In the midst of good news regarding increased government reimbursement rates to health insurers for sicker insured customers, stocks of health care insurers are trading near their all-time high. I updated my models, which now suggest that WellPoint (WLP) and Aetna (AET) are trading noticeably above fair values and UnitedHealth (UNH) is slightly overvalued. As a result, purely from a perspective of valuations, I strongly recommend selling your positions in these three stocks , especially when there are noticeable insider sales at WellPoint and Aetna.
Below is a stock price chart pinpointing my buy and hold calls on 1/20/2013, 2/15/2013 and 7/10/2013 and related events since 11/30/2012. It is followed by some concluding thoughts supporting my sell recommendations. WLP has been up 47% since my first buy rating on 1/20/2013, UNH by 32% while AET by 42%, beating the 20% gain posted by S&P 500 over the same period.
Chart 1. Closing Prices since 11/30/2012
(Click to enlarge)
Grand theme of Obamacare was compromised
Healthcare.gov, the federal-run site that hosts health care exchanges for 36 states, opened on 10/1/2013 and has since been crippled with technical problems. As a result, only 26,794 people enrolled in private plans through the site in October and about 100,000 signed up in November, according to Bloomberg on 12/2/2013. The enrollment figures fell far short of the original target of half a million enrollees in October alone. 12.3 million, the number of enrollees through exchanges by 2014, projected by Centers for Medicare & Medicaid Services, now appear to be a distant, if not unrealistic, goal to reach.
Needless to say, there has been a mixed bag of headlines. It is hard to spell out their implications for health insurers without a crystal ball. However, one could get a grasp of the dominating impact by understanding the grand theme of Obamacare. Essentially, before Obamacare, the medical costs of uninsured population were largely incurred by hospitals and governments (taxpayers). The other two big players of the health care system, employers and health insurers, did not share the costs.
Obamacare intended to have health insurers and employers share a portion of such medical costs by banning pre-condition exclusions and forcing employers to buy insurances. Therefore, it was feared that Obamacare would lead to spikes in medical cost ratios (MCR) for health insurance companies, although expanding coverage to the uninsured would bring in additional premium revenue. Healthcare exchanges, if well functioned, would increase price competition and drive down revenue.
As Obama administration scales back its reforming measures in a piecemeal approach and exchanges are barely functioning, the aforementioned impacts on medical costs are more likely to be moderate, as I projected before in July.
There are two reasons why I think the above case is the worst-case scenario [MCR increases by 2.5 percentage points over the next 5 years]. First of all, it is likely that the implementation of exchanges will be further delayed on the state level and the impact will be realized in late 2014 or even 2015. CMS has been lowering its projections on health expenditures since its initial estimation in April 2010, quoting reasons such as the prolonged recovery and the lowered growth assumptions for public health programs. The current projections, upon which the worst-case MCRs are calculated, assume 12.3 million people will obtain coverage through exchanges in 2014, including 3.1 million newly insured (Page 2, bottom graph of the CMS projection). I doubt that many individuals will participate in exchanges in the first year, especially since the enforcement of a key penalty provision was delayed until 2015 according to the WSJ article on 7/3/2013. This provision penalizes businesses that hire 50 or more employees but do not offer health benefits.
Source: "Buy UnitedHealth And Hold WellPoint And Aetna To Capitalize On Obamacare" published on SeekingAlpha on 7/10/2013
Model updates
For all of the three stocks, I revised my projections in MCRs as the increase in MCRs will take place in 2015 as opposed to 2014. I also adjusted F2013 revenue growth rate to bring forecasted 2013 revenues in line with the full-year outlook in Q3 releases, which are usually very accurate at this point. The new growth and MCR parameters are listed in Table 1. Apart from that, I see no convincing signs to adjust other model assumptions for WLP and AET. I also used cash, debt, and shareholders' equity as of 9/30/2013 in the enterprise value calculation for all three stocks. The Q3 results for AET are after the merger with Coventry, which are more accurate than the pre-merger management guidance provided in Q1. As a result, target price for WLP is raised to $83.47 while AET's fair value is revised down to $59.47 a share
Table 1. Revenue Growth and MCR Projections
UNH | 2013 | 2014 | 2015 | 2016 | 2017 |
