As value investors, we look for consistent growth in a wonderful business that is currently selling at a discount. I believe that the market is offering WellPoint Inc. (WLP), an established health insurance provider, at a discount to its value.
WellPoint and its subsidiaries supply health insurance to over 100 million individuals, and was formed when WellPoint Health Networks and Anthem Inc. merged in 2007 (WellPoint, 2013). WellPoint covers HMOs, PPOs, and POSs for both individuals and companies. WellPoint also supplies insurance for the U.S. government’s Federal Employee Program and is also tied to the government through Medicaid. Finally, WellPoint is a part of Blue Cross and Blue Shield (BCBS) in 14 states and is licensed in all 50 states.
To understand how to accurately value this company, we must first comprehend the way in which the Supreme Court’s ruling on the Affordable Care Act (ACA) will impact the health insurance field and the growth that will be accelerated or slowed due to the new law. My thesis is the market has an irrational fear due to the ACA, and as a result, has mispriced WellPoint. Contrary to the market’s fear, I believe that aspects of the ACA may actually benefit WellPoint due to recent changes and acquisitions. Furthermore, I believe that even though the market has begun to recognize the opportunities that the ACA presents for WellPoint, I believe the stock is still severely undervalued. The following is my analysis of the market’s fear of the health insurance field and the irrational prices created due to the ACA, with an emphasis on WellPoint.
The ACA aims to provide everyone with basic health insurance. This includes those with disabilities and pre-existing conditions, as well as the poor. The ACA forces employers to provide coverage for their full-time employees, and failure to do so is subject to a penalty. Further, all self-employed individuals must be covered by a plan or are also subject to a penalty. The individual mandate of the ACA essentially obligates everyone to purchase health insurance whether they want to or not.
With this comes the inevitable rise in healthcare premiums. If insurance companies are forced to accept patients with pre-existing conditions, they will predictably raise premiums for all plan participants to offset the losses that result from accepting costly new customers. The market’s fear is that this will hurt the insurance company. However, I have an opposing view.
My first argument is the insurance companies can continue to raise prices as necessary. Historically, this is the reason insurance companies that lack competition have been able to survive. People understand the need for insurance and often overpay to be insured. This trend will continue into the future as costs for insurance companies rise due to the ACA.
Critics of WellPoint argue that Congress is attempting to limit the rise in healthcare premiums. This is essentially true. However, this objective will be difficult to enforce because the government has now put itself in the business of keeping insurance companies afloat. If all health insurance providers are forced to raise premiums due to increased costs, the government will not be able to refuse. As a result, the government’s talking point of keeping premiums low will be difficult to execute.
Along with this, the government is putting pressure on health service providers to lower their cost to customers. However, if everyone is already insured, the government is effectively attempting to lower costs for insurance companies, not the customer. If costs are driven down, profits should rise for insurance companies.
One of the main reasons I believe insurance companies will be able to increase revenues as necessary is due to a subsidy provided to lower income individuals who were previously uninsured. Subsidies will be available to those who make less than 400% over the national poverty line, or roughly $92,000 (Wall, 2013). For practical purposes, most people would receive some form of subsidy following these parameters. For example, a person making 138% of the poverty line would pay only $520 per year under a plan that costs $5,000. A full table displaying the subsidy corresponding to each income level is shown below in Table A (Young, 2013). This allows insurance companies to charge more, the government to subsidize the premium, and the individual to be less impacted by the elevated cost of health care.
Table A - Subsidies in Relation to Percentage of Poverty Level
Another intended result of the ACA is it encourages competition between insurance companies by offering a website with side-by-side insurance offers. Studies have shown that individuals consistently select price as the determining factor in deciding which plan to purchase (Wall, 2013). The result of this will likely be lower profit margins for all insurance companies due to increased price competition.
Although insurance companies already operate on single-digit profit margins, the number of customers will have to grow due to mandatory insurance. Nearly 84 million people who were currently uninsured or underinsured (Gregg, 2013) will be forced to purchase insurance. This should compensate for the lower margins that will result from the implementation of the ACA. The key is who will be able to withstand these thinner margins.
A major consideration that will benefit large health insurance companies is government-operated health insurance may eventually result in a situation similar to our “Too Big to Fail” policy in the financial industry. Many small banks today are being shut down due to the Dodd-Frank legislation that essentially eliminates smaller banks due to burdensome regulation and competition from larger banks. The same could soon ensue in health insurance. When small health insurance companies see their already small profit margins decline and are forced to compete with large health insurance companies on price, business will dry up and they will go broke. Customers who were previously insured by smaller insurers will be forced into plans by larger insurers such as WellPoint.
