Economic thinker and statistician E.F. Schumacher once mused: "Any intelligent fool can make things bigger, more complex, and more violent. It takes a touch of genius -- and a lot of courage to move in the opposite direction." WellPoint (WLP +2.43%), one of the nation's largest managed care organizations (health insurers, in non-financial speak), fits that profile as a company whose cash generation appears the subject of multiple ambiguities: continuously subpar results, which culminated in CEO Angela Braly's resignation; uncertainty from Obamacare, on account of its exposure to small business policies; and despite huge growth potential, added complexity from the recently completed acquisition of Amerigroup.
I take a slightly different view. Obamacare might actually be a positive, Braly's resignation provides opportunity for WellPoint to improve its cash generation and returns, the Amerigroup acquisition brings a capable group of managers and huge growth potential. Whatever the outcome, the seeming complexities don't matter. As shares trade hands at seven times my estimate of free cash flow, most all of the negative outcomes are priced in, by my math. We're buying the possibility that things end up better than the market's expectation -- which is that really bad things will happen -- at a very low price. That's simple.
That's why I'm buying a position equal to 3% of my Real Money Portfolio's capital.
Meet WellPoint
To start, a quick introduction to WellPoint for those unfamiliar: WellPoint is one of the largest managed care organizations in the States, insuring 36 million under the BlueCross BlueShield brand in 14 states, BlueCross Anthem, and others. It derives the lion's share of its profits from commercial members, with an emphasis on small businesses, but also makes a solid pull from Medicaid, Medicare, and individual policies. As one of the largest insurers in the United States, you might think of WellPoint as eBay, but for medical care -- it connects people with its extensive network of medical providers.
WellPoint benefits from some of the most powerful competitive advantages: a classic network effect, and economies of scope and scale. Providers want access to WellPoint's large customer base, and customers are drawn to the breadth and depth of WellPoint's national and local networks. In turn, WellPoint should be able to negotiate lower rates for its customers, generate solid profits, and grow its membership base. The company's size enables it to more effectively scale fixed costs relative to smaller competitors, which yet again, enables the company to charge its customers less, and make more money.
As all insurers, health insurers engage in a game of odds, pricing the probability of events whose cost and frequency are known in the long-term, but uncertain in the near-term. Because WellPoint possesses vast data stores -- generations long records of the incidence, cost, and frequency of illness -- the company should (and again, note use of the word should) be better able to effectively price business, and earn consistent, solid returns on capital.
Because insurers are paid for services rendered before doing anything, they generate a thing financial-types call float, money to invest. Players of scale have huge investment portfolios, and WellPoint is no exception -- its investment portfolio neared $20 billion at last quarter's end. Effectively, WellPoint makes money for nothing, at least in its investment portfolio.
A sick patient?
So, you might wonder, how can WellPoint shares be so cheap? Simple: management missteps, Obamacare worries, and an under-appreciated opportunity from the Amerigroup acquisition. Whatever the outcome, as WellPoint shares trade at seven times cash flow, a lot of ugly things are priced into the shares. In fact, things might be not be so bad.
Let's take a closer look.
1. BadPoints and management missteps: Let's start with one of two elephants in the room. WellPoint management's done poorly, to be kind. Theory goes that WellPoint's competitive advantages -- its scale, bargaining power with providers, the breadth of its network, and insight (via its data stores) into its end-markets -- should enable superior returns. That hasn't happened -- at all.
WellPoint's individual segment results have bounced around for several years running. In 2011, a relatively small California Medicare contract blew a hole in its profits. Management's guidance, and apparent visibility into their end-markets, has been erratic, at best. More recently, the company flagged accelerating cost trends and a competitive market -- an assessment at odds with competitors Aetna (AET +0.00%), UnitedHealth (UNH +1.03%), and Cigna (CI +0.00%) -- as cause for reduced earnings guidance, and the shares plummeted. We don't sweat a quarter's results or one year's guidance, as Foolish investors. But we do worry when, and if, it indicates a management team out to lunch. Perhaps most damning, while competitors' margins expanded and benefited from lower medical utilization in recent years, WellPoint's margins didn't get the same pop.
To be fair, WellPoint's cash generation remains prodigious, and it may not be that cut and dry. Differing geographic areas, markets, and policy mix may account for some of the difference. But explanations aside, the company's results haven't been up to par. Like that bulbous teenage zit, it came to a head three months ago: CEO Angela Braly resigned.
At its root, or so it seems, was a little soft shareholder activism -- as longtime shareholders, including Leon Cooperman's Omega Advisors, made clear their dissatisfaction. Here lies an opportunity: A company with WellPoint local, regional, and national scale, network breadth, and insight unto medical cost trends should earn better returns. For a sense of context, through 2011, UnitedHealth's five-year average return on equity was 18.5%, while WellPoint clocked in at 13.8%.
