Just as deregulation tends to boost industry-wide returns and valuation multiples, the imposition of regulations tends to spook investors and compress multiples. Certainly life has changed quite a bit for health insurance companies in the last four years, but Wall Street may yet be expecting a worst-case scenario that is unlikely to materialize. Although UnitedHealth (UNH) is facing more government influence and interference in its operations, UnitedHealth's scale and operational performance should allow it to still win in the end.
A Good Close To The Year
UnitedHealth is so big now that it doesn't actually turn on a dime. Nevertheless, there were definitely some encouraging developments this quarter.
Reported consolidated revenue rose about 8% (and more than 2% sequentially) as sluggish growth (up less than 2%) in the core managed care business was augmented by 54% growth in OptumHealth and 19% growth in OptumRx. Reported revenue growth at OptumInsight seemed non-existent, but this was due to the disposal of the clinical trials basis; on a like-for-like basis, revenue actually grew 18%.
Enrollment trends were pretty steady; overall enrollment picked up about half-a-percent sequentially and up 5% as a small sequential decline in commercial enrollment was offset by stronger results in Medicare and Medicaid.
Profitability was once again quite good. Although the commercial medical loss ratio fell 120bp sequentially, overall MLR improved by 100 basis points - suggesting a very good result in the Medicare business. Though utilization still remains weak (fewer people going to the doctor), UnitedHealth also saw good reserve development.
Overall, the company saw operating income increase almost 16%. The core managed care business was pretty steady, but the OptumInsight business saw a significant improvement in profitability. That said, this healthcare information business is a very small part of the whole and unlikely to be a major driver anytime soon.
More Deals Seem Likely
Like WellPoint (WLP), UnitedHealth built itself on deals and is not likely to stop looking. As Cigna (CI) decided to acquire HealthSpring, it is not improbable that other Medicare-heavy names like Universal American (UAM) and perhaps even Humana (HUM) could go into play.
After all, Medicare is a growth market (aging population and all that) and one that politicians dare not touch in a serious fashion. Moreover, government-mandated minimums on medical loss ratios are going to make the health insurance game more and more about scale and internal operating efficiency and it's hard to see how this won't lead to a market of just a few huge entities. With that in mind, assume that WellPoint, Aetna (AET), and UnitedHealth are all looking to shop on the right terms.
It's an open question as to whether this will hold true in Medicaid. This has never been as attractive of a market for large insurers, but that's not tantamount to saying that there is no money in it. On the right terms, Wellcare (WCG), Amerigroup (AGP) or Molina (MOH) could all likewise draw interest.
Building Out From A Strong Core
Perhaps the federal government won't allow major mergers in the managed care space; certainly it seems to defy conventional wisdom that an administration opposed to allegedly "big, evil insurance companies" to get bigger and, presumably, eviler. Even if that's the case, UnitedHealth still has some organic growth prospects.
While I said that OptumInsight isn't going to be a big contributor soon, that is not to say that the company couldn't invest more in this business and look to accelerate the growth. Healthcare information is a potential goldmine for not only insurance operators, but caregivers, employers, and healthcare companies as well. What's more, there's plenty of room to grow the pharmacy benefits business.
The Bottom Line
Wall Street still seems to be imposing a discount on this sector, something I attribute to the fact that the issue of healthcare reform is no way solved and off the table. Perhaps the Supreme Court (or a new Congress) will overturn major parts of the program, or perhaps even more intrusive regulations are on the way. Either way, Wall Street hates doubt and covers itself with a bigger discount.
On a cash flow basis, these shares seem exceptionally cheap. Assuming less than 5% free cash flow growth over the next 10 years suggests a huge discount to fair value; in fact, the stock seems undervalued based on no free cash flow growth at all.
Just as a double-check, I decided to treat UnitedHealth like a more traditional insurance business and run it through an excess returns model. Doing so with a long-term return on equity estimate of 18% (below the company's long term average but consistent with recent performance) suggests a fair value in the $60s - backing up the idea that Wall Street is still very much positioned for this story to go sour in the coming years. Given the strong management team and the essential nature of the services, that seems like a good contrarian bet to take.