Healthcare Services chapter. Global Gambits The Right Moves for Right Now. See jpmorgansavant.com for global sector valuation tools

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1 June 28, 2006 Global Gambits The Right Moves for Right Now Healthcare Services chapter The following is a chapter from, dated June 28, This chapter is presented for convenience, and should be read in conjunction with the full report and its analyst certifications and important disclosures. The full report is available on MorganMarkets.

2 Healthcare Services Cautious Optimism Global Sector Coordinator Andreas J Dirnagl (1-212) andreas.j.dirnagl@jpmorgan.com J.P. Morgan Securities Inc. Full sector coverage details on page 8 Key Drivers We see a number of positives for pharmaceutical distributors and PBMs. For distributors, the transition to feefor-service is progressing well, and should lead to increased margin stability. For PBMs, underlying script growth, coupled with increased utilization of mail and specialty pharmacy, should drive earnings. Both sectors should see a positive impact from the Medicare Drug Benefit and significant number of generic launches over the next few years. Even in a market gravitating toward more inflation-proof sectors, we believe expectations for the hospital group remain tepid. Overall earnings expectations were somewhat muted for 1Q06 generally weak admissions growth, decent pricing and signs of stability in overall year-over-year bad debt trends and caused the group to trade down. In our view, there is still long-term value in hospital names. But before a fullscale turn, we are likely to see a flight to quality for names demonstrating operating consistency/improvement, excellent leadership and strong growth prospects through solid physician and payor relationships, acquisitions, and JV/alternative ownership structures. For 2H06 and 2007, excluding hurricanerelated risks, we expect steady economic growth to show up in hospital operating metrics again, signalling a potentially broader shift for the group, where stronger cash flow and capital expansion can translate into long-term stability. We remain bullish on the small/mid-cap healthcare services. Despite strong fundamentals, we believe investors have already taken profits to compensate for tougher market conditions. Still, with generally stable and even improving industry fundamentals, higher growth rates than other areas, and clearly defined and defensible niches, we continue to view the small-mid-cap space as one of the more interesting areas for above-market returns. We think select opportunities in the managed care sector continue to be attractive in In our view, investors should look at companies with solid underwriting capabilities and pricing discipline for the balance of the year. Average 2006 premium increases in the % range should cover moderating medical cost trends in the same range. However, some companies appear to be pricing for market share and not stable margins. Early data indicates this may be limited to a couple of rogue players and may not be systemic. We recommend investors stick with companies exhibiting pricing discipline until we have more visibility which may not come until autumn. The industry also could generate accelerating enrolment in 2006 due to opportunities in the Medicare Advantage program and the introduction of the Medicare Part D prescription drug benefit a potential US$30 billion market opportunity. Finally, ongoing industry consolidation should continue to support both fundamentals and valuations. 2

3 Our Non-Consensus Views In pharmaceutical distribution, we view the impact of various industry issues as better than most. We expect feefor-service to gain traction faster than consensus expectations. In addition, our expectations for the impact of the Medicare Rx benefits are higher than the Street. In some cases, supporting the bull story in the small/midcap space has led to some overall weakness. While we are strong supporters of the general supply/demand fundamentals driving growth in the majority of the sub-sectors we cover, we think there has been some evidence of the Street getting ahead of itself on the expectations front in order to tell a good longterm operating story. In our view, this has been part of the cause for the recent sell-off. With the group now trading at the lower end of historical ranges on a PEG basis, we believe the group as a whole has re-based at nice levels for a re-entry. We have seen aggressive pricing by select public MCOs for the first time in several years. So far, we think this pricing behavior could be limited to MCOs that needed to secure membership in 1Q06 to continue their growth story. Moreover, we continue to expect medical costs will moderate, so this may offset aggressive pricing but we caution that it is a slippery slope to play the pricing game, and an unexpected uptick in medical costs could be disastrous for results. However, we expect that the ongoing mix shift in the commercial market to consumer driven health plans (CDHPs), which have lower per member costs, could provide an additional favourable offset to medical cost trends. This development lowers the risk profile of the managed care firms that exhibit pricing discipline and should allow for stable underwriting margins. 3

