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Stocks of health insurers have had a stellar year so far. As seen in Chart 1, all five major players in the industry outperformed the market by a great margin. My article published on 1/20/2013 recommended holding UnitedHealth (UNH) and WellPoint (WLP), the biggest two among the big five, the rest of which are Aetna (AET), Cigna Corp. (CI) and Humana (HUM). I could not have wished better reward from the market: WLP has returned 30% since 1/21 whereas UNH 21%, both of which are much higher than the 10% gain posted by S&P 500 over the same time period.

In light of recent events related to Obamacare, I examined the key provisions that will come in effect in 2014 and analyzed their potential impacts on the fundamentals of these firms. My updated model now incorporates the impact of Obamacare provisions in 2014. It now appears that UnitedHealth is still undervalued compared to WellPoint and Aetna; the latter two are trading near their fair values.

Chart 1. Health Insurers' Stock Performance

(click to enlarge)

Source data: Ycharts.com

Market Performance Review

Health insurance stocks tumbled in late February in response to a proposal to lower the payment rates for Medicare Advantage in 2014. Medicare Advantage is a program offered by private insurance providers as an alternative to the publicly administered Medicare program. Insurance providers are paid by the government, not the beneficiaries, to offer coverage similar to the Medicare program. Payment rates are announced ahead of time by the Center for Medicare and Medicaid Services ("CMS"). The losses were quickly recovered at the beginning of April when it was announced that payment rates would in fact increase by 3.3% in 2014, as opposed to the proposed cut of 2.2%. This stock-moving tip was leaked to Wall Street prior to market open on 4/1/2013 and the leakage triggered a Federal investigation. That said, health insurance stocks continued the rally as all uniformly reported strong first quarter results and most raised full-year outlook, such as WellPoint, Aetna and Cigna.

In retrospect, the market has clearly viewed the exposure to risk-based business as purely risk factors. As seen in Table 2, CI, AET and WLP perform noticeably better than UNH and HUM. UNH and HUM have higher exposure to risk-based business than the others by these three measures: percentage of risk-based membership over total members, Medicare Advantage exposure estimated by Credit Suisse, and percentage of premium revenue over total revenue.

Table 1. Key Statistics of Health Insurers

Company

Total Medical Members

Risk-based membership percentage

Medicare Advantage Exposure

Premium Revenue Percentage in 2012

Medical Cost Ratio in 2012

Price Return since 1/21

CI

14,045

22.17%

15.00%

61.39%

79.59%

29.21%

AET+CVH

23,604

42.55%

11.00%

88.03%

84.07%

30.86%

WLP

36,130

44.16%

n/a

91.55%

85.58%

30.20%

UNH

36,500

51.82%

28.00%

90.16%

80.44%

20.60%

HUM

12,089

89.53%

59.00%

94.59%

83.72%

17.16%

Comment: Data is as of 12/31/2012. Figures are in thousands for # of members and in millions for dollar amounts. CI's premium revenues and medical costs are of its Global Health Care segment only but include international operations. WLP's F2012 results have fully incorporated Amerigroup (AGP). Medicare Advantage Exposure was estimated by Credit Suisse and reported here. Other data is sourced from Morningstar.com or 10-K filings.

In January, I proposed that firms with a balanced mix between risk-based business and fee-based business are more likely to perform well in the long term. For instance, WLP and UNH both have their membership mix close to 50/50. I continue to maintain this view. What is more, I would like to add AET to the watch list since its membership mix is not far from half-and-half either. The combined entity of Aetna and Coventry (CVH) has the third largest membership base, resulting in economy of scale. As of December 2012, these three insurers together insure or service 96 million Americans, 30 percent of the U.S. population and 36 percent of the insured Americans. On the contrary, CI and HUM are two extreme cases. Cigna has a clear growth focus on business diversification and international expansion. Its international operations post some difficulties in building up valuation models with high-conviction growth estimates. Humana's performance is simply too volatile to model, given its heavy reliance on government payments to its Medicare business.

