<p>Revisiting Commercial Thesis<br/>for 2009<br/>SECTOR REVIEW<br/>Fundamentals Remain Challenged Despite<br/>Likely 09 Margin Relief<br/>■<br/>This morning we are revisiting our thesis on the commercial managed care<br/>industry and providing our summary thoughts as we head into 2009.<br/>■<br/>We continue to believe that the managed care industry is in the midst of a<br/>cyclical slowdown driven by decelerating rates of revenue growth. While<br/>these factors have already resulted in earnings pressure for most of the<br/>companies in our universe, we see little opportunity for sustainable margin<br/>recovery in 2009 and beyond.<br/>■<br/>We acknowledge that decelerating rates of discretionary medical utilization<br/>could favorably impact the stocks in 2009. We also note that the comps<br/>shape up favorably in the first half of the year. In that light we would not be<br/>surprised to see the recent momentum in the managed care stocks continue<br/>into 1H09 with another 10-15% upside potential from current levels.<br/>■<br/>For investors with shorter time horizons, this creates a near term trading<br/>opportunity in our opinion and we would recommend the more out of favor<br/>names (CI-OP-$19 and CVH-OP-$27) into that thesis. We simply believe<br/>there is more room for error among these stocks at current levels.<br/>■<br/>On the other hand, we remind investors with time horizons beyond 1H09 that<br/>the beneficial impacts of these factors are short-lived. Ultimately, we see<br/>limited opportunity for meaningful and sustainable margin recovery as long<br/>as revenue growth rates continue to decline. To the extent that the stocks<br/>of managed care companies with significant commercial exposure<br/>trade higher on lower MLRs in the first half of the year, we recommend<br/>that investors sell into that strength.</p><p>Introduction<br/>This morning we are revisiting our thesis on the commercial managed care industry and<br/>providing our summary thoughts as we head into 2009. For those that are familiar with our<br/>views already, our thoughts remain broadly unchanged. We continue to believe that the<br/>managed care industry is in the midst of a cyclical slowdown driven by decelerating rates<br/>of revenue growth. While these factors have already resulted in earnings pressure for<br/>most of the companies in our universe, we see little opportunity for sustainable margin<br/>recovery in 2009 and beyond. Much has been made about the potential for margin relief<br/>in 2009 and we acknowledge that decelerating rates of discretionary medical utilization<br/>could favorably impact the stocks in 2009. We also note that the comps shape up<br/>favorably in the first half of the year for the managed care stocks. In that light we would<br/>not be surprised to see the recent momentum in the managed care stocks continue into<br/>1H09 with another 10-15% upside potential from current levels. For investors with shorter<br/>time horizons, this creates a near term trading opportunity in our opinion and we would<br/>recommend the more out of favor names (CI-OP-$19 and CVH-OP-$27) into that thesis.<br/>On the other hand, we remind investors with time horizons beyond 1H09 that the<br/>beneficial impacts of these factors are short-lived. Pricing pressure will resume in 2010<br/>and comps will be harder in the second half of 2009. With that, to the extent that the<br/>stocks of managed care companies with significant commercial exposure trade<br/>higher on lower MLRs in the first half of the year, we would advise investors to sell<br/>into that strength. In short, we remain cautious on the long-term (3+ year) outlook for the<br/>commercial managed care business and prefer stocks of companies with more diversified<br/>business models and lower valuations. Among the mid and large cap names in our space,<br/>our top picks remains CIGNA and Coventry.<br/>2008 Recap<br/>Before walking through the elements of our near and intermediate term theses, we first<br/>want to provide a quick recap of the events that have led to such unexpected disruption in<br/>the managed care space last year. It didn’t take long for the bad news to start as 4Q07<br/>financial reports came in worse than expected, particularly in the commercial segment<br/>where WellPoint, UnitedHealth and CIGNA each reported disappointing quarters. Soon<br/>thereafter, the first major shot across the bow came on March 10th when WellPoint preannounced<br/>1Q08 results and subsequently lowered 2008 guidance by 8% due to higher<br/>than expected medical costs, lower fully insured enrollment and a “changing economic<br/>environment”. WellPoint’s negative earnings revision kicked off a steady parade of<br/>imitators, with Humana, UnitedHealth, Health Net and Coventry all following suit and<br/>lowering their outlooks for 2008. Investors were provided a brief respite during a series of<br/>investor conferences in the Spring where the notion that the issues that led to the revisions<br/>were all pricing related and that the outlook for 2009 was more benign became pervasive.<br/>As a result, the group enjoyed a bounce off depressed valuation levels, but the positive<br/>momentum was short lived.<br/>On June 18th, Coventry surprised the Street by bringing down full year 2008 EPS guidance<br/>by 17% on the back of higher commercial medical cost trends and operating issues related<br/>to its Medicare reserves. After Coventry dropped its second shoe, UnitedHealth followed<br/>suit, taking the opportunity to lower 2008 guidance by yet another 16%. Following the<br/>2Q08 wave of guidance revisions, sentiment improved temporarily on the view that the<br/>bad news was behind us and margins would stabilize from 2Q levels. The period of calm<br/>was short lived. From September 15th and October 10th, following the announcement that<br/>Lehman would seek bankruptcy protection, the HMO index dropped a staggering 33%<br/>before experiencing a short reprieve. On October 21st Coventry pre-announced, again, this<br/>time slicing 2008 EPS guidance by 31% on the back of higher medical trend and<br/>underwriting errors. Two weeks later CIGNA reported weak third quarter results, bringing<br/>down full year expectations largely on charges in its run-off segment. The final guidance<br/>blow was delivered by Health Net a few days later. Citing poor execution, Health Net</p><p>delivered disappointing 2009 guidance and another reduction in 2008 guidance. The<br/>trough was finally reached on November 21 before the group began a sharp rally to end<br/>the year. All told, managed care’s poor operating performance combined with general<br/>weakness in the broad market led to a decline of 55% in the HMO index during 2008.</p><p></p><p> <br/></p><p></p>