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Table of Contents
A. INDIVIDUAL COMPONENT ....................................................................................................... 1 1. Company Analysis ........................................................................................................................... 1
1.1. Introduction ............................................................................................................................... 1
1.2. The Industry Economic Characteristic ...................................................................................... 1
1.3. Company Strategies .................................................................................................................. 2
1.4. Quality of Financial Statements ................................................................................................ 3
1.5. Company’s Profitability and Risk ............................................................................................. 6
1.6. Forecasting Financial Statements ........................................................................................... 12
1.7. Valuation of the Firm .............................................................................................................. 20
1.8. Conclusion .............................................................................................................................. 23
B. GROUP COMPONENT ................................................................................................................ 24
2. Economic Characteristics and Competitive Dynamics in Industry ............................................... 24 2.1. Introduction ............................................................................................................................. 24
2.2. Porter’s Five Forces ................................................................................................................ 24
2.3. Value Chain Analysis ............................................................................................................. 26
2.4. Industry Outlook ..................................................................................................................... 28
3. Company Strategy Comparison ..................................................................................................... 29
4. Risk Profitability and Efficiency Comparison of Companies ........................................................ 31 References .......................................................................................................................................... 33
A. INDIVIDUAL COMPONENT
1. Company Analysis
1.1. Introduction
WellPoint, Inc. (WellPoint or Company) was formed when WellPoint Health Networks
Inc. and Anthem, Inc. merged in 2004 to become the nation's leading health benefits company
with nearly 35 million members. The Company is the largest health benefits company in
terms of medical membership in the United States, serving 33.3 million medical members
through its affiliated health plans and a total of 69.2 million individuals through all
subsidiaries. Through its networks nationwide, the company delivers a number of leading
health benefit solutions through a broad portfolio of integrated health care plans and related
services, along with a wide range of specialty products such as life and disability insurance
benefits, dental, vision, behavioral health benefit services, as well as long term care insurance
and flexible spending accounts.
Headquartered in Indianapolis, Indiana, WellPoint is an independent licensee of the Blue
Cross and Blue Shield Association, an association of independent health benefit plans, serving
members in California, Colorado, Connecticut, Georgia, Indiana, Kentucky, Maine, Missouri,
Nevada, New Hampshire, New York, Ohio, Virginia and Wisconsin; and specialty plan
members in other states through UniCare. The Company is licensed to conduct insurance
operations in all 50 states through its subsidiaries.
The purpose of this project is to analyze the financial statements of WellPoint and to value
it. The project is to evaluate data provided for analysis consisting of the 2005-2010 financial
statements and other financial information sources, such as Management Discussion and
Analysis and 10-K forms. 2005-2010 financial statements are collected from the web site of
Warton Research Data Services1, other financial information is collected from the web site of
Securities Exchange Commission2.
The firm and financial statements analysis and the subsequent results are provided in the
following sections. The analysis performed on the provided data consisted of calculations and
estimation performed utilizing FSAP.
1.2. The Industry Economic Characteristic
The industry analysis is conducted in group part.
1 https://wrds-web.wharton.upenn.edu/wrds/ 2 http://www.sec.gov/edgar.shtml
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1.3. Company Strategies
The focus of the WellPoint executive leadership team, after 2004 merger, turned toward
the development of a strategy to ensure the long-term growth and success of the newly formed
company as well as meeting the short-term expectations of its shareholders. In 2006 the
WellPoint 2010 strategy was implemented with a focus on transforming the healthcare
industry. A key component of this new strategy was the creation of a workforce capable of
leading a healthcare revolution. Leaders throughout the organization began to realize that in
order to achieve this vision they needed to gain a deeper understanding of the company
strategy, the external factors driving the strategy, and how their decisions and actions
would/could impact that strategy.
The Company’s strategy is driven by its focus on achieving the following objectives:
- Create the best health care value in the industry.
- Excel at day-to-day execution.
- Capitalize on new opportunities to drive growth.
The Company’s business strategy establishes a framework that yields tangible value for
all of its constituents - members, employers, health care professionals, associates, and
shareholders. Due to the rapidly evolving and expanding programs, the need for transparency,
accuracy and oversight in is great.
With a reputation for innovation, WellPoint is committed to establishing a relationship
with customers, physicians, hospitals and other health care clinicians as trusted partners.
Consumers want a choice of products and health care professionals, and they want more
control over their health care decisions. Employers also want the maximum amount of cost
control while also being sensitive to employee needs. WellPoint and its affiliated health plans
have created a variety of PPOs, HMOs, various hybrid and specialty network-based dental
and health care services that combine the attributes consumers find attractive with effective
cost control techniques. Employer groups and individual members can select from basic as
well as comprehensive plans to meet their specific needs. Also available are a wide range of
related specialty products and other services including flexible spending accounts and
COBRA administration.
WellPoint's affiliated health and specialty plans are organized around the following
customer segments:
National Accounts: National Accounts are generally multi-state employer groups
primarily headquartered in a WellPoint service area with 5,000 or more eligible employees, of
which at least 5% are located outside of the headquarter state.
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Local Group: Local Group includes customers with less than 5% of eligible employees
located outside of the headquarter state, as well as customers with up to 5,000 eligible
employees.
Individual: Individual customers under age 65 and their covered dependents
Seniors: Medicare-eligible individual members age 65 and over who have enrolled in
Medicare Advantage, a managed care alternative for the Medicare program, or who have
purchased Medicare Supplement benefit coverage.
State Sponsored Business: Members with State-Sponsored managed care alternatives in
Medicaid and State Children’s Health Insurance programs.
Federal Employee Program: FEP members consist of United States government
employees and their dependents within geographic markets through participation in the
national contract between the Blue Cross Blue Shield Association and the U.S. Office of
Personnel Management.
Blue Card: Blue Card host members represent enrollees of Blue Cross and/or Blue Shield
plans not owned by WellPoint who receive health care services in BCBSA licensed markets.
Specialty Products: WellPoint offers a broad array of specialty products including,
behavioral Health, Life, Disability, Dental and Vision, products which provide administrative
efficiency and enhanced product value.
WellPoint markets its products through an extensive network of independent agents and
brokers for Individual and Senior customers, as well as certain Local Group customers with a
smaller employee base. Products for National Accounts and Local Group customers with a
larger employee base are generally sold through independent brokers or consultants retained
by the customer and working with industry specialists from its in-house sales force.
1.4. Quality of Financial Statements
In financial statements analysis, WellPoint’s December 31, 2005-2010 annual financial
statements are utilized. These financial statements were prepared according to US GAAP and
audited by Independent Registered Public Accounting Firm compliance with SEC auditing
regulations under Securities Exchange Act of 1934. The Company’s 2005, 2006, 2007, 2008,
2009 and 2010 annual financial statements were audited by Ernst&Young LLP (one of the
Big Four Auditing Companies) and had an unqualified opinion, e.i the financial statements, in
conformity with U.S. generally accepted accounting principles, present fairly, in all material
respects, the consolidated financial position as a whole. The above mentioned financial
statements are provided I.
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Therefore, we assume, they represent the financial position and performance of WellPoint
in fairly manner.
The above mentioned financial statements are provided in Table 1.
Table 1.1. 2005-2010 Balance Sheet
Company Name: WELLPOINT, INC.
