Why You Should Buy These Health Insurers

David is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

The country's leading health insurer, UnitedHealth (NYSE: UNH) trades at less than 10x forward earnings at a time when it is likely to get a nice stream of free cash flow from the Affordable Care Act. As the insured population increases, greater demand and risk will be placed on resources to help raise premiums. 

UnitedHealth

Analysts forecast 11.2% annual EPS growth over the next 5 years, which gives the company strong room to appreciate through multiples expansions and off of a 10% discount rate.

There are, however, several reasons to be pessimistic about United. It looks like the company is on a cyclical decline over the next two years. As the pricing cycle declines and utilizations go up, commercial margins will depress. More concerning is the prospect of missing out on the effects of the economy moving towards full employment. Commercial enrollment growth has historically lagged macro recovery by as much as 2 years. If you back United or any of its peers, Aetna (NYSE: AET) or WellPoint (NYSE: WLP) now, you could miss out on the growth that other industries are likely to experience.

Despite this concern, it is likely that consumers will move towards quality insurers, like United. In the long-run, this cyclical decline in the commercial business could actually help United increase market share and thereby secure a larger base from which to yield greater cash flow. Moreover, 73% of WellPoint and 58% of Aetna versus just 34% of United, according to Wedbush, is exposed to commercial risk. As the analyst rightly notes, United has the best experience in dealing with long-term treatment and dual eligibles - complexities that will enable the insurer to deal with rapid market expansion over the next 2 years. The expansion in Medicaid has yet to be appreciated as a catalyst for shareholder value in Centene. In fact, it could boost enrollment by nearly 20% through 2014. Accordingly, I strongly recommend making an investment as the firm benefits from these longer-term trends.

Aetna & WellPoint

WellPoint and Aetna are still worthy of an investment. Aetna trades at less than 7x forward earnings and a PEG ratio of around 0.7, which indicates that future growth has not been fully accounted for in the stock price. With the stock now closer to its 52-week high than its 52-week low, now is an attractive entry point to accumulate shares. From the acquisition of the Medicare Supplement business to the acquisition of third-party administrator lines, Aetna is laying down the foundation of solid vertical integration.

At the same time, Aetna's utilization is looking better while the existing business is doing just fine. I am particularly optimistic about commercial MLF, which should see around a 400 bps y-o-y increase - accounting for decelerating pricing yields and lower PPD. Lifting of CMS sanctions will also enable Aetna to experience a strong enrollment growth in Medicare Advantage. WellPoint will likely benefit from these enrollment trends. Over the years, however, free cash flow generation has been weak. In 2Q12, the firm generated only $200 million more than it did four years ago at $2.7 billion. Even still, revenue growth is trending upwards. Accordingly, I recommend buying a smaller stake to supplement larger ones in Aetna and United.

 


TakeoverAnalyst has no positions in the stocks mentioned above. The Motley Fool owns shares of WellPoint. Motley Fool newsletter services recommend UnitedHealth Group and WellPoint. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.If you have questions about this post or the Fool’s blog network, click here for information.

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