4 Healthcare Services: Top Picks Company Key Financials Rationale and Catalysts Caremark Rx Ticker: CMX US / CMX E 2007E Price (Local): US$ E 2007E Mkt Cap (US$): 21.1 bn Analyst: Lisa Gill EV/EBITDA (Calendar) Phone: (1-212) E 2007E lisa.c.gill@jpmorgan.com Medco Health Solutions Ticker: MHS US / MHS E 2007E Price (Local): US$ E 2007E Mkt Cap (US$): 15.8 bn Analyst: Lisa Gill EV/EBITDA (Calendar) Phone: (1-212) E 2007E lisa.c.gill@jpmorgan.com Source: Company data, Bloomberg, JPMorgan estimates, JPMorgan SaVanT. Prices as of June 15, In our opinion, fundamentals of the PBM industry are strong. Prescription drugs have been the fastest growing component of US healthcare spending by a wide margin, and positive utilization trends are driving solid underlying growth at PBMs. Secular industry trends such as rising mail penetration, generic utilization, and specialty pharmacy sales have driven increasing per claim profitability metrics. We believe the company has the best business model in the group, combining a strong mail order franchise with an established specialty pharmacy offering, which, in turn, drives the company s industry-leading profitability metrics. We believe the current 2006 EPS guidance, which calls for an EPS growth in the 19-22% range is conservative, based on the potential for upside related to generic launches, Medicare Part D and capital structure improvements. Valuation is attractive, as shares trade at 16.8x our calendar 2007 EPS estimate of US$2.84. This represents the lowest multiple of among the big three (despite historically trading at a premium), and is well below the historical average of 23x forward 12-month EPS since In our view, Medco is one of the premier players in the PBM segment. The company s mail order facilities are the largest, most technologically sophisticated in the industry. Further, the recent acquisition of Accredo Health bolsters the company s presence in the rapidly growing specialty pharmacy segment. We also cite several key factors that should continue to support strong earnings growth in 2H06 and beyond, like generic Zocor, synergy capture from the Accredo acquisition, new business, and capital structure improvements. Medco s shares currently trade at 16.9x our calendar 2007 EPS estimate of US$3.09, which represents a discount to the average multiple of its peers. Given the strong outlook, we believe this valuation disparity should continue to narrow as we move through

5 Healthcare Services: Top Picks (cont d) Company Key Financials Rationale and Catalysts Psychiatric Solutions Inc. Ticker: PSYS US / PSYS E 2007E Exchange: NASDAQ P/E (Calendar) Price (Local): US$ E 2007E Mkt Cap (US$): 1.5 bn Analyst: Andreas J Dirnagl EV/EBITDA (Calendar) Phone: (1-212) E 2007E andreas.j.dirnagl@jpmorgan.com The core of our investment thesis is PSYS ability to follow through on its aggressive acquisition strategy with strong top-line and margin growth throughout the entire facility portfolio, and it continues to deliver. In our view, stellar 1Q06 results not only showed a great deal of operating momentum in the facility portfolio, but with a strong acquisition pipeline and deep bench of management strength, we think this story has years to play out. In our view, PSYS reached a milestone in 1Q06 with record-high SS EBITDA margins of 20.0%. In essence, this highlights a key to our investment thesis, namely the stellar operational and leadership integrity of both the corporate and facility-level management teams. We continue to believe there is more room to grow both SS and corporate EBITDA margins several hundred basis points over the next few years as it continues to utilize its acquisition execution play book. As we are only halfway through the year, we think there is still upside to our 2006 EPS estimate of US$1.10, which includes two unidentified acquisitions (on each in 3Q and 4Q) in 2H06 versus the recent announcement of the acquisition of nine new facilities. Trading at only 20.3x our 2007 EPS estimate of US$1.40, at a significant discount to our expected long-term EPS growth rate of 25-35% (and our estimate for 27% 2007 EPS growth), we reiterate our Overweight rating and US$44 January 2007 price target based on a target multiple at the mid-point of our growth range. Risks to our price target are if the company fails to produce further growth through acquisitions or if samefacility margins do not continue to follow their current positive trajectory, our price target could prove too optimistic. Triad Hospitals Inc. Ticker: TRI US / TRI E 2007E Price (Local): US$ E 2007E Mkt Cap (US$): 3.4 bn Analyst: Andreas J Dirnagl EV/EBITDA (Calendar) Phone: (1-212) E 2007E andreas.j.dirnagl@jpmorgan.com We continue to be hopeful that given the acute care hospitals status as an extreme lagging economic indicator, a continuing stable and improving economy will lead to improved fundamentals as we head into 2H06/2007. We believe that TRI is particularly well positioned to take advantage of any turn in improving industry fundamentals (uptick in volumes and bad debt stabilization) given its focus on physician-relationships ( PLGs ), facility development and an active acquisition pipeline, which should likely result in it capturing incremental volume and leveraging top-line growth, resulting in expanded margins over time. We would note that TRI has among the most conservative bad-debt reserving policies amongst its peers, and accordingly, we believe the company s excess reserves may be a source of potential upside to earnings if, as we believe is likely, the economy continues to improve and self-pay accounts as a percentage of revenue improve in 2H06. Additionally, TRI maintains a relatively unleveraged balance sheet, and importantly has one of the most conservative management teams, which tends to preach the under-promise and over-deliver mantra. Given that TRI s shares are trading at 6.2x our 2006 EBITDA estimate on an EV/EBITDA basis, well below the hospital industry average of 7.1x, and its historical trading range of 7-9x, we believe the shares are attractive at current levels. Source: Company data, Bloomberg, JPMorgan estimates, JPMorgan SaVanT. Prices as of June 15,

