operates licensed health plans in nine states namely California, Florida, Michigan, New Mexico, Ohio, Texas, Utah, Washington and Wisconsin with Illinois to begin in 2013. Washington and California appear to be the biggest states cumulatively accounting for nearly 42% of the total enrollment. Enrollment by Product & Geography

5%

5%

4%

2%
23%

12% 14% 16% 19%

WA TANF ABD Medicare Adv NM

CA UT

TX FL

OH WI

MI

Revenue Growth
In general, Medicaid health plans grow revenue by increasing their membership or generating higher rates from state governments. The latter portion is often left up to negotiations between plans and states: states often have the final say, but given cost savings managed care can generate, they are loathe to bring rates so low that plans will not want to participate. In terms of membership, growth can be achieved through two ways: by an increase in Medicaid-eligible lives within the plan's existing footprint, or by successful contract procurement, either in a new market or within an existing one. For example, MOH entered the state of TX in 2007 and in May 2010 was awarded a contract to serve Medicaid managed care patients in the seven-county Dallas service area. In September 2010, MOH won an additional contract to administer the CHIP program in 174 predominately rural counties across the state. During the 2012 state expansion, MOH added three new service delivery areas. More recently, the company has also expanded its OH footprint and effective June 01, 2013 would be expanding into 38 new counties. MOH will also be entering the state of Illinois in 2013. As a result, its membership has been growing at a CAGR of 9% from 2007-2012. MOHs major contributor, TANF and CHIP has been growing relatively slower at a CAGR of 7% (2007 -2012) while the smaller ABD and Medicare Advantage segments have witnessed rapid growth recording CAGRs of 24% and 48% respectively during the same period. As a result of this member growth, revenues have been growing rapidly as well. Not that this should accelerate in 2014, driven by the onset of Obamacare and a large California-based contract set to begin in April of next year.

IB Equity Research
September 11, 2013
14.0
Membership (000s)

1800 1600 1400 1200 1000 800 600 400

Revenue (B)

12.1 12.0
10.0
MA
ABD TANF

10.8

8.0 6.0

7.1
4.8

6.0
4.0 2.0 2.5 3.1

3.7

4.1

200 0
2007 2008 2009 2010 2011 2012

0.0
2007 2008 2009 2010 2011 2012 2013E 2014E 2015E

Margin Profile
By design, government-sponsored healthcare programs, particularly health plans, have low margins. Publically-traded Medicaid HMOs often characterize their Medicaid businesses as having pretax margins in the 3-5% range over the long-term. Except for 2009 and 2012, MOH's gross margins have been trending in the mid teen range. Sudden increases healthcare utilization levels led to lower trending gross margins in these years. Barring 2009 and 2012 MOHs operating margin has been in the 3 -4% range (Exhibit 5). A relatively high 14% YoY increase in 2009 G&A expenses was one of the primary factors behind a significant boost in operating expenses, leading to a significant drop in FY 2009 operating earnings. In 2012, the company witnessed exceptionally high utilization, especially in the newly expanded TX region, leading to lower operating margins. While this can be painful initially, as Medicaid plans have small margins to begin with, it is often quickly corrected, as states will incorporate that higher cost trend into their assumptions for future rate payments.
Margin Performance 18% 16% 14% 12% 10% 8% 6% 4% 2% 0% 2007 2008 2009 2010 2011 2012

Gross Margins

EBIT Margins

Market Overview
Medicaid is a rapidly growing segment within healthcare, which should directly benefit MOH. In addition to typical market growth of mid-single digits, there are several supplemental drivers.

Healthcare Reform (Obamacare)

Under current reform provisions starting 2014, Medicaid would expand coverage to additional 11M uninsured. Based on its presence within key states such as CA, MI and OH, MOH could accrue another 500K members, which could lift revenue by $1.5B. Note that this could ultimately prove conservative if additional states opt into the expansion.

IB Equity Research
September 11, 2013

Outsourcing into Managed Care

As entitlement program costs continue to rise, states are increasingly receptive to managed care solutions, which can provide immediate and long-term savings over traditional fee-for-service programs. On this State driven privatization, MOH's presence in FL, CA, TX and IL should be a top line tailwind. In addition, following the successful defense of its OH, WA and NM markets, the company faces little reprocurement risk. MOH successfully defended reprocurement of its Washington Medicaid contract in 34 counties and added one additional county effective 7/1/12. Similarly in OH, following a protest, the company was able to defend its existing Medicaid contract in the state. The company also expanded to 38 new counties effective 6/1/13. Apart from this reprocurement, MOH is also looking at expansion opportunities as many of them are in MOH's existing markets.

The Dual Eligible Opportunity

Typically, states incur the majority of their entitlement program expenses from a small minority of the patients. Most often, this cohort is eligible for both Medicare (intended for seniors) and Medicaid (for the indigent). MOH has already won dual contracts in CA, TX, OH and IL, though the margin profile may be weak in the initial years. Under the Californias Coordinated Care Initiative (CCI), starting June 2013, MOH plans to enroll 50K duals in the state of CA boosting revenues by ~$900M on an annual basis. Under the CA dual demonstration project (known as California's Coordinated Care Initiative) there is mandatory managed care enrollment of the Medicaid portion of the benefit while there exists an opt-out option for the Medicare portion. The government is also integrating long term support services (LTSS) into the contract which will include long-term nursing facility care, personal care adult day care and other support services which should help boost premiums for plans and achieve desired savings. MOH has also won the OH and IL dual integration proposals with enrollment expected to begin in Q4 2013. The company will enroll 25K duals in OH which would boost revenues by $400M while in IL MOH could add 17K duals at a PMPY of $25K boost annual revenues by ~$425M.

