Bill Cara’s Blog for Aug 17, 2010 [See post-close report]

Credit Suisse analyst C. Boorady initiates coverage of Managed Care industry with OVERWEIGHT

• This sector view matters more than stock selection because MCO stocks are 85% correlated and highly controversial after passage of the Patient Protection and Affordable Care Act (PPACA). One brokerage announced they will drop coverage because managed care is "not suitable for long-term investors." We believe winners and losers will emerge in managed care. Winners will have access to public equity capital and invest strategically to offset margin compression by taking market share from 1,200 insurers that may not survive; low-cost to compete on price through exchanges; M&A track record; Medicare, Medicaid & HMO experience; and real-time HCIT capabilities to coordinate with physicians implementing electronic health records and ACOs.

• Differentiation: We analyzed over 2,000 pages of PPACA legislation and related regulations still being written and interviewed scores of industry and government officials to build dynamic industry and company models of how PPACA will affect each end market and each company each of the next ten years and beyond. These models feed our discounted cash flow valuations.

• Why DCF?: P/E and P/B cannot capture the nonlinear phase-in of reform that differs by end-market over each of the next 10 years, nor can it capture how we expect mix of business to evolve for each company or balance sheets.

• Our DCF Conclusions - No Lost Decade: Managed care stocks rose 330% in the S&P500's "lost decade" (2000-2010), driven by U.S. health spending growth, expansion of private sector Medicare and Medicaid, and M&A. Similar outperformance may result from the similar drivers for these intermediaries. Our models suggest MCO industry revenue reaches $795 billion by 2019 from $590 billion in 2010 as U.S. health spend reaches 20% of GDP from 17%, while margins fall to 4.5% from 6.5% pretax. We model EPS drops 5% (ex Medicaid) in 2011 before EBT rises 3.3% CAGR (EPS 8%) for 2011-2019.

• Catalysts, Risks: EPS upside for 2H10 from lower medical costs, but after record upward revisions we see consensus 2011 EPS too high, and expect noise in 2011 from minimum MLR and related rebate accounting. November elections, share repurchases support stocks. Long-term risk of government "single payer" is not affordable; we see growing private sector involvement.

• Stock Calls: We are initiating coverage on AGP, CNC, CI, CVH, HNT, HUM, MOH, GTS, UNH and WLP. Our favorite names are large-cap UNH, then WLP and SMID-cap CVH and HUM. We are Neutral on Medicaid focused AGP, CNC, and MOH as we believe current valuations already reflect high growth potential. Our Outperforms all have strong capital positions which we believe will help drive EPS growth through accretive capital management. UNH is our top pick on business diversification within health benefits and services, high liquidity, M&A track record, and dividend yield.

UnitedHealth Group (UNH) OUTPERFORM [V] Industry Weighting: OVERWEIGHT
CP: US$ 31.90 TP: US$ 41 CAP: US$ 36.3b
INITIATING Coverage with a OUTPERFORM Rating and Target Price of $41

• Initiating Coverage with an Outperform rating and $41 target price. UNH is a leading diversified employee benefits organization that provides healthcare benefits and services. UNH operates under four segments: Health Benefits (78% of revs, 81% of profits); Prescription Solutions (15% revs, 8% profit), Optum Health (5% revs, 8% profit), and Ingenix (2% revs, 4% profits).

• What We Like Most About UNH: UNH's diversification, especially dual Medicare-Medicaid eligibles, and strategy of increasing exposure to health services (20% op earnings today, 30-40% target) from health benefits should partially mitigate negative impacts of health reform. Strong capital position. Potential to monetize assets (i.e. in-house PBM) may drive shareholder value. Stock liquidity makes UNH a bellwether in the group.

• Among the Risks for UNH: High exposure and high margins in Medicare Advantage in a challenging reimbursement environment. Additionally, exposure to Individual and Small Group products and mandated minimum MLRs will likely pressure margins in 2011+.

• Catalysts: Min MLR regs (earliest late Aug), 3Q earnings (Oct-Nov), mid-term elections (Nov), and annual Investor Day (likely in December).

• Valuation: Our DCF-derived $41 target price embeds a 10.9% WACC, 4.2% revenue and 4.1% earnings CAGR for the period 2011-2019. UNH trades at 9.5x our 2011 EPS, a 360bps discount to its 5-year average. Our 2010-2013 EPS estimates are $3.60, $3.35, $3.50, and $3.75.

WellPoint. Inc. (WLP) OUTPERFORM Industry Weighting: OVERWEIGHT
CP: US$ 51.62 TP: US$ 68 CAP: US$ 22.1b
INITIATING Coverage with a OUTPERFORM Rating and Target Price of $68

• Initiating coverage with an Outperform rating and $68 target price. WLP is the largest health plan by enrollment and is one of only two publicly traded Blue Cross Blue Shield Association health plans (the other is GTS). WLP operates under three segments: Commercial (60% of revs, 72% of profits); Consumer (28% revs, 25% profit) and Other (12% revs, 3% profit).

• What we like most about WLP: We estimate $2.8bn in cash at the parent by year-end plus $3.7bn in excess capital above BCBSA mins equates to $15/shr in excess capital (31% of mkt cap). The Blues brand and high local market share will contribute to success through exchanges beginning 2014.

• Among the risks for WLP: Above average exposure to health reform targets Individual & Small Group products (we estimate over 25% of profits) present significant risks to owning WLP given minimum MLR regs beginning 2011 as reflected in our '11 and '12 EPS estimates that are below consensus by 9% and 11%, respectively. Negative earnings revisions could pressure the stock near term. California exposure presents near-term pricing challenge and 2014+ guaranteed issue risk.

