Name That Trade $UNH – Failed Breakout

by Enis April 30, 2013 1:33 pm • Commentary

Health insurance is not a glamorous business.  It’s widely blamed, rarely praised, and viewed as a scourge on the American economy.  It’s believed to drive up costs for all, and encourage suboptimal health outcomes at the same time.  The story is probably more nuanced, not quite so black and white, but as a financial observer from afar, it’s evident that it’s also pretty darn profitable.

UnitedHealth is one of the largest health care insurers in the world, at a $61 billion market cap.  Here’s their own description from their most recent quarterly release, for a sense of their size:

Through UnitedHealthcare and Optum, in 2012, we managed nearly $150 billion in aggregate health care spending on behalf of the constituents and consumers we served. Our revenues are derived from premiums on risk-based products; fees from management, administrative, technology and consulting services; sales of a wide variety of products and services related to the broad health and well-being industry; and investment and other income.

That’s a long way of saying that they insure the health care of about 10% of Americans.  One read through the quarterly report (if you can stay awake) is enough to understand that government rules on health care reimbursement will have a significant impact on UNH’s business in the coming years.

So it made sense that the stock broke out above the important $60 level earlier in April, when the Centers for Medicare and Medicaid Services (CMS) reversed its prior decision to cut key Medicare premium rates.  Premium revenues from CMS represent about 29% of UNH’s total revenues.

This is what I wrote on April 2nd in the CotD post, following that breakout:

Here’s the 3 year chart showing the importance of its gap higher today:

3 year weekly chart of UNH, Courtesy of Bloomberg

3 year weekly chart of UNH, Courtesy of Bloomberg

The chart shows the strong performance in 2010 and 2011.  In 2012, UNH spent most of the year consolidating its prior gains, as the stock ranged between 50 (in red) and 60 (in green) for most of the year.  The stock’s gap up today is a clean breakout higher, and I expect the 60 level to act as strong support for the stock going forward.

I was wrong though, as UNH was not able to hold that $60 support.  The catalyst was a disappointing earnings report.  A major factor continues to be government rate pressure.  Another key takeaway from that report:

In government programs, we are seeing continuing rate pressures, and rate changes for some Medicaid programs are slightly negative. Unlike in prior years, recent Medicaid reductions have generally not been mitigated by corresponding benefit reductions or care provider fee schedule reductions by the state sponsor

The stock’s now back under $60, though $58 has acted as important support and is the key level to watch on the downside:

1 year daily chart of UNH, Courtesy of Bloomberg
1 year daily chart of UNH, Courtesy of Bloomberg

Despite the poor reaction to earnings though, the company’s 4 year performance is impressive.  Its average Return on Equity in that period is around 18% per year, though the stock has doubled in that time frame (but flat in the last year).  Its valuation has inched higher over that period as well, though it still looks cheap vs. the broader market:

10 year chart of UNH Trailing P/E, Courtesy of Bloomberg

10 year chart of UNH Trailing P/E, Courtesy of Bloomberg

Though the company has grown earnings at 10-25% over the last few years, investors are clearly nervous about regulatory changes in the insurance business.  Its trailing P/E around 11.50 is still much below the broader market, though its growth prospects are also lower now, about 5% this year.

Put it all together, and I think this is a cheap company in a generally expensive market backdrop, but with risks if more drastic changes to health insurance are pushed forward.  We are considering a range trade targeting the 58 to 64 range given the push/pull of these competing factors.  For now, it’s a watch and wait situation. But we may become more interested towards the low end of that range.

Here’s what we would probably do a little bit lower in the stock:

Buy June 55/60/65 call fly

If we could get this trade for under 2 dollars that would offer us a nice range of just under 57 to just over 63 in the stock, a range we would feel pretty comfortable with earnings beyond that expiration date.

This is not a trade we’re putting on here but will be watching the stock for a good entry