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|  | JANUARY 10, 2006
 FOCUS STOCK By Phillip Seligman A Promising Prognosis for WellPointStandard & Poor's sees healthy days ahead for the managed-care company, due to its powerful market positionWe at Standard & Poor's Equity Research Services believe that managed-care organization (MCO) WellPoint (WLP ; recent price, $79) will continue to produce above-average revenue and earnings growth through disciplined premium pricing, medical and administrative cost control, and its December, 2005, acquisition of WellChoice. Given our view of the company's promising growth prospects and attractive valuation, we have a 5 STARS (strong buy) recommendation on the shares. The acquisition of WellChoice, the last publicly traded Blue Cross Blue Shield licensee outside of WellPoint, provides the company with about 5 million additional members and, therefore, a large foothold in the metropolitan New York City market. In our view, the Blue Cross Blue Shield name, and what we see as its long-standing reputation for high-quality service, should help WellPoint attract members at rates above those of most peers. We're also encouraged by what we believe to be WellPoint's proactive efforts toward medical cost control. An example was its successful push to convert nonsedating antihistamine drug Claritin to over-the-counter, rather than generic-drug, status. We also think the MCO giant's size and No. 1 market-share position in 13 of the 14 states in which it's located will help it in negotiations with providers, including hospitals, clinics, and doctors, as well as with drugmakers, owing to WellPoint's ownership of an in-house pharmacy benefit manager. STATE SPREAD. We expect additional synergies to be realized from the November, 2004, Anthem-WellPoint merger. Moreover, the fact that WellPoint doesn't have the lowest selling, general, and administrative (SG&A) costs as a percentage of revenues among its for-profit peers suggests to us that there's room for additional improvement in its SG&A cost ratio. WellPoint is the largest publicly traded commercial health-benefits company in the U.S. and an independent licensee of the Blue Cross & Blue Shield Assn. The company's health-benefits operations include Anthem Blue Cross and Blue Shield plans serving members in Colorado, Connecticut, Indiana, Kentucky, Maine, Nevada, New Hampshire, Ohio, and Virginia (excluding the Northern Virginia suburbs of Washington, D.C.); Blue Cross and Blue Shield plans serving members in Georgia, Missouri (excluding 30 counties in the Kansas City area), New York (28 counties in eastern New York, including 10 in the New York City metropolitan area, as well as some in New Jersey), and Wisconsin; and Blue Cross of California. On a pro forma basis, as of Sept. 30, 2005, WellPoint had a total membership of 29 million people, compared to more than 27.7 million as of Sept. 30, 2004. WellChoice, acquired in December, 2005, and providing WellPoint's New York presence, had 5 million members as of Sept. 30, 2005. OTHER SERVICES. The company's product portfolio includes a diversified mix of managed-care products, including health maintenance organizations (HMOs), preferred provider organizations (PPOs), and point of service (POS) plans, as well as traditional indemnity products. WellPoint also offers administrative and managed-care services and partially insured products for employer self-funded plans, including underwriting, stop-loss insurance, actuarial services, provider network access, medical-cost management, claims processing, and other administrative services. In addition, the company offers group life, disability, prescription management, workers' compensation, dental, and vision. WellPoint has other subsidiaries providing a variety of products and services, including the administration of government health-benefits programs. HealthLink provides network rental for workers' compensation and health-benefits programs in Missouri, Arkansas, Illinois, Indiana, Iowa, Kentucky, and West Virginia. UniCare is WellPoint's full-service health plan offered in several different regions throughout the country where the company does not have a licensed Blue plan. AdminaStar Federal, headquartered in Indiana, and United Government Services, headquartered in Wisconsin, are administrators of WellPoint's government health-benefits programs, primarily Medicare. The prescription management services subsidiary is a wholly owned pharmacy benefit manager providing pharmacy network management, pharmacy benefits and mail order prescription services. BLUE RIBBON. We believe WellPoint's expansion into the metro New York region will help attract more large multisite employers in its existing territory, while its large footprint across the U.S. will attract those based in the New York area, where the headquarters of 86 Fortune 500 employers are located. In our view, WellPoint has a strong chance to gain share in the metro New York large group market. Why? We believe that large employers are becoming increasingly interested in a single MCO solution, and that the "Blues'" brand reputation provides an advantage for the company. With its recent acquisition, WellPoint gains access to WellChoice's strong presence in the relatively high-margin small-group market, in our view. We see WellChoice's contribution to EPS increasing over the next five years via the realization of synergies, which WellPoint expects to rise by at least $25 million a year to reach at least $125 million by 2010 on a pretax basis. We look for overall operating revenue growth of about 30% in 2006, which mainly includes the recent WellChoice acquisition, 3% organic commercial enrollment growth, and the start of the Medicare Pharmaceutical Drug Plan. TAKEOVER BAIT? At S&P, we project further moderation of medical-cost