6 Healthcare Services: Top Picks (cont d) Company Key Financials Rationale and Catalysts WellPoint Inc. Ticker: WLP US / WLP E 2007E Price (Local): US$ E 2007E Mkt Cap (US$): 45.7 bn Analyst: William D. Georges, J.D. EV/EBITDA (Calendar) Phone: (1-212) E 2007E william.d.georges@jpmorgan.com WellPoint is our top pick in managed care for 2006, as we see the stock offering a compelling investment story in 2006 and beyond. The company boasts of unmatched scale, with almost 35 million members, making it around the same size as Aetna, Cigna, Coventry and Humana combined in terms of membership. Moreover, it has leading fully-insured, self-funded, and specialty product capabilities. We believe WellPoint should be capable of producing EPS growth in the 15-20%+ range in both 2006 and 2007, given the expanded growth and synergy opportunities. We expect annual enrolment growth of at least 3% in 2006 and beyond. The company should generate US$250 million in annualized synergies in 2006 from the ATH merger. We estimate the new Medicare Part D drug benefit could add an incremental US$1.7 billion in revenue and about US$0.06 to EPS in 2006, with additional growth in We see the potential for additional upside to our estimates since we include only cost savings from the Anthem/WellPoint merger in our model and have not included the potential for significant revenue synergies. As the new WellPoint builds momentum, we expect additional revenue upside as it leverages its industry-leading market position and Blue brand name. We also have not included potential revenue synergies from the acquisition of WellChoice. The stock appears undervalued relative to its long-term EPS prospects and lower risk profile. UnitedHealth Group Ticker: UNH US / UNH E 2007E Price (Local): US$ E 2007E Mkt Cap (US$): 60.3 bn Analyst: William D. Georges, J.D. EV/EBITDA (Calendar) Phone: (1-212) E 2007E william.d.georges@jpmorgan.com Source: Company data, Bloomberg, JPMorgan estimates, JPMorgan SaVanT. Prices as of June 15, We think United s stock option overhang has created a unique opportunity for investors to buy the company s stock at an attractive valuation. While we acknowledge the possibility of additional downside in the event of a management ouster, which we do not believe is priced into the stock at current levels, the company s operations are sound and fundamentals intact, in our view. We believe the company has significant earnings momentum that, combined with a deep management pool, leads us to believe that it will weather the stock option storm, which should result in significant upside for the stock when the sky clears. United s medical cost trends continue to show a stable-to-downward bias at 7.5%, while premium yields track at or above cost trends, yielding a favorable price-cost spread the most important fundamental metric in the MCO business. We also expect to see accelerating growth in the commercial fee-based, Medicare, and specialty businesses. Part D initiatives showed strong momentum in their first quarter of operations with enrolment reaching 4.5 million and initial claims experience tracking favorably relative to United s internal forecasts, potentially providing some dry powder for earnings upside throughout the course of the year. SG&A continues to be an earnings lever, and we project a 70bps drop in this metric in 2006, which includes US$40 million in merger-related expenses and US$100 million in pharma sales by Prescription Solutions, which were both expensed in 1Q06. We believe UNH should produce EPS growth in the 15-17%+ range in both 2006 and We maintain our Overweight rating since it appears undervalued relative to the long-term EPS prospects and solid operational profile. 6

