Description

Summary/Abstract

UNH is the leading company in a critically important and steadily growing industry enjoying a supply advantage from technological expertise and network leadership coupled with the scale of the largest public national operator in an industry resistant to disruptive innovation but undergoing a sustaining innovation that UNH is leading. This results in a cash flow machine with a defensible barrier to entry generating high returns on capital and free cash flow yields. The market seems to misperceive the nature of UNH’s business model, it is not simply an insurance company, rather it is a healthcare technology company that gathers, organizes and unlocks consumer health data with superior capabilities and technology, and then capitalizes on that edge with risk based insurance and other fee based operations. UNH is available at a discount to most any reasonable intrinsic value due to short term, largely non-operational, issues.

 Background
Company Overview
UnitedHealth Group is an example of a wonderful company with a strong franchise that has fallen victim to issues of a non-operational and short term nature resulting in a current price well below its potential intrinsic value. UNH is the largest managed care company by revenue and by market cap, while it is second to a newly formed Wellpoint in lives. As a managed care company UNH is traditionally viewed as an insurance provider, however I would argue that it is actually a technology company that monetizes its capabilities in gathering, structuring and sorting healthcare related data via providing risk based insurance coverage and fee based insurance services. The differences between an insurer and a technology company are significant. Insurance is a commodity business where rates are transparent and the only advantage is from being the low cost provider (e.g. Geico). However, technology driven companies create value by leveraging an expertise or capability that they do better than the competition (e.g. GOOG in search). Being a low cost provider and being differentiated via a technology platform are both competitive advantages, but both are vulnerable to attack. The first by mimics and the second by innovation. But, when a competitive advantage is coupled with economies of scale, a significant barrier to entry can be created that allows for lucrative excess value creation.

UNH is the leader in technology in the managed care industry. This is manifest in a lower SG&A ratio than competitors. But more importantly, the technology investment allows them to push the managed care envelope by providing a more efficient and cost effective product while also better managing the spread between premiums and healthcare costs (the Medical Loss Ratio- MLR).  The technological edge is coupled with a scale advantage on both a local network level and on a company wide fixed cost level. These two factors, technological expertise coupled with economies of scale translate into an excess cash creation machine that is excellently positioned to recover from the current headlines and recover to a more normalized intrinsic value range. Other than the scandal overhang the primary knock on managed care and UNH is that subscriber growth is slowing and competition is tightening up. To that I say, yes, but that’s ok. The growth of the past is not requisite to make this investment work. High single digits top line growth is all we need, not the twenty percent year over year growth of the past. And from a competitive perspective, no other company is positioned to thrive the way UNH is, the barriers to entry it is building and maintaining should provide for a continuation of the remarkable margins and returns on capital of the past.

This discussion of UnitedHealth will likely feel a little light on specific details and in-depth analysis of operating segments. This is by design for brevity and redundancies sake, some sell-side analysts have done good work on the segments of the company and the recent analyst day gave an excellent overview. I could go on for quite awhile about the vision of starting Exante bank and how it plays into the consumerism platform that UNH is developing, but a lot of these details are ancillary to my basic thesis, so I left them out of this piece. I would be happy to follow up on questions though.

Options Issues
I’m sure everyone is familiar with the options expensing situation at UNH so I am not going to dwell on it here. The revered CEO, Bill McGuire, has been pushed out as the poster boy for the options backdating scandal that has been making the rounds of the headlines. There are investigations and reviews ongoing, most recently the SEC’s escalation of their review to ‘formal’ status. While I do not to overlook the seriousness of the issue or deny that the headline risk or lack of near term resolution could act as an anchor on the stock price, I would argue that the news is more than priced in and even a worst case hit from a penalty and tax perspective would not change the attractiveness of UNH’s operations. The non-cash charges recently announced are largely priced in as well. Actually the headline effects are one of the major reasons this opportunity is available at these prices. Suffice to say, there are several risks here to address; that there will be a hefty fine and tax penalty, that losing McGuire permanently damages management’s ability, that the earnings restatement negatively impacts historical multiples, and that the headlines leave a negative association with the brand of UnitedHealth in the mouth of consumers.

