UnitedHealth Group’s (NYSE:UNH) shares dropped 5% as the insurance company, which has a reputation for beating market estimates, reported earnings in line with expectations.  Sales growth of 12% was offset by Federal budget cuts in the Medicare Advantage program and lower levels of reserve development, which led to a 160 basis point increase in the medical care ratio, (medical costs to premiums) reaching 80.6% for the quarter. Net income of $1.6 billion or $1.53 per share was up just 0.8% from the third quarter of 2012.
Total enrollments increased by 24% or 9 million over the prior year. This figure included the addition of 4.8 million from the October 2012 acquisition of Brazilian insurer, Amil S.A. , as well as 2.9 members from TRICARE, the health care program for active and retired U.S. military personnel and their families launched during the second quarter of 2013. The health services division, Optum, continued to expand with 33% year-on-year revenue growth. The division accounted for a quarter of the company’s operating income, compared to 16% in the same period last year. We believe that continued growth and margin expansion in the Optum division can lead to significant upside for UnitedHealth.
Our $75 price estimate for UnitedHealth’s stock is in-line with the current market price.
ObamaCare To Lead To More Enrollments…
The employer and individual division, which is UnitedHealth’s largest division, accounting for 37% of revenues, reported a 3% decline in sales. However, this decline was not alarming as it was largely due to a large customer’s shift from risk-based products to fee-based products. UnitedHealth covers the risk associated with medical as well as administrative costs for customers choosing risk-based products, whereas companies choosing fee-based products generally self-fund healthcare costs of their employees with UnitedHealth taking care of administrative services. As a result, premiums are lower for fee-based services than their risk-based counterparts.
Overall, the employer and individual division added 30,000 new customers in the third quarter with a net growth of 3.2 million through the year. Around 50,000 senior citizens joined UnitedHealth’s Medicare Advantage plan in the three months ending September, with 405,000 new enrollments year-to-date leading to 14% year-on-year revenue growth for the Medicare and Retirement division. In the Medicaid division, the company reported 15,000 new enrollments through the quarter, with 125,000 joining the program so far this year.
As a part of the Patient Protection and Affordable Care Act (PPACA), the Federal website for health coverage along with various state health insurance websites went live in early October, establishing insurance exchanges designed to make insurance affordable and accessible to uninsured U.S. citizens. According to the last U.S. census, around 17% of the U.S. population is still uninsured.  Around 7 million Americans are expected to enroll in health insurance plans by 2014 with an additional 8 million citizens enrolling in the Government run Medicaid program as a result of the new laws and exchanges. 
UnitedHealth has achieved 13% penetration in the overall U.S. population  and accounts for nearly 15% of the total private health insurance enrollments in the country and 10% of the total Medicaid enrollments. However, due to the establishment of the exchanges, which offer more choices to consumers, we expect the company to lose market share in the coming years.
…But Will Cut Into Margins
Apart from the Federal budget cuts to Medicare funding, UnitedHealth’s margins are also likely to be affected by the PPACA, which mandates a minimum medical care ratio of 80% for individual and small group plans, and 85% for large group plans. Medical costs account for more than 80% of UnitedHealth’s operating expenses (excluding D&A) and the company has maintained a medical care ratio of 80% for the last three years, allowing its EBITDA margins to stay around 9%.
In the September quarter, the medical care ratio for the employer and individual division increased 110 basis points to 81.3% as the operating margin dropped from 8.6% in the third quarter of 2012 to 7.1%. We expect the medical cost ratio to increase to 83% in the coming years but the company has enacted several cost cutting measures to ensure that operational costs remain as low as possible. We expect the long term EBITDA margins for insurance divisions to remain around 7% in the coming years.
The Optum Growth Story
Optum provides health services to individuals, employers, government as well as life sciences companies. The division reported a 33% year-on-year increase in revenues, led by a 41% increase in OptumRx sales. OptumRx is responsible for processing and paying prescription drug claims of its clients. It offers pharmacy benefits management (PBM) services serving more than 14 million people nationwide by processing over 300 million retail, mail and specialty drug prescriptions annually.
The other two subdivisions included in Optum are OptumInsight, which provides software and information products and services; and OptumHealth, which provides health and wellness services such as behavioral solutions, care solutions, financial services, collaborative care and logistics health. Expansion in government services allowed OptumInsight revenues to increase 11% over the prior year while OptumHealth revenues grew 21% due to expansion of clinical services.
UnitedHealth estimates the total market potential for Optum to be around $500 billion.  We expect further expansion, particularly in the OptumInsight business, driven by the newly formed Optum360 business, in collaboration with Dignity Health. Dignity Health operates around 39 hospitals and 300 care centers in 21 states across the U.S. and will use Optum360 technology to consolidate resources.
The main upside to the Optum division comes from margin expansion. The operating margin for the division improved from 5.6% in the third quarter of 2012 to 6.6% this year. The management attributed this increase to improved business alignment and productivity.Our current forecast accounts for a marginal near term decline in margins due to increased competition arising from the implementation of the PPACA as well as increasing medical costs. However, our estimate for UnitedHealth’s EBITDA could increase by 10% if margins improve to over 7% through the decade. There is a 10% upside to our price estimate in the scenario.Notes:
- UnitedHealth Slides On Smaller Earnings Upside, Forbes, October 17, 2013 [↩]
- Health Status by Selected Characteristics and Health Insurance Status: 2010 [↩]
- Obamacare launch poised to reach millions despite shutdown drama, Reuters, October 1, 2013 [↩]
- UnitedHealth Group Incorporated Management Discusses Q3 2013 Results – Earnings Call Transcript [↩] [↩]