By Valuentum Analysts
One of our favorite income growth ideas in the health care sector is UnitedHealth Group Inc (UNH). The company adeptly navigated headwinds created by the coronavirus (‘COVID-19’) pandemic while maintaining its fortress-like balance sheet and stellar cash flow generating abilities. UnitedHealth is quite shareholder friendly, and its capital allocation priorities include utilizing a combination of dividend increases and share buybacks to return cash to shareholders.
At the high end of our fair value estimate range, derived through our discounted free cash flow analysis process, we value UnitedHealth at $511 per share. We define free cash flow as net operating cash flow less capital expenditures. Later in this article we break down how we arrived at that figure in great detail.
From November 2011 to November 2021, UnitedHealth increased its quarterly dividend from $0.1625 per share to $1.45 per share, highlighting its tremendous dividend growth track record. In our view, there is ample room for UnitedHealth to further increase its payout going forward as its growth outlook is quite bright. Shares of UNH yield ~1.2% as of this writing.
UnitedHealth is a diversified health care and well-being company that is represented by a large health insurance unit, UnitedHealthcare, and a large health care services provider unit, Optum. Its two business platforms operate through four core segments: UnitedHealthcare, OptumHealth, OptumInsight, and OptumRx. The firm provides health care benefits to a wide range of customers in an array of domestic health care markets. UnitedHealth was founded in 1974 and is headquartered in Minnesota.
According to the US Centers for Medicare & Medicaid Services [‘CMS’], spending on health care in the US reached $4.1 trillion in 2020, equal to 19.7% of the nation’s GDP. Looking ahead, demographic changes (growing cohorts of individuals aged 65+ and individuals aged 80+) indicate US health care spending will likely continue to grow going forward. That provides a major secular tailwind for UnitedHealth to capitalize on.
The firm’s UnitedHealthcare segment can be broken down into four operating divisions: Employer & Individual, Medicare & Retirement, Community & State, and Global. UnitedHealth is the largest health insurance provider in the US. Its UnitedHealthcare business served 2.2 million more people in 2021 than it did in 2020, aided by “continued strong growth in Medicare Advantage and Dual Special Needs Plans and expansion in the broader Medicaid market” according to its latest earnings press release.
Though UnitedHealth is a behemoth, it is not without its fair share of competition, which in its case comes from a variety of sources. Managed health care companies, insurance companies, HMOs, TPAs, PBMs, and business services outsourcing companies all provide similar services to any one of its businesses. UnitedHealth’s significant scale is an advantage.
Earnings and Outlook
When UnitedHealth published its fourth quarter 2021 earnings on January 19, the company beat both consensus top- and bottom-line estimates. Its GAAP revenues grew by 13% year-over-year and its GAAP operating income surged higher by 58% year-over-year in the final quarter of 2021. Strength at both its UnitedHealthcare and Optum businesses helped drive sales growth last quarter as revenue at each unit was up double-digits year-over-year.
As it concerns UnitedHealth’s operating income performance last quarter, productivity improvements, the repeal of a health insurance tax back in 2019, and a reduction in its ‘operating costs’ line-item on a year-over-year basis were key here. Its operating costs shifted lower last quarter in part because dealing with the COVID-19 pandemic has become more manageable. The company’s non-GAAP adjusted EPS climbed higher by 78% year-over-year last quarter aided by net income growth and a shrinking outstanding weighted-average diluted share count.
For all of 2021, UnitedHealth grew its GAAP revenues by 12% year-over-year, which hit $287.6 billion, and its GAAP operating income by 7% year-over-year, which hit $24.0 billion. Its non-GAAP adjusted EPS rose by 13% year-over-year, hitting $19.02 last year. Widespread strength across its key business operating segments combined with growing economies of scale supported UnitedHealth’s financial performance last year. Its medical care ratio, defined as medical costs as a percentage of premium revenues, stood at 82.6% in 2021, up significantly from levels seen in 2020 primarily due to elective surgeries in the US resuming in earnest.
Management expects that UnitedHealth’s growth trajectory has room to run and reaffirmed the firm’s promising near term guidance in conjunction with its latest earnings report (which was first issued out in November 2021). This year, the company estimates that it will post $317-$320 billion in revenue (represents 11% annual growth at the midpoint of UnitedHealth’s guidance) and $21.10-$21.60 in non-GAAP adjusted EPS (represents 12% annual growth at the midpoint of UnitedHealth’s guidance). Additionally, the firm is forecasting that it will generate $23.0-$24.0 billion in operating cash flow (represents 5% annual growth at the midpoint) in 2022. We appreciate that UnitedHealth’s management team views the firm’s near term growth trajectory so favorably.
