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By Matthew Coffina

We have generally been favorable on the managed-care organizations over the past four years, as the stocks were put on sale first by underwriting concerns and later by fears about health reform. Although our thesis has mostly been successful, our recurring top pick WellPoint (WLP) has been a disappointment, particularly over the past year. We believe the company's underperformance has created an ongoing opportunity for investors to buy a high-quality business at an attractive valuation.

Even though we see WellPoint's relative lack of exposure to Medicare Advantage as a strength over the long run, underperformance in this product was actually WellPoint's biggest problem in 2011. Most significantly, adverse selection in the Northern California Medicare market weighed on WellPoint's medical cost ratio. A few competitors apparently exited that market last year, and their relatively unhealthy members ended up transferring to WellPoint. WellPoint recognized this issue in the second quarter, giving it time to incorporate expectations of higher costs in its 2012 Medicare bids, which were due in the middle of the year.

WellPoint is one of only two managed-care organizations that we think has a narrow economic moat (UnitedHealth (NYSE: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 (NYSE: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. To the extent that medical spending fell below these floors, MCOs would have to rebate the difference to consumers, taking accounting reserves for these rebates throughout the year.

As it turned out, the minimum MCR regulation had little adverse impact on most managed-care organizations. The PPACA described a unique calculation methodology for medical cost ratio, for example, allowing plans to add administrative costs that improve health-care quality to medical costs and to subtract taxes (including income taxes) from premium revenue. This methodology adds perhaps 300-500 basis points to the MCRs insurers usually report, with the greatest offset occurring in the most profitable subsidiaries. Thanks to this unusual calculation methodology, companies like Aetna (NYSE:AET) were able to report consolidated medical cost ratios that fell below even the lowest 80% minimum.

We knew WellPoint was at a disadvantage in 2011 relative to the MCR regulation because of a business mix that is much more heavily weighted toward small-group and individual commercial business than peers. Small-group and individual business comes with relatively high administrative costs and broker commissions, making it harder to meet the MCR minimum while remaining profitable. WellPoint may have been disadvantaged in another way as well that we didn't fully appreciate at the beginning of the year. The PPACA allows for "credibility adjustments" to medical cost ratios of relatively small insurance pools. If a pool of members (for example, individual policyholders in Delaware) contains few enough members, the insurer is allowed to add a few percentage points to the calculated MCR for the purpose of determining rebates. WellPoint has a lot of members concentrated in a relatively small number of geographic regions, so most of its rebate pools probably exceeded credibility thresholds and didn't benefit from this adjustment. In contrast, Aetna disclosed that nearly 80% of its pools were not fully credible, as the company has fewer members and they are much more geographically dispersed.

Also, WellPoint is a relatively small player in the Medicare Advantage business, in contrast to Humana or UnitedHealth. The headwinds created by the PPACA for commercial business were front-end loaded, while the headwinds to Medicare Advantage--such as reimbursement cuts and an 85% minimum medical cost ratio--won't take effect until later years. While this put WellPoint at a disadvantage in 2011, it should leave the company relatively well positioned in 2013 and beyond.

Even though we see WellPoint's relative lack of exposure to Medicare Advantage as a strength over the long run, underperformance in this product was actually WellPoint's biggest problem in 2011. Most significantly, adverse selection in the Northern California Medicare market weighed on WellPoint's medical cost ratio. A few competitors apparently exited that market last year, and their relatively unhealthy members ended up transferring to WellPoint. WellPoint recognized this issue in the second quarter, giving it time to incorporate expectations of higher costs in its 2012 Medicare bids, which were due in the middle of the year.

The most important question for WellPoint investors is whether recent poor performance was the result of bad luck or some more fundamental flaw in the operating model. We have generally viewed WellPoint's underwriting discipline favorably, as the company was the first to detect accelerating cost trends in the 2008 industry downturn and reacted quickly to adjust premiums and improve margins. In our view, any insurer can experience an occasional underwriting misstep.