As to the first, I have attempted to take the financial impact of penalties and back taxes and the possible margin impact of having to replace some of the employee retention benefits of ‘mispriced’ options with higher SG&A expenses into account. There have been several good analyses on the potential tax penalties and fines but for simplicity sake I went with a nice round $1 billion as a ballpark estimate for fines and taxes. A couple hundred million on either side would not really change the valuations either way. Also I adjusted SG&A going forward by roughly $200 million per year to account for a potential higher cost of attracting and maintaining talent. The second risk, that McGuire is the critical cog for value creation, seems to me overstated at this stage of the company’s life cycle. Granted in the nineties he was the visionary and primary driving force. However, today UNH is a well defined and positioned company with several units functioning fairly independently. McGuire was not all that involved on a day to day operational basis over the last few years. I think I saw that the current management team has no less than 6 former CEOs of major companies on board. While McGuire’s visionary capabilities may be missed, we will see that the extra percent of top line growth that maybe only he could have found are not requisite to make UNH very attractive here. The new management team is highly experienced with a super deep bench of executives. Concerns over the change at the top, new CEO and CFO, are legitimate, but ultimately will not me an issue. While not the visionary or perceived guru that McGuire was, Helmsley is a stable operator that brings an experience and calm that the company probably needs at this stage. Mike Mikan, the new CFO, is a young whiz kid who by all account is sharp as they come and excellent at what he does. If the investor day last week was any indication of how these guys will run the company and communicate with the market than things seem to be in good shape.

As far as earnings restatements, the company has given updated guidance as to the impact, the majority of which are non-cash adjustments. The potential cash adjustments from different tax rates going forward have been captured in the higher SG&A and slightly higher tax rate. To the last objection, that being painted with the scandal brush may negatively impact the operations of the business with consumers, I admit that is a risk. However, with the increasing prevalence of options accounting problems that has pulled in several hundred companies thus far (with the latest high profile offender being Apple and Steve Jobs over the last week), I think UNH may fade into the background as an early headline grabber, but more importantly, as just one of the crew. The public perception that “everyone was doing it” may actually lessen or remove the impact to any one company. So this is a risk, but not an overly scary one to me.

The Industry
The managed care industry has resulted from the evolution of the health insurance model from pure indemnity based for the majority of the century to a more managed model (PPOs and MCOs). The next stage of development is to a more distributed, individual level model. Whereas the indemnity model addressed large groups of individuals on a pure cost basis, the managed care model evolved to recognize that managing care with a network of providers for defined groups of insured was more efficient and cost effective. The coming consumerism model takes the managed care mentality a step forward by focusing on preventative care and empowering individual consumer’s to understand and harness their health and well being information to reduce the need for costly interventions after the fact. The industry is currently at the tail end of the managed care model with some of the companies, notably UNH, moving strongly to the next model of consumer based healthcare. While the healthcare insurance industry is one that is resistant to disruptive innovation (unless the federal government intervenes with some sort of national plan), it is undergoing a sustaining innovation with this evolution to a consumer based model.

Consumerism is a powerful concept in that it is a net benefit to both sides of the transaction, the consumer and the provider. The consumer benefits from access to information in a coherent and organized fashion that can paint a comprehensive picture of their situation and their options. The provider benefits from an educated consumer who is taking ownership of their insurance situation rather than treating it as a third party paid cash ATM to be used with every sniffle. Studies have shown that up to 50% of health problems result from behavior, smoking, obesity, etc. The consumerism model aims to address these behavioral shortcomings via access to information. This is where UNH’s technology edge comes into play. Due to high returns on capital, low capital reinvestment requirements, and simply pure scale, the company is able to spend significantly more in capex than the competition. For the year 2006, it looks like UNH will spend over $600 million on capex, much of it in technology investment. The next largest capex spend is by AET at roughly $270 mill and then WLP under $200. These technology investments allow UNH to further push the envelope on technological capabilities of gathering, organizing and linking information on a platform that the consumer can understand and benefit from.

