Health Care: Managed Care

INITIATING COVERAGE REPORT

William C. Dunkelberg Owl Fund th February, 5 2014 Michael Lam: Lead Analyst mlam@theowlfund.com Ethan Friedland: Associate Analyst efriedland@theowlfund.com Niclas Dombrowski: Associate Analyst ndombrowski@theowlfund.com

United Health Group, Inc.

Exchange: NYSE Ticker: UNH Target Price: $83.83 COMPANY OVERVIEW United Health Group (UNH) is the largest publicly traded managed care organization (MCO). UNH provides employers with products and resources to plan and administer employee benefit programs and services. UNH currently serves over 45 million members through a network of 780,000 physicians and 6,000 facilities. The United Healthcare segment (75.45% of revenues) includes Employer & Individual: Private insurance for individuals and family members (39.5% of total premiums) Medicare & Retirement: Government-run Medicare services to 50 + individual (38.8% of total premiums) Community & State: Medicaid solutions to economically disadvantaged (16.1% of total premiums) International: Private healthcare services to individuals and corporates in Brazil. (5.6% of total premiums) The Optum segment (24.55% of revenue) includes OptumHealth: Specialized health and wellness services (6.53% of total revenues) OptumInsight: Provides process outsourcing, advisory, and data processing. (2.10% of total revenues) OptumRX : Pharmacy benefits management business ( 15.9% of total revenues) INVESTMENT THESIS UNH is currently trading at a discount to itself, its implied multiple against its peers, and its implied multiple against the S&P 500 Managed Care Index on a 10 year average P/E ratio. Historically UNH trades at an average 18% premium to its peers but is currently trading at a 7% premium. The depreciation of UNHs multiples is due to funding cuts for the government run Medicare Advantage program, and uncertainty surrounding the implementation of the Affordable Care Act provision set to go live in 2014. However, UNH is still the largest publicly traded MCO that has developed above average operating performance through an economic moat developed through UNHs industry leading size, diversified business units, switching cost, and moderate network effect. Moving forward, UNHs continue d growth and diversification via its Optum platform, the expected increase enrollment generated by the ACA, and other industry tailwinds will be significant catalysts. These catalysts will enhance UNHs size and long term performance via above average margins and returns; which will restore UNH back to normal trading levels and result in an overall yield of 20.80% return.

Sector Outperform Recommendation: BUY

Key Statistics:
Price Projected Return Shares O/S (mm) Market Cap $70.21 20.80% 1,010 $7,329 52 Week Low 52 Week High Dividend Yield Enterprise Value $52.51 $77.33 1.5% $8,094

Earnings History:
Quarters 1Q13 2Q13 3Q13 4Q13 EPS $1.16 $1.40 $1.53 $1.41 Rev. YOY 11.21% 11.53% 12.17% 8.09% Price -3.77% 6.52% -5.08% -2.78%

Earnings Projections:
Year 2011 2012 2013 2014e 2015e Q1 $1.22 $1.31 $1.16 $1.097 $1.250 Q2 $1.16 $1.27 $1.4 $1.332 $1.509 Q3 $1.17 $1.50 $1.53 $1.627 $1.747 Q4 $1.17 $1.20 $1.41 $1.546 $1.679 Total $4.72 $5.28 $5.50 $5.60 $6.19

All prices current at end of previous trading sessions from date of report. Data is sourced from local exchanges via CapIQ, Bloomberg and other vendors. The William C. Dunkelberg Owl fund does and seeks to do business with companies covered in its research reports.

