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On July 28, 2010, WellPoint Inc. ([url=]WLP[/url]) reported its second-quarter income from continuing operations of $702.8 million or $1.67 per share, surpassing the Zacks Consensus Estimate of $1.56. This also compares favorably with the income of $731.5 million or earnings of $1.50 in the year-ago quarter. The improved showing was attributable to higher-than-expected favorable reserve development and continued strong performance in capital management.

WellPoint’s income from continuing operations excludes net investment gains of $19.6 million after-tax, or $0.04 per share in the reported quarter and net investment losses of $38.0 million after-tax or $0.07 per share in the prior-year quarter.

Including these one-time items, WellPoint reported a net income of $722.4 million or $1.71 per share as opposed to $693.5 million or $1.43 per share.

Behind the Headlines

Total operating revenues for the quarter came in at approximately $14.2 billion as opposed to $15.3 billion in the year-ago quarter, down 6.8%. The decline was attributable to the conversion of the large municipal group to a self-funded arrangement, and was also driven by the transfer of UniCare business in Texas and Illinois, along with lowering fully insured membership due to economic conditions. The sale of the NextRx pharmacy benefit management subsidiaries to Express Scripts ([url=]ESRX[/url]) in the fourth quarter of 2009 also contributed to the decline.

It was also disappointing to see a significant decline in medical enrollment during the reported quarter, with enrollment of 33.5 million members as on June 30, 2010, down 2.1% from approximately 34.2 million as on June 30, 2009. Most of the decline occurred in the non-Blue business, due to the transfer of Wellpoint's UniCare members in Texas and Illinois to another Blue Cross & Blue Shield plan during 2010. Also, continued high unemployment and overall economic conditions added to its woes.

WellPoint posted a benefit expense ratio (benefit expenses as a percentage of premium revenue) of 82.9% in the reported quarter as against 83.9% in the second quarter of 2009, driven by the Local Group business. The decline in the quarter was also impacted by the conversion of the large municipal account, which historically maintained a benefit expense ratio higher than the company's average. However, this decline was partially offset by an increase in the benefit expense ratio for Individual business due to the delay in implementing rate increases in California.

The selling, general, and administrative (SG&A) expense ratio (SG&A expenses as a percentage of premiums, administrative services fees and other revenue) climbed to 15.3% in the second quarter of 2010, a year-over-year increase of 90 basis points from 14.4%, reflecting lower operating revenue partially offset by a reduction in operating expenses.

Segment Results

Commercial Business
: Operating gains in the segment increased 28.0% year over year to $745.7 million in the second quarter of 2010 from $582.8 million. The increase was attributable to operating improvements in the Local Group business as well as an estimated $40 million of higher-than-anticipated favorable reserve development recognized in the quarter.

Consumer Business: Operating gains in the segment plummeted 21.3% year over year to $300.9 million in the second quarter of 2010 from $382.1 million. The decline was driven by lower performance in the Individual business as well as in WellPoint's Medicare Advantage business. The segment also recognized an estimated $60 million of higher-than-anticipated favorable reserve development in the reported quarter, compared to approximately $100 million realized in the prior-year quarter.

Other: Operating gains in this segment significantly plunged 90.8% from the second quarter of 2009, due to the sale of NextRx in the fourth quarter of 2009.

Evaluation of Capital Structure

WellPoint generated a lower operating cash flow of $256.1 million in the second quarter of 2010 compared to $377.6 million in the prior-year quarter, due to the two estimated federal income tax payments made during the quarter. Cash and investments of the parent company totaled approximately $2.1 billion at the end of the quarter.

Days in Claims Payable (DCP) as of June 30, 2010, were 42.1 days, a decrease of 1.3 days from 43.4 days at March 31, 2010. DCP declined primarily due to a prior-period reserve development in the second quarter. The other reason for the decline related to the timing of pharmacy claims payments and a seasonal decrease in claims payment cycle times, partially offset by the impact of the large municipal account conversion.

As of June 30, 2010, the Board of WellPoint approved a share repurchase authorization of approximately $1.0 billion. The company expects to utilize this authorization in the second half of 2010, subject to market and industry conditions.

During the second quarter of 2010, WellPoint witnessed net investment gains of $30.4 million pre-tax, consisting of net realized gains from the sale of securities totaling $36.5 million, partially offset by other-than-temporary impairments totaling $6.1 million. In the prior-year quarter, WellPoint experienced net investment losses of $58.3 million pre-tax, resulting primarily from other-than-temporary impairment charges.

As of June 30, 2010, WellPoint's net unrealized gain position was $807.5 million, consisting of net unrealized gains on fixed maturity and equity securities totaling $671.4 million and $136.1 million, respectively.

Comparison with Competitors

Rival company Unitedhealth Group, Inc. ([url=]UNH[/url]) reported its second quarter results on July 20, 2010. Unitedhealth’s second-quarter income from continuing operations were 99 cents per share, substantially better than the Zacks Consensus Estimate of 75 cents. This also compares favorably with 73 cents in the year-ago period.

Another competitor, Aetna Inc. ([url=]AET[/url]), also reported a second-quarter profit from continuing operations of 75 cents per share on July 27, well ahead of the Zacks Consensus Estimate of 73 cents. Aetna reported a profit of 77 cents in the year-ago quarter.

CIGNA Corporation
([url=]CI[/url]), another competitor of WellPoint, will report its second quarter earnings on August 5, 2010.

Outlook for Fiscal 2010

WellPoint now anticipates a net income of at least $6.30 per share, including net investment gains of $0.08 per share recorded during the first six months of 2010, partially offset by the first quarter 2010 intangible asset impairment charge of $0.03 per share. This outlook includes no net investment gains or losses or asset impairment charges beyond those recorded during the first six months of 2010.

WellPoint re-affirmed its medical enrollment expectation of approximately 33.1 million for fiscal 2010, consisting of 19.5 million self-funded members and 13.6 million fully insured members.

Operating revenue is expected to be approximately $58.0 billion for fiscal 2010, as against the earlier projection of $58.5 billion.

For fiscal 2010, WellPoint continues to project an underlying medical cost trend in the range of 7.5%-8.5%, and believes that the cost trends will be closer to the lower end of the range.

The benefit expense ratio is now expected to be approximately 83.9% with the SG&A expense ratio at approximately 14.8% for fiscal 2010, as against the earlier projection of 84.3% and 14.6%, respectively.

Operating cash flow of WellPoint is now anticipated to reach $1.2 billion in fiscal 2010, including the unfavorable impact of the $1.2 billion of first quarter tax payments related to the sale of NextRx.

Our Recommendation

WellPoint is well positioned in its peer group and has a strong cash flow position. It has been strengthening its portfolio through its acquisition strategy, the synergies of which lead to margin expansion and top-line growth. Further, the sale of WellPoint’s in-house pharmacy benefits business to Express Script has strengthened the strong balance sheet and fueled a major stock repurchase.

However, given the headwinds that WellPoint and other health insurers face in the form of weak demand for their products and services and uncertainties related to the implementation of health insurance reforms recently passed into law are expected to stretch profit margins. Moreover, concerns over continued high unemployment are likely to overshadow the stock.

Currently, WellPoint carries a Zacks #3 Rank, which translates into a short-term Hold recommendation, indicating no clear directional pressure on the shares over the near term.

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