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By Erik Kobayashi-Solomon | 10-28-2010 09:31 AM

Sky Didn't Fall for UnitedHealth

UnitedHealth stock has advanced as investors saw reform would not be as negative as anticipated, and there is still upside from here.

Securities mentioned in this video
UNH UnitedHealth Group Inc

Erik Kobayashi-Solomon: Hi, I'm Erik Kobayashi-Solomon, co-editor of Morningstar's OptionInvestor.

Today it's my great pleasure to welcome Matt Coffina, who is an equity analyst in charge of managed care here at Morningstar.

Matt, thanks for coming

Matthew Coffina: Thanks for having me, Erik.

Kobayashi-Solomon: Okay, so back in November of last year, you co-authored an article about UnitedHealth, and at the time your argument was, look, everybody is too worried about health-care reform and insurance reform; the stock was trading at $26 a share. There is a lot of upside from here. So, looking back how much did health-care reform actually affect UnitedHeath?

Coffina: As it turned out, there really weren't any surprises versus what we were expecting back in November. Back then we already had a pretty good sense of where the bill is going in terms of what we had out of the Senate and out of the House, and there was still uncertainty as to whether or not the bill would be passed at all. But we thought we had a pretty good handle on what it would look like if it did get passed, and it did get passed in more or less that form.

There is going to be a few effects on UnitedHealth, positive and negative. We outlined those back in November, and really those haven't changed. Medicare reimbursements are coming down, which is going to be negative for UnitedHealth. There is going to be new regulation of medical costs, which is going to be a negative, and on the flip side, there is going to be a major expansion in the number of people with insurance, which should be a positive.

Kobayashi-Solomon: Even the negatives though – I mean UnitedHealth has plenty of time to kind of prepare for this, to cut their cost structure and things like that, right?

Coffina: I think most of the negatives will already be showing up in 2011. There is these medical cost ratio floors that are going to take effect in 2011, where basically they have to spend a certain percentage of premiums on medical costs instead of administration or profits.

So I think that next year's earnings we're looking to be down about 9% versus this year, and then they should return to growth after that. So not that big of a negative impact to begin with and it should be mostly out of the way as of next year.

Kobayashi-Solomon: I've got to tell you, I'm really happy that you talked me into this. It was a sensible idea when you first told me about it, and I just sent out a mail closing this position for a gain of about 86% in less than a year. So, a very nice gain for us.

Coffina: That's great. Our fair value in UnitedHealth is still a bit higher than where the stock is at, about $50. That puts the stock right about 4-star range, so not quite a buying opportunity. But I think there is still upside from here, but given that your options were about to expire in January and there aren't that many near-term catalysts.

Kobayashi-Solomon: So that's what I was going to ask about. What about – I mean everybody is talking about political change in November, do you think that political change would do something positive for UnitedHealth?

Coffina: I think if the Republicans take control of the House or both chambers, I think that will be a marginal positive for UnitedHealth, mostly just because it removes that uncertainty of the Democrats doing something even worse to them on the regulatory front as they are implementing health reform.

I don't think there is really any realistic chance that health reform as it has already been passed is going to be repealed or really meaningfully changed. The President still has veto power if nothing else.

So I think it's a marginal positive, but it's not something that I'd expect the stock to shoot up right after the election, especially since it's already expected at this point that the Republicans are going to take control.

Kobayashi-Solomon: Sure, and it should already be priced into the stock. So, of course, with option investing different from stock investing, you have an expiration, and our expiration is coming up, and time value is just starting to leak away. So, I thought well we have about doubled on this position. Let's go ahead and close it right now.

Coffina: Yeah, I think there is still room for UNH to move up as I said, it might be…

Kobayashi-Solomon: In terms of the stock, right?

Coffina: Yeah, but it might be gradual over the next few years. I think, as investors get more comfortable about exactly what the impact of health reform is going to be on earnings, that it won't be as bad as people still seem to be expecting.

Kobayashi-Solomon: Realize that the sky isn't falling.

Coffina: Basically. Back in November when we took the position originally, everyone was really worried that the sky was falling, this was the business model that wasn't going to be around…

Kobayashi-Solomon: Right, right. It's a really controversial call at the time, I think.

Well, Matt thanks very much. I really appreciate the time that you have put into this and your help today.

Coffina: Sure, thanks for having me.

Kobayashi-Solomon: Thank you for joining us. Please stop by the OptionInvestor website where you'll find many more option ideas based on Morningstar's fundamental research.

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