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INDUSTRY OVERVIEW The managed health care industry is coming off a strong 2013 with the S&P 500 Managed Health Care index raising 45.1%; offsetting a 4.9% increase in 2012. Moving into 2014, Managed Care Organizations (MCO) will be faced with headwinds related to the continued implementation of the Affordable Care Act (ACA). In 2014, Medicare Advantage plans will begin to face restrictions on medical spending as a percentage of premiums (Medical Cost Ratio, MCR), and operate through funding cuts. However consensus estimates show that average annual enrollment gains could be as high as 25 million by 2017 (primarily in Medicaid). Premiums and fee revenue is expected to rise by an average of 9% in 2014 due to higher premium rates on commercial and Medicaid plan, and an expected increase in enrollment from over 11 million newly insured individuals and Medicare enrollment. However, MCR is expected to be higher as Medicare and Medicaid membership becomes a higher portion of total membership and the rates are reduced for Medicare Advantage. Expectations are that larger MCOs will be able to more readily navigate through these ACA changes by leveraging their large membership base to efficiently spread costs. CATALYSTS Service Diversification: UNH continues to diversify its exposure to the health insurance trends, ACA implementations, and Medicare funding cuts through its Optum segment. The segment offers higher margin business units with revenue growth of at least 20%. The platform is unique to UNH and should stabilize any fluctuation in earnings caused by ACA. Industry Consolidation: ACA generated headwinds (such as increased restrictions, competition, costs, and transparency requirements) will lead to industry consolidation. Smaller MCOs will not have the resources to comply with these changes or challenge larger MCOs increasing enrollment and scale. Thusly, leading to potential M&A activities ACA Enrollment: Increase in enrollment is expected to be as high as 25 million by 2016 for the industry. The increase enrollment is expected to offset increases in MCR requirements, non-deductible implementation costs, and decrease in funding for government run programs. Increase in Healthcare Expenditure: According to the Center of Medicare and Medicaid Services (CMS), healthcare spending represented 16% of total US GDP. At the current growth rate, the CMS predicts that health care expenditures could increase to 25% of US GDP in 2025 driven by an aging population and changes in lifestyles. Shareholder Returns: In FY2013 UNH paid out over $4 billion to shareholders via share repurchases and dividends. UNH is expected to increase this amount in 2014. RISKS Increase in regulation: Government reform on healthcare or changes in rates requirements would have adverse effects on profitability, and enrollment growth. ACA Implementation: Requirements of ACA calls for increased regulation, transparency and competitive pressure. Inability to comply will result in the erosion of UNHs moats, and industry leader status. US Economy: Any slowdown or failures would decrease employment growth, and intensify budget debates. These two developments would adversely affect enrollment growth and health care spending. Enrollment activity: If enrollment numbers continue to come in lower than projected due to poor execution of ACA mandates, then growth forecast will drop dramatically.

ECONOMIC MOATS: Narrow Size/Scale: UNH is the largest publicly traded MCO with over 45 million health plan members. The size of its membership bases allows for greater use of economies of scale and grants higher negotiating power to receive better terms with providers. Diversification: UNHs segments are further diversified into different sub segment. These sub segments limits UNH exposure to any changes in specific healthcare plans. More importantly, UNHs Optums platform provides stability and diversification. Switching Costs: Switching between health care coverage is time consuming, costly, and susceptible to tax penalties. Therefore, members tend to commit and remain with MCOs that can provide a wide network at a reasonable rate. Network Effect: UNH experiences a higher marginal gain with each incremental increase in its membership base and provider network. Expansion of its membership base increases flexibility, expands provider network, and creates more customized service plans.

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TARGET PRICE
The target price is derived from first identifying the 10 year average premium that UNH historically trades at against its peers. The premium factors are multiplied by the individual peers NTM P/E, and averaged together to yield a target multiple of 14.95x. The target multiple is multiplied by consensus NTM EPS of $5.61 per share to yield an $83.83 price target. Factoring in the companys dividend yield of 1.50% results in a total projected return of 20.80%.

PEER GROUP IDENTIFICATION

Aetna Inc. (AET) o Provides health care benefits in US through its Health Care,
Group Insurance, and Large case pension segments

Cigna Corp. (CI) o Provides health services and insurance though its
commercial, government, group disability, and global supplemental benefits, and run off reinsurance segments

Humana Inc. (HUM) o Provides insurance product, and health services through its
retail, employer group and health care services segments

Health Net, Inc. (HNT)

o Provides managed care services through commercial, Medicare, Medicaid, and other sponsored products Provides network based managed care plans through its commercial, consumer, and other segment

