Since the Supreme Court upheld the constitutionality of PPACA as a tax, healthcare insurers have declined in value. UnitedHealth (UNH), Aetna (AET), and WellPoint (WLP) have depreciated by 7.5%, 9.7%, and 9.8%, respectively, since the ruling while the S&P 500 has risen by 11.4%.
And for good reason: these firms will have to deal with more burdensome regulations and accept high-risk individuals into their insurance pools. This will drive up premiums and eliminate consumer options by grouping more individuals of high-risk backgrounds with those of healthy background. Greater oversight from the federal government and an expansion of Medicaid will further add headwinds to value creation. With that said, I believe the market reaction has been overblown in light of the industry's low multiples. Below, I review the fundamentals - the pros and cons - of UnitedHealth, Aetna, and WellPoint.
UnitedHealth released 2Q performance in yesterday's earning call, and the results showcased strong growth. Consolidated medical ratio of 81.3% beat expectations as momentum continued in UnitedHealthcare and Optum, particularly in regard to pharmacy services. Government programs at UnitedHealth are improving while Medicaid is doing a little worse. Total enrollment in health plans were up 5% to 35.9M, thanks in large part to the XL health acquisition. As a whole, performance was so strong that management yet again boosted full year EPS guidance.
Analysts currently rate UnitedHealth around a "buy" and expect solid growth in the years ahead. EPS is expected to grow around 31% from 2011 to $6.22 in 2014. At a 13x multiple, the company would have a future stock value of $80.86. Discounting backwards by 10% yields a present value of $60.75, which doesn't offer a spectacular margin of safety.
Some have argued that healthcare reform approval will be beneficial to the industry, since it supposedly reduces uncertainty. With a leading moat in its field, UnitedHealth stands to particularly benefit if that sentiment is true. But the fact is that the company has underperformed since the SCOTUS ruling. I believe it has underperformed because investors have been distracted from the more important issues at hand, like the upcoming contract awards from Ohio, Washington, Michigan, New York, Texas, and Florida.
Aetna is the cheapest companies highlighted in this article from a multiples standpoint. It trades at just a respective 7.3x and 6.7x past and forward earnings with a dividend yield of 1.8%. The PEG ratio currently stands at 0.68, which means future growth is not being properly factored into the stock price. Analysts currently expect EPS to grow by 10.9% annually over the next 5 years. This compares to 12% over the past 5.
If consensus estimates hold true, Aetna will have 2016 EPS of around $7.61, which, at a 12x multiple, translates to a future stock value of $91.31. Discounting backwards by a rate of 10% yields a present value of $56.70, which provides more than a 50% margin of safety to the growth story. Only at a 19% discount rate would Aetna's current valuation be justified. Accordingly, I recommend investors open a long position.
The recently announced Teacher Retirement System of Texas contract will add $0.06 to 2013 EPS through a contribution of $600-$800M in revenue. Going forward, investors should expect more catalysts to be unlocked in the second quarter when the company typically releases reserves. Unusual utilization patterns in the preceding two years have, however, led to abnormally-elevated 2Q releases.
Like Aetna, WellPoint trades at fairly low multiples. It is valued at just a respective 8.5x and 7.3x past and forward earnings with a PEG ratio of 0.85. Annual EPS growth is expected to be around 70 bps lower than Aetna's over the next half decade at 10.2%. And like UnitedHealth, the company has also committed itself to transformative businesses in order to adapt to the era of PPACA.
The $900M planned acquisition of 1-800 Contacts is expected to close sometime in 3Q12, and, while criticized by many for being irrelevant to the core business, I see it as being a meaningful way to upsell clients. In 1Q12, WellPoint seemed to showcase signs of higher acuity scores despite low acuity dollars. The firm is generally regarded as having the highest commercial risk to pricing decline through 2014.
I recommend buying shares in WellPoint under the belief that multiples will expand. Local scale, combined with a top brand name image, makes for stellar administrative leverage. In the long-term, analysts are bullish on the stock and rate it a "buy" according to FINVIZ.com. The current price target of $82.18 provides ideal risk/reward.