Year (Most recent in far right column.) 2005 2006 2007 2008 2009 2010
BALANCE SHEET DATA
Assets:
Cash and Cash Equivalents 2,740 2,602 2,768 2,184 4,816 1,789
Marketable Securities 16,780 2,523 3,932 2,849 16,907 17,504
Accounts Receivable - Net 3,283 3,693 2,870 3,043 3,281 3,042
Inventories
Prepaid Expenses and Other Current Assets
Deferred Tax Assets - Current 682 475 560 779 524 461
Current Assets of Discontinued Segments 0 0 0 0 0 0
Other Current Assets (2) 2,459 2,514 2,902 3,275 2,543 3,345
Current Assets 25,945 11,807 13,032 12,130 28,071 26,141
Long Term Investments 0 15,687 14,715 12,542 1,038 1,121
Property, Plant & Equipment - at cost 1,231 1,154 1,116 1,160 1,207 1,259
<Accumulated Depreciation> -152 -165 -120 -105 -107 -103
Amortizable Intangible Assets (net) 9,686 9,396 9,221 8,827 8,259 7,997
Goodwill and Nonamortizable Intangibles 13,469 13,384 13,435 13,461 13,265 13,265
Deferred Tax Assets - Noncurrent
Other Non-Current Assets (1) 1,226 497 661 388 393 488
Other Non-Current Assets (2)
Total Assets 51,405 51,760 52,060 48,403 52,125 50,167
Liabilities and Equities:
Accounts Payable - Trade 7,784 8,533 8,748 8,847 8,382 7,828
Current Accrued Liabilities 1,235 1,295 1,115 1,088 1,050 891
Notes Payable and Short Term Debt 0 0 0 98 0 100
Current Maturities of Long Term Debt 481 521 20 909 61 706
Deferred Tax Liabilities - Current
Income Taxes Payable 833 538 0 0 1,229 0
Other Current Liabilities (1) 4,524 4,437 4,505 4,078 3,952 4,484
Other Current Liabilities (2)
Current Liabilities 14,857 15,323 14,388 15,020 14,674 14,010
Long Term Debt 6,325 6,493 9,024 7,834 8,338 8,148
Long Term Accrued Liabilities
Deferred Tax Liabilities - Noncurrent 3,306 3,350 3,004 2,099 2,470 2,587
Other Non-Current Liabilities (1) 1,924 2,017 2,654 2,018 1,780 1,610
Other Non-Current Liabilities (2)
Total Liabilities 26,412 27,184 29,070 26,972 27,262 26,354
Minority Interest
Preferred Stock
Common Stock + Paid in Capital 20,325 19,856 18,447 16,848 15,197 12,866
Retained Earnings <Deficit> 4,668 4,720 4,388 5,479 9,599 10,722
Accum. Other Comprehensive Income <Loss> 0 0 156 -896 68 225
Other Equity Adjustments
<Treasury Stock>
Common Shareholders' Equity 24,993 24,576 22,990 21,432 24,863 23,813
Total Liabilities and Equities 51,405 51,760 52,060 48,403 52,125 50,167
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Table 1.2. 2005-2010 Income Statement
INCOME STATEMENT DATA 2005 2006 2007 2008 2009 2010
Revenues 45,136 56,953 61,168 61,251 65,028 58,802
<Cost of Goods Sold> -33,356 -42,493 -46,470 -48,734 -47,539 -44,927
Gross Profit 11,780 14,460 14,698 12,517 17,489 13,875
<Selling, General and Administrative Expenses> -7,205 -8,818 -8,702 -8,497 -9,110 -8,839
<Research and Development Expenses>
<Amortization of Intangible Assets> -356 -324 -291 -286 -266 -242
<Other Operating Expenses (1)> 0 0 0 -141 -263 -21
<Other Operating Expenses (2)>
Other Operating Income (1)
Other Operating Income (2)
Non-Recurring Operating Gains
<Non-Recurring Operating Losses>
Operating Profit 4,220 5,318 5,706 3,592 7,850 4,773
Interest Income
<Interest Expense> -226 -404 -448 -470 -447 -419
Income <Loss> from Equity Affiliates
Other Income or Gains
<Other Expenses or Losses> -103 0 0 0 0 0
Income before Tax 3,890 4,914 5,258 3,122 7,403 4,354
<Income Tax Expense> -1,427 -1,820 -1,913 -632 -2,657 -1,467
<Minority Interest in Earnings>
Income <Loss> from Discontinued Operations
Extraordinary Gains <Losses>
Changes in Acctg. Principles
Net Income (computed) 2,464 3,095 3,345 2,491 4,746 2,887
Net Income (enter reported amount as a check) 2,464 3,095 3,345 2,491 4,746 2,887
Other Comprehensive Income Items 0 0 106 -1,052 964 157
Comprehensive Income 2,464 3,095 3,451 1,439 5,710 3,044
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Table 1.3. 2005-2010 Statement of Cash Flows
STATEMENT OF CASH FLOWS DATA 2005 2006 2007 2008 2009 2010
Net Income 2,464 3,095 3,345 2,491 4,746 2,887
Add back Depreciation and Amortization Expenses 598 603 586 572 554 601
Add back Stock-Based Compensation Expense 102 156 177 156 154 136
Deferred Income Taxes -103 274 -106 -481 61 102
<Income from Equity Affiliates, net of Dividends>
<Increase> Decrease in Accounts Receivable -234 -649 -449 -559 -484 110
<Increase> Decrease in Inventories
<Increase> Decrease in Prepaid Expenses
<Increase> Decrease in Other Current Assets (1) 52 25 -3 103 -63 5
<Increase> Decrease in Other Current Assets (2)
Increase <Decrease> in Accounts Payable 310 -92 23 89 205 -389
Increase <Decrease> in Other Current Liabilities (1) -89 85 126 -27 -27 -159
Increase <Decrease> in Other Current Liabilities (2)
Increase <Decrease> in Other Non-Current Liabilities (1) 633.8 851.8 177 -797 -249 -208
Increase <Decrease> in Other Non-Current Liabilities (2)
Other Addbacks to Net Income
<Other Subtractions from Net Income>
Other Operating Cash Flows -477 -304 469 989 -1,857 -1,668
Net CF from Operations 3,257 4,044 4,345 2,535 3,039 1,417
Proceeds from Sales of Property, Plant, and Equipment 12 6 57 13 0 1
<Property, Plant, and Equipment Acquired> -161.8 -193.9 -322 -346 -378 -451
<Increase> Decrease in Marketable Securities -5,568 1,203 -254 1,142 -1,193 -745
Investments Sold 2,568 1,185 0 5 4,672 0
<Investments Acquired> -1,556 -2,589 -299 -198 -66 0
Other Investment Transactions (1) 286 -69 48 -32 -76
Other Investment Transactions (2) 0 0 0
Net CF from Investing Activities -4,420 -457.3 -769 616 3,003 -1,272
Increase in Short-Term Borrowing 688 544 503 98 -98 100
<Decrease in Short-Term Borrowing> -688 -130 0 -901 -397 -164
Increase in Long-Term Borrowing 2,508 2,668 1,978 525 990 1,089
<Decrease in Long-Term Borrowing> -155 -2,468 -510 -39 -919 -482
Issue of Capital Stock
Proceeds from Stock Option Exercises 429 696 785 121 127 144
<Share Repurchases - Treasury Stock> -333 -4,550 -6,151 -3,276 -2,638 -4,360
<Dividend Payments>
Other Financing Transactions (1) -3 -485 -14 -264 -467 505
Other Financing Transactions (2) 0 0 0 0
Net CF from Financing Activities 2,447 -3,725 -3,410 -3,736 -3,403 -3,169
Effects of exchange rate changes on cash 320 0 0 0 -7 -3
Net Change in Cash 1,603 -138 166 -584 2,632 -3,027
Cash and Cash Equivalents, Beginning of Year 2,740 2,602 2,768 2,184 4,816
Cash and Cash Equivalents, End of Year 2,602 2,768 2,184 4,816 1,789
1.5. Company’s Profitability and Risk
The aging of the population and other demographic characteristics and advances in
medical technology continue to contribute to rising health care costs. WellPoint managed care
plans and products are designed to encourage providers and members to participate in quality,
cost-effective health benefit plans by using the full range of innovative medical management
services, quality initiatives and financial incentives. The Company’s leading market share and
high business retention rates enable to realize the long-term benefits of investing in preventive
and early detection programs. Its ability to provide cost-effective health benefits products and
services is enhanced through a disciplined approach to internal cost containment, prudent
management of its risk exposure and successful integration of acquired businesses. In
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addition, its ability to manage selling, general and administrative costs continues to be an
increasing driver of its overall profitability.
WellPoint’s profitability depends in large part on accurately predicting health care costs
and on its ability to manage future health care costs through underwriting criteria, medical
management, product design and negotiation of favorable provider contracts. Government-
imposed limitations on Medicare and Medicaid reimbursement have also caused the private
sector to bear a greater share of increasing health care costs. Changes in health care practices,
demographic characteristics, inflation, new technologies, the cost of prescription drugs,
clusters of high cost cases, changes in the regulatory environment and numerous other factors
affecting the cost of health care may adversely affect its ability to predict and manage health
care costs, as well as its business, financial condition and results of operations. Relatively
small differences between predicted and actual health care costs as a percentage of premium
revenues can result in significant changes in its results of operations. If it is determined that
assumptions regarding cost trends and utilization are significantly different than actual results,
its income statement and financial position could be adversely affected.
In addition to federal and state regulatory agencies may restrict Company’s ability to
implement changes in premium rates. For example, PPACA includes an annual rate review
requirement to prohibit unreasonable rate increases. Fiscal concerns regarding the continued
viability of programs such as Medicare and Medicaid may cause decreasing reimbursement
rates or a lack of sufficient increase in reimbursement rates for government-sponsored
programs in which Company participate. A limitation on Company’s ability to increase or
maintain its premium or reimbursement levels or a significant loss of membership resulting
from its need to increase or maintain premium or reimbursement levels could adversely affect
business, cash flows, financial condition and results of operations.
The results of operations depend in large part on accurately predicting health care costs
and ability to manage future health care costs through adequate product pricing, medical
management, product design and negotiation of favorable provider contracts.
Company’s future results of operations may also be impacted by certain external forces
and resulting changes in its business model and strategy. During the first quarter of 2010, the
U.S. Congress passed and the President signed into law the Patient Protection and Affordable
Care Act, or PPACA, as well as the Health Care and Education Reconciliation Act of 2010, or
HCERA, which represent significant changes to the current U.S. health care system. The
legislation is far-reaching and is intended to expand access to health insurance coverage over
time by increasing the eligibility thresholds for most state Medicaid programs and providing
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certain other individuals and small businesses with tax credits to subsidize a portion of the
cost of health insurance coverage. The legislation includes a requirement that most individuals
obtain health insurance coverage beginning in 2014 and that certain large employers offer
coverage to their employees or they will be required to pay a financial penalty. In addition,
the new laws encompass certain new taxes and fees, including an excise tax on high premium
insurance policies, limitations on the amount of compensation that is tax deductible and new
fees on companies in its industry, some of which will not be deductible for income tax
purposes. The legislation also imposes new regulations on the health insurance sector,
including, but not limited to, guaranteed coverage requirements, prohibitions on some annual
and all lifetime limits on amounts paid on behalf of or to members, increased restrictions on
rescinding coverage, establishment of minimum medical loss ratio requirements, a
requirement to cover preventive services on a first dollar basis, the establishment of state
insurance exchanges and essential benefit packages and greater limitations on how WellPoint
prices certain of its products. The legislation also reduces the reimbursement levels for health
plans participating in the Medicare Advantage program over time.
These and other provisions of the new law are likely to have significant effects on future
operations, which, in turn, could impact the value of its business model and results of
operations, including potential impairments of goodwill and other intangible assets.
The following factors, among others, are the major risk factors for WellPoint business,
financial condition, and results of operations, stated in MD&A, 2010.
- Recently enacted federal health care reform legislation, as well as expected additional
changes in federal or state regulations,
- Changes in the regulation of business by state and federal regulators,
- An inability to contain health care costs, implement increases in premium rates on a
timely basis, maintain adequate reserves for policy benefits, maintain current provider
agreements or avoid a downgrade in ratings may adversely affect its business and
profitability,
- A reduction in the enrollment in health benefits programs,
- Various risks associated with participating in Medicare and Medicaid programs, and
contracting with CMS to provide Medicare Part C and Medicare Part D Prescription Drug
benefits,
- Adverse securities and credit market conditions,
- Regional concentrations of business,
- Negative publicity,
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- Competition in many of markets, and flexibility of customers and brokers in moving
between competitors,
- A change in health care product mix,
- The substantial indebtedness outstanding and additional indebtedness in the future,
- The litigation risks,
- The termination of license agreements or changes in the terms and conditions
of these license agreements,
- Large-scale medical emergencies,
- The impairment of value of intangible assets,
- Not be able to realize the value of deferred tax assets.
