One of the great things about investing in common stocks is that although the same information is available to all market participants, differing views in terms of strategy or outlook enable one to find diamonds lying in the rough. Once in awhile, it is possible to find an undervalued business with an extremely strong competitive position in a huge market with attractive growth prospects and a management that understands that it is the shareholders that own the company and who are entitled to capital returns when prudent. Such an opportunity is present in the shares of WellPoint Inc. (WLP), with the stock trading at just over $64 a share. This is a company that we at T&T Capital Management (TTCM) have written up on two occasions, both at even cheaper prices, but we believe the stock still offers a very attractive margin of safety for the long-term investor. The acquisition of Amerigroup, shifting healthcare dynamics, and prudent capital allocation should allow the company to attain an annual EPS growth rate in excess of 10% over the next five years, which bodes very well for the investor buying the stock at around 8.5 times projected 2013 earnings.
In December of 2012, WellPoint closed on the acquisition of Amerigroup that is predicated on enhancing the company's competitive position in Medicaid to align itself to prosper in an era of Obamacare. Combined, the company now serves more than 36MM medical members and has a Medicaid presence in 20 states, which is the largest in the industry. WellPoint's size and scale provides it with significant bargaining power with health care providers. In addition, the company is able to leverage fixed costs across a larger corporate footprint, enabling it to have a margin advantage versus smaller competitors. While some other MCOs such as UnitedHealth Group (UNH) have outperformed WellPoint in many metrics, I believe WellPoint's future might look better than its respectable recent past. WellPoint is the exclusive licensee of the Blue Cross and/or Blue Shield brands in 14 different states, giving the company significant brand recognition, which should become increasingly important in an era where medical benefits are procured from exchanges by individuals instead of the decisions being exclusively made by the employer. While margins should come under pressure for WellPoint due to enhanced scrutiny pertaining to premiums and new competitive influences in the industry, WellPoint has a wonderful opportunity to materially grow its membership base in excess of the margin pressure, enhancing net income.
For fiscal year 2012, WellPoint had adjusted earnings per share of $7.56, which exceeded its outlook of $7.30-$7.40, assisted by a tax benefit and lower medical costs. 4th quarter adjusted EPS was $1.03, up from $0.99 per share last year. On a GAAP basis, 4th quarter EPS was $1.51 and full year EPS was $8.18. These numbers were boosted by that $0.48 tax benefit, but were partially offset by higher costs related to the Amerigroup acquisition. The benefit expense ratio was 87.3% in the 4th quarter, down 30 basis points YoY, led by improvement in Commercial, partially offset by increasing expenses in Medicare and Medicaid. It is always important to examine insurance companies' progression for past reserves, and WellPoint's reserves have developed favorably with a $514MM favorable prior year development, up from $210MM in 2011. WellPoint issued additional low-cost debt to fund the Amerigroup acquisition, and ended 2012 with a debt-to-cap ratio of 38.6%. The company intends to shed that by 100 bps in 2013, and hopes to have it below 35% by the end of 2014. In the 4th quarter, the company generated $760MM of operating cash flow, and for the full year, operating cash flow was $2.7 billion. Both numbers were materially higher than net income, which speaks to the quality of WellPoint's earnings.
My favorite part about WellPoint is the company's willingness to return capital to shareholders when it makes sense to do so. For the full year 2012, WellPoint repurchased a staggering 39.7MM shares, or 11.7% of the company's shares outstanding as of 12/31/2011. Even more importantly, I believe these buybacks were done at a significant discount to intrinsic value. This increases the intrinsic value of the stock on a per share basis, and enhances shareholders' ownership stake in the business. Just in the 4th quarter alone, WellPoint repurchased 11MM shares for $668MM. The company has raised the dividend by 50% over the last few years since it was initiated, and the stock currently yields approximately 2%. The company is able to be generous to shareholders because of the strength of the business and operations cash flows, combined with the lack of meaningful capital expenditures in comparison to other industries. Clearly, WellPoint saw real value in Amerigroup and jumped at the opportunity to enhance its competitive position in Medicaid, but when opportunities such as this do not exist, management has shown a willingness to allocate capital to the next best opportunity.
Effective March 25, 2013, Joe Swedish will be taking over as CEO of WellPoint. Swedish brings extensive experience on the health provider side of the business and hopefully, will maintain WellPoint's strong capital allocation policies. WellPoint sold-off when the announcement of Swedish's hiring was made, but I'll certainly wait till we learn more about his strategy for the company before assigning any judgment whatsoever. Thus far, we know that WellPoint intends to invest approximately $300MM in 2013 to drive growth in 2014 and beyond. This includes investing $100MM in 2013 to continue integrating the Amerigroup acquisition. Amerigroup grew revenues by 60% in 2012 as Medicaid continued to expand, and more space went out for proposals. Management believes the acquisition should be mid-teens accretive to earnings in year 1, inclusive of all one-time costs. In 2015, management believes the acquisition should add another $1 to earnings, largely due to the absence of one-time costs related to the integration. The company expects M&A to drive 2-3% per annum growth over the next few years, with the majority of that being driven by this acquisition. WellPoint believes the company can grow organically by 4-6% per annum through expanding its business. In addition, the company expects to grow by 4-5% a year through capital deployment, principally stock repurchases. Over a 5 year period, WellPoint hopes to attain a compound annual growth rate of 10-14%. When you look at the fact that the company is trading at a single-digit price to earnings multiple, your appetite for the stock should begin to whet, assuming you give any credibility to management's guidance.
For 2013, WellPoint is projecting operating revenue of $71.5-$73 billion and operating cash flow of at least $2.6 billion. Minimum earnings per share of $7.60 are expected, and I believe that all of these numbers are extremely conservative. There is no doubt that the exchanges will bring considerable change and uncertainty to MCOs and every other part of the health care industry. WellPoint has invested about $150MM just to prepare for the exchanges, including regional testing of consumers' preferences for price, brands, etc. WellPoint holds the number one market share in the country in selling directly to the consumer, and is also number one in small group employees purchasing coverage. Over time due to the new regulations, small group and large group markets will start migrating to the individual consumer making the decision as opposed to the employer. I believe that WellPoint has an opportunity to do very well with that new system, and it is just the uncertainty that has led to the mispricing of the stock. If earnings compound at just 10% a year starting from $7.60 in 2013, earnings per share would grow to $11.17 in 2017. Just a 10 multiple on those earnings would call for a near doubling of the stock. WellPoint trades just below book value, and due to its prodigious free cash flow generation, I believe downside is extremely limited, aside from short-term mark-to-market fluctuations. I believe there is significant upside for a higher compound annual growth rate, and have been accumulating long positions in the stock opportunistically over the last year.