Description

Thesis

Yet, WLP arguably has the best assets in the industry and should grow earnings 5-8% per year and EPS at 10%+ (given buybacks).   It’s odd that we’re about to debate growth at all for a company trading at below 10x EPS and expected to use $2b+ for capital management this year that has retired 50% of its shares in the past 6 years and is expected to continue buying back.  In short, we think this company can earn $10-$12 per share in 2-3 years and a 10-12x multiple seems reasonable – up ~50% from the current stock price. 

Competitive Advantage

Wellpoint is a managed care company that is an independent licensee of the well-known Blue-Cross Blue-Shield brand.  The company is a roll-up of state-specific enterprises that culminated in the 2004 merger between Anthem (located inIndianapolis) and Wellpoint (located inCalifornia). 

WLP’s key competitive advantage is its local market share.  This is particularly important for the insurance-exchanges since it gives the company purchasing power and thus a cost advantage – if they can’t earn a profit, others shouldn’t be able to either (more below).  On average, WLP has ~30% market share and closer to 50% for individual health care policies. 

Market Share by State:

IN, NH, VA (40-45%)

ME, KY, CT (30-35%)

MO, GA, OH, CA (25-30%)

NY, CO (20-25%)

NV, WI (15-20%) 

Overview of Operating Profit

The company doesn’t break out operating profit by division (the way investors and analysts think about the different businesses), but based on comments from management and competitor information, we think the following is a rough breakdown of 2012 operating profit.  We think this is important because we believe investors are throwing a blanket of fear over the stock without considering (or even trying to analyze) what is at risk.  By actually going through the numbers, we think it becomes clear that both the risk from insurance exchanges is smaller than folks think and the opportunity to improve other portions of the business is greater than perceived. 

• Large Group: $1,330m (est 5% margin on $26.6b of rev)
• Small-Group: $795m (mgt suggested 7% margin on $11.3b of rev)
• Individual: $220m (guessing 4% based on mgt comments; $5.5b of rev)
• Medicare Advantage: $150m (mgt suggested close to 2%; have $7.5b of rev)
• Medicaid: $120m (guessing 2% margin on $6b of rev – mgt suggested they would be happy with half the margin of AGP (~4.5%) at investor meeting in July)
• Self-Funded Fee Business: $690m (based on sales, which is given, and 17.5% margin).
• Net Investment Income: $685m (given)
• Other: $340m (residual from above)
• Total: $4,325m in 2012. 

Small-Group / Individuals / Exchanges – Main Source of Controversy

As shown above, it looks like WLP earns ~$1b from its small group and individual business.  The individual business already has faced margin pressure in the past few years with management suggesting it is earning about a 4% margin (this is consistent with commentary from Aetna’s management about its individual business). Thus, most of the earnings headwind will likely come from the small group business, which we think generates ~$800m. 

Management recently suggested that it may face ~$400m headwind from the small group business.  To get a 400m drop, you need to assume that 75% of membership goes to the exchanges and earns a 3% margin, while the other 25% gets large-group pricing (some small groups will team up and get large-group pricing).  400m seems like a big decrease with WLP using pretty pessimistic assumptions.

However, this will be offset by volume growth from previously uninsured people.  WLP is in 14 states with total population of 122m.  Given ~16m lives expected to come on exchanges, this suggests about 6.5m lives available in WLP states.  Based on WLP’s total mkt share by state (incl small and large), WLP would get ~1.7m lives.  But, WLP has 48% mkt share (next competitor is typically ~10%) for the individual product in its states, which would imply they could get ~3m lives. With 2m lives, $350 premium per-member-per-month, and a 4% margin, WLP could generate an additional $350m, nearly offsetting the margin headwind from the small group business.     

We think WLP should earn a 3-5% margin on exchange-based members.  We believe this is reasonable because: 1) ROIC – to get a reasonable return-on-capital (including acquired capital, which we believe accounts for the cost of building a scaled and thus advantaged business), a 3-5% margin is necessary.  2) Regulators have suggested this range is reasonable – in the initial filing on exchange rules, regulators pointed to a similar margin range as necessary to induce private capital to participate.     