- The failure to effectively maintain and upgrade information systems,
- Indiana law, and other applicable laws, and articles of incorporation and bylaws,
- Any requirement to restate financial results in the event of inappropriate application of
accounting principles,
The information about WellPoint past 5 years profitibility and risk factors is presented
Table 2. As seen in Table 2.1-a., ROA fluctuates around 7.1% and ROCE fluctuates around
14% and both ratios decline in 2010, there is a deteriotion in erning ratios. These deteriotions
can be attributed to the both decline in profit margin and asset turnover, morever, for ROCE,
to the slight decline in capital structure leverage. As there is no nonrecurring items in the
income statement, there are no differences in ratios when excluding the effects of
nonrecurring items. Revenue growth rate fluctuates around 6.1% but in 2010 it turns into
negative, -9%. Because of these drop, net incom growth rate also turns into negative. There is
also deteriotion in operating control index.
There is an improvement in liquidity ratios, it increased 0.77 in 2005 to 1.87 in 2010.
Quick ratio also shows similar pattern due to lack of inventories. There is a deteriotion in the
operating cash flows to current liabilities. Althought, the account payable turnover is around
the 5.5, other turnovers improved in first two years and then deterioted in last two years, it is
very obvious in the last year. Wellpoint solvency ratios showed a fluctuated pattern and
generally they are stable.
WellPoint’s stock market based ratios are also unstable and it fluctuated. Because of 2008
financial crisis, stock return declined to 52% in 2008, because of decline in sales growth, it
has negative stock return in 2010. With the recent crisis, there is also deteriotion in price
earning ratios and market value to book value ratio. Especially, regulatory pressure in the
industry gives rise to uncertainity about WellPoint earning and returns.
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Table 2.1-a. Profitibility Factors
PROFITABILITY FACTORS:
Year 2006 2007 2008 2009 2010
RETURN ON ASSETS (based on reported amounts):
Profit Margin for ROA 5.9% 5.9% 4.6% 7.7% 5.4%
x Asset Turnover 1.1 1.2 1.2 1.3 1.1
= Return on Assets 6.5% 7.0% 5.6% 10.0% 6.2%
RETURN ON ASSETS (excluding the effects of nonrecurring items):
Profit Margin for ROA 5.9% 5.9% 4.6% 7.7% 5.4%
x Asset Turnover 1.1 1.2 1.2 1.3 1.1
= Return on Assets 6.5% 7.0% 5.6% 10.0% 6.2%
RETURN ON COMMON EQUITY (based on reported amounts):
Profit Margin for ROCE 5.4% 5.5% 4.1% 7.3% 4.9%
x Asset Turnover 1.1 1.2 1.2 1.3 1.1
x Capital Structure Leverage 2.1 2.2 2.3 2.2 2.1
= Return on Common Equity 12.5% 14.1% 11.2% 20.5% 11.9%
RETURN ON COMMON EQUITY (excluding the effects of nonrecurring items):
Profit Margin for ROCE 5.4% 5.5% 4.1% 7.3% 4.9%
x Asset Turnover 1.1 1.2 1.2 1.3 1.1
x Capital Structure Leverage 2.1 2.2 2.3 2.2 2.1
= Return on Common Equity 12.5% 14.1% 11.2% 20.5% 11.9%
OPERATING PERFORMANCE:
Gross Profit / Revenues 25.4% 24.0% 20.4% 26.9% 23.6%
Operating Profit / Revenues 9.3% 9.3% 5.9% 12.1% 8.1%
Net Income / Revenues 5.4% 5.5% 4.1% 7.3% 4.9%
Comprehensive Income / Revenues 5.4% 5.6% 2.3% 8.8% 5.2%
PERSISTENT OPERATING PERFORMANCE (excluding the effects of nonrecurring items):
Persistent Operating Profit / Revenues 9.3% 9.3% 5.9% 12.1% 8.1%
Persistent Net Income / Revenues 5.4% 5.5% 4.1% 7.3% 4.9%
GROWTH:
Revenue Growth 26.2% 7.4% 0.1% 6.2% -9.6%
Net Income Growth 25.6% 8.1% -25.5% 90.5% -39.2%
Persistent Net Income Growth 20.6% 8.1% -25.5% 90.5% -39.2%
OPERATING CONTROL:
Gross Profit Control Index 97.3% 94.6% 85.0% 131.6% 87.7%
Operating Profit Contol Index 99.9% 99.9% 62.9% 205.8% 67.2%
Profit Margin Decomposition:
Gross Profit Margin 25.4% 24.0% 20.4% 26.9% 23.6%
Operating Profit Index 36.8% 38.8% 28.7% 44.9% 34.4%
Leverage Index 92.4% 92.2% 86.9% 94.3% 91.2%
Tax Index 63.0% 63.6% 79.8% 64.1% 66.3%
Net Profit Margin 5.4% 5.5% 4.1% 7.3% 4.9%
Comprehensive Income Performance:
Comprehensive Income Index 100.0% 103.2% 57.8% 120.3% 105.4%
Comprehensive Income Margin 5.4% 5.6% 2.3% 8.8% 5.2%
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Table 2.1-b. Profitibility Factors
RETURN ON ASSETS ANALYSIS (excluding the effects of non-recurring items)
Level 1 RETURN ON ASSETS
2008 2009 2010
5.6% 10.0% 6.2%
Level 2 PROFIT MARGIN FOR ROA ASSET TURNOVER
2008 2009 2010 2008 2009 2010
4.6% 7.7% 5.4% 1.2 1.3 1.1
Level 3 2008 2009 2010 2008 2009 2010 Turnovers:
Revenues 100.0% 100.0% 100.0% 20.7 20.6 18.6 Receivables
<Cost of Goods Sold> -79.6% -73.1% -76.4% N/A N/A N/A Inventory
Gross Profit 20.4% 26.9% 23.6% 59.7 60.4 52.2 Fixed Assets
<Selling, General and Administrative Expenses> -13.9% -14.0% -15.0%
Operating Profit 5.9% 12.1% 8.1%
Income before Tax 5.1% 11.4% 7.4%
<Income Tax Expense> -1.0% -4.1% -2.5%
Profit Margin for ROA * 4.6% 7.7% 5.4%
* Amounts do not sum.
RETURN ON COMMON SHAREHOLDERS' EQUITY ANALYSIS (excluding the effects of non-recurring items)
RETURN ON COMMON SHAREHOLDERS' EQUITY
2008 2009 2010
11.2% 20.5% 11.9%
2008 2009 2010
PROFIT MARGIN FOR ROCE 4.1% 7.3% 4.9%
ASSET TURNOVER 1.2 1.3 1.1
CAPITAL STRUCTURE LEVERAGE 2.3 2.2 2.1
Table 2.2. Risk Factors
RISK FACTORS:
Year 2006 2007 2008 2009 2010
LIQUIDITY:
Current Ratio 0.77 0.91 0.81 1.91 1.87
Quick Ratio 0.58 0.67 0.54 1.70 1.59
Operating Cash Flow to Current Liabilities 26.8% 29.2% 17.2% 20.5% 9.9%
ASSET TURNOVER:
Accounts Receivable Turnover 16.3 18.6 20.7 20.6 18.6
Days Receivables Held 22 20 18 18 20
Inventory Turnover N/A N/A N/A N/A N/A
Days Inventory Held N/A N/A N/A N/A N/A
Accounts Payable Turnover 5.2 5.4 5.5 5.5 5.5
Days Payables Held 70 68 66 66 66
Net Working Capital Days -48 -48 -48 -48 -46
Revenues / Average Net Fixed Assets 55.10 61.65 59.75 60.38 52.15
Cash Turnover 21.3 22.8 24.7 18.6 17.8
Days Sales Held in Cash 17.1 16.0 14.8 19.6 20.5
SOLVENCY:
Total Liabilities / Total Assets 52.5% 55.8% 55.7% 52.3% 52.5%
Total Liabilities / Shareholders' Equity 110.6% 126.4% 125.8% 109.6% 110.7%
LT Debt / LT Capital 20.9% 28.2% 26.8% 25.1% 25.5%
LT Debt / Shareholders' Equity 26.4% 39.2% 36.6% 33.5% 34.2%
Operating Cash Flow to Total Liabilities 15.1% 15.4% 9.0% 11.2% 5.3%
Interest Coverage Ratio (reported amounts) 13.2 12.7 7.6 17.5 11.4
Interest Coverage ratio (recurring amounts) 13.2 12.7 7.6 17.5 11.4
RISK FACTORS:
Bankruptcy Predictors:
Altman Z Score 2.58 2.77 2.22 2.63 2.27
Bankruptcy Probability 5.76% 3.83% 11.12% 5.16% 10.29%
Earnings Manipulation Predictors:
Beneish Earnings Manipulation Score -2.45 -2.73 -2.32 -2.40 -2.33
Earnings Manipulation Probability 0.72% 0.31% 1.01% 0.82% 0.98%
STOCK MARKET-BASED RATIOS:
Stock Returns -1.7% 11.5% -52.0% 38.4% -2.5%
Price-Earnings Ratio (reported amounts) 16.33 15.78 8.85 5.90 8.19
Price-Earnings Ratio (recurring amounts) 16.33 15.78 8.85 5.90 8.19
Market Value to Book Value Ratio 2.0 2.1 1.0 1.1 0.9
12
1.6. Forecasting Financial Statements
Forecasting a firm's financial statements can help both financial analysts and managers.
