UnitedHealth Ready for the Storm -- and Long-Term Success

There's little doubt that the next couple of years will be "interesting" for UnitedHealth (NYSE: UNH  ) . This giant health insurance, benefits, and health technology company has built its way to the top of the heap through strong management, ongoing M&A, and substantial reinvestment in the business, but the arrival of the Patient Protection and Affordable Care Act (commonly referred to as "Obamacare") is going to significantly change the way health insurance markets operate for UnitedHealth and large peers like WellPoint (NYSE: WLP  ) , Aetna (NYSE: AET  ) , and Cigna (NYSE: CI  ) . While most of the panic has worn off, investors may yet have a worthwhile long-term opportunity in this health care giant.

Watch and wait
Like Cigna and Aetna, UnitedHealth has been relatively cautious and conservative in participating in state exchanges at this point. While Cigna doesn't have a long history of selling individual insurance in very many states, these companies have only decided to participate to the tune of single digits.

The motivation behind this caution is relatively straightforward -- insurance companies are worried that only those most likely to use health care will be signing up right away, with healthier people staying away and choosing to pay fines instead. That makes it tricky to price these policies appropriately; while UnitedHealth has reams and reams of data on health care costs, trends, and consumption patterns, this is a new and different risk pool. So, they're doing what most insurers do when faced with a new business -- they're wading in slowly.

There's really not much for UnitedHealth to lose here by waiting. Rivals like WellPoint are participating more aggressively, mostly to maintain their Blue Cross Blue Shield businesses in 14 states, but I do not believe there will be all that much loyalty in these exchange-based products . If and when UnitedHealth steps in later, I believe customers will evaluate them on the price and features of their plans, not on whether they were there from day one.

A fringe benefit to Medicaid?
The ACA enrollment process may also end up benefiting UnitedHealth in a couple of ways that were not part of the original plan. The one-year extension on plans that would otherwise be canceled shouldn't do UnitedHealth any harm, as the plans were profitable for them.

Medicaid may also end up being an unexpected benefit to UnitedHealth in this process. A surprisingly large number of people using the Health Exchange website have discovered that they are eligible for Medicaid coverage. As the second-largest administrator of Medicaid plans, that means more potential covered lives (and more revenue and profits) for UnitedHealth, as well as market share leader WellPoint. Medicaid is not as much of a driver for Cigna and Aetna, though Aetna did increase its Medicaid exposure with the Coventry deal in 2012.

Optum and Amil offer interesting growth possibilities
One of the things I really like about UnitedHealth is its growth prospects outside of its historical core insurance operations. Under the Optum banner, services like disease management, specialty benefits, software/services, and pharmacy benefits management give the company some high-growth addressable markets that generally fall outside of regulated markets. True, there is competition here from sizable rivals like Cerner and Express Scripts, but UnitedHealth has been more than holding its own (and, perhaps in a bit of irony, got the general contractor role in the "tech surge" to fix the Healthcare.gov website).

Last and least is Amil, the Brazilian health insurance company that UnitedHealth acquired in 2012. Although Brazil has a universal health program, the program uses a hybrid design that allows people to buy private insurance that offers different levels of access, services, and so on than the government-sponsored system. Banco Bradesco has had more than 50% share in the Brazilian market for some time, but it has never had to compete with the likes of UnitedHealth before, and I like UnitedHealth's odds for gaining share in this market.

The bottom line
WellPoint has also tried to increase its non-premium-based businesses, but acquisitions like 1-800 Contacts haven't been as well-received as UnitedHealth's moves. Even so, I expect other insurance companies to follow UnitedHealth into non-regulated lines of business that can offer good combinations of growth, margins, and cash flow.

As it stands today, UnitedHealth is a so-so stock. I am very much inclined not to underestimate a company that has done so well for so long, particularly given the company's growth potential in Medicare Advantage and non-insurance operations. An excess returns model (a model based around estimated ROE and commonly used to value banks and insurance companies) suggests UnitedHealth is fairly valued if it can limit the erosion in ROE to 15% (against a trailing 5-year average of nearly 18%). If UnitedHealth can maintain its ROE at its recent rate of 17.5%, the fair value jumps to just over $80. A discounted cash flow model likewise suggests undervaluation, as a forward free cash flow growth rate of 5% (against a trailing rate of almost 5%) results in a target in the low $80s.

I do believe there is some risk that the market is underestimating the cost and medical loss impacts of the ACA over the next couple of years. Even if that's true, though, I think that could create some excellent buying opportunities in UnitedHealth. This company is a master of pricing risk and managing expenses, and with several high-quality non-insurance businesses I like the company's growth prospects.

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