Motley Fool stock selection

WellPoint
Large scale and reach give it a healthy competitive advantage.
It produces a torrent of cash, which enables it to buy back shares.
Headquarters: Indianapolis, Ind.
Recent Price: $39.35
A major provider of healthcare services and benefits, WellPoint boasts one of the largest medical memberships in the United States, with 35 million customers, compared with 73 million for UnitedHealth (NYSE: UNH), 16.8 million for Aetna (NYSE: AET), and 10.2 million for CIGNA (NYSE: CI). Its membership is roughly a 50-50 mix of fully insured and self-funded members. For the fully insured, the company receives a premium and takes on the risk, making it responsible for covering the cost of medical services. For the self-funded, it charges a fee for services such as administrative work and fee negotiations, but the employer or plan sponsor reimburses all or most of the healthcare costs.

As does UnitedHealth, WellPoint has a size advantage over the competition. Being big means it can spread nonmedical costs over a larger membership base, which improves profit margins. Larger networks are more valuable to healthcare providers -- imagine having access to WellPoint's 35 million members -- and therefore such networks can negotiate lower prices. This is a win-win for members, who have access to cheaper health insurance and a wider selection of healthcare providers.

The national network has a local effect, since people tend to use healthcare services close to home. WellPoint is the exclusive licensee for Blue Cross and Blue Shield brands in 14 states, giving it the No. 1 or No. 2 market share in these areas. On top of its scale and price advantages, WellPoint's membership base has yielded reams of historical data that should help the company understand underwriting risks and plan its business on economical terms.

Like all insurance companies, WellPoint earns considerable interest on its premium float, unearned premiums paid plus unpaid losses. In 2007, interest on WellPoint's cash plus its float exceeded $1 billion and free cash flow was $4 billion. WellPoint has been using this strong free cash flow production to buy back shares -- a worthy use of capital at today's low stock price.

WellPoint isn't a fast growing company -- mid-single-digit growth should come from 1% to 1.5% enrollment growth and 4% to 5% price increases. And the medical-cost ratio could inch up as cost increases slightly outpace price increases -- though management is confident that it can match the two.

The Risks
Systemic health-care reform presents a small risk, but I expect the largest insurers, like WellPoint, to do well while smaller rivals suffer more and experience further consolidation.

If the medical-cost ratio rises higher than expected it could lower the value of WellPoint. Also, as is the case for all insurance companies, WellPoint has an investment portfolio, including in mortgage-backed securities. Almost all these securities are guaranteed by government-sponsored entities, but that doesn't preclude risk.

The Foolish Bottom Line
WellPoint is an extremely fit company selling at a significant discount to its true value, based on little more than uncertainty. In turn, Wall Street has priced the shares as though the business is in terminal decline. Underwriting results will inevitably wax and wane, but WellPoint's long-term prospects are anything but declining. It operates in an industry with long-term growth built in as baby boomers age, and WellPoint should produce healthy returns far in excess of the market.