Little Relief for UnitedHealth

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UnitedHealth also said it will pay $17 million to settle a separate Employee Retirement Income Security Act class action filed in June 2006.

The settlement payments, while painful, are manageable in view of the company's strong balance sheet and cash flows, says Aaron Vaughn, an analyst at Edward Jones in St. Louis, who has a "buy" rating on the stock. Knowing it's a liability the company can deal with means one less risk going forward, he says.

Revising Benefits

Of the nearly $1 billion reduction in operating income, $400 million is the result of competitive pressure in the commercial market for employee health benefits, the company said on a June 2 conference call, while the remainder of the lost earnings is related to its special needs and prescription drug plans under Medicare.

Vaughn believes the higher-than-expected costs of the special needs plans, which cover chronic medical conditions such as diabetes and congestive heart failure, amount to a profit reduction of just 10¢ a share, as there are only 75,000 people enrolled in those products, out of a total 1.5 million Medicare customers. The larger part of the problem is that reimbursement from prescription drug costs is lower than the company projected, he says.

"Other companies are seeing exactly the same thing," including Humana and HealthSpring (HS), he says.

UnitedHealth appears to have realized the problem in time to have at least included a portion of the higher costs in a revised 2009 benefit design plan it submitted to the Centers for Medicare & Medicaid Services in June, analyst John Rex said in a July 2 research note for JPMorgan (JPM). (He rates the stock overweight; JPMorgan does and seeks to do business with companies covered in its research reports.)

Margin Pressures

Boosting profit margins in the commercial risk business won't be as easy to do, however.

The company said it sees commercial medical costs staying within the previously estimated range of 7% to 8% for 2008, but the consolidated medical cost ratio—the cost of health care divided by revenues from premiums—is now expected to rise slightly, to 82% to 83% for the full year, while the commercial medical cost ratio is also estimated to be higher than before at 83% to 84%,

UnitedHealth faces more margin pressure next year, given its intention to be just as competitive then as it is now, and with cost trends expected to rise, says Stifel's Carroll. "If they price ahead of cost plans, they'll lose customers. If they don't, then their [costs] will be higher," he says.

Edward Jones's Vaughn applauds the company's moves to cut 4,000 jobs and lower capital spending in a bid to improve its profit margins, as well as to try to be more responsive to customer needs at the local level.

But Goldman Sachs (GS) analyst Matthew Borsch said in a July 2 note that he believes industry margins will move lower in 2009 and 2010, although stock valuations already reflect this to some degree. (He has a neutral rating on UnitedHealth; Goldman Sachs does and seeks to do business with companies covered in its research reports.)

With most managed-care providers pricing slightly below cost trends, Carroll thinks the industry is feeling the pressure right now and will revert to more rational pricing over the next year or two.

Bogoslaw is a reporter for BusinessWeek's Investing channel.