Dividend Growth Stock of the Month for November 2019: UnitedHealth Group (UNH)

UnitedHealth Group (UNH) is a diversified healthcare company, headquartered in Minnetonka, MN. It provides healthcare benefits globally, serving individuals, employers, and Medicare and Medicaid beneficiaries.

UNH serves its customers through two distinct platforms:

UNH’s Dividend Record

UNH’s dividend record is very good for the kind of dividend growth company that it is: Low-yield, fast-growth.

While its yield is low, UNH has been growing its dividend like gangbusters. Its 5-year dividend growth rate (DGR) is 27% per year. In 2018 and again in 2019, it raised its dividend 20% each year. That is very fast.

Simply Safe Dividends gives UNH a near-perfect score on dividend safety: 99 out of 100 points.

UnitedHealth’s Business Model and Company Quality

UnitedHealth is the largest health care management company in the USA, offering health benefits and services to people in all 50 US states as well as clients in more than 130 other countries.

UNH provides a range of healthcare products and services:

• traditional risk-based health insurance plans
• fee-based health insurance plans
• administration of health insurance plans
• pharmacy benefit management
• healthcare delivery optimization strategies.

UNH has two business segments:

• UnitedHealthcare, which focuses on health insurance plans
• Optum, which focuses on healthcare optimization.

The UnitedHealthcare segment provides health care benefits globally, serving individuals, employers, and Medicare and Medicaid beneficiaries. This segment offers a full spectrum of health benefits programs, including basic health insurance, employer-provided plans, Medicare Advantage and Medicare supplement plans, and online resources for healthcare providers.

In the USA alone, UNH serves over 43 million customers. On a state-by-state basis, UNH is either the first or second-largest insurer (in terms of premiums collected) in 28 states. The UnitedHealthcare segment delivers about 53% of UNH’s profits.

The Optum segment is a health services business serving the global health care marketplace, including payers, care providers, health systems, employers, governments, life sciences companies, and consumers. It uses market-leading information, data analytics, technology, and clinical insights to introduce efficiencies into the healthcare system. Optum delivers about 47% of UNH’s profits.

This slide shows the broad and integrated nature of UNH’s business.

The Optum segment is a real growth engine. The slide below illustrates 21% earnings growth on 11% revenue growth from 2017-2018 (the last full year for which numbers are available).

Optum’s share of profit delivery to the parent company has grown from 26% to 47% of the parent’s overall total over the past five years. Optum’s efficiency “products” and impacts are attractive throughout the industry. Further, as UnitedHealthcare makes acquisitions, those providers become all-but-guaranteed customers for Optum’s services.

Medicare/senior healthcare is a strong growth driver for the UnitedHealthcare segment.

Morningstar awards UNH a Wide moat (its highest rating), based on:

• The wide breadth and sheer size of its business leading to benefits of scale
• The integration of its business across the two segments creates network effects that benefit both segments, in a way that competitors have not replicated
• In turn, the network effects enable UNH often to be the low-cost provider of insurance services

UnitedHealth’s Financials
Value Line gives UNH its highest Financial Strength grade of A++. The company has held that grade since 2014.

Let’s look under the hood at some key financial categories.

Return on Equity (ROE) is a standard measure of financial efficiency. ROE is the ratio of profits to shareholders’ equity.

The average ROE for all Dividend Champions, Challengers, and Contenders is 11%. The following chart shows UNH’s ROE 2009-2018.

[Source of all yellow-bar charts in this section: Simply Safe Dividends]

UNH’s ROE is well above average.

Debt-to-Capital (D/C) ratio measures how much a company depends on borrowed money. Companies finance their operations through a mixture of debt and equity (shares issued to the open market) as well as their own cash flows.

A typical D/C ratio for a large, healthy company is 50%.

The normal use of D/C is to gauge risk, because it helps determine how strong the balance sheet is. All else being equal, stocks with high D/C ratios are generally riskier than those with low D/C ratios.

Again, UNH comes in much better than average, with a D/C ratio of just 38% at the end of 2018. Its most recent quarterly report showed D/C of 43%.

