Shares of UnitedHealth Group (NYSE:UNH) fell by about 1.5% on Wednesday as investors digested the company’s earnings release, which was better than expected. While Q2 results were solid, the company’s decision to maintain full-year guidance was a disappointment, given the weak second-half implied. Even though I suspect the company is being conservative and can exceed that guidance, shares appear fully valued.
In the second quarter, UNH earned $7.12, nearly $2.00 ahead of consensus, while revenue of $62.1 billion was $1.4 billion light. Adjusted earnings were nearly double last year’s results (UNH’s financial results can be accessed here). Operating earnings rose to $9.2 billion from $4.7 billion, sending the net margin to 10.7% from 5.4%.
Ironically in the short term, health insurers are among the biggest winners from a global pandemic. This may seem counterintuitive, but in response to COVID-19, many state governments temporarily halted non-essential surgeries. Individuals also may have been less inclined to visit the doctor’s office due to the fear of getting the virus.
These deferred health expenses far outweighed any COVID-19 expenses UNH faced. Consequently, medical care expenses dropped to 70.2% of premiums from 83.1% last year. Now, many of these non-essential surgeries still have to occur. If someone had a heart issue, they may have been able to delay surgery a month, but the heart issue did not suddenly go away.
That is why UnitedHealth expects its medical care ratio to worsen in the second half of the year and cede back much of these savings. In other words, don’t be surprised when next quarter the medical care expense is closer to 90% than 70%. Still, there likely are some permanent savings that UNH enjoyed, as some individuals who would have visited a doctor and gotten a prescription for a cold or minor illness instead opted against seeking care and fought it off themselves.
While no one can know for certain how much of this windfall UNH will retain, management is guiding very conservatively. Of the $4.5 billion in better-than-expected earnings from operations, the company only reaped a favorable reserve development of $1.4 billion, in essence expecting over $3 billion of increased profits to be ceded back as deferred care is received. As such, the company is maintaining its full-year operating EPS guidance of $16.25-16.55.
Just how conservative is this guidance? Well, in the first of this year, the company has earned $10.84 per share. So in the second half of the year, UNH is expecting to earn about $5.56, plus or minus $0.15, or a quarterly run-rate of $2.78. Now for perspective, in 2019, UNH earned $15.11, or $3.78 on average. This implies net income of about $1 billion less per quarter than last year, which when factoring in its 3% larger revenue base essentially implies giving back that $3 billion in Q2 earnings from deferred care.
This is a reasonable scenario, but it also is a conservative one, as it may take longer for elective care to return to normal. Similarly, some, but not all, medical activity likely has been forgone for good. As such, I view the company’s EPS guidance as a floor; if it only gives back half of the Q2 savings, earnings for the year would come in closer to $17.25, so I would consider $16.50-17.25 as a likely landing spot for full-year earnings. It is worth being mindful of the fact that this is a presidential election year, and insurance companies are never popular. UNH in the middle of a pandemic does not need headlines about raising its profit estimate. To be clear, I am not suggesting that UNH had politics determine its guidance. Rather given all of the uncertainty, the political landscape is just one more reason to err on the side of conservatism in guidance.
Now because UNH’s underlying business is solid and continuing to generate solid cash flow, the company increased its quarterly dividend from $1.08 to $1.25 last month, a 15.7% increase. Over the past five years, the company has increased its dividend by an over 22% annual rate. UNH has been increasing its payout since 2010. Even with these increases, the company is only paying out about 30% of earnings in dividend. This makes the dividend very affordable while paving the way for continued growth in future years. For income-oriented investors seeking secure and growing income, UNH is a suitable investment. However, for investors seeking capital appreciation, I see less reason to own shares.
Now, one risk to highlight is that 26.77 million of the 48.4 million UNH provides insurance for are on commercial plans. This total is down 990,000 year to date and 270,000 quarter on quarter. This quarterly drop is largely due to increased layoffs. One risk over the next year is that the large employers UNH serves shed workers due to lower economic output, thereby reducing UNH’s revenue base and providing a headwind to earnings, though this can be partially offset by growing Medicaid and Medicare enrollment.
Healthcare reform is an ever-present risk for UNH as well. While former vice president Joe Biden does not support Medicare-for-All, policies that move individuals from employer-based health care to government health does decrease UNH’s potential revenue base. That said, the Biden plan appears to have a larger impact on the individual market via larger subsidies than the employer market, which would minimize its impact on UNH. Nonetheless, politics can often drive price volatility in these stocks, even if unjustified, and investors should prepare for that.
Overall, UNH has reaped benefits from lower healthcare spending due to COVID, and as such, there is a risk to the upside from its earnings guidance. That said, the company has some exposure to a weaker labor market via lower enrollment numbers. In addition to potentially lower enrollment, abnormally low medical care expenses will not persist forever. A 70% medical care expense ratio is not sustainable as there will be a normalization of activity by 2021, and if not, there will be downward pricing pressure as other insurers use outsized margins to gain market share by giving a bit of price. Even though, I see upside risk vs. management’s 2020 guidance due to an only partial unwind of Q2’s excess profit, that tailwind will not be there in 2021.
Due to that, while I see the company generating about $17/share in EPS in 2020, it will struggle to grow EPS much if at all in 2021, barring a much brisker rebound in the labor market. Indeed, my $17 estimate assumes about $1.25-1.50 of net benefit from the drop in medical care expenses. That tailwind will be mostly if not entirely eliminated in 2021. In a sense, the company will be trying to grow from a $15.50-15.75 base level of recurring earnings. As consequence, it will be difficult to get much past $17/share next year due to enrollment headwinds, partly offset by smaller share count due to repurchase activity.
At $305, UNH is trading at 18x this year’s earnings and 17.5-18x 2021 earnings. Given the company’s slow growth profile and headwinds to 2021 profitability, I believe this to be a full valuation for a company that won’t generate much headline EPS growth for at least 18 months. I wouldn’t short shares given the potential for an H2 earnings beat, but in the $305-310 zone, I don’t see much potential upside and would rather rotate into companies like JPMorgan Chase (JPM), which trade at much lower forward earnings multiples as I discussed here.
Disclosure: I am/we are long JPM. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Source: Seeking Alpha