Proforma statements help the financial analysts value the firm, help financial managers plan
the firm's financial needs. With an estimate of future income statement, balance sheet
accounts and cash flow statement, financial analyst can tell how much the value of the firm
and financial manager can tell how much financing might be needed, and when it might be
needed. The accuracy of proforma statements is limited by the validity of the assumptions
used in creating them. Often a series of statements is developed by making different
assumptions about sales and about the relationship between sales and the balance sheet
accounts.
Income Statement:
Sales: The first step in preparing forcasted financial statements is to forecast sales. Sales
normally influence the current asset and current liability account balances. For example, as
sales increase, the firm will generally need to carry more inventory and will have a larger
accounts receivable balance. Retained earnings are also tied to sales through the profit margin
and dividend payout ratio. Although difficult, forecasting sales is essential. Sales typically
depend on the industry, the economy, the season, and many other factors. During the period of
2005-2010, WellPoint compound sales growth is 5.4. However, last two years growth rates
are 6.2 and -9.6 respectively. If we take into consideration average 3 % industry growth and
leadership position of Company in the industry, for sale projection, 4.5 percent is good
estimate, as stated in MD&A for forecasting period and 3% for contunuing periods.
Cost of Goods Sold: The common-size income statement date indicate that WellPoint’s
cost of goods sold as a percent of sales has steadily fluctuated 76.4%. In the MD&A section
of the annual report, WellPoint follows the cost-effective health benefits products and services
is enhanced through a disciplined approach to internal cost containment and manage selling,
general and administrative costs. However, due to aging population and increase in healthcare
services cost, we assume that, COGS of WellPoint would increase and therefore, WellPoint
can maintain the 77.4 % ratio in the future, 1% increase is predicted.
Selling, General and Administrative Expenses: The common-size income statement data
reveal that WellPoint’s selling, general and administrative expenses as a percentage of sales
varied around 15.5%. As disclosed in the 2010 Annual Report MD&A section, this ratio is
expected to maintain in the future.
Amortization of Intabgible Assets: In 2005 through 2010, WellPoint recognized expenses
for amortization of intagible assets amounting $356 million, $324 million, $291 million, $286
13
million, $266 million and $242 million respectively which are equivalent to 0.5 percent of
sales. We assume that this trend will keep going in the future.
Other Operating Expense and Income and Nonrecurring Operating Gains and Losses:
As other operating expense and income are both immetarial and occationally occur, we
assume these accounts are zero balance. By the same token, we assume that nonrecurring
amounts will be zero in the future.
Interest Income and Interest Expense: The common-size income statement data reveals
that WellPoint disclosed 0 interest income, therefore, we assume that, this account will be
zero balance in the future. For interest expense, we can project our first-iteration estimate of
interest expense, based on our projected balances in interest bearing short-term and long term
debt. Note 12 “Long Term Debt” indicates that on February 5, 2009, WellPoint issued $400.0
of 6% notes due 2014 and $600.0 of 7% notes due 2019 under shelf registration statement.
Moreover, on August 12, 2010, WellPoint issued $700.0 of 4.350% notes due 2020 and
$300.0 of 5.800% notes due 2040 under shelf registration statement. Recently at maturity on
January 15, 2011, WellPoint repaid the $700.0 outstanding balance of our 5 % senior
unsecured notes. So we assume that average debt rate 6.5%.
Income Taxes: The common-size income statement data reveal that WellPoint’s average
effective income taxes rate as a percentage of net income varied around 33.3%. As disclosed
in the 2010 Annual Report MD&A section, the effective tax rates in 2010 and 2009 were
33.7% and 35.9%, respectively, but the decline in effective rates did not have a material
impact on the lower overall income tax expense. The decrease in effective tax rates resulted
primarily from the impact of the PBM sale in 2009 which produced a higher effective tax rate.
Moreover, as disclosed in the 2009 Annual Report MD&A section, the effective tax rates in
2009 and 2008 were 35.9% and 20.2%, respectively. The lower effective tax rate in 2008 was
primarily due to the settlement of the outstanding IRS disputes. In WellPoint’s MD&A
section titled “IX. Critical Accounting Policies and Estimates” under the “Income Taxes”,
WellPoint discloses that it expects an average taş rate of 34.8 percent, equal to average
effective tax rate for last two years.
Balance Sheet:
Cash and Cash Equivalent: The Analysis worksheet FSAP computes the average
turnover of sales through the average cash balance each year, so we use those ratios to
projecst WellPoint’s ending cash balance during the forecast horizon. WellPoint, like other
firms, needs a certain amount of cash on hand for day-to-day liquidity. WellPoint cash
holdings has varied between 2005 to 2010. The common-size data reveal that WellPoint’s
14
average ending cash balances equal to 15 days sales. We assume that WellPoint will maintain
average cash balance equivalent to 15 days sales in the future.
Marketable Securities: During the last two years, WellPoint’s marketable securities
balance (also commonly referred to as short-term investments) flactuated inversely with the
cash balances implying that WellPoint managed marketable securities and cash as
complementary sources of liquidity. Over this period, marketable securities ratio to sales
increased 32.4% to 34.9%, however cash to sales decreased 9.2% to 3.6%. Previous preiods
showed different pattern. The common-size data reveal that WellPoint’s average ending
marketable securities balances for last two years, 2009-2010, equal to 82 and 106 days sales
respectively. As in the industry, the collected premium is overwhelmingly invested in the
short-term securities for current insurance claims, we assume that WellPoint will maintain
marketable securities balance equal to 103 days sales in the future.
Account Receivables: As this account fluctuates with sales, therefore in forecast, it is best
way to take the relative amount of it to sales. The data reveal that WellPoint’s average ending
account receivables balances equal to 5.6 percent of sales. We assume that WellPoint will
maintain this ratio in the future.
Inventory: As WellPoint operates in financial services, it does not carry any inventory.
Prepaid Expenses and Other Current Assets: Historically, this account has zero balances.
Deferred Tax Assets-Current: The common-size data reveal that WellPoint’s average
ending deferred tax assets-current balances equal to 1.1 percent of total assets. We assume
that WellPoint will maintain this ratio in the future.
Prepaid Expenses and Other Current Assets: Historically, this account has zero balances.
Other Current Assets: The common-size data reveal that WellPoint’s average ending
deferred tax assets-current balances equal to 5.7 percent of total assets. We assume that
WellPoint will maintain this ratio in the future.
Long-term Investment: As stated in the MD&A, the long-term investments consist
primarily of real estate, cash surrender value of corporate-owned life insurance policies and
certain other investments, due to their less liquid nature, these investments are classified as
long-term. The common-size balance sheet data reveal that WellPoint’s average ending long-
term investments balances for last two years In 2009 and 2010, long-term investment to sales
ratio increased 2.0% to 2.2%, however previous preiods shows different pattern. We assume
that WellPoint will maintain the long-term investment balances equal to 2.2 percent of total
assets.
15
Plant, Property and Equipments: As WellPoint is a financial service company, the fixed
assets do not play the crucial role in generating revenue. Therefore it is a better way to project
them as percentage of the total asset. Last three years, these percentages are the same, 2.4. We
assume that WellPoint will maintain this ratio in the future.
Depreciation: As stated in the MD&A, depreciation is computed principally by the
straight-line method over estimated useful lives ranging from 15 to 39 years for buildings and
improvements, three to seven years for furniture and equipment. The common size data
indicates that the average usefull life of fixed assets is almost 10 years. We assume that
WellPoint will continue to use a 10 years average usefull life for depreciation.
Amortizable Intangible Assets (Net): As stated in the MD&A, amortizable intangible
assets consist of subscriber base and provider and hospital networks. The common-size
balance sheet data reveal that WellPoint’s average ending long balances for analyzed periods
is 17.2 percent of the total asset. However, last two years, this ratios are 15.8 and 15.9 percent
of the total assets respectively, there is a declining trends. So we assume that WellPoint will
maintain last year this ratio, 15.9% in the future.
Goodwill and Nonamortizable Intangible Assets: As stated in the MD&A, WellPoint
follow FASB guidance for business combinations and goodwill and other intangible assets,
which specifies the types of acquired intangible assets that are required to be recognized and
reported separately from goodwill. Under the guidance, goodwill and other intangible assets
(with indefinite lives) are not amortized but are tested for impairment at least annually.
Furthermore, goodwill and other intangible assets are allocated to reporting units for purposes
of the annual impairment test. These tests involved the use of estimates related to the fair
value of the goodwill reporting unit and other intangible assets with indefinite lives, and
required a significant degree of management judgment and the use of subjective assumptions.
The common-size balance sheet data reveal that WellPoint’s average ending goodwill and
nonamortizable intangible balances for analyzed periods is 26.1 percent of the total asset. We
assume that WellPoint will maintain this ratio in the future.
Deferred Tax Assets–Noncurrent: Historically, this account has zero balances.
Other Non-Current Assets (1): The common-size balance sheet data reveal that
WellPoint’s average ending this account balances for analyzed periods is 1.0 percent of the
total asset. We assume that WellPoint will maintain this ratio in the future.
Other Non-Current Assets (2): Historically, this account has zero balances.
Accounts Payable–Trade: As WellPoint has no inventory, we project this account by
using the percent of total sales. The common-size data reveal that WellPoint’s average ending
16
this account balances for analyzed periods is 13.7 percent of sales. We assume that WellPoint
will maintain this ratio in the future
Current Accrued Liabilities: The common-size balance sheet data reveal that WellPoint’s
average ending this account balances for analyzed periods is 2.1 percent of the total assets.
We assume that WellPoint will maintain this ratio in the future.
Notes Payable and Short Term Debt: As stated in MD&A, WellPoint is a member of the
Federal Home Loan Bank of Indianapolis and the Federal Home Loan Bank of Cincinnati,
collectively, the FHLBs, and as a member it has the ability to obtain cash advances subject to
certain requirements. In order to obtain cash advances, it is required to pledge securities as
collateral to the FHLBs, initially equal to a certain percentage of the cash borrowings,
depending on the type of securities pledged as collateral The common-size balance sheet data
reveal that WellPoint’s average ending this account balances for analyzed periods is 0.1
percent of the total assets. We assume that WellPoint will maintain this ratio in the future.
