WellPoint Uncertainty Creates Opportunity For Attractive Returns

| About: Anthem, Inc. (ANTM)

At TTCM, we profiled WellPoint Inc. (WLP) earlier in the year, and this is an update on how the business is progressing. On November 7th, WellPoint reported 3rd quarter EPS of $2.15, which included $0.06 per share of net positive contributions, resulting from investment gains, partially offset by acquisition-related costs. Excluding these extraneous items, adjusted EPS was $2.09, up 18% YoY from $1.77. This impressive performance exhibited improved core operating performance and administrative expense management. The company isn't yet seeing the significant increase in medical cost trends that it predicted could occur earlier in the year, and I believe the company is on pace to exceed its $7.30-7.40 adjusted EPS guidance for FY 2012. For the first 9 months of 2012, WLP has generated $6.46 per share of EPS. Q4 tends to be a seasonally weaker quarter, but if the company can earn around $1.00 per share, like it did last year, the company should beat. WellPoint projects SG&A expenses to be up in the quarter, primarily accounted for by strategic investments, and the seasonal increase in marketing and enrollment costs.

WellPoint's medical cost ratio (medical costs as a percentage of revenue) declined 30 basis points to 85.4%. Expenses increased in the consumer segment, as expected, but this was partially offset by improvement in the commercial segment. Other companies are outperforming WLP, and while this speaks poorly of prior management, it could potentially augur well for the opportunity that the company has to improve operations in the future. Membership declined sequentially, by 54,000 or .02% overall. The company believes that it will end 2012 with about 33.4MM members. Operating revenue was basically flat for the quarter YoY, as the impact of a lower fully insured local group membership was partially offset by growth in the senior business. WellPoint also increased rates to cover cost trends, which helped in the quarter, as did the inclusion of recently acquired 1-800 CONTACTS.

The balance sheet has benefited from favorable prior year development of $483MM YTD, which was up from a benefit of $206MM at the same time last year. The debt to capital ratio was 36.3% and parent cash totaled $4.9 billion on 9/30/2012, in preparation for the Amerigroup Corp. (AGP) closing. Management believes that debt to capital will be around 39%, once the acquisition closes, and that $1.2 billion in cash will be left at the parent company. WellPoint continues to generate a tremendous amount of cash flow, setting the stage for accretive stock buybacks, and debt repayment. In the 3rd quarter, operating cash flow was $240MM, as it reflected only 2 monthly MCS payments. The July payment was received early in June, but had it been received in the 3rd quarter, operating cash flow would have been $952MM, or 1.4x net income. In the quarter, WellPoint repurchased 11.3MM shares for $655MM, and then amazingly the company bought another 10.4MM shares during October for $634MM. Year to date, WellPoint has bought back over 39MM shares, or 11.5% of the shares outstanding as of 12/31/2011. Because of the discount, WellPoint is trading at our estimate of intrinsic value, and we view this as wonderful capital management.

2013 will be an extremely important year for the company, as it repositions itself to deal with an entirely new healthcare environment. The company plans to make significant investments in areas including exchanges, Medicare, duals, as well as other initiatives. Management expects these incremental investments to roughly total $200-$300MM pre-tax. In addition, the company should be closing its acquisition of Amerigroup in December of 2012 that will increase WellPoint's offerings, particularly in Medicaid. In addition, after firing the prior CEO earlier in the year, the company believes that it should have a new one in place within 3-6 months. For 2013, the company expects roughly flat adjusted earnings, reflecting some overall pressure on enrollments. The company still plans on using free cash flow to buy back stock, so we could see some upside on EPS assuming the company prices risk accordingly.

Moving forward in a world of Obamacare, it is likely that WellPoint will see long-term gains in enrollment, offset by a decline in profit margin. Since the market hates uncertainty, the current stock prices reflects extremely pessimistic assumptions, and management is taking the right steps by broadening its offerings, and buying back stock at a large discount to intrinsic value. The company expects to return about $2 billion next year to shareholders through share buybacks and dividends. The current dividend is about $400MM, leaving about $1.6 billion for buybacks. This could potentially decrease the share count by nearly 10%, assuming the stock price hovers around current levels. With the potential for dividend tax rates to be increased, I'd hope management doesn't increase the payment, and instead allocates more capital to buybacks and debt repayment.

At $56.25, WellPoint is trading at around 7 times forward earnings. The company still trades at a reasonable discount to its $23.6 billion in shareholder equity, despite consistently generate ROE in excess of 11%. There are a lot of intangibles and goodwill in WellPoint's shareholder equity, so I don't believe book value to be a great proxy for liquidation value in this scenario, but this is largely irrelevant due to the company's strong profitability and free cash flow production. We believe that long-term investors should both buy the stock at current prices and sell long-term put options to further reduce the cost basis. Currently, the $55 puts for January 2014 are selling for roughly $7.00. This means that if WellPoint closes above $55 at expiration, the investor will have made 14.5% on the maximum risk of $4,800. If the stock closes below $55, the breakeven will be $48.00 per share, leaving ample room for upside appreciation potential. We believe WellPoint should trade in excess of $70 per share, and that the company is one of the best opportunities in the healthcare space.

Disclosure: I am long WLP. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.