Obamacare mainly entails mandated expansion of Medicaid and Medicare coverage, statutory floor on medical loss ratios, restrictions on premium increases and pre-existing conditions, non-deductible healthcare industry tax, and the commoditization of individual health insurances as a result of insurance exchanges. As major provisions of Patient Protection and Affordable Care Act (PPACA) are implemented in 2013 and 2014, UnitedHealth Group (UNH) and WellPoint (WLP) are better positioned than their peers for upcoming changes. They both possess competitive advantages because of their scale, right customer mix, and sound management. They are very likely to become winners in the new era of healthcare. Both stocks are trading significantly below their fair value estimates calculated by my DCF models, which indicate that they are solid long-term investments. I recommend holding both stocks in equal positions.
Benefits of scale
Large national healthcare insurers benefit from economies of scale in three ways: health risk diversification, lower administrative cost per member, and greater bargaining power with healthcare providers. As it is shown in Table 1, UnitedHealth, WellPoint and its recent acquisition, Amerigroup (AGP), together insure or service 72.8 million Americans, close to a quarter of the U.S. population. This number dwarfs the total number of members insured or served by other major insurers: Humana (HUM), Aetna Inc (AET), which is acquiring Coventry (CVH), and Cigna Corp (CI). Premium revenues of UNH, WLP and AGP in the first nine months of 2012 sum up to be $122.6 billion, 1.7 times of that of the other four combined.
It is clear that both UNH and WLP reap such benefits of scale noted above. Simply speaking, insurers manage health risks by accurately predicting health cost trend and matching it up with premium increases to remain profitable. Medical loss ratio (MLR) measures medical expenses as a percentage of premium revenues. It generally reflects how well the risk is managed. UNH has the lowest MLR among the six largest health insurance companies. WLP has the lowest operating expenses per member among them.
In terms of bargaining power, UNH has most members in the health insurance industry. With the second biggest membership base, WLP has a strong regional presence in the fourteen states where it operates under its Blue Cross and Blue Shield brands. Therefore, both companies are able to negotiate better rates with physicians and hospitals than their smaller competitors. Anecdotally, Bloomberg reports on August 15, 2012 that WLP is voted least popular by hospital executives in an industry survey conducted by ReviveHealth. The article further notes that "WellPoint's tough stance may reflect the dominance of its Blue Cross plans in states where it operates, said Jason Gurda, a Leerink Swann & Co. analyst in New York." In this survey, UNH and WLP are both ranked poorly in terms of hospital payment rates. In other words, they too are less generous at paying hospitals than their peers.
Table 1. Key Metrics of Major Health Insurance Companies
Percentage of Risk-based Members
Total Number of Members
Medical Cost Ratio
Operating Expense per Member
EBIT Margin TTM
Note: Data is as of 9/30/2012 and sourced from 10-Qs , except for EBIT Margin TTM, which is as of 9/30/2012 but sourced from Morningstar.com. Numbers are in thousands for Total Number of Members and in millions for dollar amounts except for Operating Expenses per Member. Members are categorized as risk-based or fee-based to the best of my knowledge based on disclosures on segment information in their filings.
Balance between fee-based and risk-based business
PPACA, as well as the political atmosphere, makes health risk management very challenging for health insurers. Over the next few years, it is certain that hefty premium increases will be viewed with great scrutiny. Furthermore, since January 1, 2011, health insurers have been required to rebate the portion of premiums that exceed the statutory MLR limits. These limits are 80% for individual and small group plans and 85% for large group plans that cover more than 100 workers; self-insured plans are not subject to such limits.
As risk management becomes more difficult, insurance companies need to have a balanced mix between risk-based and fee-based business. The fee-based business is much less impacted by PPACA than the risk-based business from a risk perspective. This part of the business should provide a relatively stable income stream that is immune from missteps in risk management. However, given the stagnant job market, little near-term growth is expected from self-insured, fee-based clients. They are large-size companies, which are unlikely to grow their headcounts significantly over the next few years and usually resort to contractors before hiring full-time employees to avoid giving out health benefits.
The growth opportunity comes from the mandated inclusion of approximately 32 million uninsured Americans, who are currently uninsured due to poverty or pre-existing conditions. A strong presence in the risk-based business, particularly in Medicare Advantage and Medicaid, is much needed to capture this opportunity. Health insurance companies have moved fast on this. WLP acquired AGP primarily to boost its Medicaid exposure, following the Supreme Court ruling that upheld the mandated individual coverage on June 28, 2012. AET announced in August 2012 that it would acquire CVH, which specialized in Medicare Advantage and Medicaid.
Referring back to Table 1, UNH and WLP plus AGP have a healthy mix between risk-based and self-insured memberships, with risk-based members accounting for 44.32% and 51.88% of total members, respectively. HUM's business is heavily concentrated in the risk-based category and CI's exposure to risk-based business is too small. AET and CVH combined will have a membership mix fairly similar to that of WLP plus AGP, but 30% fewer members in total. Moreover, AET itself has a worrisome MLR of 88.53%, the highest among all six insurers.
Management and stock repurchases
Morningstar considers UNH's management team as "exemplary" in terms of corporate stewardship. Executive compensations seem reasonable and strongly correlate with financial performance, as share-based compensation has consistently been about 0.38% of the annual revenue between 2008 and 2012.
