Why Steve Romick Owns WellPoint (WLP): Stock of the Week ~ market folly

Monday, April 16, 2012

Why Steve Romick Owns WellPoint (WLP): Stock of the Week

The stock of the week this time around is WellPoint (WLP) and the analysis below takes a look at some potential reasons as to why Steve Romick of FPA Crescent might like the company. Last week we featured: why David Einhorn owns Dell.

The following is written by Tsachy Mishal, portfolio manager of TAM Capital Management.

Hedge funds as a group have struggled performance-wise in recent years. However, there is one sector which has treated them very well: the HMO's. In 2010, at the height of uncertainty surrounding Obamacare, many hedge funds took positions in HMOs such as UnitedHealth (UNH), Cigna (CI) and WellPoint (WLP).

Since then, most of the stocks in the group are up by 50%, with some nearly doubling. Even after this large rise, many stocks in the the group are still cheap. Currently, Farallon Capital Management and Steve Romick of FPA Crescent hold positions in WellPoint.

WellPoint currently trades at $69.25 a share. They are expected to earn $7.70 in the current year and $8.50 next year. WellPoint is planning on repurchasing $2.5 billion worth of their own shares this year, which amounts to nearly 11% of the shares outstanding at the current price.

The most often cited reason for this bargain basement price is the continued uncertainty surrounding Obamacare. While Obamacare will lead to more customers, there is uncertainty regarding many of the new laws (specifically the mandate that requires them to accept customers at their quoted price, even if they are already sick).

The stock has underperformed its peers in the HMO sector recently as earnings disappointed last quarter. Wellpoint mispriced a large policy in California, which they have since terminated. As a result, Wellpoint trades at a discount to the group, even though it is the second largest HMO in a business where scale matters.

What I Like:

- The valuation of 8.15 times 2013 earnings estimates is extremely attractive assuming estimates are anywhere near accurate.

- Management has an excellent track record of returning cash to shareholders and have said they will return $2.5 billion this year via share repurchases. The share repurchase should put a floor under the stock as there will constantly be a large buyer in the market.

- There is little to no European risk in the business and economic sensitivity is minimal.

- Management recently reiterated their intent to repurchase $2.5 billion worth of shares this year, which likely means that this year is less than a disaster.

What I Don't Like:

- Low health care utilization has helped the earnings of HMOs in recent years. This trend is likely to end at some point.

- Obamacare is a wildcard as it can help or hurt earnings. While there will be more customers there will also be new regulations. This large change is a big uncertainty, which investors don't like.

- A decade ago, HMO industry profits plunged as companies fought for market share. Since then, the industry has consolidated and become more rational. However, there is still the risk that the industry is more cyclical than most believe.

There are numerous risks in WellPoint, such as Obamacare and the risk that margins for the industry contract. However, at a little over 8 times next year's earnings there is a large margin of safety in WLP's stock price. Even if estimates are off by 20% the stock is still cheap. The nice part of the business is that it is insulated from Europe and has little economic sensitivity. As a result, I am long WellPoint.

Be sure to scroll through all of our stock of the week posts for further equity analysis.

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