AET Aetna Inc. (delisted)

We have downgraded our recommendation on WellPoint Inc. (WLP) to ‘Neutral’ from ‘Outperform’ based on weak economic cues that give way to operating and financial leverage risk and price declines that are encountered off and on.

The company reported second-quarter income from continuing operations of $701.6 million or $1.89 per share, surpassing the Zacks Consensus Estimate of $1.79 per share. While operating earnings declined from $722.4 million in the year-ago quarter, earnings per share rose from $1.71 in the year-ago quarter due to a reduction in share count.

Improved membership growth and decline in selling, general and administrative (SG&A) expenses led to higher-than-expected revenues. However, these improvements were offset by an increase in the Medicare Advantage expenses, predominantly in the Senior business, leading to lower earnings as compared to the year-ago quarter.

WellPoint enjoys the exclusive right to market products under Blue Cross Blue Shield Association (BCBSA), the most recognized brand in the industry. Additionally, the company significantly remains focused on the ability of health plans to deliver competitive medical costs.

With over 34 million members, WellPoint is a dominant player in its entire 14 Blue Cross and Blue Shield state markets, and its ability to access the provider networks of any other BCBS plan across the US further reinforces WellPoint’s competitive strength against its arch rivals such as Aetna Inc. (AET), Humana Inc. (HUM) and UnitedHealth Group Inc. (UNH). Although membership is expected to be sluggish in the second half of 2011, management expects a significant improvement in new memberships beginning 2012, which is encouraging.

WellPoint has further strengthened its portfolio through the recent acquisition of a privately held Medicare specialist–CareMore Health Group–in order to expand its presence in the US government program for the elderly. While the acquisition will help WellPoint penetrate deeper into the integrated and individualized health care markets of California, Arizona and Nevada, the deal is expected to break-even in 2012 and add to earnings from 2013 onwards.

WellPoint has been witnessing substantial earnings growth over the past few quarters, spurred by membership gains, improvements in operating cost structure, strategic acquisitions and capital transactions. These have also helped in boosting the company’s operating cash flow, which has fueled cash dividends and stock repurchases. Additionally, a stable ratings outlook on the financial strength and other debt bodes well for WellPoint’s long-term growth.

On the flip side though, the recent $1.1 billion debt primarily raised to fund the recent CareMore acquisition has further escalated WellPoint’s debt-to-capital ratio to about 30%, thereby raising the financial leverage risk. Although the company’s debt-to-capital ratio is still within the targeted range of 25% to 35%, as indicated by bank covenants, it stands higher than the average for the health and managed care sector. We believe higher debt could further weaken the financial leverage and weigh on the company’s capital position and borrowing costs.

Additionally, medical cost trends are expected to rise by about 7.5% in 2011, primarily due to higher unit cost owing to health reform coupled with lower-than-expected underlying utilization. Besides, management expects growth in Senior business to be lower than expected in 2011 given the ongoing challenging economic environment. These factors have also affected the benefit ratio adversely, which has deteriorated by 160 bps to 83.9% in the first half of 2011. The company is also expected to continue experiencing modest attrition throughout the second half of 2011.

Overall, given the uncertain impact of other healthcare reforms and restructuring expenses related to complying with the reform requisites, will further weigh on margins in future.

Hence, given the pros and cons, the Zacks Consensus Estimate of earnings for the third quarter of 2011 is currently pegged at $1.65 per share, down from $1.74 in the year-ago quarter, reflecting the ongoing economic volatility and rising costs. Of the 19 firms covering the stock, 6 firms have revised their estimates upward while 10 downward revisions were witnessed in the last 30 days. However, earnings are expected to increase to $7.00 per share for 2011, up about 5% over 2009.

Additionally, the quantitative Zacks Rank for WellPoint is currently #3, indicating no clear directional pressure on the shares over the near term.

 
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