We are lowering our rating on UnitedHealth Group Inc. (NYSE: UNH) to HOLD from BUY as we expect the company to face earnings headwinds from rising medical utilization. While UNH raised its EPS guidance for 2020, it also expressed substantial caution about its outlook for the remainder of 2020 and 2021. The updated guidance reflects the cost of customer assistance programs, more normal care patterns (which could rise above the seasonal baseline), and rising acuity from the resumption of surgical procedures. The combination of declining commercial enrollment and rising utilization is likely to pressure margins going forward.
On valuation, UNH is trading at 18.0-times our 2021 EPS estimate, above the mean of 16.2 for our coverage universe of managed care stocks. We think this valuation is pricey given the company’s current challenges, and that a HOLD rating is now appropriate.
UnitedHealth posted mixed 3Q20 results on October 14. Adjusted EPS fell 10% from the prior year to $3.51, but topped the consensus estimate by $0.41. GAAP net income fell to $3.256 billion or $3.30 per share from $3.538 billion or $3.67 per share. Consolidated revenue rose 8% to $65.1 billion, driven by strong 21% growth in the Optum segment.
The lower earnings reflected costs for customer assistance programs, including the waiving of co-pays for COVID-19 testing; accelerated payments to care providers; and higher expenses for the direct care and testing of COVID-19 patients. These costs were partly offset by reduced demand from members and care providers due to social distancing protocols. While demand for care rose sequentially from 2Q20, it fell slightly from the prior year. The 3Q medical loss ratio (MLR) was 81.9%, compared to 82.4% in 3Q19.
By business segment, revenue at UnitedHealthcare rose 4.7% to $50.4 billion. The segment margin was 4.1%, down 140 basis points. Growth in public sector businesses (Medicaid) and senior programs (Medicare Advantage and MedSupp) was partially offset by declines in commercial membership.
Revenue at Optum grew 21.4% to $34.9 billion, though the segment margin fell 80 basis points to 7.4%. The higher sales reflected increased service volume at senior clinics, as well as growth in in-home services and virtual telemedicine visits. At OptumInsight, the revenue backlog rose by $500 million to $20 billion.
We are concerned that total care activity and medical utilization, recovering quickly from their 2Q20 troughs, will shoot above the seasonal baseline in 4Q20 and 1Q21. We are also concerned about declining enrollment in UnitedHealthcare commercial plans due to private-sector job losses. The combination of rising utilization and reduced enrollment could pressure margins in the coming quarters. On its 3Q earnings call, management said that total care activity in the quarter exceeded 95% of the seasonal baseline, with certain categories approaching normal. By contrast, total care activity fell to about two-thirds of the baseline at the lowest point in 2Q20.
Surgical activity at Optum ambulatory surgery centers showed an even more dramatic recovery. These centers operated at 95% of the seasonal baseline in 3Q20, up from 55% in 2Q20.
The recovery in high-acuity activity, such as surgical procedures, is consistent with recent reports from medical device companies regarding sales of surgical tools and implants.
EARNINGS & GROWTH ANALYSIS
UNH has raised its 2020 adjusted EPS guidance to $16.50-$16.75 from $16.25-$16.55. While this appears positive on its face, management expressed considerable caution due to the cost of customer assistance programs, COVID-19-related costs, and rising medical utilization.
Based on these factors and management’s revised guidance, we are raising our 2020 adjusted EPS estimate to $16.55 from $16.30. Given the conservative early outlook for 2021, we are lowering our 2021 estimate to $18.40 from $18.60.
FINANCIAL STRENGTH & DIVIDEND
The company has a solid balance sheet and strong cash flow. Cash flow from operations in the first nine months of 2020 was $16.1 billion, compared to $12.3 billion in the same period a year earlier. The debt/equity ratio at the end of 3Q20 was 58.6%, compared to 60.0% at the end of 2Q.
UNH pays an annualized dividend of $5.00 per share, for a yield of about 1.6%. Our dividend estimates are $5.00 for 2020
UnitedHealth faces competitive risks in both the commercial and government markets as rival insurers, both for-profit and not-for-profit, seek to expand share. It also faces actuarial risks, as it must estimate the growth of healthcare costs and the utilization of medical services by its members. The profit margin of the UnitedHealthcare insurance segment is measured by the medical loss ratio, which is ratio of medical costs to premium revenue. A lower ratio means a higher profit margin.
By revenue, UnitedHealth Group is the nation’s largest publicly traded managed care company. It operates through two business segments, UnitedHealthcare and Optum. UnitedHealthcare provides healthcare benefits through four membership groups: Employers & Individual, Medicare & Retirement, Community & State, and International. Optum uses advanced data analytics and technology to help optimize the performance of clients. Optum includes OptumRx, which operates a pharmacy benefit management service (PBM).
UNH is trading at 18.0-times our 2021 EPS estimate, above the mean of 16.2 for our coverage universe of managed care stocks. We think this valuation is pricey as we expect the company to face pressure from rising medical utilization, increased COVID-19 costs, and declining commercial enrollment. As such, we are lowering our rating to HOLD.
On October 16, HOLD-rated UNH closed at $329.90, up $5.33.