Peer Analysis Target Price= $83.83

Relative Target Multiple = 14.95.x NTM Forecasted EPS = $5.61

WellPoint Inc. (WLP)

o

Affordable Care Act Overview: Changes that have already been implemented include the inability for insurance companies to raise premium payments without government confirmation from the state government, mandated MCR of at least 80% of premiums, and the inability to deny coverage to those with pre-existing conditions. Implementations set for 2014 include the creation of health insurance exchanges, employer mandates, and individual mandates. However, enrollment numbers have come in lower than expected due to risk adverse actions by MCOs and the inability to provide the proper access mediums. Insurance companies have been timid in participating in public exchanges, where less than 2% of total revenues is generated from these exchanges. The Congressional Budget Organization predicts that when fully implemented, the exchanges will provide insurance for 7% of Americans. The White House claims that 6 million people have enrolled but, this figure is combination of 2.1 million people who have enrolled under federal and state healthcare insurance exchanges and 3.9 million who have qualified for coverage on Medicaid. Information on the number of uninsured Americans will not be issued till the March 31st enrollment deadline however the latest data issued showed that there was still 48 million or 15.4% of American without health insurance. March 31st deadline will be the start of the individual and employer mandates where uninsured individuals will face a tax penalty, and employers who do not provide insurance will face a fee. Expectations are that 80 percent of Americans will get their insurance through an employer or the government (Medicaid or Medicare). The remaining 20% must purchase health insurance or pay a tax penalty, when fully phased in by 2016 will reach as high as $695 per individual or 2.5 percent of income. In order to avoid paying a tax penalty this year, purchases must be made by by Feb. 15 for a start date of March 1. (Insurance purchased on March 15 would not start until April 1, one day too late to avoid the penalty.) The Congressional Budget Organizations budget outlook predicts a late enrollment surge in the next couple of months. The CBOs also expressed fears that the ACA will reduce full-time employment by 2.5 million jobs by 2024 due to the expectations that employer will develop a higher unwillingness to hire and employees wanting to cut back on hours in order to receive government subsidies. However, many health insurance CEOs remain highly optimistic at the growth prospects and have taken on certain initiatives to ensure they can navigate through and capitalize on ACA changes.

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Spring 2014
FINANCIALS Revenue Total revenue has grown at a CAGR of 8.89% since 2009 and is projected to grow at a CAGR of 7.06% for the next 3 years. Expectations are that growth in total revenue will be driven by increased enrollment numbers, and high growth levels from the Optum platform. The United Health segment has grown at a CAGR of 8.30% since 2009. The segment is expected to continue growing at due to increase enrollment created via ACA. UNH total enrollment for 2013 was roughly 45 million, and represents an increase of 11.7%. Within the last 4 years UNH experienced an increase of 14 million to its membership base. Employer & Individual: decreased by 3.43% YOY due to a large customer conversion from risk based to fee based service that resulted in a decrease of 2.3 billion or 4.86%. Medicare & Retirement : grew by 12.4% YOY driven by double digit grout in enrollment for its Medical Advantage, Medical Supplement Products, and Medicare Part D plans Community & State: grew by 12.47% YOY due to state reprocurement in Tennessee and renewals/expansion in Hawaii. International: reported revenue of $6.4 billion in its first full year of operating. The Optum has grown at a CAGR of average 16% since 2009. In 2013, Optum revenues grew by 26% driven by double digit growth in each of its three sub-segments. OptumHealth: grew by 21% YOY, due to the strong performance in local delivery care. OptumInsight: grew by 10% YOY due to growth in revenue management services provided through Optum 360 OptiumRX: grew by 31% YOY due to a combination of services expansion to external clients, completing the transition of services for current members, and a 46% increase in script volumes. Margins: Gross margin has grown from 25.1% in 2009 to 27.1% in 2013, EBITDA margin grew from 8.1% in 2009 to 9.0% in 2013, and Net margin has grown from 4.4% in 2009 to 4.6% in 2013. However, all three operating margins for 2013 were slightly down versus its 2012 numbers due to increase in commercial risk enrollment, and ACA regulation compliance. Overall margins have remained consistent since 2009; which is a testimony to the companys ability to properly manage costs and to the growth of the industry. Operating margin in the United HealthCare segment was 6.4% and represents a 1.2 % decline due to funding reduction in its Medicare Advantage products. Operating margins in Optum was 6.25% and represents a 1.35% increase due to growth and effective management of its sub segments. OptumHealth: operating margin of 9.9%, a growth of 3.02 % YOY due to an improved cost structure. OptumInsight: operating margin of 19.0%, a growth of 2.2% YOY due to growth in revenue management services provided through Optum 360 (revenue cycle management) OptiumRX: operating margin of 3.06%, a growth of .92% YOY due to pricing discipline, cost management, and improvement in its generic based mix.

