AET Aetna Inc. (delisted)

We are reiterating our Neutral recommendation on the shares of UnitedHealth Group Inc. (UNH)  following the second quarter 2011 results. UnitedHealth Group reported second quarter 2011 operating earnings of $1.16 per share, beating the Zacks Consensus Estimate of 93 cents.

Earnings also compared favorably with 99 cents per share reported in the prior-year quarter. Net earnings increased 13% year over year to $1.3 billion in the reported quarter. Results were aided by strong revenue growth from UnitedHealthcare, as well as from Optum businesses.

UnitedHealth is benefiting from low medical utilization by members owing to a lingering recessionary mind-set among Americans who are postponing or forgoing medical care. This low level of medical use has led to an increase in cash reserves and increased profitability for the company. Lower-than-expected increases in care use year to date has helped contain the company’s costs in the form of lower claims paid.

We expect the company to post positive earnings surprises backed by this trend, which is expected to prevail at least till 2011 end as it will take a while for spending to recover from a recession as bad as this one.

UnitedHealth Group is one of the most diversified of the listed managed care companies. With a broad product and service offering, the company targets the full spectrum of the population. As a result, earnings are buffered to a certain degree against any single change in market dynamics at the divisional level. This has been witnessed by a growth in the company’s revenues for the past five years.

Though the market remains challenging, we expect the company to grow revenues, albeit at a slower rate. Since its December guidance, the company has upped its revenue estimate four times, which now stands at $101 million, implying an organic growth rate of 7% year over year. 

UnitedHealth’s health service business, which comprises OptumHealth, OptumInsight, and OptumRx, is a very important part of the company’s diversification strategy. Revenues from the health services segment delivered a 17% year-over-year growth for the second quarter 2011 and 20% year-over-year growth for the first quarter 2011.

Management is expanding the health service business to 30–40% of operating earnings over the longer term, and thus, the company has been making acquisitions in the area. Currently, health services generate about 20% of operating earnings. Management thinks that the company is under-penetrated in the health service area and that investment in this field will reap benefits over the long term. 

UnitedHealth stands healthy from a balance sheet perspective. The company has maintained its debt-to-capital ratio at favorable levels of 30.8% as of March 31, 2011. For the past five years, its debt ratio stands at an average of 32.1%. The company is also consistent in its dividend paying capability.

During May 2011, UnitedHealth raised its annual dividend by 30% from 50 cents per share. The dividend was last hiked in May 2010 to 50 cents from a mere 3 cents per share. The latest dividend increase is the highest level of hike currently in the industry. Its annualized 10-year dividend growth rate has been 52.2%.

Historically, the company has favored share buybacks and mergers over dividend payments as a way to deploy capital. The company has been generating strong cash flow from operations, and this further signals strong longer-term cash flow prospects.

Further, shareholder’s return will be maximized with regular share repurchases. UnitedHealth spent $620 million in the first quarter of 2011 to buy back 15 million shares, and expects to spend $2 billion to $2.5 billion for repurchasing shares in full-year 2011.

The company has approved the repurchase of 110 million shares, which is about 10% of UnitedHealth’s outstanding shares, at the cost of about $5.3 billion. The company’s solid capital management is reflected in its return on equity, which has averaged at 18.97% for the past five years.

However, the U.S. recessionary economic environment has impacted the demand for certain products and services of UnitedHealth. For example, a reduction in workforce has lowered the number of health care beneficiaries, thus putting pressure on top-line growth for its Healthcare and OptumHealth businesses.

Moreover, UnitedHealth will expectedly witness increased operating costs through 2011 due to higher medical and operating cost pressures related to the Affordable Care Act and Mental Health Parity Act. The company would also experience heightened expenses for complying with the federally mandated ICD-10 coding and HIPAA 5010 standards.

Also, there remains a concern over low interest rates, which will expectedly culminate into low investment income, thereby putting earnings under pressure.

UnitedHealth is currently carrying Zacks #2 Rank, which translates into short-term ‘Buy’ rating. The company competes with Aetna Inc. (AET), WellPoint Inc. (WLP), CIGNA Corp. (CI) and Humana Inc. (HUM), with the first two carrying long-term Neutral recommendation and the other two carrying long-term Outperform recommendation.

 
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