- UNH has produced lower FCF margins over the past few years despite massive revenue growth.
- It is also in the midst of tremendous dividend growth, which is consuming a higher and higher proportion of FCF each year.
- The buyback has suffered due to lower levels of available FCF.
UnitedHealth (NYSE:UNH) has been one of the best growth stories in the mega-cap space for years now. The company’s ability to continue to rapidly grow revenue and profits has been staggering and the stock price reflects all of that good news today, seemingly constantly reaching new highs. UNH is also a company that returns a lot of money to shareholders including the very successful buyback program as well as its rapidly growing dividend. These things are key for shareholders for different reasons but both contribute to the total return of the stock in excess of earnings growth that drives stock price appreciation. In this article, I’ll take a look at UNH’s ability to support these capital returns with FCF as well as any implications it has on the stock going forward.
I’ll be using data from Seeking Alpha for this exercise.
We’ll begin by taking a look at UNH’s revenue and FCF for the past five years to get an idea of where it has come from.
UNH’s growth in revenue and FCF have been huge in the past five years. Revenue has risen from $111B five years ago to $185B last year, making UNH one of the biggest companies our market has to offer as measured by revenue. That amounts to a two-thirds increase in just five years and that surely is a terrific start to the FCF discussion, particularly considering the scale of UNH and the fact that it has been able to see that sort of expansion in such a short period of time.
In addition, the FCF bars show some growth but to be fair, that growth isn’t nearly on the same level as revenue. FCF was $6.1B in 2012 and $8.1B last year, representing growth of one-third, or half the rate of revenue growth. While growing FCF is terrific and very desirable, FCF is critically important as well and as we’ve just seen, UNH hasn’t been able to boost FCF or even have it keep pace with revenue growth. Most companies surely would be enthralled to grow FCF by a third in five years but given revenue growth, it's just not that good unfortunately.
To that end, here’s a chart of UNH’s FCF margin (FCF divided by revenue) so that we can get an idea of how productive UNH is at turning revenue into free cash and implications of movement in margin over time.
Two things are evident on this chart and relevant to the discussion; the level of FCF margin and the trend down we’ve seen over time. First, UNH’s FCF margin is underwhelming to say the least. Despite the fact that revenue is up by almost 70% in the last five years, FCF continues to hover in the mid-single digit area. That’s actually quite low among mega-caps and while it varies by industry (of course), this level of FCF margin naturally inhibits tremendously high capital returns unless revenue grows into the stratosphere. Fortunately, UNH has been able to do just that but what if revenue slows? That’s what shareholders must consider even though revenue growth certainly hasn’t been a problem up to this point.
Second, and just as important, is the fact that FCF margin has declined over this time period. Last year’s FCF margin of 4.4% is the lowest in this time frame and a full 20% decline from the 5.5% we saw in 2012. While UNH’s FCF margin is somewhat lumpy, which isn’t unusual, the trend is clear and it isn’t a good one. To be fair, it is still producing FCF but declines in margin like this during a period when revenue is up by so much are concerning to me.
But why, you ask? What’s the concern? The concern for me is that UNH has really picked up the dividend in earnest in recent years, as highlighted in the linked article above. The yield right now is rather pedestrian but that is down to the very strong, sustained rally we’ve seen in the shares rather than management’s lack of commitment to raise the payout. That’s certainly a good problem to have but shareholders are no doubt going to demand further increases in the dividend as time goes on, and that consumes FCF.
Second, UNH’s buyback has diminished in size immensely in the past couple of years. It used to buy back several billion dollars’ worth of stock yearly and thereby reduced the float, juicing EPS growth. In the past two years, however, the buyback hasn't netted out at even one billion dollars either year. That has kept EPS growth lower than it otherwise would have been as the float hasn’t been reduced in the way that it was from 2012 to 2014. While UNH has been able to grow anyway, the point stands that things could be looking even better if FCF margin had kept pace; imagine what UNH could do with an additional 20% of its FCF every year.
And that’s the problem with declining FCF margin; cash for capital returns has to come from somewhere and the only recurring source is FCF. UNH certainly appears to have designs on becoming a serious dividend stock and it largely already is, but it needs cash to sustain the move over time and with FCF margin declining, that’s going to get tougher and tougher as time goes on. Indeed, UNH has issued a net of $21B in debt over the past five years to cover cash needs because it used much of its FCF on capital returns. That means that as FCF margin declines and the dividend in particular consumes more and more of its FCF, debt issuances will almost certainly become more common, introducing higher financing costs into the equation. It also means that the buyback may slow further or even stop depending upon the circumstances, which isn’t good for EPS growth. If you own UNH for the dividend growth, just keep in mind that FCF and the dividend are rapidly moving against each other.
Please don’t take my commentary as overly bearish because I’m not; UNH is a terrific company to own with very strong prospects. But I’d be lying if I didn’t say I was concerned about its ability to continue to fund enormous dividend increases and the buyback and the potential impacts those things have on shareholders. UNH is probably going to reach its FCF limit in terms of what it can spend on the dividend more quickly than it would have hoped given FCF margin continues to decline so if you’re long, you’d do well to keep an eye on FCF. It matters a bunch for UNH’s dividend growth story and right now, FCF margin is a bit concerning. To be clear, it has a few years at least before dividend growth would actually be crimped by FCF availability, but the buyback and funding for everything else like acquisitions may not be so safe.
This article was written by
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