Management clearly recognizes the trend towards distributed health care responsibility as well as the nature of UNH’s competitive advantage versus the rest of the industry. They are defending and widening the moat that is their technical edge and further augmenting the economies of scale that they already enjoy. While WLP now exceeds UNH on total lives, on a total revenue basis on which to spread fixed cost UNH is by far the largest. Also, UNH has the best combination of macro-scale with the micro scale of having leading networks in individual markets. Network effects on a local market level drive growth and profitability. The best network of doctors and hospitals with the most local members translates into a heady advantage. UNH has the higher number of market share leading positions in local markets than any of its public competitors. Macro scale coupled with micro scale translates into higher profitability and returns on capital than competitors, not to mention massive cash flow generation that nearly always exceeds accounting earnings. Management noted at the investor day that they feel the industry and UNH in particular enjoy significant barriers to entry at this stage. They pointed out that the requisite combination of financial depth and healthcare expertise, replicating the database, networks, information stream and application know how would take years and huge sums that would make the subsequent return on capital so low as to make the investment uneconomical. If this is correct the managed care space will increasingly migrate to a handful of large players with large scale and accumulated years of technological and healthcare insurance expertise. To make inroads at this point, management notes, a competitor would have had to have started at least a decade ago. 

Fundamental Snapshot & Valuation

To demonstrate the effectiveness of UNH’s operating model and how odd it is that the company is currently priced at parity with its competitors (which in their own right could well be undervalued here) I’ve included a couple data points:

	Price/Cash Flow		Price/Earnings		Avg. 5	Avg. 5 yr	Avg. 5 yr
	2006	2007Est	2006	2007Est	Year ROE	Year ROC	OpMar.
UNH	13.8	12.4	18.0	15.6	30.1%	22.6%	9.0%
WLP	14.1	12.1	16.5	14.2	12.8%	10.5%	5.8%
AET	11.4	11.2	15.4	13.4	4.7%	4.7%	1.0%
CI	15.2	12.6	14.5	13.0	16.7%	14.3%	9.0%

Of course the past is not indicative of the future (as every disclaimer trumpets), but UNH’s five year track record merit notice, especially as I believe the future it will likely continue to be stellar.

Valuation Drivers
In the valuation section below I categorize the different scenarios by the four primary inputs to UNH value creation outlined here, the MLR ratio, top line growth, SG&A levels and buybacks.  The primary leverage point for value creation is the management of the medical loss ratio (MLR). UNH’s MLR is the ratio between medical cost incurred (the numerator) and premiums earned (denominator). It measures how well the company priced its insurance and managed its healthcare costs. Over the past decade the company’s MLR has ranged from 0.79 to 0.85. The MLR typically ticks up after an acquisition as operations are integrated. The current MLR level has increased over the last few years due to the relative increase in size of Medicare business, which has been growing at double digit rates recently. On a company wide level this pulls the MLR ratio up and puts it higher than some peers. However we have to look through the Medicare business and other low margin lines to appreciate the relative efficiency of the UNH platform. To be conservative in my valuations I’ve used MLRs ranging from analyst expectations of about 0.815 for 2007 and fluctuating thereafter depending on the scenario. In the optimistic scenarios is fluctuates down to 0.79, where it was in 2005, all the way up to 0.85 ranges where it hovered in 2000.

Top line growth is clearly the other primary value driver for UNH. The good news is we don’t need anything like the heady high teens low twenties growth rates of the last decade to make UNH an attractive investment here. In fact top line growth rates of 9-10% are more than enough. With US population growth of 1 to 1.5% per year and medical cost increases settling firmly in the 7% per year range, it doesn’t take much in the way of risk based market share growth or fee based revenue (as long at the MLR ratio is maintained) to get to 9-10% growth. In the scenarios below I use from 5-10% top line growth in different cases, but never higher than 10.5%. This may be conservative as management is guiding to a minimum of 10% organic growth in 2007 and 15% EPS growth over the next five years. SG&A management goes along with the MLR in the margin management department. The good news is that UNH has the lowest SG&A ration in the industry due to combination of their technological expertise and their scale. I see no reason for this to change but have used scenarios fluctuation around 14-15% of revenue as a baseline.

The buybacks are the final piece, and are really just the icing on the cake. The company is a serial repurchaser of stock, which isn’t always a good thing, but when the stock price is too low, as it is at the moment, it’s an excellent thing. For some of my valuation numbers I estimate that UNH buys back from 1 to 2% of its outstanding stock per year. 1% on the current cap is about $700 mill, which is well within the range of historical levels and company ability. Management has indicated that the buybacks will resume as soon as the current issues are resolved.

The scenarios below are based on a free cash flow to firm discounted cash flow valuation, which I feel is most appropriate for this situation. I triangulate an intrinsic range from three outputs, a DCF based on terminal multiples, a DCF based on a terminal perpetuity and a future price multiples based range. I have subjectively probability weighted the five scenarios and then arrived at a weighted average intrinsic value, which should really be viewed as the midpoint of a range of $5-$10 on either side.