• Catalysts: Min MLR regs (earliest late Aug), 3Q earnings (Oct-Nov), and mid-term elections (Nov).

• Valuation: Our DCF-derived $68 target price embeds a 9.4% WACC, 3.9% revenue and 0.7% pre-tax earnings CAGR for the period 2011-2019. WLP trades at 8.6x our 2011 EPS, a 360bps discount to its 5-year average. Our 2010-2013 EPS estimates are $6.40, $6.00, $6.50, and $7.10.

CIGNA (CI) NEUTRAL [V] Industry Weighting: OVERWEIGHT
CP: US$ 33.37 TP: US$ 37 CAP: US$ 9.2b
INITIATING Coverage with a NEUTRAL Rating and Target Price of $37

• Initiating Coverage with a Neutral rating and $37 target price. CIGNA is a leading diversified employee benefits organization that provides healthcare and related benefits offered through the workplace, including healthcare products and services (72% of revenues, 67% of profits); group/disability/life (14% revenues, 24% profit), and international (11% revenues, 19% profit).

• What We Like Most About CI: Diversified earnings stream and low percentage of risk-based medical lives mitigates risk of healthcare reform. Experience with minimum MLR rules considering the shared returns product. We believe that CI's footprint in group, disability, and international insurance products limits the company's downside risk if healthcare reform develops into a worst-case scenario event. CI is also a leader in care management, though low market share limits potential.

• Among the Risks for CI: Regulatory risk, implementation of guarantee issue, minimum loss ratio, rate review, continued erosion of health benefit market share owing to limited local market share that reduces leverage with providers, and the risk of an acceleration of medical trend, though recent trends have been weak, with a weak government program track record.

• Catalysts: MLR regs (late Aug the earliest), Nov earnings & election.

• Valuation: Our DCF-derived $37 target price embeds a 11.9% WACC, 2.7% revenue and -1.4% earnings CAGR for 2011-19. On a P/E basis, CI trades at 7.5 times our 2011 EPS estimate, a 100-basis-point discount to its peer group reflecting equity market exposure of its run-off reinsurance business. Our 2010-13 EPS estimates are $4.35, $4.45, $4.60, and $4.75.

Humana Inc. (HUM) OUTPERFORM Industry Weighting: OVERWEIGHT
CP: US$ 49 TP: US$ 60 CAP: US$ 8.3b
INITIATING Coverage with a OUTPERFORM Rating and Target Price of $60

• Initiating coverage with an Outperform rating and $60 target price. HUM is a government-focused (78% of revs, 88% of profits) MCO heavily leveraged to Medicare Advantage (58% of revs, 70% of profits). Commercial is a weakness (22% of revs and 13% of profit, including investment income).

• What we like most about HUM: HUM has the #2 market share in Medicare Advantage (MA) and has demonstrated the ability to grow enrollment while maintaining target margins in a challenging reimbursement environment. We expect HUM to gain share as smaller plans exit the market. We model 3% CAGR in enrollment and stable margins in '14-'19 after a 140bp drop from 2010 levels.

• Among the risks for HUM: Retention of the TRICARE contract, which we estimate represents 4% of our '11E earnings (HUM will retain the contract through 1Q11) remains an overhang. Cuts to Medicare reimbursement and elimination of private fee-for-service (HUM has 480k PFFS lives that will need to be transitioned to network-based MA plans in '11) are also risks.

• Catalysts: TRICARE decision (expected any day), Min MLR regs (earliest late Aug), MA bids, and 3Q earnings/Investor Day/elections (all Nov).

• Valuation: Our DCF-derived $60 target price (adjusted for potential loss of TRICARE) embeds a 10.3% WACC, 3.6% revenue and 5.5% earnings CAGR for the period 2011-2019. HUM trades at 8.4x our 2011 EPS, a 450bp discount to its 5-year average. Our 2010-2013 EPS estimates are $6.45, $5.85, $6.10, and $6.35.

Coventry Health Care (CVH) OUTPERFORM [V] Industry Weighting: OVERWEIGHT
CP: US$ 20.50 TP: US$ 25 CAP: US$ 3b
INITIATING Coverage with a OUTPERFORM Rating and Target Price of $25

• Initiating coverage with an Outperform rating and $25 target price. CVH is a diversified regional MCO that operates local health plans in 23 markets, primarily in the Mid-Atlantic, Midwest, and Southeast. CVH's operations include three segments: health plan and medical services (76% of revs, 61% of profits), specialized managed care (16% of revs, 15% of profits), and workers' compensation (7% of revs, 24% of profits).

• What we like most about CVH: We estimate CVH ends mid 2011 with $745mn in cash at the parent, coupled with $800mn in excess capital above state mins equates to $11/shr in excess capital (51% of current market cap). Though we do not expect large scale M&A near-term, we have always viewed CVH as a potential takeout candidate.

• Among the risks for CVH: The high liquidity may lure CVH into a risky acquisition. Exposure to Small Group products (we estimate 19% of profits) present risks to CVH given minimum MLR regs beginning 2011 and is why our '11 and '12 EPS estimates are 6.8% and 8.8% below consensus, respectively. CEO Allen Wise, who resumed the role after running CVH from 1996-2004, is expected to leave the company in December 2011.

• Catalysts: Min MLR regs (earliest late Aug), 3Q earnings (Oct-Nov), and mid-term elections (Nov).

• Valuation: Our DCF-derived $25 target price embeds a 10.9% WACC, 3.7% revenue and -3.9% pre-tax earnings CAGR for the period 2011-2019. CVH trades at 8.4x our 2011 EPS, representing a 400bp discount to its 5-year average. Our 2010-2013 EPS estimates are $2.75, $2.45, $2.50, and $2.55.