Description

WCG long: WellCare $19.40, ($820mkt cap), is a Medicaid and Medicare HMO trading at just 6X trailing EPS, 2.4X trailing adjusted FCF and $322 on an EV-per-member basis vs. peers valued at $987. The stock, now at $19 is down from its peak of $122 before an October 2007 FBI raid of its headquarters. Investors dumped the stock assuming WCG was engaged in a massive fraud, would lose its government contracts and be dealt a crippling fine. However, the fraud proved to be limited primarily to overbilling in its Florida Medicaid subsidiary and a new management team with an excellent track record was successful in settling the criminal aspect of the investigation. On 5/5/09, WCG entered into a Deferred Prosecution Agreement and agreed to pay an $80m fine. It established an additional reserve of $50m related to settling the civil charges. Ultimately the total settlement cost will be $130m vs. the $4bn in market cap that was wiped out when the investigation was first announced.  That $130m is insignificant vs. WCG's 2008 adjusted FCF of $340m and its $1billion of net cash, although most of which is at the subsidiary level.

Despite new management's progress in settling the investigation, getting current with its SEC filings, and holding its first conference call in nearly two years, WCG remains dramatically undervalued.  At $19.40, the stock is trading at 7X our 2009 EPS estimate of $2.73 and 6X our 2010 estimate of $3.22. Even at current depressed sector multiples with Medicare HMOs trading at 5.8X 2010 EPS and Medicaid HMOs at 9.3X, WCG is worth at least $26 on a blended multiple (66% Medicaid/34% Medicare) of 8X.  Moreover, we think WCG is a very attractive acquisition target to a large commercial HMO, given that Medicaid will be the fastest growing segment in managed care over the next 1-5 years, as the administration leverages the Medicaid platform to cover the 46m uninsured. WCG is trading at $322 EV-per-member, just a fraction of its Medicaid peers trading at $700 per member, and its Medicare peers trading at $1300. Applying the lower Medicaid multiple of $700 per member to its entire enrollment base would imply a market cap of $1.7bn and a stock price of $40 or 12X our 2010 EPS.

• New management with solid track record
• Charles Berg(Executive Chairman), was instrumental in Oxford's turnaround and eventual sale to UNH. He joined Oxford in April 1998 as Executive VP, when the stock was at ~$15. He was promoted to COO in March 2001(stock at $29), and then CEO from Nov 02(stock at ~$33) to July 04, at which point he sold the company to UNH for $57. Berg has upside on 472k shares (172k stock, 300k options).
• Heath Schiesser CEO and Pres - He joined WCG in 2002 as head of marketing, and successfully led company's entrée into the Medicare Part D program in 2006 - essentially going form $0 - $1bn in rev in its first yr. Prior to WCG, he founded an online pharmacy for ESRX and worked at McKinsey. Heath has upside on 846k shares (278k stock, 568k options).
• We model EPS of $2.73 in 2009, $3.22 in 2010, $3.87 in 2011, and $4.31 in 2012, based on our detailed model by state and product and modeling pre-tax margins around 3.5%. We conservatively assume Medicare earnings decline each year starting in 2009, given reimbursement pressures. While we expect Medicaid revenues and earnings to grow by double digits from 2010-2012.
• We think the street is underestimating WCG's earnings power, with published consensus estimates of $2.01 in 2009 and $2.21 in 2010, which are partly weighed down my some analysts including non- recurring settlement costs in their numbers. In addition, some analysts are taking an overly conservative interpretation of WCG's disclosure that 2009 earnings will be materially down from 2008 primarily because of reimbursement pressures in strapped state budgets. We think our $2.73 estimate, based on 2.6% pre-tax margin will prove achievable. And is amply supported by the strength of 2008 FCF and increased federal funding for state Medicaid program in the stimulus.
• 2008 adjusted FCF/share of $8.10, implies earnings power meaningfully ahead of reported EPS of $3.17. WCG reserved overly conservatively in 2008 as we saw a 1Q09 PPD of $0.46, and we could see that benefit continue to play out in 2009.
• On a EV/ member basis WCG is trading at fraction of its peers, making it an attractive acquisition

• ~$1bn of net cash, with $64m free at the parent. We see WCG ending 2010 with $244m cash at the parent 30% of current market cap, after paying settlement fines and keeping 40% of 2010 FCF at the sub level.

• WCG Medicaid business is an attractive asset to any of the HMOs. AET, UNH, WLP ,HUM, CVH are all tying to grow their Medicaid business.
• Medicaid HMOs are an underappreciated "Obama Play"- Healthcare reform to cover the 46m uninsured, will likely be built off the proven Medicaid HMO platform which has broad bipartisan support. We think that the total Medicaid HMO enrollment could grow by 20-50% over the next few years, far outpacing any other segment of managed care.

Risks: 

• WCG, along with WLP is currently banned from enrolling new Medicare members. We think this ban will be lifted by the start of the 2010 selling season in the fall. If it is not, WCG will be unable to grow in Medicare business in 2010.

Catalyst

 Catalysts:

• Formal settlement in the civil case
• Lifting of the Medicare marketing ban
• 2Q EPS and potential 2009 guidance
• More regular management communication with investors
• Takeout