Description

WellPoint trades for 7x my 2010 estimate of free cash flow, and 10x 2008 estimated free cash flow.  This seems cheap for a business that should grow EPS 15% per year, has mild cyclicality, earns 50% returns on tangible invested capital, and is run by a shareholder friendly management that deploys capital aggressively into share repurchases.

My 10,000 Foot View of Managed Care

Managed Care Organizations (MCOs) add value by purchasing healthcare for its customers in bulk, and secondarily pricing and spreading risk.  MCOs negotiate prices with providers, and mark up those services by around 20%.  The MCO collects insurance premiums upfront and earns investment income on the float, but also has some overhead. 

As the industry operates today medical costs per member may increase 7% for example, and WLP might raise premiums per member 7.5%.  The business is very scalable on G&A.  At WLP G&A has declined as a percent of revenue by 100 bps per year on average over the last several years.

Each MCO has a unique mix of members in Commercial, Medicare and Medicaid plans.  The consensus is that Commercial in general has the least member growth potential as incrementally healthcare inflation is pricing many employers out of the market.  On the plus side employees who aren’t covered by a group plan often purchase individual plans that carry higher margins than group plans since MCOs can be more choosey about who they cover.  Medicare is viewed by most as the high growth segment for two reasons.  First, a higher percentage of seniors are going to privately-run Medicare Advantage plans as opposed to government-run traditional Medicare plans.  Second, the senior population is growing.  However there’s considerable controversy surrounding Medicare Advantage funding as it is about 13% higher per member than traditional Medicare, and MLRs are likely lower.  The Medicaid business is viewed by many as a potential minefield given straining state budgets, but is generally viewed as having decent member growth potential. 

Politics

The market seems concerned about the outcome of any potential healthcare reform.  While I think in some scenarios reform could be a threat, based on conversations with industry experts I think it could more easily be an opportunity, particularly for WLP.  

Universal coverage in itself would be positive – 47 million potential new customers – but margins are more important than members.  Of the iterations of universal coverage models, one that concerns me is guaranteed issuance combined with optional coverage.  Guaranteed issuance would ensure that no one is denied coverage.  Auto insurance operates on a universal coverage model, but coverage is mandated.  Actuarially speaking this is important because safe drivers, who wouldn’t buy insurance voluntarily, subsidize risky ones.  Were auto insurance optional, premiums would be significantly higher for everyone.  The managed care industry in New York operates under a guaranteed issuance/optional coverage model.  MCOs can operate profitably in New York, but anecdotally average premiums are $400-500 per month versus $200 per month in California where there is no guaranteed issuance.  Guaranteed issuance could disincentivize good membership.  As you probably know, groups already operate on a sort of guaranteed issuance model, it would only be a risk for the individual business.  Individuals are 7% of WLP’s membership, so exiting that business would be relatively painless.

Another byproduct of universal coverage might be government funding cuts to Medicare and/or Medicaid as these programs might be expanded to extend coverage to a larger population.  So many industry insiders fear that Medicare Advantage margins are at risk, but again any margin compression would likely accompany an influx of volume.

The risks to the group business seem minimal to me.  The issue is about covering the uninsured, not nationalizing the already insured. 

My overriding thesis on reform is that MCOs have a number of levers they can pull to stay profitable, and MCOs are good at pulling levers.  Benefits can be cut, premiums can be raised, in every imaginable combination.  Case in point, last year California had an ambitious reform agenda that included putting a floor on medical loss ratios.  In the commercial segment the target floor was to be 85%.  After some back and forth, concessions were made.  Premium taxes were allowed into the MLR calculation (not the case for GAAP), which lowered effective GAAP MLR to maybe 82.5%, and some GAAP G&A was permitted into the calculation which brought effective GAAP MLR to around 80%, pretty close to where most insurers write commercial business anyway.  Note that California ultimately abandoned the reform effort because of the state’s precarious budget situation.  Ultimately, in America we generally don’t impair an industry without some input from industry participants who understand the implications of the action. 

