At its current price, WellPoint, Inc. (WLP) is too attractive to pass up. Strong profitability and cash flow generation, combined with prudent capital allocation make WellPoint an intrinsic value compounding machine moving forward.
WellPoint is one of the largest domestic health insurance companies, serving about 33.5 million people. The company has strong brand recognition through its exclusive license to the Blue Cross and/or Blue Shield names in 14 states, including California and New York. WellPoint has long been focused on the commercial market with an emphasis on small-group coverage. The company benefits from significant scale, which ultimately leads to cost advantages versus some of the company's smaller competitors both nationally and regionally.
WellPoint, and the health insurance industry overall, has a reasonable amount of uncertainty and risk, primarily due to heightened regulatory oversight pertaining to premium increases, and the more burdensome regulations forcing the insurers to accept more high-risk individuals. It is very difficult to forecast what will be the ultimate result of these changes to the health care industry, but the financially strongest companies have the ability, through acquisitions or innovation, to position themselves to benefit.
At $52.91 per share, WellPoint has a market capitalization of $17.5 billion on 331 million diluted shares outstanding. The company has $23.64 billion in shareholder equity, even after returning capital aggressively to shareholders through stock buybacks and dividends over the last several years. Therefore, the company can be purchased at just over 0.7 times book.
In the last five years, annual net income has not been less than $2.5 billion and has been as high as $4.7 billion, but through aggressive stock buybacks, the company's share count has dropped from 602 million diluted shares in 2007 to 331 million currently. In the first half of 2012, WellPoint has purchased 17.4 million shares for $1.2 billion, and the company still maintains the authorization to purchase another $3.2 billion worth of stock.
Because WellPoint does not have large capital expenditures, the majority of earnings results in free cash flow that has enabled the company's aggressive capital allocation strategy. While investors are currently able to buy WellPoint at a material discount to book value, the company has consistently posted a return on equity greater than 11%, and a return on invested capital in excess of 8%.
Therefore, stock buybacks at a discount to book value are enormously accretive to intrinsic value and earnings per share. International Business Machines Corp (IBM) and DIRECTV Group Inc. (DTV) are examples of companies that have created tremendous value for shareholders with strong capital allocation programs,even though they haven't posted robust revenue growth like Apple Corp. (AAPL) or Google Inc. (GOOG). I fully expect WellPoint to deliver for shareholders as more clarity emerges on the healthcare front.
WellPoint's massive scale enables the company to spread administrative costs over a larger population of members, and provides pricing advantages when negotiating deals with health care providers. WellPoint has recently made significant acquisitions of CareMore and Amerigroup, which will increase the company's exposure to Medicaid. That will reduce its exposure to the commercial market, which is likely to face increasing margin pressure. WellPoint will incorporate these firms into its existing operations with the hopes of reducing SG&A expenses.
Last month, the company also completed an acquisition of 1-800 Contacts, which serves 3 million active customers, which should enable WellPoint to expand its direct-to-consumer expertise in a growing business segment. While new legislation is likely to increase scrutiny on premium increases, these headwinds should impact the industry as a whole, including WellPoint's competitors. Ultimately, the larger managed care organizations like WellPoint should be the big winners through being the low-cost operators.
Yesterday, WellPoint reported second quarter net income of $643.6 million, or $1.94 per share, including net costs of $0.10 per share of expenses related to litigation and settlement costs pertaining to the 1-800 Contacts acquisition. At $2.04 per share, adjusted net income was up 11.5% from $1.83 in the second quarter of 2011.
WellPoint's stock sold off substantially after the company lowered its 2012 earnings per share outlook to $7.30-$7.40, which was down about 4% from the mid-point of previous guidance. WellPoint cited an uptick in the medical cost trend, most notably in outpatient and physician visits, as its primary reason for the revised guidance. WellPoint continues to expect 2012 operating cash flow of at least $2.7 billion, and at least $2.9 billion in share repurchases and cash dividends.
Medical enrollment totaled 33.5 million members at June 30, 2012, a decrease of 639,000 members, or 1.9%, compared to approximately 34.2 million at June 30, 2011. Membership in the Local Group and National business declined by 585,000 and 259,000, respectively, due to repositioning the product offerings in the New York small group market, and through adjustments in the administrative fee structure for certain National Accounts in 2012.
Enrollment was also impacted by economy-related attrition in group membership. These declines were partially offset by membership growth in the Senior and State Sponsored businesses. Senior membership increased by 163,000, which reflected the company's geographic expansion into new Medicare Advantage service areas for 2012, and the acquisition of CareMore in the third quarter of 2011. State Sponsored enrollment increased by 50,000, due primarily to growth in existing programs.
Operating revenue for the quarter was $15.2 billion, up about $293.5 million, or 2%, from $14.9 billion in the second quarter of 2011. The benefit expense ratio was 85.4% in the second quarter of 2012, which was down 30 basis points from 85.7% in the second quarter of 2011. This was driven by the Senior and Local Group businesses, and was partially offset by an increase in the ratio for State Sponsored business.
For the full year of 2012, WellPoint expects that underlying Local Group medical costs will be in the range of 7%, plus or minus 50 basis points, and likely towards the upper half of this range. Higher costs and higher utilization are the primary culprits for increased costs as usual. SG&A Expenses crept up 20 bps to 13.7% from 13.5% YOY, largely because of the costs incurred in the 1-800 Contacts settlement.
At the current stock price, WellPoint has a 14% earnings yield based on adjusted projected 2012 net income. We believe that WellPoint will experience low single digit revenue growth while improving operating margins slightly from leveraging recent acquisitions. Aggressive stock buybacks at or near current prices could likely lead to 8-10% EPS growth over the next 3-5 years. This would boost earnings per share to around $10 a share, and I'd expect some slight multiple expansion. In the next 12 to 18 months, we believe WellPoint could easily trade up to $70, representing 32% upside from the current price.