The biggest concern for health insurers is not necessarily that the industry as a whole will earn a low margin, but that a particular insurer will be hurt by adverse selection (basically getting stuck with a sicker sub-set of the insured population because of poorly designed underwriting).  This is well understood by regulators and thus the following measures have been put in place to ensure that reasonable profits are maintained and to incentivize managed care companies to participate on the exchanges. 

• Risk Adjustment — plans will be compensated based on the underlying health status of the people they enroll, and therefore protected against losing money by covering people with high-cost conditions.  The companies will participate in reinsurance pools and insurers who receive a more healthy population will compensate insurers with a more sick population. 
• Require People Buy (Individual mandate) – this doesn’t correct adverse selection between insurers, but requiring folks to purchase insurance (or pay a penalty/tax), will help ensure a more balanced risk pool.  Tax credits to individuals with less income should lead to more participation. 
• Same Plan, Same Premium – premium rate must be same in and out of exchange, so insurers can’t lure healthy folks away from the exchanges.    
• Plans must offer all tiers – cant just offer the low-end plans which will attract the healthy people. 
• Marketing Requirements – cant promote in way that encourages healthier consumers to enroll or discourages sicker folks.  I.e., promoting a Medicare plan only on the 6^th floor walk-up of a city apartment – inherently attracting a healthier sample of people. 

Bottom Line on Exchanges: The market is concerned about margins and we agree that they will likely fall.  Yet, we think total operating profit dollars for the individual and small group segment will not be impacted as much as the market seems to imply.  As illustrated above, the exchanges could only be a modest headwind and the top-line should continue to grow roughly in-line with medical cost inflation.   

And again, WLP is the low-cost producer with a strong brand with ~3-5% COGS advantage in their markets and their surveys show that their brand is “worth” 3-10pts of premium advantage versus competitors when consumers are selecting on simulated exchanges.  If they can’t earn an adequate return on the exchanges, we don’t think others can either. 

Large-Group

The large-group business shouldn’t be impacted by health care reform.  WLP has ~6m members as of 2012.  At $350 premium per member per month and a 5% margin, WLP earns $1.3b.  While the company says it is earning a good margin, a review of statutory data by state suggests that they may be under-earning v. their peers.  As of 2011, WLP’s MLR was 90% v. low-to-mid 80’s for AET, UNH, CI, and HUM (based on data provided by Dowling and Partners).  WLP suggested to us that ~1% may be related to their federal employment program, which has a low-margin, but gives them good volumes with little overhead. 

While we’re not counting on any margin upside in our assessment of the large-group business, we think this information provides some additional room for improvement and adds to the margin of safety. 

Bottom Line on Large Group: Enrollment is depressed because of high unemployment and margins may have room for improvement.  This segment should continue to provide healthy free cash flow to the parent. 

Medicare

WLP has 1.55m members in its Medicare business (as of 1Q13, they had 1.4m members).  Most of the premium comes from the Medicare Advantage (MA) book, which has ~700k members.  WLP doesn’t give the exact premium, but at $900 per-member-per-month, it’s ~$7.5b.  They also don’t disclose their margin, but based on commentary, it’s likely between 0-2% (Best-in-class operating margins are closer to 5%).  Part of the reason for the low operating income has been the build-out of its Caremore business, which was acquired in mid-2011 (though its not clear how much of this investment is capitalized v. expensed).  However, this drag should diminish over time as the payback period on these outlays is ~18 months. 

One reason the MA book has performed so poorly is that it was built on a commercial platform, run by commercial operators.  Also, the company had three people running the business so no one was accountable.  Recently, they moved to one division head.  Another reason is that WLP offered preferred-provider products (broad networks), which worked for commercial, but not for MA – since it is much more important to control costs for this older and sicker population.  They currently have about 40% HMO and 60% PPO, but are moving more towards HMO.  This was originally put in place because the government paid more than a normal share at first for PPO, but that’s going away. 