	Value Range		Avg.	Weight	Des.
Meltdown	$45.00	$60.00	$52.50	5%	Topline 4.5-6.5%, MLR = .82 to .85, SG&A pressure; impact of Dem. control of Congress?
Neg	$60.00	$75.00	$67.50	15%	Topline, First 5 Yr: 8-9%, 2nd: 6-7%, 10+: 5%, MLR .815 to .83 fluctuates, some SG&A Pressure
Base	$75.00	$95.00	$85.00	45%	9-9.5%, 7-7.5%, 5%, .815 trailing to .80, flat SG&A
Positive	$85.00	$105.00	$95.00	30%	10%, 8%, 6%, .81 to 0.79
Great	$110.00		$110.00	5%	Pos Scen, plus 2% per yr buyback, enthusiastic market multiple of 20, 7-8 yrs out
			Weighted Intrinsic	$85.00
			Current	$53.73
Management	$95.00	$110.00	$102.50		Guidance at the shareholder meeting of organic topline growth of 10%, continue share buy-back and EPS growth of 15% per
Guidance Based					year for next five, ROE in the mid to high 20% range

 One of the more striking thing is possibly the downside protection displayed by the “Meltdown” scenario having a range of $45 to $60 versus a current stock price of about $54. Now that’s an upside/downside balance to get excited about! I also found it interesting that simply plugging in the guidance management provided at the analyst day have a value range of $95 to $110, which is well above my weighted intrinsic value of $85. The weighted intrinsic price of $85 really implies an intrinsic range of just under $80 to about $95, an upside range of 50% to 75% from current levels. Alas the real opportunity was when UNH hovered around $46 for awhile. I have been following the situation closely for a couple months and have been planning a write-up, but decided to wait and see what the analyst day held. Fortunately for clients I was buying for them though! It is also worthwhile to note that what I rank as the highest probability scenarios to determine UNH a favorable investment with little risk of capital loss are both substantially less optimistic than the company’s actual guidance. If UNH performs as management thinks it can than the stock could be a double over the next few years.

Risks
There is certainly the outside risk that the penalties and fines are bigger than anticipated by the company or by me. That being said, even a hit on the order of AIG’s fine of $1.5 billion fine coupled with a cash charge from taxes would not materially impact the undervaluation.

I can’t conceive of any truly disruptive innovation that would change the industry model of insurance that UNH operates under (but isn’t that the nature of a disruptive innovation, it is unseen by the market until it is too late!). However there could be some real disruption from a regulatory perspective. Under a scenario where the Democratic Party was able to control Congress with a significant majority and the presidency following 2008, there would certainly be the possibility of regulation or legislation that could restrict the operations and the profitability of the managed care industry.

More drastically, some form of single payer, government sponsored health insurance would have completely unknowable, but almost certainly a detrimental, impact to UNH’s business.

There are competitive and industry risks to keep a close eye on. WLP is sizing up to a more competitive scale and the BlueCrossBlueShield networks, which is the largest insurer in the country when all the Blues are aggregated with roughly 38% market share, could throw a wrench in the pricing and growth area. BCBS generally acts on a local level with many different organizations each managing themselves. It doesn’t seem that they can coordinate to take advantage of national scale or pooled capex on technology. However, if BCBS and the other public companies act rationally from an economic perspective UNH should be in good shape. Irrational and short term pricing by some competitors to win or maintain market share is not unheard of though, and would be harmful to the entire industry.

Catalyst

The current market view of UNH is summed up by one sell side analyst’s opinion that:
“We like UNH operationally and believe it is still one of the best companies in the space. But for now there is too much market risk and uncertainty to safely begin purchasing shares.”
However, I feel it is best to buy when the future is uncertain due to some issue that is fixable or nonoperational in nature but that has left the market anchored on the negative perceptions of the recent past to the detriment of the more positive long term scenario.

The primary catalyst is time, the passing of this current scandal. When the reviews are completed and the penalties announced UNH will be recognized for its strong operating results. More specifically, each quarter’s earnings announcement will serve as a venue for the markets to get comfortable with new management and be encouraged by the strong operating results the company will likely be reporting. Also, upon resolution the firm will be free to continue its share buyback, which has been the avenue of returning capital to shareholders historically. There is $6 billion remaining on the current buyback authorization and management has said they will resume the process as soon as possible.