State OH IL AZ ID MI RI SC TX VA NM VT WA NY CA Total

Eligible Duals 114,000 136,000 98,235 22,548 198,644 22,737 68,000 214,402 65,415 40,000 22,000 115,000 133,880 526,902 1,777,763

Revenue Opportunity ($B) $3.4 $4.1 $2.9 $0.7 $6.0 $0.7 $2.0 $6.4 $2.0 $1.2 $0.7 $3.5 $4.0 $15.8 $53.3

Effective Date Jan-14 Jan-14 Jan-14 Jan-14 Jan-14 Jan-14 Jan-14 Jan-14 Jan-14 Jan-14 Jan-14 Jan-14 Jul-14 Apr-14

Overview of Catalysts / Key Value Drivers

Investor Day Could Provide a Positive Update to LT Growth
MOH has been under pressure of late, without much reason. After beating 2Q consensus EPS estimates, even after including roughly 12c/share in one-time costs, the stock is down roughly 11% from pre-earnings levels, which presents an excellent entry point. MOH is hosting a semi-annual investor day on 9/19. Based on recent developments since its previous investor day in February, the company may provide a positive update with respect to its long-term revenue guidance. In addition, MOH may provide additional color on various state payment rates, which should be positive, and the CA dual eligible program, among other

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September 11, 2013

things. With little explanation for the stock's recent weakness, this catalyst should reinvigorate the stock, which is trading at a discount to its historical levels.

2014 Estimates Are Too Low

2014 consensus reflects an overly cautious view of operations. While some degree of conservatism is appropriate given the rapid revenue growth, estimates appear to be implying an unreasonable degree of caution on margins. The "bridge" from 2013 guidance makes this apparent. Included in MOH's guidance of $1.55 in EPS is roughly 60c/share in preparatory costs related to either the Obamacare expansion or new contract implementations. Of the 60c/share in preparatory costs, roughly half (30c/share) is not expected to recur in 2014. Off of that EPS base of $1.85, MOH should grow revenue by roughly $3 billion in 2014, between typical organic growth, Medicaid expansion via Obamacare, the new dual eligible contract in California and other new contracts. Even assuming lower than typical margins on the new business, the revenue growth equates to roughly $0.80/share in incremental earnings in 2014, equating to 2014 EPS of $2.65 ($1.55 + $0.30 + $0.80 = $2.65), well above consensus $2.28. The company will provide an initial view of 2014 guidance either on its 4Q13 conference call or during its Winter investor day in February.

3Q Earnings Should Be Strong

Hospital admission surveys in 2Q showed Y/Y deterioration, which led to meaningful earnings shortfalls in for publically-traded hospital companies. Lower utilization should benefit HMOs' gross margins, as it suggests medical costs may be lower than anticipated. These trends appear to have continued into 3Q. In addition, MOH is facing easy comparisons relative to flu-related costs, given the intensity of last year's season.

IB Equity Research
September 11, 2013

Financial Overview
Molina Healthcare (MOH) FY end (Dec 31) Income Statement ($M) Revenue EBITDA EBIT Pretax Net Income EPS Dil. Shares Margin and Returns (%) EBITDA EBIT Pretax Net ROIC ROA ROE Balance Sheet and Cash Flow ($M) Cash and Equivalents Total Assets Total Debt Shareholder's Equity Change in Working Capital CFFO Capex FCF Selected Operating Metrics Total Premiums ($M) Membership (K) Medical Loss Ratio SG&A Ratio 2012 $6,028.76 $99.18 $35.47 $19.07 $9.79 $0.21 46.80 2013E $6,908.14 $264.87 $182.50 $139.81 $71.50 $1.58 46.42 2014E $10,210.74 $347.81 $237.10 $184.13 $114.59 $2.65 45.20 2015E $12,100.81 $382.31 $266.74 $223.40 $145.23 $3.05 44.09 CAGR 26% 57% 96% 127% 146% 144% -2%

1.6% 0.6% 0.3% 0.2% 2.0% 0.5% 1.3%

3.8% 2.6% 2.0% 1.0% 5.8% 3.1% 8.5%

3.4% 2.3% 1.8% 1.1% 6.9% 3.8% 10.7%

3.2% 2.2% 1.8% 1.2% 7.2% 4.0% 12.4%

N/A N/A N/A N/A N/A N/A N/A

$353.90 $1,931.82 $262.94 $782.31 $74.84 $344.30 $78.15 $266.15

$612.98 $2,708.04 $585.83 $902.64 $579.86 $102.29 $83.35 $18.93

$521.03 $2,721.98 $585.83 $1,004.58 $118.47 $136.47 $48.92 $87.55

$625.23 $2,803.64 $585.83 $1,105.03 $343.28 $159.75 $55.91 $103.84

21% 13% 31% 12% 66% -23% -11% -27%

$5,826.49 1,797.00 87.5% 8.8%

$6,577.34 2,008.00 85.5% 8.6%

$9,721.80 2,269.04 86.2% 7.9%

$11,521.36 2,382.49 86.4% 7.8%

26% 10% N/A N/A