Vitaliy Katsenelson: HMOs, Heal thyself!

Mr. K's insightful and methodical analysis is highly respected by contemporary value investors and that includes me.

My brief comments and disclaimer: I own UNH and plan to add to my position on dips hopefully in the low 20's and high teens as the US election looms. My target price is $60/share based on a DCF analysis similar to this one by Dr. Price. I don't think that this company is a "great" one and don't plan to hold it for the very long term: it is known for treating its employees and clients very poorly. I do think that it is extremely undervalued (due to the emotional reaction many investors have towards the company?), even considering worst case political outcomes.as Vitaliy elaborates on below. Don't forget that the "vital few" agree with recognition of this value: Warren Buffett, Chris Davis and Edward Owens are amongst 9 gurus who own substantial amounts of UNH stock (WE recently bought at $47/share, adding to a 6.4 Million share holding).

You Don’t Have to Be Sick To Own HMO Stocks: UnitedHealth Group, WellPoint and Aetna
July-29-2008
[b]Vitaliy N. Katsenelson column: [/b]You want to buy straw hats in the winter. This sums up an important kernel of successful value investing: making decisions (buying and selling) that are unpopular at the time. (Of course, one has to make sure that, due to global climate change, winter is not swiftly followed by an ice age. In the case of the stocks I am about to discuss, today is winter and the summer will come again.) Shares of [b]UnitedHealth Group (UNH)[/b] and those of its HMO comrades have declined significantly over last six months. UNH has taken down its earnings guidance twice in 2008 from $3.90 to about $3 per share. Competition among HMOs is intensifying; the weak economy is not helping, as employers are looking for ways to save money and downgrading their health care coverage. HMOs have underestimated their medical costs. Of course, the rising unemployment is hurting enrollments and adding more pressure to an already sobering situation. So that is the bad news. Everybody knows it. HMOs' current, ex- (and there are plenty of those) and future shareholders know it. The bad news is more than priced into these stocks. With single-digit price-earnings ratios, HMO stocks are priced as if the sun will never to shine again, as if a lunar eclipse became a permanent celestial feature for the industry. UNH, as well as [b]WellPoint (WLP), Aetna (AET)[/b] and others, are priced as if they were going out of business. They are not! The sun will shine again. The baby boomers are getting older and are consuming more and more medical services. For good or bad, the HMO's role in the health care industry is unlikely to diminish. The industry has changed dramatically over the past decade. It consolidated. Now the top five companies account for roughly 80% of industry revenues. With fewer players, the more rational their behavior should be (read: stable pricing). The price war that took place in late 1990s, when the industry was very fragmented, and was responsible for record low margins, is unlikely to take place, at least to the same degree, this time around. Also, instead of trying to fight ever-rising costs of health care and getting a bad rap from consumers, HMOs are focusing on two things: 1) exercising tremendous buying power by extracting lower prices from health care providers and 2) embracing the inflation in medical costs by taking a cost-plus approach to pricing; in other words, passing medical inflation on to consumers. In the short run, as is apparent from recent announcements, both the "cost" and the "plus" parts are going in the wrong direction. The industry underestimated the recent rise in medical costs, and the weak economy has been (temporarily) detrimental to pricing. The value of a company is the present value of its discounted future cash flows. Thus, a great way to judge a company's worth is through the discounted cash flow model, which projects future cash flows and discounts them back at particular rate. Even if we project significantly lower, declining future cash flows (an unlikely scenario), we will still get intrinsic values that are higher than today's depressed stock prices suggest. Finally, there is a political risk--the elephant in the room. We have a presidential election and a strong Democratic candidate with a social agenda. This is bad for the HMO stocks, right? Well, though HMO stocks may have starred as villains in Michael Moore's movie Sicko, they are not at the core of the health care crisis and are likely to be a part of the solution. Public health care companies have generated $250 billion in revenues and $13 billion in profits in 2007. This may sound like a lot of money, and it is, but that only represents a net margin of 5% and a return on capital of 5%. Neither number screams, "We're fleecing the public!" In fact, they are close to the economics of government- regulated electric utilities. Let's say politicians decide to go after HMOs. They only have $13 billion of profits to work with; even if they halve HMOs' profitability, $6.5 billion will not solve trillion-dollar health care problems. Also, 81% to 83% of these companies' revenues go to paying for health care services (doctors, hospitals, drugs) and another 3% to 4% of revenues fall into Uncle Sam's pockets. It is hard to milk this industry for political gain. At the same time, if the new head of government decides to fix the health care problem by insuring the 45 million uninsured Americans, government will call on--you guessed it--the private sector HMO industry. HMO stocks look ugly in the short term, and the news flow may get worse before it gets better. But these stocks are trading at incredibly attractive valuations, have strong financial positions and great cash flows. Though they don't pay meaningful dividends, they are using every ounce of tremendous free cash flow to buy back stock. At today's depressed prices this could make a meaningful difference. In the case of UNH, the company can buy roughly 17% of its outstanding shares a year from its free cash flows. The short-term negatives--and I believe they are short term in nature--may be a blessing in disguise.


