UnitedHealth Group's Free Cash Flow Generation Impresses

| About: UnitedHealth Group (UNH)


UnitedHealth's revenue is on the rise, increasing ~20% to ~$160 billion in 2015, and it is expected to hit ~$180 billion in 2016.

UnitedHealth is leaving most of its Obamacare exchanges, which is expected to cause a ~$650 million loss in its exchange business.

We'll be paying very close attention to how any changes in the healthcare landscape brought about by a new Trump administration may impact United Health's business dealings.

Let's take a look at the firm's investment considerations as we walk through the valuation process and derive a fair value estimate for shares.

Click to enlarge

By The Valuentum Team

There's a whole lot to like about UnitedHealth (NYSE:UNH), as the largest insurance provider in the US with two primary business platforms: 'UnitedHealthcare' (provides health benefits) and 'Optum' (for health services). Its revenue is on the rise, increasing ~20% to ~$160 billion in 2015, and it is expected to hit ~$180 billion in 2016. Most of the revenue growth is coming from Optum, as Optum's revenue grew by ~40% in 2015 and its backlog by 20%; we expect strong expansion to continue. Management expects EPS to advance strongly in 2016, and we're huge fans of its free cash flow, which has averaged ~$6.8 billion during the past 3 years (2013-2015), accelerating to $8.2 billion in 2015.

UnitedHealth is leaving most of its Obamacare exchanges, which is expected to cause a ~$650 million loss in its exchange business. Acquisitions will remain an important part of the company's growth strategy (its goodwill balance stands at $50+ billion), as it continues to scoop up assets (selection and overpayment risk are high). However, we are very pleased with UnitedHealth's deal making in light of portfolio benefits and strong incremental free cash flow generation. Competition from other companies including Aetna, Anthem (NYSE:ANTM) and Cigna (NYSE:CI) pose threats, but with financial resilience, UnitedHealth's foundation is solid. Share repurchases will continue to eat up capital, and long-term debt stood at ~$26 billion at the end of the third quarter of 2016.

At last check, United Health registered a 2.4 Dividend Cushion ratio; with annual dividend growth of 30%+ (2010-2015), future hikes should be expected. Growth from the current dividend yield of 1.6% will be a welcome change. Though perhaps less significant for a company with such a robust Dividend Cushion ratio as that of United Health, capital requirements have the potential to weigh on its dividend potential, but the firm's tremendous free cash flow generation should have no trouble handling such obligations, in our view. We'll be paying very close attention to how any changes in the healthcare landscape brought about by a new Trump administration may impact United Health's business dealings.

Image source: Valuentum

Image source: Valuentum

UnitedHealth Group's Investment Considerations

Image source: Valuentum

Investment Highlights

• UnitedHealth Group is diversified healthcare and well-being company, and the firm provides health care benefits to a wide range of customers in an array of markets. Its two business platforms operate through four segments: UnitedHealthcare, OptumHealth, OptumInsight, and OptumRx. The company was founded in 1974 and is headquartered in Minnesota.

• The firm's UnitedHealthcare segment can be broken down into three operating divisions: Employer & Individual, Medicare & Retirement, and Community & State. UnitedHealth is the largest health insurance provider in the US.

• The company's Optum businesses, which focus on improving the healthcare system itself, have been performing extremely well as of late. In the second quarter of 2016, for example, Optum revenues jumped 52% on a year-over year basis, and revenue at each Optum business increased by at least 18%. UnitedHealthcare has consistently grown revenue at a low double-digit rate as well in recent quarters.

• After experiencing losses on the exchanges, UnitedHealth announced in early 2016 that it plans to leave the majority of the Affordable Care Act markets in which it has operated after concluding that it can no longer serve it on an effective and sustained basis. The exchanges business accounts for a relatively small portion of its overall portfolio.

• After a strong start to 2016, UnitedHealth has upped its earnings guidance. The firm now expects adjusted earnings per share for the year to be in a range of $7.75-$7.95 compared to initial guidance of $7.60- $7.80.

