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Alan Brochstein, 420 Investor (1,292 clicks)
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I saw some “smoke” on 4/27, and it reminded me of a fire I have been expecting for a while.

In all fairness to the reader, I was negative on WellCare Health Plans (WCG) (86.50, $3.5 billion, S&P 400/R1000 member) 45 points ago. Specifically, the Medicaid HMO’s were blowing up after a recent spate of IPOs followed by a series of “one-time events” that affected all of them as well as other more diversified players, such as UNH and CVH.

On top of that, WCG won a massive contract in a state in which it had never had any prior operations (Georgia). My negativity back then was three-fold: They could be hit by negative industry trends, they could fail to implement Georgia and/or they could have significantly under-bid Georgia. Of course, the first two never happened. The answer to #3 remains open. The stock has been a rocket:

WCG 1

The Medicaid HMO concept is pretty nifty, as private companies contract with States to provide health insurance services to an indigent population that is very expensive to serve. The thesis that managed care practices can ultimately save costs to the public relative to just paying for the ultimate E.R visit makes a lot of sense, as an ounce of prevention is worth a pound of cure. There are 4 publicly traded companies with a primary focus in that market: Amerigroup (AGP) (29.26, $1.5 billion), Centene (CNC) (21, $911mm), Molina (MOH) (31.68, $853mm) and WCG, which has a market cap in excess of the other three combined. Big players involved include CVH, UNH and WLP.

The companies don’t compete too much against each other and tend to have geographic concentrations. Within counties or regions within a state, often there are one or two providers awarded contracts at a fixed price. Georgia and Ohio had very large mandates in the past 18 months. The risk to providers obviously is utilization in excess of their expectations (underwriting risk). AGP and CNC both went public in 2001, while MOH followed in 2003 and WCG in 2004. Growth plans have been predicated upon new state mandates, which I understand have hit a lull, as well as acquisitions of private plans.

In early 2005, the group was hot, trading at 22X, quite a premium to the overall Health Insurance industry. Today, the valuation has come down to about 16X, still a slight premium. In the middle of the year, the proverbial fan was hit, with MOH imploding first, then AGP and ultimately CNC. Additionally, CVH and UNH reported problems with Medicaid. By late 2005, the group had bottomed in price and valuation. Prices were cut in half and the forward PE had declined to 13.5X for the group. WCG never had any problems in its markets, but it did contract from 24X to 14X. While none of the other three have ever returned to their peaks in 2005, they have seemingly bottomed. WCG, though, has not only rocketed on to more than double its peak, it has moved again to a significant premium valuation relative to the overall Health Insurance industry, trading now at almost 20X forward estimates:

WCG 2

So, is there something that sets apart WCG from its peers? I think that many investors obviously took comfort in their avoiding the mishaps that plagued the industry in 2005. Also, while the other three are pure-plays, WCG does have exposure to Medicare as well. The real differentiation would appear to be in earnings estimates, as WCG expected earnings have been ramping up, while those of CNC and MOH have continued to be under pressure. AGP has recovered, but only from severely depressed levels. What is driving the earnings at WCG? Clearly, it is Georgia, which is always on my mind (sorry, Willie!).

When WCG won Georgia (which was split into 5 regions), it was a stunning victory. WLP, through its Blue Cross Blue Shield, remarked, after losing, that WCG had been too aggressive in its pricing. Was it sour grapes? I am not sure, but they, as the largest by far provider of medical services in the entire state, had access to experience data and contracting relationships with doctors and hospitals in the state. The first two regions, Atlanta and Central, were implemented on 6/1/06, while the rest were delayed and implemented three months later.

With all of that background, what then now are my concerns? If I understand the accounting properly, there is a tremendous amount of estimation regarding medical loss ratio for this new Georgia business which doubled the size of the company. I did speak with a Wall Street analyst, who confirmed that we won’t know the true picture until Q2, when the company anniversaries the start-up. For those not familiar, and I plead not to be an expert, there is a wealth of history regarding insurance accounting issues (they go both ways, as the overall industry benefited greatly in 2005 from “favorable” prior period reserve developments. I am not in a position to predict with conviction that WCG will experience negative developments, but, if I were an owner, I would be concerned given that it walked into a state where it had no operations and offered to accept less for the same risk than an established player.

The “smoke” to which I alluded in the opening paragraph was reported on Briefing.com, which mentioned some sort of money transfers to the Cayman Islands. The stock, which had closed at 90 on the prior day, quickly dropped as low as 84.37 before closing at 86.50 on very high volume. I am not sure if this is any reason to be concerned, but it does perhaps indicate the vulnerability of the stock. WCG has been overbought modestly for a while and sits about 41% above its 200dma of 64. There is a large block of volume over the past two years down at the 60 area. In my opinion bad news, which probably won’t come until next quarter though they report Q1 on May 7th, could send the stock down to these levels. To their credit, insider selling has been modest. Short-interest is quite high and rising at 4.9mm shares. Further, the analyst community isn’t at all optimistic as reflected in their overall slightly-below-neutral rating. Perhaps they understand what may be going on better than the investment community? Interestingly, the two largest holders are Barclay’s and State Street, known for their indexed products (not fundamentally driven). After that, the rest are “growth” players, with “momentum” investor American Century vaulting into the top-5 in Q4 by doubling their position.

While I don’t think that this is a good short today in most likelihood (crowded and probably too early), I would be looking into selling the stock after they report if the stock is unable to clear resistance at 90. More importantly, I would want to make sure I have a firm understanding regarding the adequacy of reserving and the potential for a negative PPRD. It is too easy to simply look at the stellar earnings “growth” and “reasonable” PE in my opinion. If those earnings prove fictitious, there is not a lot of tangible book value to support the stock. Additionally, its premium PE multiple would contract and be applied to a lower expectation. If one were to apply a current group multiple of 15 to earnings that are only 10% higher in 2007, the price would drop to 56. Six months ago, analysts were forecasting 3.40 for 2007, so a pullback from 4.17 to 3.75 isn’t unimaginable. Based on the top holders, I would expect an extremely sharp decline with any disappointment. As you can see, WCG stands out for its premium valuation:

WCG 3

Disclosure: Long WLP, no position in any other stock mentioned.

Source: WellCare Health Plans' Day of Reckoning May Have Arrived