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Stock Strategist

Got Health Care? This Stock Is Poised to Gain 40%

We think investors will be rewarded for sticking with this insurer.

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WellPoint, Inc.
Moat: Narrow | Risk: Average | Price/Fair Value Ratio*: 0.49 | Three-Year Expected Annual Return*: 40.0%

What It Does: WellPoint (WLP) is the largest U.S. health insurer by commercial enrollment, serving 35 million members. It holds the exclusive license to the Blue Cross and/or Blue Shield names in 14 states, including California, Georgia, New York, and Ohio. Traditional risk-based insurance products are complemented by non-risk-based plan management, pharmacy benefit management, disease management, and other services.

What Gives It an Edge: According to Morningstar analyst Matthew Coffina, WellPoint's economic moat is founded on its scale. With a dominant share of almost all of its markets, WellPoint can negotiate the best prices with health-care providers and pass those savings along to its members. Providers want business from its large customer base, while customers want access to its network of providers. Coffina thinks this helps entrench and perpetuate WellPoint's competitive advantages over time. Also, the company's costs (like investments in technology) are largely fixed, resulting in economies of scale that further secure its position as the low-cost provider.

What the Risks Are: Changes in state and federal regulation could have sudden and unpredictable impacts on WellPoint's business. Health-care reform is a key issue in the upcoming presidential election, and all three candidates have proposed far-reaching changes that could hurt WellPoint if enacted. WellPoint's results could be harmed by regulation that limits the premiums it can charge or mandates the benefits it must provide, by decreased funding of Medicare and Medicaid products, or by new government programs that compete with its existing business lines. Also, a significant portion of WellPoint's value is invested in fixed-income and equity securities that could lose value, especially its $5.4 billion worth of mortgage-backed securities. Finally, managed care is a highly competitive industry, and battles over market share could lead to deteriorating underwriting standards that cut into WellPoint's margins.

What the Market Is Missing: WellPoint reduced its earnings guidance for 2008 because of a surprise increase in medical costs, and the stock plunged. Coffina believes the market overreacted. WellPoint generally increases premiums ahead of medical costs and Coffina acknowledges that the current year was an underwriting mistake. However, while it's locked into insurance contracts for this year, the firm will get a chance to rebuild margins in 2009. With the stock trading at 7.5 times the low end of its revised earnings guidance, Coffina is confident that investors will be rewarded for sticking with WellPoint.

* Price/fair value ratios and expected returns calculated using fair value estimates, closing prices, and cost of equity estimates as of Friday, March 28, 2008.

Jeff Viksjo does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.