WLP has implied that this segment is a significant underperformer and has ~$600m of incremental profit potential over the next few years (half from margin improvement and half from top-line).  A 2% margin improvement would add $150m of op profit.  It’s possible that they’re actually earning closer to 0% and could improve by $300m from margin improvement.  The rest of the operating profit increase would have to come from volume (and price increases).    

At $1000 per-member-per-month and a 4% margin, it seems that WLP would have to nearly double its Medicare Advantage enrollment to achieve its goal. 

Bottom Line on Medicare: We think there is a lot of room for improvement, but have a tough time comprehending the $600m expected operating profit improvement.  Nonetheless, the stock price seems to imply no progress at all. 

Plus, given the Medicare Advantage rate cuts that were announced in February and then finalized in April, by CMS, it will likely make this improvement even more difficult (as confirmed by IR recently).  The potential Medicare Advantage profitability for WLP is unclear, but our view is that very little of WLP’s current earnings stream comes from this segment (compared to Humana, which generates a significant amount of profits from Medicare).  Also, it would be relatively easy for WLP to shut down its Medicare business if it didn’t earn any money.   

Medicaid

At a conference last summer, WLP said it would be thrilled if its Medicaid business earned half the operating margin of Amerigroup, which has been about 4.5%.   Again, Wellpoint’s history as a commercial operator has hindered WLP’s effectiveness in its Medicaid business. 

WLP did ~$6-7b of Medicaid premium in 2012; at a 2% margin, this would be ~$130m of operating income.  AGP has ~$10b of revenue at a 3.5% margin currently; ~$350m of operating income. 

Medicaid is a growth opportunity over the next few years and with Amerigroup, the company should be better positioned.  In fact, WLP now has the largest Medicaid enrollment among managed care companies.  

The total addressable market for Medicaid is ~60m lives with managed care currently controlling about 30m (WLP/AGP has 4.6m).  The dual-eligible population offers the biggest opportunity These folks qualify for both Medicare and Medicaid; often the oldest, sickest, most expensive, and least effectively managed. 

According to the Kaiser Family Institute, there are ~9m Americans covered under both Medicare and Medicaid (“Duals Opportunity”).  Although they only account for ~15% of enrollment, they comprise ~40% of spend.  Depending on the estimate this addressable market is ~$300-$400b annually and ~$180b will be spent in states that WLP is established (the top four states account for $100b of spend).  Managed Care currently captures ~15% of this spend. WLP’s goal of $10b seems reasonable and at a 3% margin would be about $0.65 of EPS on the current share count.  

Thoughts on AGP Deal – We think WLP overpaid for AGP, but think the deal is justified.  They got a better operator, were able to fund the deal with cheap debt, and most importantly got growth in premiums, which WLP can write against their excess capital (more below). 

Tallying it All Up

Consistent with the discussion above, we see a reasonable path to $10-12 of earnings over the next few years.  

• 2013 EPS expected to be ~$8.  (Guidance for 2013 is “at-least $7.80” but this seems conservative, given an assumed share count of 300-305m shares.  4Q12 weighted-avg share count came in at 307m and they are guiding to ~$1.6b of buybacks in 2013.  At $70 per share, this would be 23m shares and a more likely full-year assumed share count of ~290m shares would add $0.25 alone.  The company is also including $0.20-0.25 of AGP integration costs, which will likely be treated as one-time.) 
• Arguably, WLP is leaving $1 on the table b/c of poor operational performance (estimate of 1% lower MLR).  From the Medicare, Medicaid, and Large-Group Business. 
• $3b of buybacks in 2014/2015 at $70 would add $1.50 to EPS.
• $1 accretion from AGP by 2015 (WLP est).
• Call individual/small-group a wash – maybe hurts $0.50-$1.00.
• Organic growth, including and increase for medical cost inflation +$0.50-$1.00.