Premium Revenue growth - Base | 10.00% | 8.00% | 7.00% | 6.00% | 5.00% |
Premium Revenue growth - Bull | 10.00% | 9.00% | 8.00% | 8.00% | 8.00% |
Premium growth - Bear | 6.50% | 5.00% | 3.50% | 2.00% | 2.00% |
MCR - Base | 81.50% | 82.00% | 82.00% | 82.00% | 82.00% |
MCR - Bull | 80.50% | 80.50% | 80.50% | 80.50% | 80.50% |
MCR - Bear | 81.50% | 82.25% | 83.75% | 83.75% | 83.75% |
WLP | 2013 | 2014 | 2015 | 2016 | 2017 |
Premium Revenue growth - Base | 1.00% | 1.00% | 2.00% | 3.00% | 4.00% |
Premium Revenue growth - Bull | 3.00% | 4.00% | 5.00% | 6.00% | 7.00% |
Premium growth - Bear | 0.00% | 0.00% | 1.00% | 1.50% | 2.00% |
MCR - Base | 85.50% | 85.50% | 85.50% | 85.50% | 85.50% |
MCR - Bull | 85.50% | 85.50% | 85.50% | 85.50% | 85.50% |
MCR - Bear | 86.00% | 86.00% | 86.00% | 86.00% | 86.00% |
AET | 2013 | 2014 | 2015 | 2016 | 2017 |
Premium Revenue growth - Base | 3.00% | 3.00% | 3.00% | 3.00% | 3.00% |
Premium Revenue growth - Bull | 6.00% | 6.00% | 6.00% | 6.00% | 6.00% |
Premium growth - Bear | 1.00% | 1.00% | 1.00% | 2.00% | 2.00% |
MCR - Base | 84.00% | 84.25% | 84.75% | 85.00% | 85.25% |
MCR - Bull | 84.00% | 84.00% | 84.00% | 84.00% | 84.00% |
MCR - Bear | 84.50% | 85.00% | 85.75% | 86.25% | 86.50% |
I made some substantial changes in estimating operating revenue and costs for UNH. In my previous models, I broke out "premium revenue" and "other revenue" for UNH, and broke out "medical cost," "depreciation & amortization," "interest expense" and "other expenses" to arrive at pre-tax operating income. I now categorize revenue and cost line items similar to how they are reported in the 10-k filing. Table 2 details the related assumptions I made. F2013 EPS is estimated to be $5.43, in line with management's full-year outlook. Other parameters that are not discussed above are the same as those in my 7/10/2013 article.
As a result, the fair value estimate for UNH decreases from $79.73 to $70.72. There are two lessons learned: firstly, going forward, I should continue to refine my models to reflect more accurate economic relationships matching costs to revenues. Secondly, having a margin of safety is critical to cushion any off-target projections in modeling. The buy rating on UNH with a target of $80 was first issued when it was trading around $56 in late January and retained when stock price was around $68 in early July. Suppose the intrinsic value has always been at $71, one would have still bought the stock at a bargain in January and at an almost fair price in July.
Table 2. UNH Model Assumptions
Line Items | Figure | Comment |
Service and product revenue over premium revenue | 9.93% | 3-year average |
Investment Income | $647 millions | 3-year average |
SG&A over total revenue | 15.36% | 3-year average |
COGS over service and product revenue | 25.52% | 3-year average |
Source: UNH 2012 10-k.
Risk/Return profiles deteriorated
As seen in Table 3, the risk/return profile for UNH is more or less neutral while those of WLP and UNH have turned unfavorable, with downside risk overshadow upside potential.
Table 3. Risk/Return Profiles and Fair Value Estimates
UNH (12/2/2013 close at $74.16) | Bull case | Base case | Bear case |
Fair value estimate per share | $107.85 | $70.72 | $50.17 |
Terminal EV/E | 16.15 | 17.01 | 17.72 |
Terminal EV/CFO | 12.37 | 11.60 | 11.07 |
Terminal EV/S | 0.80 | 0.55 | 0.45 |
Fair value P/E | 19.99 | 13.10 | 9.30 |
Fair value P/CFO | 15.44 | 10.12 | 7.18 |
Fair value P/S | 1.00 | 0.65 | 0.46 |
Upside/Downside potential | 45.43% | -4.64% | -32.35% |
Upside/Downside potential ($) | $33.69 | -$3.44 | -$23.99 |
WLP (12/2/2013 close at $93.96) | Bull case | Base case | Bear case |
Fair value estimate per share | $106.66 | $83.61 | $63.91 |
Terminal EV/E | 15.51 | 15.92 | 16.28 |
Terminal EV/CFO | 12.38 | 12.17 | 11.79 |
Terminal EV/S | 0.56 | 0.51 | 0.44 |
Fair value P/E | 12.21 | 9.57 | 7.31 |
Fair value P/CFO | 11.81 | 9.26 | 7.08 |
Fair value P/S | 0.53 | 0.41 | 0.31 |
Upside/Downside potential | 13.56% | -10.98% | -31.96% |
Upside/Downside potential ($) | $12.74 | -$10.31 | -$30.01 |
AET (12/2/2013 close at $68.46) | Bull case | Base case | Bear case |
Fair value estimate per share | $85.75 | $59.47 | $40.76 |
Terminal EV/E | 13.87 | 13.69 | 13.43 |
Terminal EV/CFO | 11.96 | 11.48 | 10.83 |
Terminal EV/S | 0.61 | 0.50 | 0.39 |
Fair value P/E | 18.62 | 12.91 | 8.85 |
Fair value P/CFO | 16.94 | 11.75 | 8.05 |
Fair value P/S | 0.84 | 0.59 | 0.40 |
Upside/Downside potential | 25.25% | -13.13% | -40.47% |
Upside/Downside potential ($) | $17.29 | -$8.99 | -$27.70 |
Market thinks health insurer stocks are less risky now
DCF models are very sensitive to cost of equity, which feeds into the calculation of WACC, the factor I use to discount future cash flows. In my July update, I provided the following reasons to set cost of equity at 12%. The higher the discount rate, the lower the fair value is.
