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Investors at first cheered the managed care provider's plans to cut costs on July 2, but the shares wound up closing lower amid increasing concerns about its margins
That sound you heard on Wall Street on July 2 was a tentative sigh of relief upon UnitedHealth Group's (UNH) announcement that it was cutting its 2008 profit outlook by 16%—a move widely expected by investors—and slashing 4,000 jobs as part of a cost-cutting effort. The moves lifted shares of both UnitedHealth and the broader managed health-care group. Only later in the day did the challenges the industry faces in the next year or two come back into focus, causing the stocks to come off their earlier highs.
The Minneapolis-based health-care provider said it now expects adjusted earnings for the full year to be $2.95 to $3.05 a share, down from its prior forecast of $3.55 to $3.60 a share. The company also reduced its projection for cash flow from operations to nearly $5 billion from a previous range of $5.7 billion to $6 billion.
Separately, the company said it will pay about $912 million to settle two separate class actions filed over stock options backdating.
Chief Executive Stephen Helmsley cited smaller-than-expected gross margins from the company's commercial risk business, which serves employees enrolled in their company health plans, during the second quarter. It also said efforts to raise premiums have lowered enrollment so far this year, which has contributed to the lower earnings estimate.
A Sector on Hold
Talk began to spread among investors two weeks ago that a downward revision was coming when UnitedHealth declined to affirm its original earnings forecast after Coventry Health Care (CVH) slashed its full-year earnings outlook by nearly 17%. At that time, other managed-care providers such as Aetna (AET) and Humana (HUM) did reaffirm their initial profit projections.
UnitedHealth shares, which had been falling since the last week in May, traded as much as 6.4% higher before sliding back to close 2% lower, at $25.12, on July 2. Aetna also gave back earlier gains to end slightly lower, while WellPoint (WLP) and Coventry finished higher, albeit off their intraday peaks.
Thomas Carroll, an analyst at Stifel Nicolaus (SF) in Baltimore, attributed the short-lived rebound in UnitedHealth's stock to short-covering by investors who bet against the stock in anticipation of a reduced earnings forecast. "There's a feeling that it's not going to get any worse. Deep-value investors who have been waiting on the sidelines to get past this hurdle are starting to support this stock. We're seeing it across the whole sector," says Carroll, who has a "hold" rating on the entire sector.
Painful But Manageable Payments
Elimination of the concerns around the company's litigation exposure helped the stock price rebound temporarily. UnitedHealth said it will pay $895 million to settle a federal securities class action filed in December 2006 against the company and certain current and former officers and directors over backdating of stock options. The proposed settlement reached with chief plaintiff, the California Public Employees' Retirement System, and plaintiff class representative Alaska Plumbing & Pipefitting Industry Pension Trust in the class action will fully resolve all claims against the company, all current officers and directors named in the lawsuit, and certain former officers and directors named in the lawsuit, the company said in a news release.
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.
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.)
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.