Modeling the impact of 2014 provisions

2014 is the defining year of Obamacare. There are two provisions that will be in effect and potentially drive up costs for the industry. Firstly, an industry-wide annual, non-tax deductible fee will be levied on big health insurers, starting at $8 billion for the whole industry in 2014 and rising to $14.3 billion by 2018. Secondly, state-run insurance exchanges are expected to open on 10/1/2013. These exchanges offer health insurance plans with coverage in 2014. As a result, health cost is predicted to rise sharply in 2014. CMS predicted the national health care expenditure to increase by 7.4% in 2014, up from 3.8% in 2013. PwC forecasted an increase of 6.4% for 2014.

I am not too worried about the impact of industry fees on health insurers because they should be able to pass the major portion of these fees to consumers by simply marking up the premium. According to UNH's website, industry experts estimate the healthcare tax to be about 2.3% of premium. Since states typically scrutinize premium increases above 10%, it should not be too difficult for health insurers to get approvals from state legislators on the two percentage point increase on premium. However, just to be more conservative, I assume half a percentage point increase on the effective tax rate for each of the next five years in my models.

On the contrary, the establishment of health insurance exchanges warrants a valid concern on costs. Patient Protection and Affordable Care Act (PPACA) intends to create two types of exchanges: One is for qualified individuals, who typically have pre-existing conditions or modest income, to purchase plans and receive income-based subsidies. The other is for qualified small businesses to purchase coverage for their employees. A WSJ front-page article reported on 6/19/2013 that small-business exchanges show signs of early setbacks and that there is a lack of interest among insurance carriers to participate in exchanges. Such observations are echoed by Politico, Bloomberg and Reuters. In short, health insurance companies are worried that the first group that will flock to the exchanges are the most costly to insure. Facing high uncertainty on the cost side, insurance companies see little benefits in expanding through exchanges and confine their participations to states where they already have a presence.

The coverage expansion through exchanges is expected to be the primary force driving up medical cost in 2014, according to the following projection made by CMS.

In 2014, national health spending is projected to rise to 7.4 percent, or 2.1 percentage-points faster than in the absence of reform, as the major coverage expansions from the Affordable Care Act (ACA) are expected to result in 22 million fewer uninsured people (compared to estimates that exclude the law's impacts). Increases in Medicaid spending growth of 18.0 percent and private health insurance growth of 7.9 percent both contribute to this overall acceleration in national health spending in 2014. Conversely, out-of-pocket spending is projected to decline 1.5 percent as third-party coverage will cover expenses previously paid by consumers out of pocket. Because the newly insured populations are anticipated to be relatively younger and healthier than currently insured individuals they are expected to devote a greater proportion of their spending to prescription drugs and physician & clinical services, and a smaller proportion of their spending to more acute care, such as hospital care. Consequently, prescription drug spending growth is projected to reach 8.8 percent in 2014 (4.7 percentage-points faster than in the absence of reform) and spending on physician and clinical services is projected to grow at 8.5 percent (3.2 percentage-points faster than in the absence of reform). On the other hand, hospital spending growth is projected to reach 6.7 percent, just 1 percentage-point faster than in the absence of reform.

(click to enlarge)

Source data: CMS historical data and projection.

These projections made by CMS provide a point of reference for me to quantify how rising healthcare spending would impact medical cost ratios. In the worst scenario, suppose that managed care companies are only able to raise premium by the growth rate of nominal GDP, whereas their medical costs grow as projected above between 2013 and 2017, the medical cost ratios can be projected as follows. On average, the medical cost ratio may worsen by about 2.3 percentage points over the next 5 years.

Table 2. Projected Medical Cost Ratios under the Worst-Case Scenario

Year

2012

2013

2014

2015

2016

2017

2017 minus 2012

Projected annual percentage change of National Health Expenditures

n/a

3.79%

7.36%

5.67%

6.25%

5.94%

Projected annual percentage change of Nominal GDP

n/a

4.40%

5.10%

5.70%

5.60%

5.30%

UNH

80.44%

79.97%

81.69%

81.67%

82.17%

82.68%

2.24%

WLP

85.58%

85.08%

86.91%

86.89%

87.42%

87.96%

2.38%

AET+CVH

84.07%

83.58%

85.38%

85.35%

85.88%

86.41%

2.34%

Source data: Health expenditures and GDP growth rates are quoted from CMS projection. Medical cost ratios in 2012 are calculated from 10-K filings for UNH, WLP, AET and CVH, respectively.