Most importantly, my model sets cost of equity at 12% for all three stocks to account for uncertainty surrounding Obamacare, while corporations that operate on a similar scale in other industries well deserve a cost of equity of 10%. We hope to know a lot more about the implementation of the exchanges over the next few quarters.
Source: "Buy UnitedHealth And Hold WellPoint And Aetna To Capitalize On Obamacare" published on SeekingAlpha on 7/10/2013
Suppose the health insurers' business condition stays stable over the past six months, meaning the E of the P/E multiple is stable, the price appreciation is attributable to multiple expansions. As shown in Table 4, the market price is close to fair price calculated at the cost of equity around 11%-11.5% (in bold) and the trailing 12-month P/E ratios correspond to 11%-11.5% cost of equity as well.
Table 4. Fair Value Estimates, Cost of Equity and Implied P/E Multiples
FV at Cost of Equity = | 12% | 11.50% | 11% | 10.50% | 10% | Market Price (12/2/2013) | |
UNH | $70.72 | $74.61 | $78.91 | $83.70 | $89.07 | $74.16 | |
WLP | $83.61 | $89.60 | $96.21 | $103.54 | $111.71 | $93.92 | |
AET | $59.47 | $63.01 | $66.91 | $71.22 | $76.02 | $68.46 | |
Trailing 12-month P/E at FV using Cost of Equity = | 12% | 11.50% | 11% | 10.50% | 10% | Trailing 12 month P/E at Market Price | 5-year Avg P/E |
UNH | 13.37 | 14.10 | 14.92 | 15.82 | 16.84 | 14.02 | 10.1 |
WLP | 9.10 | 9.75 | 10.47 | 11.27 | 12.16 | 10.22 | 7.9 |
AET | 12.04 | 12.76 | 13.54 | 14.42 | 15.39 | 13.86 | 9.2 |
Source: 5-year Avg P/E ratios are sourced from Morningstar.com. Other P/E ratios are calculated using market price or fair value estimates divided by TTM earnings sourced from Morningstar.com.
Alarming insider sales
In spite of this observation, I have decided to keep cost of equity at 12%. Further delays on key provisions, malfunctioning health exchange websites, and overall stock market getting loftier all argue against lowering cost of equity estimate. What is more, intensive insider selling activities at WLP and AET also vote against lifting price targets. For instance, WellPoint's CFO, Wayne S. DeVeydt, sold $14.5 million worth of his company's stock on 9/5/2013, the same date when he exercised 149,565 options. According to Yahoo Finance, over the last six months, WellPoint's management team and boards reduced their holdings in the company by 33.8%, Aetna's by 20.9%, and UnitedHealth's by 6.8%. While one could argue that exercising stock options before the end of the year had something to do with tax planning, the selling activities at Aetna and WellPoint are much more aggressive than a typical year-end sale to lock in gains.
Conclusion
As it is also shown in Table 4, the trailing 12-month P/E for all three stocks are well above their 5-year averages. Granted, they had their heydays in early 2000s when their revenues were growing more than 20% y-o-y and P/E ratios hovering around mid-20s. These days are not coming back any time soon. In my opinion, holding these stocks would be a bet on multiple expansions and/or growths exceeding expectations that are priced in. A seasoned value investor should sell his or her holdings in these three stocks now, when stock prices do not seem to offer a meaningful discount to intrinsic values. However, my sell recommendation should not be interpreted as a short case because the health care insurance business is fundamentally sound and P/E below 15 is perfectly reasonable by Wall Street standards.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article. (More...)
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