Shares of UnitedHealth Group (NYSE:UNH) have climbed with the broad market throughout the year, and now trade at a 52-week high. UNH trades at a trailing P/E of 22.7 compared to its 5-year average of 13.8, and at a slight premium to peers on a forward P/E basis (17.9 vs. managed care industry average of 16.5). The premium over peers is justified: As the largest health insurer in the US and one of the largest pharmacy benefit managers the firm has meaningful scale advantages over rivals. UNH also has a better growth profile, thanks to the rapid expansion of its Optum division.
But the sizable premium above historical valuations gives us pause, given the uncertainty that permeates the managed care space as a result of healthcare reform. According to Morningstar, the MCO industry will now "encompass a significantly greater degree of transparency, competition, and costs that will weigh on pricing and margins". UNH is the gold standard in the managed care space, and has attractive growth prospects thanks to a secularly aging population and a thriving Optum division. But we would wait until after the election before deciding whether or not to invest in UnitedHealth. A Trump victory would introduce another wave of change in the sector, and we feel it is worth waiting to get a better feel for the healthcare landscape going forward.
UNH is better positioned than most to deal with the challenges posed by healthcare reform. Like its peers, UNH has raised premiums in an effort to mitigate non-deductible fees and government-mandated floors on loan loss ratios (medical costs as a percentage of premium revenues). But MCOs only have so much pricing power, and they must find other ways to protect margins when their ability to cut medical costs becomes compromised. UNH's operating margins have gradually eroded in recent years, from 8.35% in 2010 to 7% last year. However healthcare reform has had less of an impact on UNH's profitability compared to some of its rivals. UnitedHealth benefits from meaningful scale advantages. The company can spread fixed costs across its massive membership base (46 million members in the MCO network) to reduce unit costs and generate positive economic profits as long as membership volumes grow, which they continue to do thanks to the Affordable Care Act. UNH also benefits from scale in the Optum segment. OptumRX is the nation's third largest pharmacy benefit manager, serving approximately 115 million members. UNH bolstered its position in the space through last year's acquisition of Catamaran, the fourth largest player. Thanks to its size, UNH has can negotiate favorable drug pricing with suppliers, which allows it to provide low cost products and expand the customer base without sacrificing margins.
UnitedHealth's expanding Optum segment will be crucial for offsetting challenges in the core MCO business. Since 2011, Optum sales have increased at a CAGR of 23%, and the combination of pricing advantages and population ageing should propel growth for years to come. S&P predicts total sales for UNH will increase 16% in 2016, thanks to 20% growth at Optum. It helps that this segment, which is less subject to profit-eroding legislation and competition than the MCO business, will comprise a larger share of total firm revenues as the segment grows. This should help offset pressures in the managed care segment and keep margins stable. In 2015, operating income at Optum accounted for approximately 39% of consolidated operating income. S&P expects this segment to eventually comprise 45% of operating earnings.
UnitedHealth Group is the best of breed in the managed care space, but there is still a lot of uncertainty surrounding how well UNH will be cope with the increased regulation, transparency, and competition in its core businesses. Fortunately, UNH has insulated itself from some of this risk by expanding into other businesses lines with more attractive economics. While we believe that UNH will benefit over time from favorable secular trends in healthcare, it is worth waiting until after the election to get a clearer perspective on the outlook going forward. Despite the added costs, many analysts see healthcare reform as a net positive for the managed care industry. But this is built upon the assumption that the ACA will lead to continued growth of the customer base as previously uninsured individuals obtain coverage. If Trump wins in November he will most likely reverse this legislation. Of course, every investment decision depends upon your time horizon, but we believe investors should wait until UNH falls closer to historical levels.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.