This is ironic because the objective of the ACA was to keep health insurance affordable and encourage competition between health service providers and insurers. However, the same competition that drives rates lower also eliminates smaller companies and will likely narrow the pool of insurers down to a much smaller group. I suspect that this group will eventually consist of WellPoint (WLP), United Health (NYSE:UNH), Humana (NYSE:HUM) and possibly a few others. By reducing the number of insurers, the ACA’s end result decreases competition. I believe that the companies mentioned above will survive because of their large customer base, ability to withstand smaller margins, and pre-existing presence within government.
I believe that of these, WellPoint will emerge the strongest for a variety of reasons. WellPoint recently acquired Amerigroup (AGP), which focuses on Medicaid and elderly people with disabilities (Hegarty, 2012). The acquisition of Amerigroup has already added over 5 million new customers to WellPoint (Zhao, 2013). The ACA broadens the scope of Medicaid coverage, increases the number of people on Medicaid, and allows companies such as Amerigroup to pay lower rates of reimbursement (Weir, 2012). Following the Supreme Court’s ruling on the ACA, Amerigroup’s stock jumped 50%, a clear indication of the impact of the new law on the company.
The acquisition of Amerigroup was a brilliant idea by management. I believe it acted both as a hedge against the ACA as well as a new way to generate profits and grow the company. The acquisition occurred before President Obama was re-elected. I believe the thought process behind the acquisition was that if Obama were re-elected, the ACA would stay in place. As previously discussed, this would squeeze WellPoint’s margins. However, another effect of the ACA is it expands the scope of Medicaid. WellPoint’s smaller margins would be offset by the acquisition of a company that benefits from the ACA.
Pre-election critics of WellPoint maintained that the purchase of Amerigroup was an extremely risky bet by WellPoint (Avik, 2012). They asserted that if Romney won the election, Medicare and Medicaid reform would take place and would likely be detrimental to Amerigroup. This may have been a rational fear. However, Amerigroup has proven to be a wise investment for WellPoint, as the re-election of President Obama assures that the ACA and expansion of Medicaid are here to stay.
WellPoint also operates under Blue Cross Blue Shield (BCBS) in 14 states. In those states, WellPoint controls over one-third of all private insurance plans (Whelan & Dobbs, 2013). BCBS has historically been able to offer lower rates than competitors which will be to WellPoint’s advantage in the competitive post-Obamacare market. BCBS also gives WellPoint bargaining power in these 14 states--something their smaller competitors do not have. The national average discount rate from providers to insurance companies is roughly 20%. However, BCBS often gets discounts of upward to 60% (Whelan & Dobbs, 2013). In fact, WellPoint has been voted least popular by hospital executives due to tough negotiation tactics (Zhao, 2013). WellPoint cites BCBS as the reason for this negotiating ability, and I believe the expansion of the “brand” and “pricing” moats of BCBS into other states is essential for the long-term growth and profitability of WellPoint.
An argument for the bears that are selling and driving the price to current levels is insurance companies will not be able to withstand smaller margins. Although this may be a rational fear for smaller insurance companies that may go out of business due to the ACA, this is not the case for insurance giant WellPoint. As previously mentioned, WellPoint has the durable competitive advantages of price, quality, ACA coverage, Medicaid coverage, as well as other ties to the government. Large insurance companies will be necessary for the ACA to succeed, and although lower prices and profit margins can be expected, large insurance companies such as WellPoint will not feel the impacts to the degree that smaller insurance companies will.
In fact, it is quite clear that many large insurance companies are in favor of parts or all of the ACA. We can see this by looking at large insurance companies’ political action. One of WellPoint’s peers, insurance giant UnitedHealth, lobbied heavily for aspects of the ACA (NBC, 2012). The lobbying came when the Supreme Court was interpreting the constitutionality of the ACA legislation. UnitedHealth and Humana began lobbying for provisions to keep aspects of the ACA in place even if the larger legislation was declared unconstitutional. Because WellPoint, UnitedHealth, and Humana operate very similarly, it is reasonable to assume that WellPoint was also in favor of many aspects of the ACA. As my theory holds, this should have been expected, as the ACA will likely eliminate smaller insurance companies, thus bringing more business to insurance giants such as WellPoint.