WLP's previous CEO, Angela Braly, stepped down in August 2012 under pressure from investors. In my opinion, John Cannon, the interim CEO, has been taking a very action-oriented approach on his position. He noted that "I'm very much focused on keeping us actively moving forward, and that includes addressing areas of clear opportunity to better position us for improved results under our permanent CEO" in the Q3 2012 earnings call. Under his leadership, WLP closed the AGP deal and reorganized business segments in the fall of 2012. Furthermore, WLP used to be criticized for not having a deep bench. This has changed as AGP's senior management is mostly retained for the Medicaid segment. As WLP is getting closer to find a permanent CEO, the market may be ready for a positive catalyst.
Being cash cows, both UNH and WLP will most likely continue aggressive stock buybacks. UNH's total shares outstanding decreased by about 4% y-o-y in each of the past three years, and WLP by more than 10% y-o-y. Stock repurchases are generally welcomed by the market.
For each stock, my model forecasts free cash flow for each of the next five years and calculates a terminal value in 2017 under three scenarios: base, bull and bear. Data on income statements and balance sheets is sourced from Morningstar.com or quarterly and annual filings by UNH and WLP. Below are some key assumptions and my justifications. Details of other model entries can be found here.
Both the health insurance industry tax and insurance exchanges will be implemented in 2014. According to UNH's website, industry experts estimate the industry tax to be about 2.3% of premium. This non-deductible tax may impact topline growth as UNH seeks to pass the tax to customers by increasing the premium. Insurance exchanges may facilitate market competitions and put pressure on revenue growth as well. In the base case, I assume that annual premium revenue growth drops from 8.42% in 2012 to 5.00% in 2015 and recovers to 6.00% by 2017. The bull case assumes that UNH is able to sustain the 8% annual premium revenue growth over the next five years in spite of the two provisions mentioned above. The bear case assumes the growth rate declines to 3.5% in 2015 and stays unchanged till 2017. To put these figures in perspective, national health spending is estimated to have a CAGR of nearly 7% in this decade, according to Zacks.com.
When it comes to MLR, the bull case assumes that UNH keeps it at the current level, 80.5%. The base case supposes an increase of 0.25 percentage point per year and the bear case predicts an annual increase of 0.75 percentage point. It is worth noting that MLR floors are already in effect and UNH's 2012 operating results should have fully reflected the impact. The only exception is the Medicare Advantage program, which is not subject to a MLR floor of 85% until 2014. Therefore, it is reasonable to expect that UNH will keep its MLR under control.
To be more conservative, I estimate the effective tax rate for both companies to increase by half a percentage point each year. I also set cost of equity to be 12% for both to reflect the level of uncertainty perceived by the market; companies of comparable size and similar financial health in other industries well deserve a cost of equity of 10%. I then use the WACC as the discount rate.
For cross-check, in the base scenario, UNH's EBIT margin decreases from 7.22% in 2012 to 6.71% in 2017 and its net margin decreases from 5.05% to 4.44% in 2017. FCFF over net income remains close to 110.12%, the 2012 level.
I further assume that FCFF of both companies grows at a perpetual annual rate of 2% after 2017. One might think that my estimate of the long-term growth rate of FCFF, 2%, is rather optimistic. However, the annual growth rate of U.S. GDP between 1947 and 2012 averaged about 3.25%. As long as the health insurance industry does not disappear but expand in the new era of Obamacare, both firms are fully capable of growing at a CAGR of 2% in the long run.
Table 2. Model Assumptions for UNH
Premium revenue growth
Effective tax rate
FCFF over net income
WLP's premium growth is estimated to be weaker than UNH, given that WLP's own premium revenue stayed the same in 2012. The base case assumes a very modest growth of 1% in 2013 and 2014 for WLP's legacy business and the growth rate improves to 2.5% in 2017. The bear case assumes no growth for 2013 and 2014 and the growth rate increases to 2% by 2017. Assumptions about WLP's MLR are similar to UNH in each of the three scenarios. I further assume that AGP's results are fully incorporated in financial statements of 2013 and onward. AGP's legacy business grows at an annual rate of 5% and its MLR is stable at 86.55%.
The base case projects that WLP's EBIT margin should decrease from 6.97% in 2012 to 6.08% in 2017 and its net margin worsen to 3.35% in 2017 from 3.85%. FCFF over net income stays close to 106.65%, the 2012 level. WLP's margins are projected to be slightly worse than UNH, which is consistent with the current state.
Table 3. Model Assumptions for WLP
Premium revenue growth - WLP
Premium revenue growth - AGP
MLR - WLP
MLR - AGP
Effective tax rate
FCFF over net income
UNH is trading at $54.32 while WLP at $62.48. As it is shown below, both offer significant upside potential with limited downside risks. Keep in mind that my model incorporates very conservative estimates on revenue growth, margins and discount rate for the bear case. I strongly recommend holding both stocks in equal positions as I cannot confidently predict which one of the two will perform better.
Meanwhile, I'm convinced that UNH and WLP should outperform HUM and AET in the long run. However, given CI's diversified business and global presence, I cannot yet come to a definitive conclusion on CI's relative performance to UNH and WLP.
Table 4. Fair value estimates for UNH
Fair value estimate per share
Table 5. Fair value estimates for WLP
Fair value estimate per share