inflation but look for a rise in the consolidated medical loss ratio (MLR) -- benefit or medical costs as a percentage of premium revenues -- in 2006, mainly because WellChoice had a higher MLR than that of pre-acquisition WellPoint. We expect the MLR to trend down afterward, however. Meanwhile, we look for the SG&A cost ratio to decline on WellChoice's lower ratio and, going forward, on the consolidation synergies we expect to be realized through 2010. All told, we look for operating EPS of $3.99 in 2005, $4.57 in 2006, and $5.35 in 2007. Our estimates include estimated stock-option expense of 18 cents in 2006 and 20 cents in 2007. Our estimates represent EPS growth of 20%, 14.5%, and 17%, respectively, with the deceleration in 2006 mainly due to the inclusion of stock-option expense in EPS for the first time. In addition, we see operating cash flow of about $3.5 billion in 2006, up from slightly less than $3 billion in 2005, and rising in the midteens for the next two years. In our view, this permits wide financial flexibility. While our earnings model excludes future acquisitions, we believe not-for-profit Blues licensees that convert to for-profit status will become takeover targets. In addition, we think WellPoint isn't averse to acquiring non-Blues plans if they could aid its growth prospects. This is reflected, we believe, by the company's UniCare plans and its acquisition in June, 2005, of Lumenos, which increased its footprint in the fast-growing consumer-directed health-plan market. PREMIUM SHARES. Still, we think WellPoint's mergers-and-acquisition activity will slow, unless it acquires outfits that enable it to provide new services for its existing client base and potentially make it more attractive to new account prospects. We believe many small health plans -- some owned by providers, such as hospitals -- are acquisition prospects. However, the recent spate of health-plan consolidation has increased the price of these prospects, in our view. In addition, we believe the MCO giant would have to make a sizable acquisition (and we see few available) or several small ones to have a meaningful impact on its bottom line. Our 2005 Standard & Poor's Core Earnings estimate of $3.74 per share includes net one-time expenses, as well as estimated stock-option expense and modest pension-plan adjustments. Our 2006 and 2007 estimates of $4.55 and $5.33, respectively, reflect only modest pension-plan adjustments, as our stock option expense projections are included in our operating EPS estimates beginning in 2006. WellPoint's shares recently traded at approximately 17 times our 2006 EPS estimate of $4.57, a 28% premium to the valuation accorded the S&P 500 index and about a 2% discount to its MCO peers. We believe WLP should trade at a premium to the S&P 500, as our estimated EPS growth rate of almost 14.5% in 2006 (20% if we were to include estimated stock option expense in 2005) exceeds the 11% (or roughly 16%) growth that S&P sees for the 500's operating earnings. GOVERNANCE WATCH. We also think the shares should trade at a small premium to WellPoint's peers, rather than its current small discount, as our estimated three-year compound annual growth rate (CAGR) of 16.5% is above the peer average of 16%. Our 12-month target price of $104 is based on our projected 2007 p-e multiple of 19.5 times, compared to the 18 times to 19 times we estimate for peers, and our 2007 EPS estimate. Our discounted cash-flow model suggests that WellPoint's intrinsic value is about $104. Both our p-e analyses and DCF model expect the stock to generate a total return of almost 32% over the next 12 months. We're generally positive on WellPoint's corporate-governance policies. Three of the many positive practices we note from the proxy are that the board comprises a significant majority of independent directors (94%), its governance guidelines are publicly disclosed, and only independent directors serve on the audit, compensation, and governance committees. TROUBLE SPOTS. However, we're concerned that the same person holds the chairman and CEO positions, that shareholders face significant hurdles in attempting to change company policies, and that WellPoint has erected high barriers to prevent a takeover. Risks to our recommendation and target price, in our view, include competitive pricing, an unexpected rise in medical-cost trends, unfavorable regulatory changes, poor new product positioning, headline risk (e.g., New York State Attorney General Eliot Spitzer's probe of property and casualty insurers), and a sharp decline in the job market, which could lead to declines in enrollment. In addition, WellPoint is a consolidator in the managed-health-care subindustry and, as such, it may face integration risks in the recent WellChoice acquisition and in future acquisitions.  Analyst Seligman follows shares of managed-health-care companies for Standard & Poor's Equity Research Services All of the views expressed in this research report accurately reflect the research analyst's personal views regarding any and all of the subject securities or issuers. No part of analyst compensation was, is or will be, directly or indirectly related to the specific recommendations or views expressed in this research report. Standard & Poor's Regulatory Disclosure Any advice, analysis, or recommendations contained in articles labeled "Insight from Standard & Poor's" reflect the views of Standard & Poor's, which operates separately from and independently of BusinessWeek Online. It is possible that BWOL may from time to time publish information that is not consistent with advice, analysis, or recommendations that are published by Standard & Poor's. Standard & Poor's and BusinessWeek Online are each units of The McGraw-Hill Companies, Inc.
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