Now that the basic premises of the ACA in relation to the health insurance industry have been established, I will explain why I believe that WellPoint’s stock will outperform its peers. I will first analyze WellPoint’s management and then move to growth and profitability in relation to other companies in the health insurance field.
One of the main arguments of the bears is the lack of stable management. The former CEO, Angela Braly, was forced to resign in August 2012 (Matthews & Camp, 2013). WellPoint appointed a temporary CEO before committing to their permanent CEO, Joseph Swedish.
Although relatively new, I believe the appointment of a permanent CEO gives us more clarity into the future. If we had bought our initial positions at $55 per share, the CEO and the company’s future would have been unknown. However, with Swedish, the company’s future can be projected with greater transparency.
Additionally, the bears are also wrong because the selection of Swedish prepares the company for facing the new legislation. Swedish has previously been in the hospital business and knows the fine points of the interaction between health care providers and health insurance companies. Swedish said upon selection, “My medical background will help us forge closer ties between WellPoint and providers in areas such as quality of care and efficiency” (Fox Business, 2013). I believe that this selection was appropriate for WellPoint considering the challenges and opportunities that the ACA presents.
It is possible the change of management has already begun impacting the company in a positive way. Although the success attributed to Swedish in the most recent quarter should be limited, WellPoint reported earnings per share of $2.94 versus expectations of $2.38 and also raised its forecast for the remainder of the year. Shareholders were both excited about the earnings and outlook, as the stock rose 6% following the conference call.
Mark Giambrone, WellPoint’s largest shareholder said, “The old management team liked to overpromise and under-deliver, and that’s a disaster for the stock market. It is clear to me that his (Swedish) focus is different” (Nussbaum, 2013). Giambrone continued by saying, “What I like about him is his consistent message about execution, operating efficiency and expense control. Those are the things WellPoint had been missing, frankly. I think the assets are there. Really, the question is about execution.” It seems that market participants agreed with Giambrone, as the stock has made substantial gains since the announcement of Swedish as CEO and the most recent quarter’s earnings.
Even as shareholders viewed WellPoint’s previous management negatively, WellPoint has produced extraordinary return on investment and return on capital while maintaining zero debt. This is illustrated in Table B below. As shown, WellPoint has been extremely diligent with equity and has produced consistent returns ranging from 11-13% over the past 10 years. These outstanding returns have put Wellpoint in the upper 6% of health insurance companies (Gurufocus, 2013). The reason the previous CEO was forced to resign was lack of proper money management and business strategy. With the appointment of new and better management, I expect these numbers to surpass previous growth rates.
Table B - Investment Performance
As previously mentioned, the health insurance sector operates on relatively small margins. Relative to the industry average of 4%, WellPoint operates at 6.5%. This positions WellPoint in the upper quartile of the health insurance sector in relation to profit margin (Gurufocus, 2013). As my previous theory holds, I expect WellPoint’s margins to outperform its smaller competitors after the entirety of the ACA is implemented.
WellPoint is also attracting new customers while raising prices. Its revenue growth of nearly 9% ranks WellPoint in the top 10% of all health insurance companies. As previously hypothesized, I presume revenue will continue to grow at an even faster rate in the future as the ACA drives prices higher. Because I anticipate fewer health insurance companies will exist 10 years from today, I believe its rank relative to others will also continue to rise.
The company is buying back a substantial number of shares and has begun to return capital to shareholders in recent years. WellPoint began distributing a dividend in 2011, and weeks ago increased its dividend by 30% (See Table C and D below). Only 10% of companies are buying back shares at a faster rate and only 12% of health insurance companies pay a higher dividend than WellPoint’s $1.50 (2%) dividend. With no debt and accelerating operating cash flow per share (Table E), I consider stock buybacks and dividends suitable for the company.
Another relevant consideration is the price at which WellPoint is buying back its shares. Not only is it a positive sign the company is repurchasing stock, but also as we will soon see, the company is buying back shares at a discount to BVPS, a five-year payback time, and nearly half of the sticker price. For these reasons, I strongly agree with the company’s ongoing share buyback program.
Table C - Recent Share Buybacks
Table D - Recent Dividends (Excluding 2013)
Table E - Operating Cash Flow Per Share
Even more compelling than these figures is that the shares are inexpensive at the current market price. The stock is currently trading for 8.5 times earnings, putting WellPoint in the lowest 12% of P/E ratios of all health insurance stocks. The health insurance industry itself has a low P/E ratio of only 10.5 compared to the Russell 2000 P/E of roughly 16. I believe this low P/E is mainly due to the uncertainty surrounding the ACA, as previously discussed.
