Investors hoping for strong first-quarter numbers from the nation's largest insurer got what they were looking for last Friday.
UnitedHealth Group Inc. (NYSE:UNH) topped forecasts, with revenue and earnings per share up 13% and 33%, respectively, year over year. The company also raised its full-year revenue outlook by $2 billion to $143 billion and now expects earnings of between $6.15 and $6.30 per share this year -- even taking into account the costs of the Catamaran Corporation (UNKNOWN:CTRX.DL) acquisition.
The stock is up 50% over the past year, and 20% year to date, making it the best-performing stock in the Dow Jones Industrial Average. But the stock is pricey, with its multiple of trailing earnings now 20 times, far exceeding its five-year average of 12.5.
When a stock's surging valuation gets out of sync with its history, questions arise about whether it's still a good investment. Nothing grows to the moon, and, in fact, UnitedHealth's vulnerability was on display two days before earnings, when an announcement about a spike in hospital admissions from HCA Holdings (NYSE:HCA) ignited fears about higher health care costs for insurers. In response, UnitedHealth's stock fell 2.2%., only to recover after earnings came out.
Let's look further to see whether the stock's valuation is justified, and what lurking problems may herald significant downside risk for UnitedHealth. When a stock's valuation is far above its historical average, investors are wise to keep an eye out potential trouble ahead. We know that if the past is any guide at all, a stock that is increasingly overvalued will come back down, eventually.
Nothing alarming ... on the surface
UnitedHealth's Optum division for health services performed well last quarter, with revenues rising 15% to $12.8 billion. In addition, more than 1 million people were added to UnitedHealth rolls in the first quarter, the company said.
Fears of a possible jump in the use of medical services also didn't materialize in this quarter's numbers. Overall, subscriber health-care utilization didn't increase. In fact, UnitedHealth's ratio of medical costs to premium income was 81.1%, 1.4 percentage points lower than a year ago.
Beneath the surface, three significant risks
So where does UnitedHealth's stock go next? Here are some issues keeping me on the sidelines.
1. Share buybacks are likely to scale back. UnitedHealth's gains in the past year have been boosted by a series of successful buybacks, averaging nearly $1 billion a quarter since the start of 2014. While UnitedHealth's buyback have done a good job of creating value for stockholders, the impact will probably lessen going forward, simply because the stock price has gone up so much. In addition, as UnitedHealth Group absorbs merger expenses with Catamaran, it may not return as much cash to shareholders in the form of healthy dividend increases and buybacks. This could lower the company's future share price.
2. Integration distractions and disruptions. UnitedHealth's plan is to merge pharmacy benefit manager Catamaran with its own PBM, OptumRx. While that looks like a good match, frankly, so did Express Scripts' (NASDAQ:ESRX) 2012 deal to realign its pharmacy business by merging with Medco Health Solutions. That deal, while ultimately approved, had serious problems with customers bailing and pharmacy organizations suing to block it. Catamaran also ran into trouble in February, announcing the loss of two health-plan clients, which put pressure on its shares despite fourth-quarter earnings that beat analysts' expectations. Finally, Catamaran currently has clients that are rivals of UnitedHealth, such as those from the 10-year deal Catamaran struck in 2013 to handle pharmacy-related matters for Cigna Corporation (NYSE:CI).
3. Net debt looks set to jump. The Catamaran deal is for $12.8 billion, payable in cash, and UnitedHealth closed the first quarter with $10.4 billion in cash. While UnitedHealth's free cash flow is strong and accessing the debt market should be easy, the company's net debt looks set to jump this year.
One final risk, and it's a corker. In UnitedHealth's recent earnings call, management didn't comment about the possible impact of a Supreme Court ruling that could potentially upend health care insurers. An ongoing case, King v. Burwell, will decide whether consumers can receive premium subsidies in states that have not established their own exchanges and are instead relying on Healthcare.gov.
The decision is expected by the end of June.
If the court rules the subsidies illegal, millions of Americans would no longer be able to afford their insurance, putting insurers such as UnitedHealth in a financial bind and the law itself in jeopardy. While such a decision is unlikely, it's not off the table.
Safe stock with a bargain price? Hardly.
No one has ever been able to forecast reliably the direction of a stock over short periods. Stocks can go up a long, long way before coming back down. But what we do know is that overvalued stocks tend to produce dismal returns over the subsequent five to 10 years, while undervalued ones tend to produce excellent returns.
UnitedHealth's quarterly results have consistently beat analysts' expectations. But with its premium valuation, and the jurists (literally) still out on an issue that could completely upset the apple cart, I wouldn't be itching to pull the trigger anytime soon.
Cheryl Swanson has no position in any stocks mentioned. The Motley Fool recommends Express Scripts and UnitedHealth Group. The Motley Fool owns shares of Express Scripts. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.