Operating margin is one of my favorite financial metrics. It measures profitability: What percentage of revenue is turned into profit after subtracting cost of goods sold and operating expenses.

Per recent research, typical operating margins for S&P 500 companies have been in the 11-12% range.

UNH’s operating mrgins are below national averages, but good for the highly competitive health insurance and services sector. Its most recent quarterly report clocked in at 8%.

Earnings per Share (EPS) is the company’s officially reported profits per share. We want to see if a company has had years when it officially lost money, or if its earnings are steadily increasing, declining, or flat.

UNH’s EPS record is outstanding. This is one of the few companies I have seen whose EPS has risen every year for 9 straight years.

UNH’s most recent four quarters of earnings clock in at $13.74, so 2019 looks like it will add to the streak of consecutive annual EPS rises. Analyst estimates are for 14% growth.

Free Cash Flow (FCF) is the money left over after a company pays its operating expenses and capital expenditures. Whereas EPS is subject to GAAP accounting rules, cash flow is a more direct measure of money flowing through the company. It’s the money a company has available for dividends, stock buybacks, and debt repayment.

Excess FCF allows a company to pursue investment opportunities, make acquisitions, repurchase shares, and pay/increase dividends.

Again, UNH’s FCF record is outstanding. There are only two slight annual drops in the past nine years, and overall the trend has been strongly up. This is a great underpinning to UNH’s ability to keep raising its dividend by significant percentages.

Share Count Trend shows whether the company’s outstanding shares are increasing, decreasing, or remaining flat.

I like declining share counts, because the annual dividend pool is spread across fewer shares each year. That makes it easier for a company to maintain and increase its dividend. By buying back its own shares, the company is essentially investing in itself and expanding each remaining share into a larger piece of the pie.

Here again we see another good record, with annual share decreases for nine straight years. UNH’s most recent quarterly report shows share count down to 963 million. That is 18% fewer shares than it had outstanding at the end of 2009.

Here is a summary of the items above:

Taking everything into account, I think that Value Line’s A++ financial rating is a little too high for UNH. There are a couple areas that could be better.

That said, UNH’s financial record and outlook is very good. On a more common scale of A-F, I would give UNH a B+ bordering on A.

UnitedHealth’s Stock Valuation

I use four different valuation models, then average them out.

Model 1: FASTGraphs Basic. The first step is to compare the stock’s current price to FASTGraphs’ basic estimate of its fair value.

The basic valuation estimate uses a price-to-earnings (P/E) ratio of 15, which is the historical long-term P/E of the stock market, to create a basic fair- value reference line.

In the following chart, the fair-value reference line is orange, and the black line is UNH’s actual price. I highlighted both UNH’s current P/E ratio and the reference ratio of 15 used to draw the orange line.

Since the black price line is above the orange fair-value reference line, UNH is overvalued by this first assessment method.

To calculate the degree of overvaluation, we make a ratio out of the P/Es.

Calculating Valuation Ratio from FASTGraphs
Actual P/E ratio / Reference P/E ratio
17.3 / 15 = 1.15

That suggests that UNH is overvalued by 15%.

We calculate the stock’s fair price by dividing the actual price by the valuation ratio. We get $252 / 1.15 = $219 for a fair price.

Remember, valuation is an estimate or assessment, not a physical trait like length or width. We are making a judgement. Different models will come up with different results. That’s why I average four approaches.

Model 2: FASTGraphs Normalized. The second valuation step is to compare UNH’s current P/E to its own long-term average P/E.

This model paints a different picture. Here the price line is below the fair-value line, suggesting that UNH is undervalued. I highlighted UNH’s actual P/E ratio, as well as its 5-year “normal” P/E ratio used to draw the blue reference line.

The calculations are the same as in the first step:

• Valuation ratio = 17.3 / 18.8 = 0.92
• Fair price = $253 / 0.92 = $275

Step 3: Morningstar Star Rating. Morningstar takes a different approach to valuation. They ignore P/E ratios and instead use a discounted cash flow (DCF) model for valuation. Many investors consider DCF to be the best method of assessing stock valuations.