The fundamentals of WellPoint are sound; Table F below shows EPS, OCPS, Sales, and BVPS+Dividend growing consistently at approximately 10% per year. This consistent profitability growth in combination with management’s ability to efficiently allocate capital makes WellPoint an attractive investment.
Table F - 10-Year Growth Rates
The question now becomes whether WellPoint is “on sale.” If we assume a conservative growth rate of 11%, the sticker price is determined to be $126 with a margin of safety of $63. The stock is currently trading at roughly $73 per share. Although we cannot buy the stock on the grounds of MOS, there are many other reasons to buy at the current market price.
One reason to buy WellPoint now is that it has a payback time of five years and an eight-year payback of $108 (See Table G below). This again assumes a growth rate of 11%.
Table G - Valuation
A second reason to buy now is WellPoint has a BVPS of roughly $78 (see Table H). This shows that the stock is now trading at a discount to its tangible book value. Its closest peer, UnitedHealth (UNH: NYSE), is trading at $60, has a P/E ratio of 11.5, an MOS of $40, a payback of $63 in eight years, and a BVPS of $27, making UnitedHealth a much less attractive investment on the grounds of valuation.
Table H - Book Value Per Share
Although UnitedHealth has better ROI, ROE, and equal growth, I believe that WellPoint is the better investment due to its greater discrepancy between price and value. Also, WellPoint is trading below BVPS while UnitedHealth is trading at roughly double BVPS. Additionally, I believe WellPoint will outperform UnitedHealth due to its competitive advantages such as better management, ties to government programs, and Blue Cross Blue Shield. For these reasons, I believe WellPoint to be the best investment in the health insurance industry.
It appears that I am not alone in this belief. Value investor Daniel Loeb recently added shares to his already existing position in WellPoint (Gurufocus, 2013). Although he initiated his position near $55 per share, he recently added 47% more at a higher price. This shows that other value investors may possibly see the same price and value discrepancy as I do in.
Ideally, we would have made our initial investment at around $55 per share when Loeb was investing; however, I believe the upward movement in the stock is just the start of a much larger bull run. Following earnings, WellPoint broke out of the key technical level of $70 (See Table I below). If it can maintain above this ceiling, $70 is likely to become a new floor.
Table I - Key Technical Levels
Another technical advantage is presented by using Fibonacci Retracements. WellPoint’s stock movement is a perfect example of these expected retracements. As shown in Table J below, I took the more recent floor and ceiling and extended Fibonacci Retracements. It worked perfectly that the next Fibonacci level is at its previous ceiling of roughly $82. This is an approximate 14% increase from the current market price of $72. If the newly established floor holds, I expect WellPoint to go to $82 in the relatively near future. After reaching $82, I would expect it to test its all-time high of $90 before moving higher.
Table J - Fibonacci Retracements
For these fundamental and technical reasons, I believe WellPoint is a solid buy at the current market price. I would begin stockpiling by purchasing one tranche at the current market price and selling puts at the technical levels of 65, 60, 55, and 50. This is illustrated in Table K below. If WellPoint dropped to $50, we would have initiated all positions we wished to enter and the stock would be trading at roughly 70% of BVPS. At these levels, I would feel very confident in the investment.
Table K - Tranches
Options are trading slightly higher than their historical average, with current implied volatility of 0.2467 and historical volatility of 0.2124 (see Table L below). This shows current volatility is roughly 16% above its historical average, suggesting we will get paid slightly more than normal for selling puts to enter into new positions. If we had entered these positions when Loeb did following the ACA Supreme Court ruling, we would have been rewarded with higher premiums at a lower strike because of a volatility rush. Volatility spiked to 0.50, or 238% of its historical volatility.
To get paid more for selling options, we may have to wait for another volatility rush. If we were to sell the June 65 put today (10% away from the market), we would get paid $0.50, a 1% return. I wouldn’t recommend entering this trade yet due to its low return, but would wait to see if the current floor holds. If the stock breaks beneath the floor, volatility will increase and the premium for the 65 and 60 puts will pay a greater premium. We would then be able to enter additional tranches at these levels.
Table L - Implied/Historical Volatility
I believe that WellPoint presents an excellent opportunity for value investors from both a technical and fundamental standpoint. My hypothesis is the ACA will help, not hurt, WellPoint by adding customers and drive smaller competition out of the market. Finally, I believe WellPoint offers a solid management team, has a durable competitive advantage, and is selling at a discount to its true value.
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