Current Maturities of Long Term Debt: The common-size balance sheet data reveal that
WellPoint’s average ending this account balances for analyzed periods is 0.9 percent of the
total assets. We assume that WellPoint will maintain this ratio in the future.
Deferred Tax Liabilities–Current: Historically, this account has zero balances.
Income Taxes Payable: The common-size balance sheet data reveal that WellPoint’s
average ending this account balances for analyzed periods is 0.7 percent of the total assets.
We assume that WellPoint will maintain this ratio in the future.
Other Current Liabilities (1): The common-size balance sheet data reveal that
WellPoint’s average ending this account balances for analyzed periods is 8.4 percent of the
total assets. We assume that WellPoint will maintain this ratio in the future.
Other Current Liabilities (2): Historically, this account has zero balances.
Long Term Debt: As stated in the MD&A, total long-term debt at December 31, 2010 was
$8.9 billion, and included $336.2 million of commercial paper and $100.0 million outstanding
on a Federal Home Loan Bank loan. The carrying values of the commercial paper
approximate fair value as the underlying instruments have variable interest rates at market
value. The carrying value of the Federal Home Loan Bank loan approximates fair value due to
the relatively short-nature of the note and its collateralization. The remainder of the debt is
subject to interest rate risk as these instruments have fixed interest rates and the fair value is
affected by changes in market interest rates. The common-size balance sheet data reveal that
WellPoint’s average ending this account balances for analyzed periods is 15.7 percent of the
total assets. We assume that WellPoint will maintain this ratio in the future.
17
Long Term Accrued Liabilities: Historically, this account has zero balances.
Deferred Tax Liabilities–Noncurrent: The common-size balance sheet data reveal that
WellPoint’s average ending this account balances for analyzed periods is 5.2 percent of the
total assets. We assume that WellPoint will maintain this ratio in the future.
Other Non-Current Liabilities (1): The common-size balance sheet data reveal that
WellPoint’s average ending this account balances for analyzed periods is 3.6 percent of the
total assets. We assume that WellPoint will maintain this ratio in the future.
Other Non-Current Liabilities (2): Historically, this account has zero balances.
Minority Interest and Preferred Stocks: Historically, this account has zero balances. As
stated in MD&A, the board of directors is authorized $100,000,000 shares issue and but so
far, they have not issued preferred stocks and showed any intention.
Common Stock + Paid in Capital: As stated in MD&A, WellPoint’s management
regularly reviews the appropriate use of capital, including common stock repurchases and
dividends to shareholders. The declaration and payment of any dividends or repurchases of
common stock are at the discretion of our Board of Directors and depends upon our financial
condition, results of operations, future liquidity needs, regulatory and capital requirements
and other factors deemed relevant by Board of Directors. Historically common stock
repurchase program, has been our primary use of capital, and WellPoint have not previously
paid any cash dividends on common stock through December 31, 2010. As long term
financing, WellPoint uses the debt, we assume that in the future, it will not issue large amount
of debt. The common-size balance sheet data reveal that WellPoint’s average ending this
account balances for analyzed periods is 32.7 percent of the total assets. However, there has
been stable decrease in this ratio, in 2005, 38.4%, in 2010, 25.6%. The compound growth rate
is -8.0%. As WellPoint maintain stock repurchase program, we assume that first year, capital
account will decrease this ratio and for later years, growth rate is -6%.
Retained Earnings: The common-size balance sheet data reveal that WellPoint’s average
ending this account balances for analyzed periods are 9.1%, 8.4%, 11.3%, 18.4% and 21.4%
respectively over 2006-2010 periods. From this date, it can be seen that there is a obvious
trend in retained earnings to the total asset ratio. As we use this account as an flexible
account. We assume that retained earnings are 24.4, 26.6, 28.6, 30.4 and 32.1 percent of the
total assets, respectively over year 1 to year 5.
Accum. Other Comprehensive Income <Loss>: We assume this account zero.
Other Equity Adjustments and Treasury Stock: Historically, these accounts have zero
balances. As stated in MD&A, WellPoint has executed the stock repurchases program, but
18
these transaction effects are indicated in common stock and retained earning accounts.
Therefore, we also assume this account zero.
Implied Statement of Cash Flows
After completing the income statement and balance sheet forecast, the FSAP has
estimated the implied statement of cash flows, which is illustrated below.
Table 3. Implied Statement of Cash Flows
Actuals Forecasts
IMPLIED STATEMENT OF CASH FLOWS 2009 2010 Year +1 Year +2 Year +3 Year +4 Year +5 Year +6
Net Income 4,746 2,887 2,271 2,387 2,494 2,607 2,724 2,806
Add back Depreciation Expense (net) 2 -4 22 6 6 6 6 4
Add back Amortization Expense (net) 266 242 307 321 336 351 366 377
<Increase> Decrease in Receivables - Net -238 239 -399 -155 -162 -169 -177 -123
<Increase> Decrease in Inventories 0 0 0 0 0 0 0 0
<Increase> Decrease in Prepaid Expenses 0 0 0 0 0 0 0 0
<Increase> Decrease in Other Curr. Assets (1) 0 0 0 0 0 0 0 0
<Increase> Decrease in Other Curr. Assets (2) 732 -802 382 -133 -139 -146 -152 -106
Increase <Decrease> in Accounts Payable - Trade -465 -554 590 379 396 414 432 301
Increase <Decrease> in Current Accrued Liabilities -38 -159 200 49 51 54 56 39
Increase <Decrease> in Income Taxes Payable 1,229 -1,229 364 16 17 18 19 13
Increase <Decrease> in Other Current Liabilities (1) -126 532 -117 197 205 215 224 156
Increase <Decrease> in Other Current Liabilities (2) 0 0 0 0 0 0 0 0
Net Change in Deferred Tax Assets and Liabilities 627 179 6 96 100 105 109 76
Increase <Decrease> in Long-Term Accrued Liabilities 0 0 0 0 0 0 0 0
Increase <Decrease> in Other Non-Current Liabilities (1) -239 -170 262 84 88 92 96 67
Increase <Decrease> in Other Non-Current Liabilities (2) 0 0 0 0 0 0 0 0
Net Cash Flows from Operations 6,496 1,162 3,887 3,246 3,393 3,545 3,705 3,611
<Increase> Decrease in Prop., Plant, & Equip. at cost -47 -52 11 -56 -59 -61 -64 -45
<Increase> Decrease in Marketable Securities -14,058 -597 -341 -803 -839 -877 -916 -638
<Increase> Decrease in Investment Securities 11,504 -82 -23 -51 -54 -56 -59 -41
<Increase> Decrease in Amortizable Intangible Assets (net) 302 21 -598 -694 -725 -758 -792 -674
<Increase> Decrease in Goodwill and Nonamort. Intang. 197 0 -305 -611 -638 -667 -697 -485
<Increase> Decrease in Other Non-Current Assets (1) -5 -95 -32 -23 -24 -26 -27 -19
<Increase> Decrease in Other Non-Current Assets (2) 0 0 0 0 0 0 0 0
Net Cash Flows from Investing Activities -2,107 -806 -1,287 -2,239 -2,339 -2,445 -2,555 -1,902
Increase <Decrease> in Short-Term Debt -947 746 -286 23 24 26 27 19
Increase <Decrease> in Long-Term Debt 504 -190 15 367 384 401 419 292
Increase <Decrease> in Minority Interest and Preferred Stock 0 0 0 0 0 0 0 0
Increase <Decrease> in Common Stock + Paid in Capital -1,651 -2,330 -1,029 -710 -668 -628 -590 277
Increase <Decrease> in Accum. OCI and Other Equity Adjs. 964 157 -225 0 0 0 0 0
Increase <Decrease> in Treasury Stock 0 0 0 0 0 0 0 0
Dividends -627 -1,764 -338 -575 -675 -775 -876 -2,207
Net Cash Flows from Financing Activities -1,756 -3,383 -1,863 -895 -934 -976 -1,020 -1,619
Net Change in Cash 2,632 -3,027 736 113 119 125 130 90
Check Figure:
Net change in cash - Change in cash balance 0 0 0 0 0 0 0 0
Analyzing Forecasted Financial Statements
The reasonableness of the forecast assumptions and their internal consistency can be
tested by analyzing the projected financial statements using the same ratios and other
analytical tools. Table 4 presents a ratio analysis provided by FSAP for WellPoint based on
financial statement forecasts for Year 1 to Year 6.
Forecast growth rates for sales are consistent with WellPoint’s average past sales growth
performance. The forecast of net income show growth rates are less volatile than those
WellPoint experienced. The projected rate of ROA (return on assets) is almost the same,
5.2%. The main drivers for this result are constant profit margin for ROA and constant asset
19
turnover. Similarly, the projected rate of ROCE (return on common equity) is stable at 9.5%.
This occurs due to stable capital structure leverage.