There are two reasons why I think the above case is the worst-case scenario. First of all, it is likely that the implementation of exchanges will be further delayed on the state level and the impact will be realized in late 2014 or even 2015. CMS has been lowering its projections on health expenditures since its initial estimation in April 2010, quoting reasons such as the prolonged recovery and the lowered growth assumptions for public health programs. The current projections, upon which the worst-case MCRs are calculated, assume 12.3 million people will obtain coverage through exchanges in 2014, including 3.1 million newly insured (Page 2, bottom graph of the CMS projection). I doubt that many individuals will participate in exchanges in the first year, especially since the enforcement of a key penalty provision was delayed until 2015 according to the WSJ article on 7/3/2013. This provision penalizes businesses that hire 50 or more employees but do not offer health benefits.

In addition, I believe that health insurance companies are able to contain costs so that their medical cost ratios will not deteriorate to the extent illustrated above. For the record, all five health insurance providers reported favorable medical cost trends for the first quarter of 2013. What is more, employers are also motivated to keep healthcare cost down. According to PwC, large corporations have taken a few measures to control medical costs. For instance, offering high deductible plans is a very effective way to make beneficiaries more cost-conscious. The below graph shows that average deductibles of in-network visits have almost doubled since 2009. 17 percent of employers surveyed only offer high-deductible plans and 44 percent of employers surveyed are considering doing so in 2014. In the meantime, WSJ reported on 5/20/2013 that small business owners are looking at offering high deductible, low premium health plans that meet minimum requirements of PPACA.

Chart 3. Average Deductibles for Hospital Visits

(click to enlarge)

To conclude, I smooth out the projected MCRs under the worst-case scenario for each of the three companies. As illustrated in Table 3, for the base-case scenario, I assume that on average MCR increases by 0.25 each year till 2017. I assume no MCR deterioration under the bull case. I also project greater increases in MCRs for UNH than the other two firms because of its higher exposure to Medicare and Medicaid.

Table 3. Medical Cost Ratio Projections for UNH, WLP and AET

UNH

Year

2012

2013

2014

2015

2016

2017

2017 minus 2012

Base

80.44%

81.50%

82.50%

82.75%

83.00%

83.25%

2.81%

Bull

80.44%

80.50%

80.50%

80.50%

80.50%

80.50%

0%

Bear

80.44%

81.50%

83.00%

83.50%

84.00%

84.50%

4.06%

WLP

Year

2012

2013

2014

2015

2016

2017

2017 minus 2012

Base

85.58%

85.75%

86.25%

86.50%

86.75%

86.75%

1.17%

Bull

85.58%

85.50%

85.50%

85.50%

85.50%

85.50%

0%

Bear

85.58%

86.00%

86.75%

87.25%

87.75%

88.00%

2.42%

AET+CVH

Year

2012

2013

2014

2015

2016

2017

2017 minus 2012

Base

84.12%

84.00%

84.75%

85.00%

85.25%

85.50%

1.38%

Bull

84.12%

84.00%

84.00%

84.00%

84.00%

84.00%

0%

Bear

84.12%

84.50%

85.50%

86.00%

86.25%

86.50%

2.38%

Valuations

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. I keep the perpetual growth rates of free cash flow after 2017 at 2% and cost of equity at 12%, the same as my previous model. Data on income statements and balance sheets is sourced from Morningstar.com or quarterly and annual filings by UNH, WLP, AET and CVH. AET finished its acquisition of Amerigroup in 2012, and I made necessary adjustments in the model. I also manually adjusted certain financial figures of Aetna and Coventry in my model, because the merger of these two was completed in May 2013. Below are some key assumptions and my justifications. Details of other model entries, including how the merger and the acquisitions are handled, can be found here.