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Spring 2014 Company HUM WLP CI HNT AET Median Mean UNH
Medical Cost Ratio (MCR) Medical Cost ratio is measured as the average medical spending as a percentage of premiums. ACA mandates have set MCR floors to be at 80% to ensure that members are getting high quality treatments. UNH historically maintained a consistent MRC within 1% of 80%, where as its peers have struggled with the same task. In FY 2013, UNH announced a spike in MRC from 80.4% in 2012 to 81.5% in 2013 due to expected reductions in Medicare advantage funds, a shift toward more government run membership mix, ACA transitional and implementation costs, and higher commercial risk enrollment. With its industry leading membership base and extensive provider network, UNH should be able to effectively spread out costs to continue posting lower than industry average MCR. Administrative Expenses Ratio Administrative Expenses ratio is measured as the firms total a dministrative expenses divided by total revenue or total premiums. The ratio represents how efficiently UNH is managing non-medical related cost and is a measure for the effectiveness of its non-medical related operations is in generating incremental gains in enrollment. UNHs Administrative ratio has been increasing in the past couple years to 15.8% in 2013 from 15.2% in 2010. The increase is attributed to increase spending in its Optum business as opposed to a decrease in efficiency. Earnings: UNH has not missed earnings estimates since the 4Q 2008 and beats these estimates by an average of 8.6%. Earnings have grown at a CAGR 14.14% since 2009 and are projected to grow at a CAGR of 7.86% till 2016. For 2013, earnings growth can be attributed to UNHs high annual growth in enrollment in the last few years (14 million in the past four years), growth in its Optum platform (61% YOY growth in operating income), and expansion into Brazil via its acquisition of Amil. Managements EPS guidance for 2014 is $5.40 $5.60 which represents a modest growth of 1.83%. Free Cash Flow: From 2009 to 2013 FCF increased at a CAGR of 4.5% and is expected to grow at a CAGR of 6.7% from 2013 to 2016. Growth in FCF will be driven by CFFO growth where enrollment growth and sales growth from the Optum platform will make the largest contribution to growth. CFFOs has grown at a 5.58% CAGR since 2009, and projected to grow by 6.14% CAGR for the next 3 year. CAPEX have been projected to grow at 9.7% as the UNH continues to invest in the growth of Optum and comply with changes to ACA.