Table 4. Forecast Validity Check Data
Forecasts
2009 2010 Year +1 Year +2 Year +3 Year +4 Year +5 Year +6
FORECAST VALIDITY CHECK DATA:
GROWTH
Revenue Growth Rates: 6.2% -9.6% 4.5% 4.5% 4.5% 4.5% 4.5% 3.0%
Net Income Growth Rates: 90.5% -39.2% -21.4% 5.1% 4.5% 4.5% 4.5% 3.0%
Total Asset Growth Rates 7.7% -3.8% 3.6% 4.5% 4.5% 4.5% 4.5% 3.0%
RETURN ON ASSETS (based on reported amounts):
Profit Margin for ROA 7.7% 5.4% 4.3% 4.3% 4.3% 4.3% 4.3% 4.3%
x Asset Turnover 1.3 1.1 1.2 1.2 1.2 1.2 1.2 1.2
= Return on Assets 10.0% 6.2% 5.2% 5.2% 5.2% 5.2% 5.2% 5.2%
RETURN ON ASSETS (excluding the effects of nonrecurring items):
Profit Margin for ROA 7.7% 5.4% 4.3% 4.3% 4.3% 4.3% 4.3% 4.3%
x Asset Turnover 1.3 1.1 1.2 1.2 1.2 1.2 1.2 1.2
= Return on Assets 10.0% 6.2% 5.2% 5.2% 5.2% 5.2% 5.2% 5.2%
RETURN ON COMMON EQUITY (based on reported amounts):
Profit Margin for ROCE 7.3% 4.9% 3.7% 3.7% 3.7% 3.7% 3.7% 3.7%
x Asset Turnover 1.3 1.1 1.2 1.2 1.2 1.2 1.2 1.2
x Capital Structure Leverage 2.2 2.1 2.1 2.1 2.1 2.1 2.1 2.1
= Return on Common Equity 20.5% 11.9% 9.4% 9.5% 9.5% 9.5% 9.5% 9.5%
RETURN ON COMMON EQUITY (excluding the effects of nonrecurring items):
Profit Margin for ROCE 7.3% 4.9% 3.7% 3.7% 3.7% 3.7% 3.7% 3.7%
x Asset Turnover 1.3 1.1 1.2 1.2 1.2 1.2 1.2 1.2
x Capital Structure Leverage 2.2 2.1 2.1 2.1 2.1 2.1 2.1 2.1
= Return on Common Equity 20.5% 11.9% 9.4% 9.5% 9.5% 9.5% 9.5% 9.5%
OPERATING PERFORMANCE:
Gross Profit / Revenues 26.9% 23.6% 22.6% 22.6% 22.6% 22.6% 22.6% 22.6%
Operating Profit Before Taxes / Revenues 12.1% 8.1% 6.6% 6.6% 6.6% 6.6% 6.6% 6.6%
ASSET TURNOVER:
Revenues / Avg. Accounts Receivable 20.6 18.6 19.0 18.3 18.3 18.3 18.3 18.1
COGS / Average Inventory N/A N/A N/A N/A N/A N/A N/A N/A
Revenues / Average Fixed Assets 60.4 52.2 53.9 55.9 55.9 55.9 55.9 55.5
LIQUIDITY:
Current Ratio 1.9 1.9 1.9 1.9 1.9 1.9 1.9 1.9
Quick Ratio 1.7 1.6 1.6 1.6 1.6 1.6 1.6 1.6
SOLVENCY:
Total Liabilities / Total Assets 52.3% 52.5% 52.9% 52.9% 52.9% 52.9% 52.9% 52.9%
Total Liabilities / Total Equity 109.6% 110.7% 112.3% 112.3% 112.3% 112.3% 112.3% 112.3%
Interest Coverage Ratio 17.5 11.4 7.1 7.3 7.3 7.3 7.3 7.3
The operating performance ratios, liquidity ratios, assets turnover ratios, and solvency
ratios confirm that forecast assumptions are reasonable given WellPoint’s expected future
financila performance and position. Unfortunately, these ratios cannot confirm whether
forecast assumptions will turn out to be correct. These ratios do not tell us whether we have
accurately and realistically captured WellPoint’s future sales growth, profitability, cash flows,
and financial position.
20
1.7. Valuation of the Firm
Economic theory teaches that the value of an investment equals to the present value of the
projected future payoffs from the investment discounted at a rate that reflects the time value
of money and the risk inherent in those expected payoffs.
In securities markets that are less than perfectly efficient, price does not necessarily equal
value for every security at all times. Therefore, it can be very fruitful to search for and analyze
securities that may have prices that have deviated temporarily from their fundemantal values.
When buying a security, the investor pays the security’s price and receives the security’s
value, when selling a security, the investor receives the selling price and gives up the
security’s value. Price is observable from market, but value is not, value must be estimated.
In theory, the value of a share of common equity is the present value of the expected
future dividends the shareholder will receive. Dvidends are the one of the most fundemental
value relevant measure of expected future payy ofs to use to value shares because they
represent the distribution of wealth from the firm to the shareholders.
Moreover, reported earnings are the single most widely followed measures of firm
performance. They play the central roles as the one of the primary value relevant measures of
performance used in the capital markets for share pricin and capital allocation. Firm’s share
prices usually react quickly to earnings announcements, and the direction and magnitude of
the market’s reaction depends on the direction and magnitude of the earnings news relative to
the market’s expectations.
In our WellPoint valuation, we use Dividend-based Valuation and Earning-based
Valuation. Valuation assumption and recent expectations and market movements effecting
stock price will be evaluated. During valuation, we utilize following assumptions:
- Risk free rate, 3 %,
- Market risk premium, 5.733,
- WellPoint Beta, 0.944,
- Perpetual sales growth, 3%.
WellPoint’s stock price is forecasted as $81.54, it is undervalued 43% as of end of
2010. Recently, WellPoint’s stock has traded at $68.45 and 52 week range was $54.10-
81.925. Valuation assumptions used for this forecast are demostrated in Table 5.
3 Pablo Fernandez*, Javier Aguirreamalloa and Luis Corres, US Market Risk Premium used in 2011 by Professors, Analysts and Companies, IESE Business School. 4 Finance.yahoo.com 5 Finance.yahoo.com
21
Table 5. Valuation Parameters
VALUATION PARAMETER ASSUMPTIONS
Current share price 56.86$
Number of shares outstanding 377.7
Current market value 21,478$
Long-run growth assumption used in forecasts 3.0%
Long-run growth assumption used in valuation. 3.0%
(Both long-run growth assumptions should be the same.)
COST OF EQUITY CAPITAL:
Equity risk factor (market beta) 0.94
Risk free rate 3.0%
Market risk premium 5.7%
Required rate of return on common equity: 8.39%
COST OF DEBT CAPITAL
Debt capital 8,954$
Cost of debt capital, before tax 6.5%
Effective tax rate -34.8%
After-tax cost of debt capital 4.24%
COST OF PREFERRED STOCK
Preferred stock capital -$
Preferred dividends -$
Implied yield 0.00%
WEIGHTED AVERAGE COST OF CAPITAL
Weight of equity in capital structure 0.71
Weight of debt in capital structure 0.29
Weight of preferred in capital structure 0.00
Weighted average cost of capital 7.17%
Table 6.1. Dividend-Based Valuation Results
Continuing
1 2 3 4 5 Value
Dividends-Based Valuation Year +1 Year +2 Year +3 Year +4 Year +5 Year +6
Dividends Paid to Common Shareholders 337.5 574.5 674.6 775.2 876.5
Less: Common Stock Issues 1,029.3 710.2 667.6 627.6 589.9
Plus: Common Stock Repurchases 0.0 0.0 0.0 0.0 0.0
Dividends to Common Equity 1,366.8 1,284.8 1,342.2 1,402.7 1,466.4 1,929.4
Present Value Factors 0.923 0.851 0.785 0.725 0.669
PV Net Dividends 1,261.1 1,093.7 1,054.2 1,016.4 980.4
Sum of PV Net Dividends 5,405.7
PV of Continuing Value 23,948.6
Total 29,354.3
Adjust to midyear discounting 1.042
Total PV Dividends 30,585.1
Shares Outstanding 377.7
Estimated Value per Share 81.54$
Current share price 56.86$
Percent difference 43%
22
Dividend Based Valuation Sensitivity Analysis:
Long-Run Growth Assumptions
81.54 0% 2% 3% 4% 5% 6% 8% 10%
Discount 5% 132.50 172.18 221.78 370.59 - - - -
Rates: 6% 108.81 128.08 147.35 185.89 301.52 - - 12.45
7% 91.97 101.68 110.18 124.35 152.68 237.67 -102.30 11.03
8.39% 75.38 78.85 81.54 85.47 91.71 103.19 304.51 6.84
9% 69.70 71.65 73.10 75.15 78.21 83.31 124.12 1.69
10% 61.99 62.31 62.55 62.86 63.29 63.94 67.21 -
11% 55.71 55.08 54.65 54.09 53.34 52.29 48.11 27.21
12% 50.52 49.32 48.52 47.51 46.22 44.50 38.48 20.40
13% 46.17 44.63 43.63 42.40 40.88 38.91 32.63 17.96
14% 42.46 40.73 39.64 38.32 36.71 34.70 28.67 16.61
15% 39.27 37.46 36.32 34.98 33.38 31.42 25.81 15.71
16% 36.50 34.66 33.53 32.21 30.65 28.77 23.62 15.04
18% 31.94 30.15 29.07 27.85 26.43 24.78 20.48 14.04
20% 28.35 26.68 25.69 24.59 23.33 21.90 18.31 13.29
Table 6.1. Earning-Based Valuation Results
Continuing
1 2 3 4 5 Value
RESIDUAL INCOME VALUATION Year +1 Year +2 Year +3 Year +4 Year +5 Year +6
Comprehensive Income Available
for Common Shareholders 2,270.5 2,387.0 2,494.4 2,606.6 2,723.9 2,805.7
Lagged Book Value of Common
Shareholders' Equity (at t-1) 23,812.6 24,491.6 25,593.3 26,745.2 27,949.3 29,206.9
Required Earnings 1,997.0 2,053.9 2,146.3 2,242.9 2,343.9 2,449.4
Residual Income 273.5 333.1 348.1 363.7 380.1 356.3
Present Value Factors 0.923 0.851 0.785 0.725 0.669
PV Residual Income 252.4 283.5 273.4 263.6 254.1
Sum of PV Residual Income 1,326.9
PV of Continuing Value 4,422.5
Total 5,749.4
Add: Beginning Book Value of Equity 23,812.6
PV of Equity 29,562.0
Adjust to midyear discounting 1.042
Total PV of Equity 30,801.5
Shares Outstanding 377.7
Estimated Value per Share 81.54$
Current share price 56.86$
Percent difference 43%
Earning Based Valuation Sensitivity Analysis:
Long-Run Growth Assumptions
81.54 0% 2% 3% 4% 5% 6% 8% 10%
Discount 5% 132.50 172.18 221.78 370.59 - - - -
Rates: 6% 108.81 128.08 147.35 185.89 301.52 - - 12.45
7% 91.97 101.68 110.18 124.35 152.68 237.67 -102.30 11.03
8.39% 75.38 78.85 81.54 85.47 91.71 103.19 304.51 6.84
9% 69.70 71.65 73.10 75.15 78.21 83.31 124.12 1.69
10% 61.99 62.31 62.55 62.86 63.29 63.94 67.21 -
11% 55.71 55.08 54.65 54.09 53.34 52.29 48.11 27.21
12% 50.52 49.32 48.52 47.51 46.22 44.50 38.48 20.40
13% 46.17 44.63 43.63 42.40 40.88 38.91 32.63 17.96
14% 42.46 40.73 39.64 38.32 36.71 34.70 28.67 16.61
15% 39.27 37.46 36.32 34.98 33.38 31.42 25.81 15.71
16% 36.50 34.66 33.53 32.21 30.65 28.77 23.62 15.04
18% 31.94 30.15 29.07 27.85 26.43 24.78 20.48 14.04
20% 28.35 26.68 25.69 24.59 23.33 21.90 18.31 13.29
23
1.8. Conclusion
WellPoint provides health insurance plan services to 33.3 million medical members
through its affiliated health plans and a total of 69.2 million individuals through all
subsidiaries. Moderate quarterly sales (4.6% growth) put WellPoint on pace to maintain our
full-year expectations. Over the last 39 quarters, on average, WellPoint has beat earnings by
4.2%. WellPoint’s current P/E is 8.7x forward earnings, below the historical average of 11.5x
and versus the historical range (+/- 1 standard deviation) of 8.7x and 14.4x. WLP has already
said to expect operating income (exinvestment income) to increase y/y in 2012, coupled with
a 10% reduction in share count, and improvements in Medicare Advantage, should allow the
company to grow EPS y/y in 2012. Investment income appears to be the major below-the-line
headwind. WellPoint's earnings have increased from $6.52 to an estimated $7.19 over the
past 5 quarters, they have shown no acceleration or deceleration in quarterly growth rates
when adjusted for the volatility of earnings. On a YTD basis, WellPoint’s quality of earnings
looks good with operating cash flow approximating adjusted net income (adjusted for
depreciation and amortization), and a sequential increase in days claims payable since fourth
quarter of 2010.