In the past five years, WellPoint has actually had remarkably steady margins for its industry. The absolute level of margins is heavily influenced by business mix, although WellPoint's 6.5% average operating margin (excluding investment income) over the past five years still compares favorably with most peers. Of even greater significance, WellPoint has experienced the lowest margin volatility in the group. Ignoring for the moment various regulatory considerations, margins tend to be mean-reverting as insurers make up for bad years by raising premiums and adjusting benefits. WellPoint's 2011 operating margin happened to be at the low end of the five-year range, but there should be some immediate opportunities for margin improvement, such as through better Medicare bids.

Emerging Risks From Regulation and Competition
On the other hand, investors should not be complacent about the possibility of real long-term problems for WellPoint. Only UnitedHealth and WellPoint carry our narrow economic moat rating, as we believe the scale of these companies endows them with bargaining power over health-care providers and the ability to leverage fixed costs better than peers. However, there are also downsides to size. WellPoint has a big political target on its back, which management has only made worse through anti-reform rhetoric and mistakes like the flawed actuarial analysis that caused the company to request an unjustified 39% rate increase in its California individual business in 2010. That actuarial mistake prompted Health and Human Services Secretary Kathleen Sebelius to urge state regulators nationwide to take a closer look at WellPoint rate requests. Uneven application of regulatory scrutiny could put WellPoint at a competitive disadvantage. Ineligibility for credibility adjustments in line with peers is another example of the emerging shortcomings of scale.

Also, our evolving views of the PPACA have given rise to new long-term concerns for WellPoint and other managed-care organizations. At the most basic level, MCOs are like distributors, connecting a diverse group of employers and individuals with various health-care providers: consolidating buying power, streamlining interactions, and guiding patients through the exceptionally complicated health-care system. Similar to any distributor, MCOs' value proposition depends on both customers and suppliers remaining fragmented. For this reason, we are becoming increasingly worried about the consolidation and coordination among health-care providers occurring through the accountable-care organization model. Although the risk remains many years in the future, we see the potential for vertically integrated ACOs to eventually compete directly with managed-care organizations. While WellPoint's regional scale leaves it relatively well positioned even in this scenario, the company is by no means immune to potential disintermediation.

Management Reshuffling Could Help, but Health Insurance Is a Complex Business
WellPoint's consumer business was the primary driver of relatively poor results in 2011. WellPoint operates through two principal segments, with the commercial segment consisting of employer group benefit plans and the consumer segment including retail-oriented plans such as individual commercial insurance, Medicaid, and Medicare. With the exception of 2009, when a remarkably strong year for consumer offset weakness in commercial, the consumer business has generally had weak and inconsistent results over the past five years, while the commercial business has produced steady performance. While Medicare Advantage adverse selection issues weighed on 2011 consumer results, Medicaid funding pressures and regulatory scrutiny of individual premium rates didn't help either.

WellPoint recently fired Brian Sassi, who had been CEO of the consumer segment since early 2008. The company has been making other important management changes in the past couple of years, such as the dismissal of chief actuary Cynthia Miller in late 2010. While it is relatively easy to blame senior-level managers for underwriting mistakes, health insurance is a highly complex business, with rapidly changing competitive dynamics, product designs, and regulation. Products like Medicare Advantage may simply be outside WellPoint's core circle of competence. The company may be able to bolster its management team and capabilities through acquisitions such as CareMore. However, we are also wary of management's focus on Medicare expansion. Despite the demographic-driven growth opportunity in Medicare, WellPoint's primary strength is in commercial health benefits, and the company risks diluting its economic moat by further shifting the business mix toward government programs.

WellPoint Remains Attractive
Helped by the industry tailwind of slow health-care utilization growth, WellPoint outperformed initial expectations in 2011. However, underwriting missteps in Medicare Advantage and a relatively strong regulatory headwind due to business mix combined to cause WellPoint to greatly underperform peers. Over a longer time frame, WellPoint has had relatively stable underwriting results, which hinders performance in a favorable environment but cushions results during industry downturns. While the company faces real long-term risks from both regulation and competition, we believe the current stock price provides an adequate margin of safety to compensate for these risks. With a 13% free cash flow yield and most cash flow returning to shareholders through stock repurchases and dividends, we think WellPoint remains attractive.

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Source: We Like WellPoint Despite Underwriting Setback