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Cost Trends Crack WellPoint

Shares fall as it follows in UnitedHealth's footsteps.



could be healthier.

The nation's largest health insurer missed revenue targets for the first quarter and simply matched bottom-line estimates, disappointing those who were looking for a bit of upside instead. The company also raised its full-year guidance less than some people had hoped. Shares fell 4% early Wednesday.

Rising medical costs -- a crucial metric for the managed care industry -- caused some pain.

First-quarter revenue increased 8.8% to $14.8 billion, falling short of the $15.1 billion consensus estimate, despite enrollment growth in most of the company's business segments. Membership in increasingly popular consumer-directed health plans jumped by 57% alone.

Net income rose 7% to $783 million, with earnings per share of $1.26 matching Wall Street targets. The company's medical cost ratio, measuring the amount of each premium dollar spent on patient care, climbed to 83.1% in the first quarter from 81.3% last year.

WellPoint blamed most of that increase on businesses outside the commercial arena, which is the sector that worries investors most. But it confessed to suffering an "unacceptably high" MCR in certain markets where it sells Medicaid plans -- a key growth vehicle for the company -- while vowing to remedy the situation.

"The company has implemented numerous cost-of-care initiatives to improve financial performance in these geographies," WellPoint assured. Moreover, "the company remains disciplined in its pricing and will take appropriate action if acceptable reimbursement cannot be obtained."

WellPoint saw an expected jump in Medicare Part D expenses as well, with seniors enjoying early-year benefits before they hit the so-called doughnut hole and start paying for drugs themselves. Meanwhile, excluding the absence of a year-ago adjustment, the company actually enjoyed a slight decline in its all-important commercial MCR.

Overall, however, WellPoint is now projecting higher medical costs for the entire year. Moreover, the company's increased 2007 profit guidance of $5.54 a share is a penny shy of analyst estimates.

Warning Signs

WellPoint stands out as the first major health insurer to report first-quarter results since


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rattled the market last week with a spike in its commercial MCR. UnitedHealth found itself surprised when users of its consumer-directed health plans rushed out for end-of-year treatments -- at the company's expense -- and suffered a rare unfavorable reserve development as a result.

Some industry experts have expressed real concern since that time.

"The question is whether this is a UnitedHealth-specific issue, or is this indicative of a broader industry trend that -- after four years of medical cost trend moderation -- we have reached the inflexion point?" Jefferies analyst Brian Wright pondered when launching coverage of WellPoint on Monday. "In our view, it is too early to make a definitive assessment."

However, he added, "we believe caution is warranted, as we view UnitedHealth first-quarter results as the most recent data point of several that warrant attention."

Based on the industry's history, Wright views flat medical cost trends -- such as those being projected by some managed care companies right now -- as unsustainable. Indeed, he says, sequentially flat medical costs surface just once in a decade. Almost always, he notes, they tend to rise or fall instead.

Unfortunately, Wright feels that those costs could soon rise and reverse a long and favorable trend for the industry.

"At the very least," he says, "we believe the case for further moderation in 2007 is a bit of a stretch."

For UnitedHealth, of course, that has proven true so far. Wright fears further surprises for the company ahead.

"The company sets reserves assuming a provision for adverse development -- a cushion, if you will," he stresses. "And that cushion was not enough. ... We believe that the company is at risk for subsequent occurrences of unfavorable reserve development" down the road.

In fact, Wright feels concerned about the industry as a whole. If medical costs increase, he says, free cash flow -- even at rich companies such as WellPoint and UnitedHealth -- will suffer. Meanwhile, he says, pretax margins for the sector have seemed to peak already.

Looking ahead, Wright says, industry sales growth will likely slow. Moreover, he adds, profit increases will rely more and more on cost savings and share repurchases going forward.

To be fair, Wright portrays WellPoint -- with its broad scale and respected Blue Cross name -- as a "relative safe haven" in this uncertain environment. Still, he remains cautious on even this industry leader. He has, therefore, launched coverage on the company with a hold recommendation and an $86 price target on the stock.

Wright has a hold recommendation on UnitedHealth as well. His firm currently has no banking ties to either company.

"With questions regarding the sustainability of the moderating medical cost trend cycle," Wright concludes, "we believe multiples will be under pressure -- even for those with potentially best-in-class membership growth."