We Still Like Wellpoint Despite Recent Underwriting Setback

WellPoint is one of only two managed-care organizations that we think has a narrow economic moat (UnitedHealth (UNH) is the other). It has a unique combination of national and regional scale. National scale--WellPoint's 34 million medical members--is critical for leveraging administrative costs. WellPoint is only now beginning to take full advantage of its national scale by consolidating its IT systems. Regional scale--WellPoint's concentration in 14 Blue Cross and Blue Shield markets--is essential for gaining bargaining leverage over health-care providers. Bargaining power is growing in importance as customers and regulators apply pressure to premium rates.

We believe investors have overestimated the headwinds WellPoint faces, causing the stock to trade at a rock-bottom valuation. We anticipate ongoing medical cost pressure for WellPoint over the next five years, which would tend to lead to margin contraction. However, we expect higher medical costs to be partly offset by lower administrative costs and steady revenue growth. Premium increases in line with health-care costs provide a mid-single-digit tailwind to revenue growth, while administrative costs are both naturally scalable and poised to fall with IT systems consolidation. In our base case, we project the medical cost ratio (medical costs as a percentage of premium revenue) to deteriorate to 86.5% by 2016, which would be far worse than anything seen in the past decade and represent 140 basis points of deterioration from 2011. Even so, we project operating income (excluding investment income) to increase 2% per year, on average.

The real highlight for WellPoint, however, is its plentiful free cash flow. At recent share prices, we estimate that WellPoint provides a free cash flow yield around 13%. The company applies this cash flow toward aggressive share repurchases, enabling the share count to plummet 43% over the past five years. Even assuming the share price appreciates to our rolling fair value estimate within two years, we anticipate that WellPoint can retire another 35% of the share count over the next five years. As a result, we project 10.6% annual earnings per share growth, despite much more sluggish operating income growth. Combined with a 1.7% dividend yield, we think investors who buy WellPoint at current prices are likely to achieve a solid return, even in the absence of price/earnings multiple expansion.

WellPoint Exceeded Expectations in 2011, but Less So Than Peers
WellPoint actually exceeded management's initial earnings per share outlook for 2011 by 11%. Along with the rest of its industry, WellPoint benefited from the ongoing slowdown in health-care utilization, which provided an unexpected boost to margins by depressing health-care cost trends. However, WellPoint outperformed by much less than its peers. The degree of outperformance in 2011 versus initial expectations is clearly correlated with recent stock price performance. Just as important, strong performance in 2011 is associated with weaker management expectations for 2012, as margins naturally reset over time. Favorable underwriting results are given back to customers, while unfavorable results are reversed through premium increases and reduced benefits.

While some competitors, such as Humana (HUM), were hitting five-year-high operating margins in 2011, WellPoint was hitting a five-year low. As usual, medical costs were the culprit. Going into 2011, we expected most medical cost ratios to deteriorate, particularly as a result of the Patient Protection and Affordable Care Act's imposition of minimum commercial medical cost ratios. The health reform law required plans, starting in 2011, to spend at least 80% of premiums on medical costs for small-group and individual business and 85% for large-group business.