Description

UNH is an undervalued major healthcare insurance and transaction processing company currently trading at 14X 2008 free cash flow with a 25% plus return on equity.  The company is growing its earnings FCF per share 12 to 15% annually through organic growth, tuck-in acquisitions, cost savings and significant share buybacks.  Since 2006 (including expected purchases in Q407), the company has bought back $8.7B in stock or over 15% of the market cap.  The company recently extended its buyback authorization to $10B (and after Q4 buybacks will still be over $7B).  Despite the recent move from $48 to $58, the stock remains extremely undervalued especially considering the high quality and consistency of the business and the high caliber of the management team.  [for a slightly different perspective, please read jstarheel85’s writeup from December 30, 2006]

I recommend purchasing the stock as well as January 2010 $50 strike price LEAPS currently priced at $15.70.  With the stock at $58.11, your break even would require a 13% increase with an implied carrying cost / interest rate of just over 6%.

Look at the math over the next two years and what the valuation should look like:

1. Shares outstanding:                
1. 2006 Actual                1.4B average
2. 2007 Estimate             1.3B
3. 2008 Estimate             <1.2B by year end (high end of co. range of 6 to 8% dec.)
2. Stock price:                             $58.11
3. Market Cap:                            $73.1B
4. Cash and ST Investments:      $11.1B
5. Debt:                                       $8.1B
6. Estimated Earnings 2007        $3.50 per share – up from 2.97 in 2006
7. Estimated FCF 2007               $4.07
8. Est. Revenue Growth 2008    9 to 10% to $83B
9. Estimated Earnings 2008        $4.00 per share
10. Estimated FCF 2008               $4.92 per share (OCF of 6.9B less 1B of capex)
11. Estimated Earnings 2009        $4.50 per share
12. Estimated FCF 2009               $5.41 per share (OCF of 7.6B less 1.1B of capex)
13. EBITDA Interest coverage     16X
14. Debt/EBITDA                        1.3X

Note that the company bought back $2.2B worth of shares in 2006 and $6.5B in 2007.  If not for the option scandal, the company would have been aggressively buying back shares in 2006.  While the company is anticipating only $5B in share repurchases in 2008, the authorization is for $10B and the vast majority will still be available in 2008.  However, a higher share price could impact the number of shares that can be re-purchased as well as the company’s propensity to repurchase them – vs. use the cash to acquire other companies. 

We look at the company in the following way: The company has a healthy amount of debt and does not need to de-lever.  Therefore, cash will accrete to shareholders.  In 2008 and 2009, the company will accumulate over $10 per share in cash.  By 2010, the company should have earnings per share of over $5 and should trade at 15 to 18X that number.  That equals a $75 to $90 share price.  Add in the $10 of earnings and we arrive at a share price of $85 to $100.

What the company does

1. Commercial: The company is one of the largest providers of insurance and benefits administration to small, mid and large corporations.  This market has grown from $460B in 2000 to $780B in 2007 and is expected to grow to $1.37T by 2015
2. Public and Senior: The company is one of the largest providers of Medicare Part D drug benefits and Medicare Advantage, the privately run Medicare offering.  The company is also a Medicaid provider through its AmeriChoice division
3. Enterprise Services – National health expenditures have from $1.35T in 2000 to $2.26T in 2007 and are expected to grow to $4.1T by 2016.  This includes the Medicare Part D service in which the company has 27% market share.  It is the 5^th largest PBM with a 3 year CAGR of 95% and 10MM lives served.  It is one of the largest actuarials and risk-based consultants to major corporations as well as a provider of services that help improve outcomes – something quite important to large corporations that need to control health care costs.  The company also provides numerous health portals to help consumers improve their health

Key Issues

1. Revenues – the company must reinvigorate the top line with increasing enrollment vs. just price increases. This create more SG&A leverage as well as general earnings growth.  Mixups in the recent past have been fixed; personnel replaced; and the company is in better shape to grow its top line – despite very conservative projections
2. Medical Loss Ratio MLR – this is the percent of each dollar of revenue that the company must pay out.  This primarily is an issue in the commercial business.  The company must keep this ratio on a blended basis in the low 80s.  This is not a fat tail business
3. SG&A – The company has the lowest SG&A ratio (as a percentage of sales) among its peers.  It must continually decrease this cost to offset risks to the MLR and help grow profitability
4. The company must continue to adapt to a changing medical cost environment and work with employers and employees as this country moves to more consumer involvement (consumerism) in healthcare
5. The federal government – There are risks that Medicare Advantage will be cut back (that has now been deferred to a much later date) or that we will move to a single payer.  The odds of a single payer ever clearing even a democratically controlled congress are slim.  It is certainly years out  Odds are that we go to a system where the healthcare plans and CMS (Medicare and Medicaid) provide healthcare as they do today with some added cost reimbursement from the federal government for those that are too poor to afford healthcare insurance

Key Developments

There were several key developments that have come out recently and were fully on display at the annual investor day earlier this month:

1. There has been a change in tone from being more arrogant and dictatorial in the market place to being more open-minded and willing to listen so the company can provide the best services.  Steve Hemsley and his team were outright apologetic at the annual investor day.
2. There is now a focus on execution and a clear plan.  Though this is coming a bit late, it is far from too late.  The company is too big and too powerful and has a great franchise.
3. The Pacificare integration is just about complete and many of the problems should be in the past
4. Enrollment declines are almost over and the company seems poised for new growth.  This would move the top line and earnings materially above current projections.

Risks

1. Costs increase faster than revenues creating a higher MLR
2. Democratic president and congress successfully push for cuts in Medicare Part D, Medicare Advantage, Medicaid and ultimately more government control.  These changes will come slowly but there will be changes

Catalyst