UnitedHealth

I keep the same growth projections as those used in my model in January, except for 2013 figures. I assume decent revenue growths in all three scenarios because UnitedHealth has been able to sustain its top line growth in mid to high single digits since 2008. Furthermore, its strong presence in public programs should support revenue growth, albeit raising medical costs. In 2013, its revenue grew 11% y-o-y in the first quarter and the full-year outlook on revenue growth is 10%, which makes the growth rate of 9% in the base case an easy target to beat. Tax rates are expected to increase due to the industry tax in 2014.

For cross-check, the base case predicts net margin to decrease from 5% in 2012 to 3.81% in 2017. FCFF over revenue decreases from 5.50% to 4.37% in 2017. Both reflect the margin contraction due to rising medical costs. FCFF over net income remains close to 110.12%, the 2012 level.

Table 4. Model entries for UNH

Year

2012

2013

2014

2015

2016

2017

Premium Revenue growth - Base

9.00%

6.50%

5.00%

5.50%

6.00%

Premium Revenue growth - Bull

10.00%

8.00%

8.00%

8.00%

8.00%

Premium growth - Bear

6.50%

5.00%

3.50%

2.00%

2.00%

Tax rate

33.46%

35.00%

35.50%

36.00%

36.50%

37.00%

Net margin

5.00%

4.89%

4.29%

4.13%

3.97%

3.81%

FCFF growth

7.57%

-5.22%

1.49%

1.91%

2.32%

FCFF over revenue

5.50%

5.44%

4.84%

4.68%

4.52%

4.37%

FCFF over net income

110.12%

111.30%

112.88%

113.39%

113.93%

114.50%

WellPoint

I keep the same growth projections as those used in my model in January. WellPoint completed its acquisition of Amerigroup before 12/31/2012. Therefore, its balance sheet reflects the combined results of both firms. Table 5 shows the projected growth rates for WLP's stand-alone business under each of the three scenarios, respectively, whereas the legacy AGP business is expected to grow at 5% per year in all three cases. Table 3 lists the projected MCRs for WLP's stand-alone business. I assume medical cost ratio for AGP's legacy operation to remain at 86.55%, its 2012 level. For the combined entity, my model assumes that the ratio of SG&A over total revenue to decrease from 13.5% in 2013 to 13.10% in 2017, reflecting operating cost reduction from the acquisition. Total revenue for WLP is projected to be $71.4 billion in 2013, near the low end of the 2013 revenue outlook provided by the firm. Tax rates for the combined entity are assumed to increase from 33% in 2013 to 35% in 2017. The 27.08% y-o-y growth of FCFF in 2013 is due to the AGP acquisition.

For cross-check, under the base case, net margin is predicted to decrease from 4.30% in 2012 to 3.21% in 2017. FCFF over revenue decreases from 3.57% to 3.37% in 2017. Both reflect the margin contraction due to rising medical costs. FCFF over net income stays between 105% and 108%. The ratio of 82.87% in 2012 is abnormal due to the acquisition in 2012, as the ratio was 107.97% in 2011.

Table 5. Model entries for WLP

Year

2012

2013

2014

2015

2016

2017

WLP Premium Revenue growth - Base

1.00%

1.00%

2.00%

3.00%

4.00%

WLP Premium Revenue growth - Bull

2.00%

3.00%

4.00%

5.00%

6.00%

WLP Premium growth - Bear

0.00%

0.00%

1.00%

1.50%

2.00%

Tax rate

31.30%

33.00%

33.50%

34.00%

34.50%

35.00%

Total Revenue Growth (WLP+AGP)

1.20%

1.53%

2.38%

3.22%

4.06%

Net margin

4.30%

3.64%

3.41%

3.30%

3.19%

3.21%

FCFF growth

27.08%

-4.03%

-1.67%

-1.27%

3.01%

FCFF over revenue

3.57%

3.92%

3.70%

3.56%

3.40%

3.37%

FCFF over net income

82.87%

107.56%

108.70%

107.71%

106.52%

104.93%

Aetna

Aetna and Coventry merged in May 2013. I assume that the premium revenue of the post-merger entity grows 3% each year in the base case, 6% in the bull case and 1% in the bear case. Table 3 lists the projected MCRs for the combined entity of AET and CVH. I set the ratio of SG&A over total revenue to be 18% per management post-merger guidance. Tax rates are projected to increase due to the health insurance tax. The 45.83% y-o-y growth of FCFF in 2013 is due to the merger.

