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Still Neutral on UnitedHealth

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We are reiterating our Neutral recommendation on the shares of UnitedHealth Group Inc. (UNH - Free Report) . Though we are bullish on the company’s long-term growth prospects, there remain certain headwinds, such as high unemployment, growing medical cost, pressure from Health Care overhaul, which might keep the earnings under check in the near term.

UnitedHealth is one of the biggest and most diversified health insurers in the U.S. It holds a huge market share in the Medicare market, which is expected to boom in the coming years as million of Americans will enter the retirement age. The company has made a number of acquisitions (most significant of which is the purchase of XL Health Corp.) to further strengthen its position in the MA market, resulting in long-term growth.

UnitedHealth’s health service business is a very important part of the company’s diversification strategy. Management is considering the expansion of the health service business to produce 30%–40% of operating income over the longer term and has been making acquisitions in the area. It believes the company is under-penetrated in the health service area and that investment in this field will reap benefits over the long term. 

UnitedHealth is also expanding its business internationally. It has made an agreement with Dubai-based Al Sagr National Insurance Co. to expand in the Middle East.  Geographical diversification features prominently in the company’s plan of action as the Health Care Reform imposes a lot of restrictions back in the U.S. Over time we expect more deals from the company, pertaining to its international expansion where it faces less competition. 

The company has also been growing its membership over the past couple of years. It added 2.6 million consumers with medical benefits over the past two calendar years. It introduced additional 1.7 million people in the second quarter 2012, and we expect the trend to continue.

Factors offsetting the positives include higher operating costs from investment in ICD-10 and health reform, higher utilization as well as low investment income.

UnitedHealth is witnessing increased operating costs due to high medical and operating cost pressures related to the Affordable Care Act and Mental Health Parity Act. The company will also face heightened expenses in complying with the federally mandated ICD-10 coding and HIPAA 5010 standards.

Though the company had experience low medical care over the past couple of years, leading to reducing medical claim cost and increasing profits management expects return to normalized medical utilization trends soon, that will wipe out the extra earnings benefit the company had been enjoying so far.

Low interest rates, which will culminate into low investment income putting earnings under pressure, are still a major cause of concern.

The company’s peers, such as Aetna Inc. (AET - Free Report) , CIGNA Corp. (CI - Free Report) , WellPoint Inc. , are also carrying long-term Neutral recommendation. The stock of UnitedHealth retains a Zacks #3 Rank, which translates into a short-term Hold rating.

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