You Don’t Have to Be Sick To Own HMO Stocks: UnitedHealth Group, WellPoint and Aetna
July-29-2008
[b]Vitaliy N. Katsenelson column: [/b]You want to buy straw hats in the winter. This sums up an important kernel of successful value investing: making decisions (buying and selling) that are unpopular at the time. (Of course, one has to make sure that, due to global climate change, winter is not swiftly followed by an ice age. In the case of the stocks I am about to discuss, today is winter and the summer will come again.) Shares of [b]UnitedHealth Group (UNH)[/b] and those of its HMO comrades have declined significantly over last six months. UNH has taken down its earnings guidance twice in 2008 from $3.90 to about $3 per share. Competition among HMOs is intensifying; the weak economy is not helping, as employers are looking for ways to save money and downgrading their health care coverage. HMOs have underestimated their medical costs. Of course, the rising unemployment is hurting enrollments and adding more pressure to an already sobering situation. So that is the bad news. Everybody knows it. HMOs' current, ex- (and there are plenty of those) and future shareholders know it. The bad news is more than priced into these stocks. With single-digit price-earnings ratios, HMO stocks are priced as if the sun will never to shine again, as if a lunar eclipse became a permanent celestial feature for the industry. UNH, as well as [b]WellPoint (WLP), Aetna (AET)[/b] and others, are priced as if they were going out of business. They are not! The sun will shine again. The baby boomers are getting older and are consuming more and more medical services. For good or bad, the HMO's role in the health care industry is unlikely to diminish. The industry has changed dramatically over the past decade. It consolidated. Now the top five companies account for roughly 80% of industry revenues. With fewer players, the more rational their behavior should be (read: stable pricing). The price war that took place in late 1990s, when the industry was very fragmented, and was responsible for record low margins, is unlikely to take place, at least to the same degree, this time around. Also, instead of trying to fight ever-rising costs of health care and getting a bad rap from consumers, HMOs are focusing on two things: 1) exercising tremendous buying power by extracting lower prices from health care providers and 2) embracing the inflation in medical costs by taking a cost-plus approach to pricing; in other words, passing medical inflation on to consumers. In the short run, as is apparent from recent announcements, both the "cost" and the "plus" parts are going in the wrong direction. The industry underestimated the recent rise in medical costs, and the weak economy has been (temporarily) detrimental to pricing. The value of a company is the present value of its discounted future cash flows. Thus, a great way to judge a company's worth is through the discounted cash flow model, which projects future cash flows and discounts them back at particular rate. Even if we project significantly lower, declining future cash flows (an unlikely scenario), we will still get intrinsic values that are higher than today's depressed stock prices suggest. Finally, there is a political risk--the elephant in the room. We have a presidential election and a strong Democratic candidate with a social agenda. This is bad for the HMO stocks, right? Well, though HMO stocks may have starred as villains in Michael Moore's movie Sicko, they are not at the core of the health care crisis and are likely to be a part of the solution. Public health care companies have generated $250 billion in revenues and $13 billion in profits in 2007. This may sound like a lot of money, and it is, but that only represents a net margin of 5% and a return on capital of 5%. Neither number screams, "We're fleecing the public!" In fact, they are close to the economics of government- regulated electric utilities. Let's say politicians decide to go after HMOs. They only have $13 billion of profits to work with; even if they halve HMOs' profitability, $6.5 billion will not solve trillion-dollar health care problems. Also, 81% to 83% of these companies' revenues go to paying for health care services (doctors, hospitals, drugs) and another 3% to 4% of revenues fall into Uncle Sam's pockets. It is hard to milk this industry for political gain. At the same time, if the new head of government decides to fix the health care problem by insuring the 45 million uninsured Americans, government will call on--you guessed it--the private sector HMO industry. HMO stocks look ugly in the short term, and the news flow may get worse before it gets better. But these stocks are trading at incredibly attractive valuations, have strong financial positions and great cash flows. Though they don't pay meaningful dividends, they are using every ounce of tremendous free cash flow to buy back stock. At today's depressed prices this could make a meaningful difference. In the case of UNH, the company can buy roughly 17% of its outstanding shares a year from its free cash flows. The short-term negatives--and I believe they are short term in nature--may be a blessing in disguise.