Choosing Among the MCOs

The table below is my best attempt to level the comparison quantitatively.  The estimates are a combination of sell-side consensus peppered with my judgment.

WLP appears statistically cheapest.  I think WLP is also superior qualitatively.

For starters WLP is a Blue Cross Blue Shield carrier.  BCBS is the most valuable brand in managed care.  33% of Americans have a BCBS plan.  BCBS has five times the brand awareness of their biggest competitor.  BCBS has more bargaining power versus providers than any MCO because of its large membership.  BCBS’ provider network is also the largest.  WLP adds the most value for members by providing a superior product for similar prices.  For this reason, WLP continually takes market share in the commercial space and is able to grow members profitably in this stagnant market. 

In my analysis, rightly or wrongly, I’ve prioritized minimizing my exposure to Medicare as Medicare funding cuts are a single point of failure.  My rationale is thusly: a plan’s exposure to Medicare today has little to no bearing on future exposure.  I want to minimize my immediate Medicare blowup risk but I don’t want to give up any upside from Medicare/Medicaid expansion in the future if that’s how universal coverage materializes.  If Medicare and/or Medicaid are expanded to extend coverage to a greater population, funding cuts will likely be necessary but would only affect existing members.  A plan with no Medicare members today could benefit from member growth in the future without having to take a step back first.  Larger plans have a cost advantage in bidding.  Anecdotally I’m told that as long as an MCO has Medicare infrastructure and know-how there is no real barrier to acquiring as many members as the plan can bid for successfully.  So I want to position myself with a large carrier with Medicare infrastructure but minimal exposure today.

The below table is a rough estimate of EPS contribution from Medicare Advantage and Medicaid for the various MCOs.  I have no doubt it contains errors, but clearly WLP is at the very low end of the spectrum.  WLP management has intentionally avoided aggressively moving into Medicare because of the questionable value proposition of Medicare Advantage that makes funding uncertain. 

Valuing WLP

Management has provided guidance for 2008.  I don’t feel smart enough to expound on the guidance except to say the sharecount guidance doesn’t make sense given their buyback guidance.  I don’t make any assumptions about benefits from healthcare reform.

                                    2007                2008E              2009E              2010E

Operating Rev              60.1                 62.6                 66.5                 70.9

Investment Income        1.0                   .85                   .9                     .97

MLR                            82.4%              81.6%             

G&A Ratio                   14.5%              14.4%

EBIT                            5.7                   6.0                   6.5                   7.1

EBIT Margin                9.3%                9.5%                9.7%                9.9%

Interest Expense           .45                   .59                   .69                   .79

Net Income                  3.3                   3.4                   3.7                   4.0

Non-Cash Expense      .76                   .76                   .76                   .76

Capital Expenditures     .2                     .2                     .2                     .2

Free Cash Flow            3.9                   4.0                   4.3                   4.6

Diluted Shares, EOP     .556                 .5                     .45                   .4

FCF/Wtd. Avg. Shr.     6.60                 7.57                 9.05                 10.75

If we apply a 14-16x multiple on $10.75, WLP could trade for $150-175 in 2-3 years.  Barring a legislative disaster I don’t see how EPS will decline, so at less than 10x ’08 FCF it’s hard to lose money from here in my view.  But a legislative disaster is possible, and it’d be a gross overestimation of my abilities to assume that I can model a worst case scenario.  Some faith that such a scenario is both unlikely and of a manageable magnitude is required.

As an afterthought on valuation, some have raised the possibility of monetizing the captive PBMs.  WLP’s PBM is the fourth largest, it processes about 400 million prescriptions per year. Medco (MHS) should do about 570 million prescriptions in 2008, and will do a little over $4 of EBITDA per prescription.  If WLP does $3 per prescription, that’d be $1.2 billion of EBITDA.  MHS trades for 12x 2008 EBITDA.  10x would mean the WLP PBM is worth $12 billion, leaving us with a stub selling for maybe a multiple point less than today.  UNH has announced that it plans to provide more detail on its PBM in 2008.  WLP will provide more, though somewhat less helpful, disclosure in 2008 as well. 

Catalyst