Will United Health's Cost Trends Cooperate?

By Stephen D. Simpson, CFA | April 24, 2012 AAA

Health insurance stocks like UnitedHealth (NYSE:UNH) are a good bet to stay volatile as the Supreme Court considers its opinion on sweeping changes to the healthcare insurance industry. While this ruling will clearly impact the future trajectory of enrollment and medical costs, it seems relatively safe to assume that UnitedHealth will adapt with the circumstances and remain a leader in this large industry.

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Mixed First Quarter Results
UnitedHealth reported 8% revenue growth for the first quarter, as double-digit service revenue growth sweetened the 7% premium growth. Enrollment rose more than 4%, as commercial fee-based enrollment rose nearly 6% and Medicare Advantage enrollment rose more than 15%.

Costs were an interesting story. Given the sort of quarters being reported by healthcare companies like Johnson & Johnson (NYSE:JNJ), it's not surprising that healthcare utilization remains relatively low and medical costs remain positive for the company. The medical loss ratio (a measure of what health insurance companies pay out in claims) dropped about half a point to 81%, though commercial medical care ratio did increase to 78.7%.

More surprising to me was the 13% increase in operating costs. Some of this was due to a mix (a higher percentage of lower-margin fee-based services and benefits), but some was also due to ongoing support of the pharmacy management business. All in all, operating income rose just 4% and management kept a lid on expectations for 2012 growth.

SEE: Understanding The Income Statement

Realism About Regulation
The changes to the healthcare insurance market that the current administration has passed will definitely change the operating environment for companies like UnitedHealth, Wellpoint (NYSE:WLP) and Aetna (NYSE:AET), assuming that the Supreme Court upholds the law. That said, I think the market has gotten a little ahead of itself in its worries about these changes.

The reality is that most insurance companies operate with a fairly extensive amount of regulation, and it doesn't change the fact that insurance can still be a lucrative industry with tight expense management and good underwriting. The anticipated changes will likely place a premium on efficiency, and that should be a change that favors a huge company like UnitedHealth.

Moreover, even if federal mandates are tossed out, states have become more aggressive in how they regulate and oversee health insurance. One way or another, more regulation seems like a reality that cannot be changed.

Are Tame Costs Setting up a Problem?
While medical cost trends look pretty tame to date, that may actually bite the sector in the coming year(s). Premium increases are based in large part on medical cost trends and if utilization starts increasing, these companies could see a year where they are stuck between rising medical costs and lower premium rate increases.

The Bottom Line
Forward expectations are all over the map when it comes to UnitedHealth, with some analysts expecting major declines in free cash flow production. I think that may be a bit extra, though I find little reason to be too aggressive today. At a minimum, the company is likely to spend capital building up its ancillary businesses.

The good news is that even a minimal growth expectation (1 to 3%) is sufficient to drive a fair value that makes the stock look interesting today. While likely to be a volatile stock, the long-term value still seems to be relatively solid at UnitedHealth.

SEE: 5 Must-Have Metrics For Value Investors

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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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