2013 MRC Admin 83.7% 15.1% 87.8% 15.0% 82.9% N/A 89.1% 11.0% 82.2% 18.8% 83.7% 15.1% 85.1% 15.0% 81.5% 15.8%

2012 MRC Admin 83.7% 15.1% 85.1% 14.2% 79.6% N/A 89.1% 8.6% 82.2% 18.3% 83.7% 14.7% 83.9% 14.1% 80.4% 15.6%

2011 MRC Admin 82.1% 14.8% 85.3% 14.4% 80.5% N/A 86.5% 8.6% 79.6% 19.7% 82.1% 14.6% 82.8% 14.4% 80.8% 15.3%

2010 MRC Admin 82.9% 13.2% 85.1% 14.1% 82.3% N/A 87.1% 8.5% 82.3% 19.4% 82.9% 13.7% 83.9% 13.8% 80.6% 15.2%

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Spring 2014
Shareholder Return UNH paid out about $3.2 billion for share repurchases in 2013, buying over 48 million shares at an average price of $65.60 per share. In June 2013, the board of directors increased and renewed a repurchasing program where 110 million shares may be repurchased. Dividends paid out in 2013 equate to $1.1 billion for a 29% growth YOY. Dividends yield has been increasing since 2009, with a 3 year average growth of 28.16%. UNHs dividend payout ratio currently is 18.8%; which is double the value of its 2010 ratio, and a 4% increase from 2012. Management expects to again return more than $4 billion to shareholders in 2014 through the completion of its current share repurchase programs and an increase to its dividend. Invested Assets: UNHs total investment income in 2013 was $21.54 billion, a YOY growth of 5.6%. Since 2009, total investment income has grown at a CAGR of 10.7%. UNHs portfolio consists of US Government and Agency Securities (13.07% of total investments), State and Municipal Securities (32.27%), Asset and Mortgage-Backed Securities (13.55%), and Corporate Debt Owned (37.84%), and Corporate Owned Equity (3.26%). UNHs investments strategy is focused on a safe long term income approach. With interest rates expected to increase, UNH has committed larger portions to low duration securities and reallocated more of the allocation in securities that are not as sensitive to interest rate risk. Debt: UNHs Debt/Equity (D/E) and Debt/Capital (D/C) was reported at 50.6% and 33.6% which are in line with its peer groups average. UNH experienced an increase in its D/E to 50.59% from 2011 to 2012 due to the acquisition of Amil. The long-term debt portion represents about 88% of total debt; where 12% ($1.9 billion) is due within the next year. UNHs liquidity level is not as strong as its competitors, where its current ratio of 0.73 is below the comp group average of 1.33. However, UNH historically operates with a current ratio below 1.0, and have utilized a $3 billion revolving line of credit and cash flow from operations of about $7 billion to finance its current liabilities. Additionally, with an interest coverage ratio of 13.59 UNH is able to pay its debt obligations.

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VALUATION Undervaluation With a significant amount of the ACA expected to go live in 2014, investors are have become overly cautious about the uncertainty surrounding ACAs effect on operational performance. Headwinds such as the expected decrease in Medicare Advantage funding, a decreasing pricing trend, and expected ACA taxes/implementation costs have been major contributors to the companys depressed multiple. Other headwinds include uncertainty with state acceptance of certain programs, the slow development of public exchange markets, and the changes in healthcare spending in relation to expected increase in enrollment. Non-healthcare related headwinds such as expectations for a correction and the Federal Reserves tapering have also contributed to the deprecation of the stock. UNH historically trades at a premium to its comps and the S&P 500 managed Care Index due to UNHs ability to generate higher returns at a lower MCR via its stable economic moats. On a 10-year average, UNH traditionally trades at 14.40 times earnings but currently trades at 13.15x, representing an 8.68% discount from its normal trading level. Against the S&P 500 Managed Care Index, UNH trades at a 12% premium versus the index on a 10 Year average P/E. However, UNH is currently trading at 1.0% premium to the index on a P/E basis. Peer Group Valuation

The companies used in the relative valuation include Aetna Inc. (AET), WellPoint Inc. (WLP), Cigna Corp. (CI), Health Net, Inc. (HNT), and Humana Inc. (HUM). The peer group includes companies that operate as a Managed Care Organization within the United States, and have significant exposure to Medicare and Medicaid. On a 10 year average, UNH trades at an 18% premium against its peers on a P/E basis. This premium is attributed to UNHs larger size and higher efficiency; where UNHs profitability ratios and operational margins are higher than its peers group averages. However, UNH is only trading at an average 7% premium due to the reasons stated above. Through the catalyst stated in the previous section, UNHs multiples should expand back to normal trading levels; resulting in an 11% multiple expansion to an implied forward P/E of 14.95x. Using the implied forward P/E multiplied by consensus EPS estimates of $5.61 per share yields a price target of $83.83. After accounting for a dividend yield of 1.50%, the total return equates to 20.80%.

Implied P/E

Consensus EPS

Target Price
$83.83

14.95x

$5.61

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APPENDIX:

UNH: 10 year P/E

UNH vs Comp. : 10 year P/E

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UNH benched against comps : 10 year P/E

UNH benched against comps : 3 year P/E

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DISCLAIMER This report is prepared strictly for educational purposes and should not be used as an actual investment guide. The forward looking statements contained within are simply the authors opinions. The writer does not own any United Healthcare Group, Inc. stock. TUIA STATEMENT Established in honor of Professor William C. Dunkelberg, former Dean of the Fox School of Business, for his tireless dedication to educating students in real-world principles of economics and business, the William C. Dunkelberg (WCD) Owl Fund will ensure that future generations of students have exposure to a challenging, practical learning experience. Managed by Fox School of Business graduate and undergraduate students with oversight from its Board of Directors, the WCD Owl Funds goals are threefold: Provide students with hands-on investment management experience Enable students to work in a team-based setting in consultation with investment professionals. Connect student participants with nationally recognized money managers and financial institutions

Earnings from the fund will be reinvested net of fund expenses, which are primarily trading and auditing costs and partial scholarships for student participants.

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