Business Quality

Image source: Valuentum

Economic Profit Analysis

In our view, the best measure of a firm's ability to create value for shareholders is expressed by comparing its return on invested capital with its weighted average cost of capital.

The gap or difference between ROIC and WACC is called the firm's economic profit spread. UnitedHealth Group's 3-year historical return on invested capital (without goodwill) is 10.8%, which is above the estimate of its cost of capital of 9.8%. As such, we assign the firm a ValueCreation™ rating of GOOD.

In the chart below, we show the probable path of ROIC in the years ahead based on the estimated volatility of key drivers behind the measure. The solid grey line reflects the most likely outcome, in our opinion, and represents the scenario that results in our fair value estimate.

Image source: Valuentum

Image source: Valuentum

Cash Flow Analysis

Image source: Valuentum

Firms that generate a free cash flow margin (free cash flow divided by total revenue) above 5% are usually considered cash cows. UnitedHealth Group's free cash flow margin has averaged about 5% during the past 3 years. As such, we think the firm's cash flow generation is relatively STRONG.

The free cash flow measure shown above is derived by taking cash flow from operations less capital expenditures and differs from enterprise free cash flow (FCFF), which we use in deriving our fair value estimate for the company. At UnitedHealth Group, cash flow from operations increased about 39% from levels registered two years ago, while capital expenditures expanded about 39% over the same time period.

Valuation Analysis

We think UnitedHealth Group is worth $133 per share with a fair value range of $106-$160.

The margin of safety around our fair value estimate is derived from an evaluation of the historical volatility of key valuation drivers and a future assessment of them. Our near-term operating forecasts, including revenue and earnings, do not differ much from consensus estimates or management guidance. Our model reflects a compound annual revenue growth rate of 7.8% during the next five years, a pace that is lower than the firm's 3-year historical compound annual growth rate of 12.4%.

Our model reflects a 5-year projected average operating margin of 7.4%, which is below UnitedHealth Group's trailing 3-year average. Beyond year 5, we assume free cash flow will grow at an annual rate of 3.1% for the next 15 years and 3% in perpetuity. For UnitedHealth Group, we use a 9.8% weighted average cost of capital to discount future free cash flows.

Image source: Valuentum

Image source: Valuentum

Click to enlarge

Image source: Valuentum

Margin of Safety Analysis

Image source: Valuentum

Our discounted cash flow process values each firm on the basis of the present value of all future free cash flows. Although we estimate the firm's fair value at about $133 per share, every company has a range of probable fair values that's created by the uncertainty of key valuation drivers (like future revenue or earnings, for example). After all, if the future were known with certainty, we wouldn't see much volatility in the markets as stocks would trade precisely at their known fair values.

Our ValueRisk™ rating sets the margin of safety or the fair value range we assign to each stock. In the graph above, we show this probable range of fair values for UnitedHealth Group. We think the firm is attractive below $106 per share (the green line), but quite expensive above $160 per share (the red line). The prices that fall along the yellow line, which includes our fair value estimate, represent a reasonable valuation for the firm, in our opinion.

Future Path of Fair Value

Image source: Valuentum

We estimate UnitedHealth Group's fair value at this point in time to be about $133 per share. As time passes, however, companies generate cash flow and pay out cash to shareholders in the form of dividends. The chart to the right compares the firm's current share price with the path of UnitedHealth Group's expected equity value per share over the next three years, assuming our long-term projections prove accurate.

The range between the resulting downside fair value and upside fair value in Year 3 represents our best estimate of the value of the firm's shares three years hence. This range of potential outcomes is also subject to change over time, should our views on the firm's future cash flow potential change.

The expected fair value of $172 per share in Year 3 represents our existing fair value per share of $133 increased at an annual rate of the firm's cost of equity less its dividend yield. The upside and downside ranges are derived in the same way, but from the upper and lower bounds of our fair value estimate range.

This article or report and any links within are for information purposes only and should not be considered a solicitation to buy or sell any security. Valuentum is not responsible for any errors or omissions or for results obtained from the use of this article and accepts no liability for how readers may choose to utilize the content. Assumptions, opinions, and estimates are based on our judgment as of the date of the article and are subject to change without notice.

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.