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The uncertainties created by the Affordable Care Act (the ACA or "Obamacare") have affected all of the players in the space, leading to a drive toward consolidation and scale through acquisitions for Aetna Inc. (NYSE: AET ) , Cigna Corporation (NYSE: CI ) , and WellPoint, (NYSE: ANTM ) . But not all of WellPoint's problems can be blamed on the ACA. WellPoint struggled operationally under the tenure of now-former CEO Angela Braly and finds itself in need of self-repair at a time when others like UnitedHealth Group (NYSE: UNH ) can use their cash flow to fund acquisitions outside of the U.S. regulated managed care space.
While WellPoint has been the laggard of the "big four" over the past two and five years, it is not as though the company's performance has been disastrous. UnitedHealth is up about 45% over the last two years and Aetna is up about 55%, while WellPoint's shares have risen about 35%. WellPoint still has meaningful scope to tighten up its operations and drive synergies from its large acquisition of Amerigroup, and while the ACA has added a lot of unknowns to the model, the company's conservatism in these early days is likely to mitigate that risk. I don't see quite the same potential in WellPoint shares as I do from UnitedHealth, but there's still enough here to be worth some consideration.
ACA Is Here, For Good Or Bad
Insurance companies are in the business of pricing risk, but they don't really like uncertainty. Unfortunately, there has been uncertainty in spades in this initial period of the ACA. Like UnitedHealth, WellPoint is going to see some benefits from the one year extension on plans that would otherwise have been canceled, but it's not really a significant driver of results.
Where WellPoint could see more benefit is in its Medicaid business. Post-Amerigroup, WellPoint administers Medicaid plans for more than 4 million people across 19 states, and thus far the enrollment process for insurance under the ACA has led to a 15% jump in Medicaid applications as people who didn't realize they were eligible for Medicaid are informed that they may be. As WellPoint has about 12% share of the Medicaid market (versus 10% for UnitedHealth and less than 5% for Aetna), that's a potentially meaningful revenue opportunity.
The impact on WellPoint's individual policy business has yet to play out. Unlike UnitedHealth, Cigna, or Aetna, WellPoint has been relatively bold in participating in exchanges as it is participating in part to maintain its Blue Cross Blue Shield franchise in those 14 states where it holds a license. WellPoint has been fairly conservative with its pricing (at least relative to group premiums and past individual policies), but nobody yet knows what the health care utilization and medical loss ratios will look like. Government policies including non-profit reinsurance entities will help mitigate the risk of outsized claims, but that is not the same as guaranteeing any particular level of profitability.
Execution Before Expansion
Given the problems under Braly's tenure, one of the key duties for CEO Joe Swedish is to restore Street confidence in the basic execution capability of WellPoint. The period of 2008 to 2012 was a mess of execution issues including elevated claims costs, compliance issues and product design flaws with Medicare Advantage, commercial enrollment challenges, and iffy expansions outside of the core managed care space.
The net result? While Aetna and UnitedHealth delivered roughly 2% to 3% annual EBIT growth over the past six years and Cigna grew over 5%, WellPoint saw profits decline almost 6% a year.
So far, the early results in Swedish's tenure have been mixed. Nobody really knows what the trends in medical loss ratios are going to look like in the first few years of the ACA, but I expect the Street to pay keen attention to trends in SG&A and the results so far this year have been mixed as SG&A has been coming in higher than expected.
As time goes on and managed care companies dial in their pricing and expectations for individual plans under the ACA, I expect attention to focus back to ancillary growth opportunities. While WellPoint could look to challenge Cigna more in the commercial self-insured fee market, I would hope that the company would turn instead to opportunities in health care information technology. UnitedHealth has already established a strong presence here, but I think there's room for WellPoint to get involved and I think it's an opportunity with better risk-reward trade-offs than acquisitions like 1-800 Contacts.
The Bottom Line
I value managed care companies with a two-part methodology that uses a discounted cash flow model and an excess returns model. Provided that WellPoint can maintain a 10% return on equity (against a trailing three-year average of over 11%), a fair value in the mid-$90s is entirely reasonable. If the synergies with Amerigroup and/or operational improvements really come through and that long-term ROE can rise to 12.5%, the target jumps to well over $100. With a cash flow model, a long-term estimate of 7% FCF growth (higher than UnitedHealth, mostly to account for the lower starting point of WellPoint after its half-decade of underperformance) points to a fair value of just about $100 today.
WellPoint does not appear to be as cheap as UnitedHealth by either of my favored methodologies, which may be a little surprising given UnitedHealth's much higher price/book and EV/EBITDA multiples. That's where the differences in margin structure, cash flow generation, and returns on equity or capital come into play. Although I think UnitedHealth may be the safer opportunity, I wouldn't rule out the possibility that WellPoint could outperform expectations and generate good returns even after a strong 2013.
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