7 Healthcare Services: Stocks to Underweight Company Key Financials Rationale and Catalysts LifePoint Hospitals Inc. Rating: Underweight Fiscal EPS (Local): Year-end Dec. Ticker: LPNT US / LPNT E 2007E Exchange: NASDAQ P/E (Calendar) Price (Local): US$ E 2007E Mkt Cap (US$): 1.9 bn Analyst: Andreas J Dirnagl EV/EBITDA (Calendar) Phone: (1-212) E 2007E andreas.j.dirnagl@jpmorgan.com We believe LPNT continues to face significant merger integration challenges and are not convinced that its operational difficulties are a thing of the past. Additionally, we remain confused as to how management was able to turn things around so quickly given that its significantly reduced earnings guidance was issued only a couple of months ago. We believe management s decision to leave 2006 earnings guidance unchanged, despite the significant 1Q06 beat and optimistic 2H06 outlook, confirms our belief of its lack of conviction in any sustained operational recovery. Notably, LPNT continues to report one of the highest bad debt levels amongst its publicly traded peers, likely due to former PRV facilities that are located in areas that have a higher concentration of economically challenged patients. Additionally, we note that reported same store statistics do not include legacy PRV facilities, which continue to deteriorate significantly. From a valuation standpoint, LPNT s shares are trading at 7.0x our 2006 EBITDA estimate on an EV/EBITDA basis, at the low end of its historical range. While we acknowledge that shares at current levels may appear attractive to some, and that improving fundamentals would have a positive impact, given the number of moving parts we also believe that there are other stocks within our coverage universe that offer greater price appreciation at lower levels of risk. Molina Healthcare Rating: Underweight Fiscal EPS (Local): Year-end Dec. Ticker: MOH US / MOH E 2007E Price (Local): US$ E 2007E Mkt Cap (US$): 1.0 bn Analyst: William D. Georges, J.D. EV/EBITDA (Calendar) Phone: (1-212) E 2007E william.d.georges@jpmorgan.com While we believe MOH is implementing an appropriate strategy to rebuild medical margins by focusing on managed care basics including implementing more rigorous medical management controls, we still would wait to see whether the company can deliver consistent, stable MLR. We believe the risk in establishing and maintaining stable medical costs is heightened by the company s rapid growth strategy that is not coupled with appropriate systems and controls. MOH s stock is trading at a premium valuation to the group despite below-average growth prospects and an elevated risk profile. Its shares are trading at a 11% premium to the other Medicaid MCOs. We are currently modelling MOH to generate both revenue and earnings growth below the Medicaid industry average in 2006 and 2007 due partially to the company s lack of exposure to the Georgia managed care market in Given our view that MOH currently has both below-average growth prospects and above-average earnings risks, we assign an Underweight rating to the stock. Source: Company data, Bloomberg, JPMorgan estimates, JPMorgan SaVanT. Prices as of June 15,

8 JPMorgan Global Healthcare Services Team Research Equity Research Credit Research Andreas Dirnagl Healthcare Distribution, Hospitals / Long-Term Care Managed Care Small/Mid-Cap Healthcare Global Sector Coordinator Information Technology and Services Pharmacy Benefit Management Americas Americas Americas Americas Americas United States Lisa Gill Michael Minchak, CFA Atif Rahim United States Latin America AndreasDirnagl Dawn Brock Eric Hammelman Andrea Teixeira, CFA Adriana Velho United States Bill Georges United States Andreas Dirnagl Dawn Brock Eric Hammelman United States Arun N. Kumar, CPA (HG-Healthcare) Shivangi Shah (HG-Healthcare) David Common, CFA (HY-Healthcare) EMEA Pan Europe Nicola Martin Asia Pacific Asia Pacific Asia Pacific Japan Masayuki Onozuka Australia Alex Smith Australia Kazuyo Katsuma Kylie Reynolds Singapore Anuj Sehgal Alex Smith Kylie Reynolds 8

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