Capital Position / Buybacks

The managed care names are commonly discussed from a margin point-of-view.  But, it’s the capital employed that really matters.  In rough terms, for every dollar of premium, about 85% gets consumed by medical costs (i.e. an 85% MLR, or medical-loss-ratio), 10% is used for SG&A, and 5% is kept as profit.  For each dollar of premium, a managed care company needs to keep about 20c of capital.  Crunch a couple numbers and you can quickly see that the return on marginal capital is quite good (~16% post-tax). But, only a handful of companies can earn these economics, given the scale that must be obtained (typically through M&A).  Thus, including the intangibles, most of the large managed care companies earn about 10% ROIC, give or take.  A good business, but not a great one. In fact, this lends to our overarching view that these companies only earn an adequate return today (it’s already a competitive industry).  We agree that margins (or returns) may be pressured under new health-care reform, but we don’t think they will drop dramatically and any profit deterioration (per member) may be offset by enrollment growth and pricing that keeps up with medical cost inflation.   

The previous discussion is important for WLP.  Regulators require that not-for-profit Blue-Cross/Blue-Shield insurance plans need to keep more capital (against medical claims) than they’re for-profit peers.   When WLP rolled-up the Blue States, they had agreements with the regulators that they would not dividend-up excess capital (above the typical previous year’s net income) to the holdco. 

As a result, they have about a 550% capital ratio at the opco’s, above the 375% required.  This buffer equals about $3b and WLP has said they will keep the ratio at above 450%, implying close to $2b of true excess capital.  We don’t think they’ll explicitly dividend this capital up, but it provides a unique source of hidden value.   

In practice, this will allow WLP to dividend-up more capital to the holdco without having to keep it at the operating level to support new business.  Some quick math suggests that WLP could grow premiums by $9b (~15%) before it has to retain capital at the sub-level to support premium growth. 

WLP’s buyback activity has been remarkable; over the past six years, WLP has repurchased $21b of stock (greater than the current market-cap) and decreased its shares by 51%.  Effectively, they’re in the market every day and thanks to their missteps, they have been able to buy the shares at a low price. 

Valuation

The stock is just cheap.  We compare the company / stock to a coiled spring – eventually the market will realize the earnings power (which is growing) of the company and value it at an appropriate price.   

Historically, the stock and most of the sector has traded around 12-14x.  Given the above review and growth prospects, we’d think a 10-12x multiple (at least) is reasonable. 

Book value per share growth – BVPS has grown from $30 in 2004to $40 in 2007, $60 in 2010, and ~$80 by 2012.  It’s trading at 1.0x BV v. 1.25x as recently as 2010 and pre-crisis levels of ~2x.  The stock is still nearly as cheap as it was in 2008/2009. 

If the stock does remain depressed or trade off, buybacks will continue to support the equity.  Even in a recession, enough cash flow should be sustained to continue repurchasing shares.  

We originally wrote this up in early 2013 and submitted to VIC for membership in early May.  Stock has run a bit, but we still believe there is enough margin of safety for investment (particularly with the market at long-term highs).  We think this overview lays out the information for a worthwhile discussion and would be even more interested in purchasing the stock at lower prices (we wouldn’t be surprised if fears of exchange-related adverse selection crept back into the picture at some point). 

Disclosure

We and our affiliates are long Wellpoint (“WLP”) and may buy additional shares or sell some or all of our securities, at any time.  We have no obligation to inform anybody of any changes in our views of WLP.  Our research should not be taken for certainty.  Please conduct your own research and reach your own conclusions.   

Catalyst

The biggest catalyst will likely be when WLP can prove that they can grow earnings (or at least EPS) in a post health-care reform environment.  Admittedly, our investment philosophy is willing to bend on timing for value. 

More consistent performance in general. Dating back to 2007, WLP has had earnings misses, guide-downs, operational blunders, and public relations embarrasments.  Simply transitioning to a steadier fundamental performer should improve the stock’s multiple, particularly as investors realize earnings could actually grow.   

2013 guidance may be conservative – management estimates include little benefit from the impact of buybacks (discussed above) and actually include the impact of AGP-integration expenses, which folks could start to treat as one-time as the year progresses.  Plus, 1Q EPS was 56c higher than FC, but management took guidance up only 20c for the year.  Admittedly, we don’t know what managements internal forecast was for 1Q, but it’s fair to assume they exceeded it by a reasonable gap.