Economic Profit Analysis
The best measure of a firm’s ability to create value for shareholders is expressed by comparing its return on invested capital [‘ROIC’] with its weighted average cost of capital [‘WACC’]. The gap or difference between ROIC and WACC is called the firm’s economic profit spread. UnitedHealth Group’s return on invested capital (without goodwill) stood at 71.4% from 2018-2020, which is above the estimate of its cost of capital of 10.2%. In the upcoming graphic down below, we show the probable path of ROIC in the years ahead based on the estimated volatility of key drivers behind the measure. The solid grey line reflects the most likely outcome, in our opinion, and represents the scenario that results in our fair value estimate.
Cash Flow Analysis
UnitedHealth is a stellar free cash flow generator. In 2021, the firm generated $19.9 billion in free cash flow while spending $5.3 billion covering its dividend obligations and another $5.0 billion buying back its stock. This is not a one-off event. From 2018-2020, UnitedHealth generated ~$16.7 billion in annual free cash flow on average.
The company also has a fortress-like balance sheet. Inclusive of long-term investments and short-term debt, UnitedHealth had a $21.0 billion net cash position at the end of December 2021, though we caution it also had significant other non-cancellable financial liabilities on the books. There is a lot to like about UnitedHealth’s financials.
UnitedHealth is steadily working towards finalizing its ~$13 billion all-cash acquisition of Change Healthcare Inc (CHNG) which was first announced back in January 2021. However, regulatory hurdles have got in the way of the acquisition. Reportedly, the US Department of Justice [‘DOJ’] has considered suing to stop the deal. These regulatory hurdles have pushed the targeted closing date back to April 2022 (from the second half of 2021 originally) and reportedly, asset deals to appease relevant regulators may be in the works.
We like UnitedHealth’s deal for Change Healthcare as it would significantly improve UnitedHealth’s presence in the billing and payment solutions space within the health care sector. Please note we are big fans of UnitedHealth with or without the deal closing as envisioned. Here is how the January 2021 press release covered the pending acquisition:
Change Healthcare will join with OptumInsight to provide software and data analytics, technology-enabled services and research, advisory and revenue cycle management offerings to help make health care work better for everyone.
This combination unites two technology and service companies focused on serving health care. Their combined capabilities will more effectively connect and simplify core clinical, administrative and payment processes – resulting in better health outcomes and experiences for everyone, at lower cost. Change Healthcare brings key technologies, connections and advanced clinical decision, administrative and financial support capabilities, enabling better workflow and transactional connectivity across the health care system. Optum brings modern analytics, comprehensive clinical expertise, innovative technologies and extensive experience in improving operational and clinical performance.
We are keeping our eyes on the deal, though again we would like to stress that UnitedHealth is a stellar enterprise in any event. UnitedHealth has the financial firepower to acquire Change Healthcare while retaining its fortress-like balance sheet. The deal, as originally envisioned, is expected to be accretive to UnitedHealth’s EPS.
Our discounted cash flow process values each firm on the basis of the present value of all future free cash flows, taking balance sheet considerations into account as well. We think UnitedHealth is worth $409 per share under our “base” case scenario with a fair value range of $307-$511 (the upper bound represents our “bull” case scenario and the lower bound represents our “bear” case scenario).
The near term operating forecasts used in our enterprise cash flow models, including revenue and earnings forecasts, do not differ much from consensus estimates or management guidance. In the upcoming graphic down below, we highlight the key valuation assumptions used in our base case scenario covering UnitedHealth. Please note that these valuation assumptions should be viewed as a baseline as there is ample room for upside here should UnitedHealth continue to outperform.
Although we estimate the firm’s fair value at about $409 per share, every company has a range of probable fair values that’s created by the uncertainty of key valuation drivers (like future revenue or earnings, for example). After all, if the future were known with certainty, we wouldn’t see much volatility in the markets as stocks would trade precisely at their known fair values. In the upcoming graphic down below, we show this probable range of fair values for UnitedHealth. We think the firm is attractive below $307 per share (the green line), but quite expensive above $511 per share (the red line). The prices that fall along the yellow line, which includes our fair value estimate, represent a reasonable valuation for the firm, in our opinion.
Future Path of Fair Value
As time passes, however, companies generate cash flow and pay out cash to shareholders in the form of dividends. The upcoming graphic down below compares the firm’s current share price with the path of UnitedHealth’s expected equity value per share over the next three years, assuming our long-term projections prove accurate. The range between the resulting downside fair value and upside fair value in Year 3 represents our best estimate of the value of the firm’s shares three years hence. This range of potential outcomes is also subject to change over time, should our views on the firm’s future cash flow potential change.
UnitedHealth is a tremendous free cash flow generator with a fortress-like balance sheet. The healthcare giant’s promising outlook combined with its stellar financials underpin its bright income growth trajectory, and in our view, the health care giant has ample room to grow its dividend going forward. Powerful secular growth tailwinds (demographic changes in the US and expected growth in the 65+ and 80+ age groups) should enable UnitedHealth to continue growing its business over the years and decades to come.