WellPoint's stock price is up 17.5% in the last 12 months, down 12.4% in the past quarter
and up 0.9% in the past month. This historical performance should lead to above average
price performance in the next one to three months. WellPoint’s gross profit margin for the
second quarter of its fiscal year 2011 has decreased when compared to the same period a year
ago. Even though sales increased, the net income has decreased. WellPoint has strong
liquidity. Currently, the Quick Ratio is 1.76 which shows the ability to cover short-term cash
needs. The Company managed to increase its liquidity from the same period a year ago,
despite already having strong liquidity to begin with. This would indicate improved cash flow.
At the same time, stockholders' equity ("net worth") has remained virtually unchanged only
increasing by 1.64% from the same quarter last year. The key liquidity measurements indicate
that the company is unlikely to face financial difficulties in the near future. The stock's P/E
ratio indicates a discount compared to an average of 14.24 for the Health Care Plan industry
and a discount compared to the S&P 500 average of 14.35. To use another comparison, its
price-to-book ratio of 0.99 indicates a discount versus the S&P 500 average of 1.94 and a
significant discount versus the industry average of 6.69. The current price-to-sales ratio is
well below the S&P 500 average and is also below the industry average, indicating a discount.
Upon assessment of these and other key valuation criteria, WellPoint proves to trade at a
discount to investment alternatives within the industry. This is consistent with our analysis.
24
Our analysis shows that WellPoint’s stock is undervalued, 43%. Therefore, buying WellPoint
stock today is a good opportunity to make reasonable profits.
B. GROUP COMPONENT
2. Economic Characteristics and Competitive Dynamics in Industry
2.1. Introduction
The health care sector, or medical sector, is the sector of the economic system that
provides goods and services to treat patients with curative, preventive, rehabilitative,
palliative, or, at times, unnecessary care. The healthcare sector comprises different industries,
ranging from managed care organizations, healthcare facilities providers and medical devices
manufacturers to biotech and pharmaceutical companies. Medical device markers, insurance
companies, pharmaceutical drug developers and government institutions are major
participants in the treatment of sick, injured and disabled patients. Health care, largely owned
and operated by the private sector, is provided by many separate legal entities. The health care
plan is a subindustry under the health care sector.
The healthcare environment today faces challenges that it has never seen before. The
industry is under attack from every possible direction from cost containment, HIPAA (Health
Insurance Portability & Accountability Act) compliance, lack of stability, to an uncertain
future. After trying various managed care techniques and concepts the onus to contain costs is
now on the healthcare consumer. Concepts such as defined contribution mutated into various
consumer driven health plans are being touted as the nirvana pill for an aching industry.
Medical and disease management is expected to play a key role for payors as they try to
manage healthcare delivery. While executives are trying to grope for answers in an ever
changing environment, the light at the end of the tunnel seems far away and a dim one at that.
2.2. Porter’s Five Forces
Porter’s five forces of competition framework views the profitability of an industry as
determined by the five forces of competitive pressure. As described below, only high
competitive rivalry detracts from the attractiveness of the health insurance industry for firms
currently in the business.
Threat of Entry (Low): Entry into the health insurance industry is blocked by high
economies of scale, high capital requirements, and high government and legal barriers.
Economies of scale are needed to establish a collection and claims payment network large
enough to provide a reasonable selection of providers for patients and also allow the insurance
25
company to have a wide geographic coverage. Moreover, a large client base is needed to
facilitate risk management. Health insurance companies need to have enough patients covered
so that they have large enough proportion premiums from healthy patients to cover the costs
of taking care of sick patients. There are also large capital requirement because health
insurance companies are required by law to have a certain amount of reserves available to pay
claims at all times. Health insurance companies are also required by law to pay out 50-65% of
their premiums in medical cost coverage. These government and legal barriers not only
determine a large portion of the financing the health insurance companies, they also determine
who can operate a health insurance company through licensing.
Supplier Power (Low): Suppliers to the health insurance industry include providers,
hospitals, and medical device/pharmaceutical companies. Most suppliers have low price
sensitivity due to intense competition to get on a health insurance companies provider list or
formulary. Since most people cannot afford medical care without health insurance, health
insurance companies provide a product that is critical for a patient to be able to access a
supplier's service or product. Additionally, the size of the health insurance company relative
to their suppliers tends to be large. Because of their size, health insurance companies purchase
health care from hospitals and doctors at a much lower cost than individual patients. Health
insurance companies also have bargaining power because suppliers are unlikely to have the
capital or skills required to integrate vertically. Hospitals and providers operate in a low
margin business that is always strapped for capital, and pharmaceutical companies don't have
the claims processing networks needed in order to provide health insurance.
Buyer Power (Low): Buyers of health insurance include individuals, employers, and
linked groups of people like AARP. Buyers tend to have high price sensitivity because health
care is a large portion of a buyers total cost, especially employers. Additionally, products
from health insurance companies are not well differentiated. However, buyers have extremely
low bargaining power due to their lack of size relative to health insurance companies,
information asymmetry, and inability to vertically integrate. Not only can health insurance
companies better negotiate with providers/hospitals for discounted health care rates, but
health insurance companies also have far superior knowledge of costs. Doctors and hospitals
don't routinely display the prices they charge to patients, but health insurance companies have
this information through their contractual relationships with providers.
Threat of Substitutes (Low): There are few substitutes for health insurance. Currently, the
main choices buyers have are to have health insurance to cover their medical expenses or pay
for health care costs themselves. The high price of medical care, especially for chronic
26
medical conditions and emergency services, makes being a self-pay patient an unattractive
option. Therefore, currently 84% of the US population has either private or government health
insurance. However, new substitutes to health insurance are being developed. Cerner, a
healthcare IT company, has started to offer claims processing services to customers of its IT
products.
Competitive Rivalry (High): Industry competition is high for several reasons. The
industry has a low concentration with the four largest companies in the health insurance
business (Wellpoint, UnitedHealth Group, Aetna, and Health Care Service Corp.) accounting
for only 25% of the group health insurance premiums written. Additionally, diversity among
competitors is low because health insurance companies are heavily regulated. There are strict
regulations on how health insurance companies can structure themselves and what type of
products they can or are required to offer6.
Exhibit 1. Porter’s Five Forces
Economic
2.3. Value Chain Analysis
The healthcare plan value chain is unlike any other. While the manufacturing value chain
is easy to decipher and understand, this one is as arcane to do so. The complexity coupled
with the dynamism has given rise to multiple organizations offering very specialized services
and working together to form the value chain. The final result of this complexity and
specialization is multiple value chains which are heterogeneous in nature.
The value chains and their sub-systems have given rise to a situation where the
competition is no longer between payors and health plans but true competition is between
competing value chains. Hence the success of a particular healthcare organization will depend
6 http://www.cerner.com/public/
27
on the composition and efficiency of its value chain. Needless to say, this will have a
significant impact on the delivery of care to the consumer.
The resulting competition in value chains will have a profound impact on the way
healthcare plan providers focus on strategy and healthcare delivery. Clearly, the increasing
complexity too is a driving force for providers to take a step back and reflect on core
competency issues and ask fundamental questions about their business models. They are
increasingly realizing that the original drivers for their existence in the past may no longer be
applicable. Customer as well as consumer demands have changed. While the downturn in the
economy has forced employers to evaluate the cost of group health benefits provided to
employees, cost increases have also been influenced by changing dynamics in demographics
and psychographics of the population (e.i. The aging of the baby boomers, Medicare cost
shifting, etc.).
The emerging business model is hence going to be one where the healthcare organization
is going to have to concentrate on those business functions which helps differentiate itself
from competition and outsource those components which play a supporting role. This
approach will allow it to effectively compete and survive in the industry.
