Tickers in this Article: UNH, WLP, AET, HUM
Leave aside the political debates about the Affordable Care Act (aka “ObamaCare”), and it's still very clear that a huge change is coming for the U.S. health insurance market. As the largest player in that market, that means huge change is coming for UnitedHealth (NYSE:UNH) as well. While the company's incredible operating scale, PBM and healthcare IT operations, and overseas expansion do mitigate some of the risk, the sizable uncertainties regarding how these changes will impact real profits have kept these shares in value territory.

SEE: 5 Things You Need To Know About Obamacare

Change Is Coming, But How Much Will It Impact UnitedHealth?

One of the most visible changes for the health insurance industry will be the launch of public exchanges where individuals can buy health insurance. While UnitedHealth has warned of “rate shock” to the tune of 60% to 100% in some markets (and price points more than double the comparable commercial rates), individual and small-group has never been a particularly large business for UnitedHealth.

California's recent exchange experience is an interesting test case. Rates here actually ended up being pretty competitive, but that would appear to be due at least in part to fairly strong competition for the business. While UnitedHealth, Aetna (NYSE:AET), and Cigna (NYSE:CI) declined to participate, WellPoint (NYSE:WLP), Healthnet (NYSE:HNT), and Molina (NYSE:MOH) did. All told, UnitedHealth has suggested it may participate in as many as 25 exchanges (and maybe even more) or as few as 10, and the extent of the competition will go a long way towards determining just how the rates work out.

All told, given the low exposures of UnitedHealth and Cigna to small-group and individual plans, I'd be surprised if they were big players in the exchange (even though UnitedHealth has started rolling out retail store locations similar to travel agencies or P&C insurance offices). On the other hand, I would think WellPoint and Aetna will be much more active on a nationwide basis.

SEE: Investing In Health Insurance

Medicare Advantage Looking Challenging

Not unlike the Affordable Care Act, Medicare Advantage has been a controversial program as well. Although various surveys have suggested that enrollees like it, the prospect of lower federal subsidies has led UnitedHealth to speak of “evaluating its options” and potential exiting certain markets. This really isn't all that surprising – insurance companies are in the business of evaluating risk and returns and if UnitedHealth cannot earn its hurdle rate in Medicare Advantage, it's not going to stick around. Here again the company's diversification pays off – backing out of MA would be a modest negative for UnitedHealth (though arguably not as much of a negative as staying in if the payments decline), but probably more serious for Humana (NYSE:HUM) and WellCare (NYSE:WCG).

Brazil Could Offer Some Upside

In its largest deal in quite some time, UnitedHealth announced back in 2012 that it was acquiring Brazil's Amil for nearly $5 billion. This is a deal that comes with a bit of irony attached – UnitedHealth is looking to diversify outside of the U.S. to lower its risk, and its first major buy is in a country that has a government-sponsored universal insurance system.

Brazil actually runs a hybrid system. There's a universal system sponsored by the government, and about 75% of the population is covered by this program. Because of the drawbacks of the national/universal program (access to healthcare, what's covered, and so on), there is also a growing private insurance system in the country, and Amil is the largest independent provider with about 9% of the market.

Given that the number two player in the market is owned by a bank (Banco Bradesco (NYSE:BBD)), I like UnitedHealth's chances of competing effectively in this market. What's more, as incomes rise in Brazil I suspect that more Brazilians will turn to private coverage to at least supplement what they already have.

SEE: Investing In Brazil 101

The Bottom Line

Modeling and valuing stocks always requires investors to make assumptions about what the future is going to look like, and there are always substantial unknowns in that process. In the case of UnitedHealth, though, those unknowns are quite a bit bigger than usual. In particular, the company's profitability (whether measured as free cash flow (FCF), earnings, ROE, etc.) is very much up in the air. While I think the plan was for the reforms to health insurance to reduce industry profitability, I wouldn't bet against the industry (or at least top players like UnitedHealth) figuring out a way to thrive in the long run.

I use two models for UnitedHealth, and they presently generate very different results. Using an excess return model with a projected long-term ROE of 15% (against a trailing 5-year average of 17.6%) suggests a value of about $69, while a discounted cash flow (DCF) analysis with a 2% free cash flow growth rate suggests a fair value of about $79. Either way, UnitedHealth looks undervalued today, but investors considering the shares of this well-run company need to be prepared for above-average volatility as the industry (and investors) adapt to the new rules and realities of the market.

At the time of writing, Stephen D. Simpson did not own shares in any of the companies mentioned in this article.

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