In a nutshell, the DCF model is based on the idea that a company is worth all of its future cash flows, discounted back to the present to reflect the time value of money.

Obviously, no one actually knows a company’s future cash flows. Estimates must be used. My experience with Morningstar is that they have a careful, comprehensive, and conservative process.

Morningstar gives UNH 4 out of 5 stars, meaning that they consider the company to be undervalued.

Here is a historical graph of their fair value estimates (black line) compared to the stock’s price (dotted).

Morningstar’s approach results in a valuation ratio of 0.81 (meaning 19% undervalued), and they calculate a fair price of $310.

Step 4: Current Yield vs. Historical Yield. My last step is to compare the stock’s current yield to its historical yield. This way of estimating fair value is based on the idea that if a stock’s yield is higher than usual, it may indicate that its price is undervalued.

This chart shows UNH’s current yield (green dot) compared to its 5-year average yield (black line).

[Source: Simply Safe Dividends]

UNH’s 5-year average yield is 1.5%, while its current yield is 1.7%. When the current yield is higher than the historical average, that suggests that the stock is undervalued.

As with the other methods, we can make a valuation ratio out of these numbers.

Calculating Valuation Ratio from Yield Comparison
Historical yield / Current yield
1.5% / 1.7% = 0.88

That suggests undervaluation of 12%. We calculate the fair price in the usual way: $252 / 0.88 = $286.

Valuation Summary:
The bottom line combining my four models is that UNH is 8% undervalued. To be conservative, I consider anything within +/- 10% of fair value to be “fairly valued,” despite the 8% discount to fair value that I calculated from the four models.

For comparison, in its most recent report on UNH, the independent financial information provider CFRA has a 12-month price target of $303 for UNH.

Miscellaneous Factors

Beta

Beta measures a stock’s price volatility relative to the S&P 500. I like to own stocks with low volatility for 2 reasons:

• They present fewer occasions to react emotionally to rapid price changes like price drops that can induce a sense of fear.
• There is industry research that suggests that low-volatility stocks outperform the market over long time periods.

UNH’s 5-year beta is 0.6, which means its volatility has been, on average, 40% less than the market’s. This is a positive factor.

Analyst’s Recommendations

In their most recent report on UnitedHealth Group, CFRA gathered the recommendations of 28 analysts covering the stock. Their average recommendation is 4.4 on a 5-point scale, where 4 = buy and 5 = strong buy. So the average recommendation is well into the buy range. This is a positive factor.

What’s the Bottom Line on UnitedHealth Group?

UNH’s positives:

• Very good dividend resume for low-yield dividend-growth company.
• Has increased its dividend 10 years in a row and sports a 99/100 dividend safety rating from Simply Safe Dividends.
• Comprehensive health insurance provider, running in parallel with healthcare services/optimization business. Segments are logical and support each other.
• High-quality company as reflected in wide moat rating, A+ credit rating, top ValueLine safety rating, and my own B+ business model rating.
• B+ financial rating from me, A++ from ValueLine. Share count consistently declining for years. Earnings on 10-year increase streak, which is unusual. Steadily declining share count.
• Low 5-year beta of 0.6, meaning that price is less volatile than market as a whole.
• Very high 4.4 out of 5 rating from sell-side analysts, translating to buy to strong buy.
• Shares are 8% undervalued.

UNH’s negatives:

• There is broad risk related to possible secular changes in how healthcare is funded and regulated.

In my opinion, UNH is a very attractive opportunity for a high-quality, well-run company selling for an 8% discount.

Here are other recent discussions of UNH on Daily Trade Alert:

High Yield Trade of the Week: UnitedHealth Group (Greg Patrick, October 2019)
Undervalued Dividend Growth Stock of the Week: UnitedHealth Group (Jason Fieber, October, 2019)
We Just Put $1000 Into this Stock for DTA’s Income Builder Portfolio (Mike Nadel, August 2019)

Remember that this is not a recommendation to buy, hold, or sell UnitedHealth Group. Always do your own due diligence. Think not only about the company’s quality, dividend outlook, and business prospects, but also about how it fits your personal financial goals.

— Dave Van Knapp

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