For cross-check, under the base case, net margin is predicted to decrease from 4.53% in 2012 to 3.50% in 2017. FCFF over revenue decreases from 4.06% to 3.24% in 2017. Both reflect the margin contraction due to rising medical costs. FCFF over net income stays around 93%, relatively close to 89.51%, the 2012 level.

Table 6. Model entries for AET

Year

2012-12

2013

2014

2015

2016

2017

Premium Revenue growth - Base

3.00%

3.00%

3.00%

3.00%

3.00%

Premium Revenue growth - Bull

6.00%

6.00%

6.00%

6.00%

6.00%

Premium growth - Bear

1.00%

1.00%

1.00%

2.00%

2.00%

Total Revenue growth (AET+CVH)

3.00%

3.00%

3.00%

3.00%

3.00%

Tax rate

35.50%

36.00%

36.50%

37.00%

37.50%

Net margin

4.53%

4.40%

3.96%

3.81%

3.65%

3.50%

FCFF growth

45.83%

-7.94%

-1.31%

-1.45%

-1.60%

FCFF over revenue

4.06%

4.14%

3.70%

3.55%

3.40%

3.24%

FCFF over net income

89.51%

94.14%

93.49%

93.23%

92.94%

92.64%

Conclusion

Below are fair estimates generated by my valuation model. As it is shown, there is still noticeable upside for UNH. WLP and AET are trading at a small premium to their fair value estimates. Their risk/reward profiles warrant a buy rating on UNH and a hold on WLP and AET.

Most importantly, my model sets cost of equity at 12% for all three stocks to account for uncertainty surrounding Obamacare, while corporations that operate on a similar scale in other industries well deserve a cost of equity of 10%. We hope to know a lot more about the implementation of the exchanges over the next few quarters. As illustrated in my analysis, the downside impact on costs is limited. The surprise may very well be on the upside. Therefore, it is optimal to hold positions in these three stocks for the rest of this year. If you are considering building a position in health insurance stocks now, UNH clearly offers a better risk/reward profile than the other two.

UNH Valuation

Bull case

Base case

Bear case

Fair value estimate per share

$119.70

$79.73

$59.02

Terminal EV/E

17.06

17.72

18.27

Terminal EV/CFO

13.33

12.69

12.23

Terminal EV/S

0.92

0.68

0.56

Fair value P/E

22.48

14.98

11.09

Fair value P/CFO

17.37

11.57

8.56

Fair value P/S

1.12

0.75

0.55

Upside/Downside potential

76.44%

17.52%

-13.01%

Upside/Downside potential ($)

$51.86

$11.89

-$8.82

WLP Valuation

Bull case

Base case

Bear case

Fair value estimate per share

$104.04

$81.13

$61.96

Terminal EV/E

15.55

15.85

16.21

Terminal EV/CFO

12.39

12.11

11.74

Terminal EV/S

0.57

0.51

0.44

Fair value P/E

11.99

9.35

7.14

Fair value P/CFO

11.60

9.04

6.91

Fair value P/S

0.52

0.40

0.31

Upside/Downside potential

23.46%

-3.73%

-26.47%

Upside/Downside potential ($)

$19.77

-$3.14

-$22.31

AET Valuation

Bull case

Base case

Bear case

Fair value estimate per share

$93.18

$61.09

$43.32

Terminal EV/E

14.24

14.01

13.78

Terminal EV/CFO

12.28

11.68

11.12

Terminal EV/S

0.63

0.49

0.40

Fair value P/E

19.00

12.45

8.83

Fair value P/CFO

17.29

11.33

8.04

Fair value P/S

0.86

0.56

0.40

Upside/Downside potential

46.61%

-3.89%

-31.85%

Upside/Downside potential ($)

$29.62

-$2.47

-$20.24

Source: Buy UnitedHealth And Hold WellPoint And Aetna To Capitalize On Obamacare