The managed care world is still quite unsettled as the industry prepares for the post-Affordable Care Act world. While a government-mandated floor on medical expenses will put a greater premium on the operating leverage of the largest players, nobody quite knows for certain what participation in state exchanges will mean for enrollment, premiums, and profits.
That's the world that companies like UnitedHealth (NYSE:UNH), WellPoint (NYSE:WLP), Aetna (NYSE:AET), and Cigna (NYSE:CI) all face. But there's more on the table for WellPoint, as years of questionable execution have led to underperformance in terms of both financials and stock market performance. With a new CEO, a strong base in individual and small group plans, and a low bar, can WellPoint deliver on what looks like an otherwise unfairly large discount to its peers?
SEE: How Does The Affordable Care Act Affect Your Taxes In 2013?
New Management Could Bring Useful Perspective
Contrary to analyst expectations, WellPoint did not look to the head of its (relatively) recently-acquired Amerigroup business, nor internal candidates, nor even other managed care executives to replace CEO Braly (who bowed to pressure to resign in August of 2012. Instead, WellPoint's board went with Joe Swedish, the former CEO of Trinity Health (a network of non-profit hospitals).
Although there has been some consternation in Street-world about choosing an executive outside managed care, I think this move could be smart on multiple fronts. For starters, holding the top spot at an insurance business doesn't necessarily demand insurance industry expertise. As Warren Bufett has ably demonstrated with Berkshire Hathaway (NYSE:BRK.A, BRK.B) it can be enough to instead choose good people to run the insurance operations and let them do their jobs.
What's more, the implementation of the ACA almost certainly means that margins are going to go down in managed care and the industry is also absorbing more rate/cost pressure in Medicare. Well, hospitals have been operating an adverse, complex climate with significant margin pressure for some time now, and WellPoint could benefit from a CEO with direct experience in dealing with those pressures. It's also not to going to hurt WellPoint to have an “insider's” perspective when it comes to dealing with healthcare providers.
SEE: Affordable Healthcare Act 101: What To Expect Now And Later
WellPoint Is Going To Be Active In Exchanges, And Margins Will Likely Suffer
WellPoint has already said that, at a minimum, it's going to participate in state exchanges where it has a presence through its Blue Cross Blue Shield operations. Ostensibly, that means it will start off as a bigger player in these exchanges than UnitedHealth and Cigna – both of which seem to be taking more of a “wait and see” attitude.
Managing this process in such a way to preserve market share but also generate economic returns will demand a lot from WellPoint's management. In the case of California, it looks like WellPoint chose to compete primarily in the “bronze” and “silver” areas, and that should be good for the company's risk exposure (presumably, healthier people will choose these cheaper options). Remember, while the ACA demands a minimum floor for medical loss ratios (the percentage paid out for covered expenses), it doesn't impose a ceiling, which means companies like Health Net (NYSE:HNT) that choose to participate in the higher categories risk taking on a larger number of unprofitable policyholders.
Time For Better Execution
With participation in the exchanges likely to carry margins in the low to mid single-digits at best, it's incumbent upon WellPoint to improve its execution across the business. To that end, WellPoint has echoed UnitedHealth's comments about potentially pulling back in Medicare Advantage due to insufficient profitability. There's also work to be done on the commercial side, though, where poor plan designs, poor risk enrollment, and just generally sub-optimal profitability have all played in a role in the company's underperformance.
SEE: Investing In Health Insurance Companies
The Bottom Line
While participation in Blue Cross Blue Shield forces WellPoint to hold more capital than its peers, and this is bad for returns, I nevertheless believe there is an opportunity for this company to perform meaningfully better than it has in recent years. The changes brought on by the ACA will indeed challenge the industry and this company, but it will still be possible to generate solid economic returns.
Using an excess returns model, I believe WellPoint could be worth almost $90 if the company can generate a 10% return on equity (ROE) over the long term. That's lower than its historical rate, which I feel is appropriate given the lower profitability associated with the expansion of individual health care insurance. It's also lower than my projected ROE for UnitedHealth, as I believe the company's model is inherently skewed toward a lower return and WellPoint lacks operations like UnitedHealth's medical information services. Even so, I believe a relatively low bar for future expectations has WellPoint looking like a worthwhile turnaround candidate at today's price.
At the time of writing, Stephen D. Simpson did not own shares in any of the companies mentioned in this article.
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