A change at the CEO post offers prime opportunity for corporate existentialism -- of WellPoint's underwriting models and strategy and its flaws, how and when to pursue business, and institutional sacred cows. Sought-after improvements won't be a flashbulb moment, but a slow, somewhat arduous turn. But the rumored candidates possess solid industry experience, histories of successful execution, and independent strategic minds: James Carlson, former CEO of Amerigroup; David Snow, former Medco CEO (acquired by Express Scripts (ESRX +0.00%)); and Ron Williams, former CEO of Aetna.
Not to put too fine a point on it, but WellPoint shares currently trade at 7 times my estimate of free cash flow. They're priced as if current results, and continued declines, will persist. I don't think that will happen.
2. Obamacare: I'll assume for a moment you've missed this thing called Obamacare. Among other things, the bill mandates that states create health care insurance exchanges, and caps insurers' profitability. Individuals and families can purchase insurance on the exchanges. For each state exchange, price increases must be approved by a state authority. It also [tentatively, per the Supreme Court's decision] expands Medicaid, the state-sponsored health care plan, coverage to about 16 million Americans.
It's been argued that many small businesses will drop employee coverage (or won't offer it), accept a fine, and let employees buy from the exchanges because it's cheaper. That argument is probably right. Some small businesses will purchase insurance via the exchanges. For WellPoint, health insurance exchanges will result in lower margins—as competition pressures pricing for individual policies, and a population of small businesses stop covering employees via commercial policies, a very profitable niche for WellPoint.
But it's not all sour cherries. WellPoint's brand strength, perception as a cost leader, and network breadth leave it ideally positioned to scoop up individual policies via the exchanges. For the most part, the old maxim -- "We'll make it up on volume..." -- are the words of a desperate and flailing enterprise. But for WellPoint, it might actually be true.
For sake of argument, let's look at a worst-case scenario: WellPoint's operating margins decline, but its membership expands under Obamacare, about 10%. Let's also assume that WellPoint's companywide margins fall to somewhere between 2.5% and 3% -- approximating Medicaid-type policies or non-profits, where payers are spendthrift or returns are, effectively speaking, regulated. In this scenario, I peg WellPoint shares' worth at $60, about today's price. To cut a long story short, the downside from Obamacare appears somewhat limited.
3. Amerigroup acquisition
Four days ago, WellPoint completed its $4.9 billion purchase of Medicaid-focused Amerigroup. In doing so, it accomplished several strategically important ends. Foremost, it bought access to a rapidly expanding corner of the market, as Obamacare could expand Medicaid coverage 16 million people.
Second, it acquired a very savvy executive team, most notably former CEO James Carlson. To understand why, a little context is in order. Medicaid is one of the most challenging corners of the managed care sphere. Margins are razor thin, competition rife, and states and municipalities determine rates of reimbursement. A small error can mushroom quickly. Under Carlson's tenure, Amerigroup's top line nearly doubled, and returns on equity averaged 12%. In a highly competitive marketplace, that's mighty impressive.
Last, the Amerigroup acquisition ideally positions WellPoint to pursue an estimated $5 billion opportunity from privatization of so-called dual eligibles, acute care patients covered by Medicaid and Medicare. While WellPoint's purchase price doesn't look cheap, at nearly 40 times trailing earnings, the potential for administrative cost reductions, added scale, and membership additions from ObamaCare and dual eligibles create opportunities a cursory glance obscures.
Valuation
Over a 10-year period, I expect WellPoint's revenue growth to average 8%, as it grows its member base from Obamacare, the Amerigroup acquisition, and dual eligibles, and increases prices at a rate slightly less than medical cost inflation. I expect operating margins to deteriorate from current levels, at 7% to a 4% long-run average, as the company's medical cost ratio (medical costs as a percentage of total premiums) declines from 85% to 90%. On this basis, I peg the shares' worth at $88.
Risks
Chief among the risks to WellPoint are the sidebar consequences from Obamacare. An increasing emphasis on individual, narrow network policies might slowly but surely disintermediate managed care organizations, as accountable care organizations and local networks take a greater share of WellPoint's bread and butter. For the time, it appears that the two can comfortably co-exist, but this risk bears watching.
To that end, as one of the big dogs in the managed care sphere, WellPoint's prices increases are subject to greater scrutiny than most, and under Obamacare, it may find it harder to pass medical cost inflation on to consumers. In related matters, Medicare and Medicaid reimbursement levels will be forced lower, as federal and state governments try to reduce deficits.
Lastly, health care is one business that sits squarely at the intersection of economics, public policy, and individual well-being. Regulation isn't so much an if, but when. WellPoint must carefully walk this tightrope, serving its customers while sustaining its profits.
The bottom line
In short, WellPoint's cheap, and the market's assumed a lot of things will go wrong. If, at the margin, a few things turn out better than expected, shares could be worth a lot more.