Exhibit 2. Health Care Plans Industry Value Chain
The role of the health care plan providers will hence be very specialized and one where it
concentrates on few business functions that are core to its strategy and market segment. The
health plan/payor will in essence control and drive the nature of the value chain and the
quality of care received by the consumer. Providers who adopt this philosophy will be nimble
and quick to respond to market changes. This will result in the most efficient value chain and
only those organizations with this built-in flexibility are likely to survive.
Health insurance markets are often highly concentrated with one insurer accounting for
over 60% of the market. Concerns about concentration in health insurance markets are linked
to wider concerns about the cost, quality, and availability of health care. The market structure
of the health insurance and hospital industries may have played a role in rising health care
28
costs and in limiting access to affordable health insurance and health care. Some argue market
concentration has led to higher health care prices. Higher prices for health care or health care
insurance may then make health insurance is now primarily provided by the government in
the public sector, with 60-65% of healthcare provision and spending coming from programs
such as Medicare, Medicaid, TRICARE, the Children's Health Insurance Program, and the
Veterans Health Administration.
2.4. Industry Outlook
When we analyze outlook for the managed health care sub-industry for the next 12
months is positive. Almost all health insurers have been guiding for higher earnings in 2011,
despite cost pressures from the new health care reform law, and the one expecting earnings to
be below its 2010 results is guiding for targets that are also higher than it originally expected.
Moreover, we view the health care reform law as positive, on balance, for managed care
organizations (MCOs). The MCOs will face fees totaling $67 billion over a 10-year period,
which would not begin until 2014. Meanwhile, in 2010, they started to face certain
restrictions, and starting in 2011 for commercial plans, floors for medical spending as a
percentage of premiums (referred to as the medical cost ratio -- MCR, or medical loss ratio --
MLR). We see offsets, including estimated enrollment gains of up to 32 million previously
uninsured individuals by 2019, and potential M&A opportunities.
The health care companies are in a difficult and sensitive business of trying to restrain
health care spending growth, which often leads to negative publicity and potentially expensive
lawsuits. Government action could have significant, sudden, and unpredictable effects
including changes to Medicare or Medicaid funding and policies, new government programs
that may compete with private insurers, or laws that restrict premiums or mandate benefits
that must be provided. Economic conditions can also further affect the health care industry,
as continued unemployment results in lower commercial enrollments, which can result in
deleveraging fixed costs.
Meanwhile, we expect MCOs to raise below-floor MCRs closer to requisite levels by
deducting their income taxes from the premiums, based on the health care reform law's MCR
formula. Still, some MCOs expect to rebate some of the premiums to achieve the MCR floors,
as the law requires. All will seek to offset the expected rise in MCRs and pending fees with
G&A cost control. We look for mid- to upper-single digit revenue growth in 2011, led by
premium rate hikes and higher Medicare Advantage (MA), Medicare drug plan and Medicaid
29
enrollment. We saw commercial membership attrition in 2010, but we expect improved
comparisons in 2011.
We expect MCRs to decline modestly in 2011, assuming that moderate hospital utilization
and favorable prior-year claims reserve development benefiting the first half outweigh the
implementation of commercial MCR floors and our assumption of more normalized medical
cost trends in the second half. We look for an upper single digit increase in EPS for the group
in 2011, compared to the 26%-plus gain in 2010. The S&P Managed Health Care Index rose
20.0% year to date to September 9, while the S&P 1500 Composite Index fell 8.4%.We think
that the relative weakness the S&P Managed Health Care Index experienced over the prior 13
weeks reflects recent market-wide pullbacks, as well as investor concerns about a potential
reduction in MA support. This would be part of the 2% cuts across the board agreed to by
Congress should an agreement not be reached in the U.S. deficit reduction talks. Even so, we
believe this scenario may lead to a shake-out in the MA market, with the publicly traded
MCOs benefiting from M&A. Table 7, below, displays some of the industry and company
comparisons:
Table 7 – Health Care Industry and Company Comparisons
Table 8, displays some of the health care company income generation and sales profile:
Table 8. Health Care Companies Financials
COMPANIES Sale s Ope rating
Income
Ne t Income
(Million USD)
AETNA 33,811 2,799 1,836
UNITED HEALTH 94,155 7,864 4,634
WELLPOINT 58,802 4,773 2,887
CIGNA 21,617 2,225 1,605
HUMANA 35,373 2,022 1,276
3. Company Strategy Comparison
WellPoint's concurrent release of a disappointing earnings report included a significant
increase in health-care costs. WellPoint's higher costs seem to be due primarily to an isolated
situation with the company's Medicare business, although management also strengthened
reserves for unpaid medical claims. This is a possible red flag for Aetna; in the last industry
downturn, WellPoint recognized accelerating medical cost trends much sooner than Aetna
30
did. Comments during Aetna's conference call seemed to indicate that management does not
believe current margins are sustainable, and that the company may not raise prices as
aggressively next year in an attempt to stabilize membership.
Despite being the nation's third-largest managed care organization, we don't think Aetna
has a sustainable competitive advantage. We are disconcerted by Aetna's apparently poor
understanding of medical cost trends and inability to react quickly to changing conditions,
especially compared to larger peers UnitedHealth and WellPoint. Size is critical in managed
care; it gives companies bargaining power when negotiating with health-care providers, and it
allows them to spread fixed costs over more customers. UnitedHealth benefits from the
network effect, where customers want access to its huge network of health care providers, and
providers want business from its huge customer base. UnitedHealth’s scale endows the firm
with significant comparative advantages. In addition, UnitedHealth’s geographic
diversification also lowers its exposure to region-specific risks like public health catastrophes
and changing state regulations.
Although Aetna is the third-largest health insurer in the United States, with 18 million
medical members, it is considerably smaller than WellPoint and UnitedHealth, each of which
has more than 30 million members. More importantly, Aetna's members are spread out across
the country, so it is generally only in the top-five insurers in terms of regional market share.
Additionally, the company relies on very large employers for a disproportionate share of its
membership, and these customers frequently have bargaining power.
Over the long run, we expect managed-care organizations (MCOs) to raise prices in line
with medical cost trends. As Aetna's experience demonstrates, it normally isn't worthwhile for
a company to seek market share gains by undercutting competitors on price. Because of mild
switching costs, it would be very difficult for an MCO to gain enough new members to make
up for margin contraction if it chose to price aggressively. On the other hand, claims aren't
paid until months after an MCO's members consume health-care services. Understanding
medical cost trends requires strong data collection and interpretation capabilities. In contrast
to peers, Aetna reported strong results in 2008. However, as the company processed and paid
2008's claims, it became clear that its underwriting results were just as bad as the rest of the
industry; management just didn't realize how much costs were increasing until a year later
than most peers. This caused the company to fail to raise premiums enough in 2008 and 2009.
Weak earnings results likely would have dragged into 2010 if the company hadn't been saved
by a surprise slowdown in health-care utilization. WellPoint and UnitedHealth reacted much
more quickly to accelerating cost trends, resulting in a swift turnaround.
31
4. Risk Profitability and Efficiency Comparison of Companies
When we compare risk profitability and efficiency among selected companies, we use the
DuPont formula. DuPont analysis (also known as the DuPont identity, DuPont equation,
DuPont Model or the DuPont method) is an expression which breaks ROE (Return On
Equity) into three parts. The DuPont identity breaks down Return on Equity (that is, the
returns that investors receive from the firm) into three distinct elements. AccorThis analysis
enables the analyst to understand the source of superior (or inferior) return by comparison
with companies in similar industries (or between industries). Within this concept, Table 9
below presents DuPont analysis results:
Table 9. DuPont Analysis Results for Health Care Industry
According to our result, Aetna seems to have highest profit margin among other
companies, on the other hand in spite of high profit margin Aetna could not achieve high ROE
comparing to Humana which provided highest ROE by means of higher asset use efficiency
reflected in asset turnover ratio. Within this concept Aetna and Humana look like different
than other companies, Aetna has highest leverage indicating the riskiest company among
other companies selected for group study, because of very low efficiency Aetna did not
provide high ROE. On the other hand we can see Humana as most successful company among
other companies providing most efficient asset use and comparatively low leverage.
If we look at this companies in terms of solvency and liquidity, our forecast results
confirms the riskiness and liquidity problem with Aetna. However, Humana took most
succesfull place among other companies interms of growth, liquidity (solvency) and
efficiency. Following tables depicts comparison between Aetna and Humana.
32
Table 10. Growth, Liquidity and Solvency Comparison
GROWTH (5 year average 2005-2010) AETNA HUMANA
Revenue Growth 8.90% 19.50%
Net Income Growth 3.60% 34.60%
Persistent Net Income Growth 5.70% 27.10%
LIQUIDITY (5 year average 2005-2010) AETNA HUMANA
Current Ratio 1.10 1.61
Quick Ratio 0.80 1.43
Operating Cash Flow to Current Liabilities 25.50% 29.70%
SOLVENCY (5 year average 2005-2010) AETNA HUMANA
Total Liabilities / Total Assets 77.46% 77.46%
Total Liabilities / Shareholders' Equity 350.25% 350.25%
LT Debt / LT Capital 25.88% 25.88%
LT Debt / Shareholders' Equity 35.18% 35.18%
Operating Cash Flow to Total Liabilities 6.01% 6.01%
Interest Coverage Ratio (reported amounts) 13.09 13.09
Interest Coverage ratio (recurring amounts) 14.53 14.53
33
References
1. Company Annual Reports, www.wellpoint.com
2. Thomson Data Base,
3. Wharton Data Base (https://wrds-web.wharton.upenn.edu/wrds/
4. SEC EDGAR Data Base, (http://www.sec.gov/edgar.html)
5. US Market Risk Premium Used in 2011 by Professors, Analysts and Companies: A Survey
with 5.731 Answers, http://ssrn.com/abstract=1805852,
6. www.morningstar.com,
7. http://finance.yahoo.com,
8. Lecture notes and text book.
