Before you arrive at the end of this sentence, another baby boomer will turn 50. By the time the last boomer turns 65, the number of Americans 65 or older will have doubled since 2000. Baby boomers control half of all discretionary purchases and 80% of the personal wealth in the United States. They're also the demographic most likely to visit a shopping mall. Along with all that, the 50-plus population presents a huge opportunity for companies serving the healthcare industry.
American industry is waking up to this market. The Department of Labor estimates that seven of the 20 fastest-growing occupations are related to healthcare. Healthcare will generate 3 million jobs between 2006 and 2016, more than any other industry. This is truly a seismic shift in the composition of the U.S. economy, which historically has been driven by the production of other goods and services. Healthcare now employs more people than manufacturing.
For investors, it can be very lucrative to invest in an industry with strong growth trends behind it. Energy and commodities produced enormous gains for investors over the past five years as demand for energy swelled around the world. Compared to those, healthcare has enormous advantages, because it isn't cyclical. Most industries go through blips where demand falls, growth slows, and stock prices plummet. The good thing about healthcare is that demand should grow steadily for the next decade or two.
But just because an industry is growing doesn't mean all companies can make bagfuls of money. Government regulation and competition can lower returns -- just take a look at airlines or automakers, both in industries with good secular growth but where companies have a hard time earning a decent return on their capital. So it's not just enough to invest in the right industry -- you have to pick the winners -- companies with competitive advantages that can earn a solid return on their shareholders' investments.
One competitive advantage in healthcare is scale, and our two recommendations have this in spades. When you're the biggest kid in the lunch line, you are going to get your choice of lunch, and a big portion at that. It's the same in business -- size gives you the ability to set terms for the rest of the industry. And while you'd usually expect to pay a sizable price for such dominance, this is one of the few occasions when the market gives us a chance to own these great healthcare businesses at a bargain price.
No one likes the big managed healthcare providers these days. Rising medical costs, lawsuits, shaky Medicare and Medicaid reimbursement, and the uncertainty of healthcare reform have all weighed on the industry. But the valuation of UnitedHealth Group [NYSE: UNH] reflects these prospects and then some. The future of health insurance is anything but declining, and with 73 million members, UnitedHealth is one of the dominant companies in the industry.
The health insurance game boils down to size. Large insurers can negotiate lower rates on behalf of their customers, be they governments, companies, or individuals, and this leads to a virtuous circle. Doctors and hospitals rely on a network of tens of millions of patients, which affords UnitedHealth tremendous pricing power, allowing it to pass savings on to its paying members. In turn, the variety of healthcare providers and lower negotiated rates attract more people to the network. And the circle is complete.
UnitedHealth's database is also a huge asset -- it includes comprehensive clinical data covering 85 million people and pharmaceutical histories for 250 million -- that enables the company to smartly underwrite risks. Plus, according to government data, UnitedHealth is getting the biggest slice of the new Medicare drug plans and Medicare Advantage plans. Its share was also boosted by a marketing arrangement with AARP and the PacifiCare acquisition. This is one of the key growth drivers for the company.
The Risks
The rising costs of healthcare are a top concern. Reimbursement rates from the government on Medicare and Medicaid are constantly at risk of being cut. Large companies are increasingly moving toward service contracts in which they take on the risk of healthcare costs and have companies like UnitedHealth manage their programs, which lowers revenue but reduces risk.
Lawsuits are also part of the health insurance business. The latest: The New York State Attorney General's Office announced its intent to sue UnitedHealth, which could lead to a cash payout but shouldn't affect the stock's valuation.
The Foolish Bottom Line
Occasionally an entire industry falls out of favor with Wall Street for reasons that are unclear -- and temporary. It is in times like these that investors can hardly go wrong in picking up the strongest companies in the sector, including UnitedHealth. Over the next five to 10 years, UnitedHealth should thrive.
A major provider of healthcare services and benefits, WellPoint boasts one of the largest medical memberships in the United States, with 35 million customers, compared with 73 million for UnitedHealth [NYSE: UNH], 16.8 million for Aetna [NYSE: AET], and 10.2 million for CIGNA [NYSE: CI]. Its membership is roughly a 50-50 mix of fully insured and self-funded members. For the fully insured, the company receives a premium and takes on the risk, making it responsible for covering the cost of medical services. For the self-funded, it charges a fee for services such as administrative work and fee negotiations, but the employer or plan sponsor reimburses all or most of the healthcare costs.
As does UnitedHealth, WellPoint has a size advantage over the competition. Being big means it can spread nonmedical costs over a larger membership base, which improves profit margins. Larger networks are more valuable to healthcare providers -- imagine having access to WellPoint's 35 million members -- and therefore such networks can negotiate lower prices. This is a win-win for members, who have access to cheaper health insurance and a wider selection of healthcare providers.
The national network has a local effect, since people tend to use healthcare services close to home. WellPoint is the exclusive licensee for Blue Cross and Blue Shield brands in 14 states, giving it the No. 1 or No. 2 market share in these areas. On top of its scale and price advantages, WellPoint's membership base has yielded reams of historical data that should help the company understand underwriting risks and plan its business on economical terms.
Like all insurance companies, WellPoint earns considerable interest on its premium float, unearned premiums paid plus unpaid losses. In 2007, interest on WellPoint's cash plus its float exceeded $1 billion and free cash flow was $4 billion. WellPoint has been using this strong free cash flow production to buy back shares -- a worthy use of capital at today's low stock price.
WellPoint isn't a fast growing company -- mid-single-digit growth should come from 1% to 1.5% enrollment growth and 4% to 5% price increases. And the medical-cost ratio could inch up as cost increases slightly outpace price increases -- though management is confident that it can match the two.
The Risks
Systemic health-care reform presents a small risk, but I expect the largest insurers, like WellPoint, to do well while smaller rivals suffer more and experience further consolidation.
If the medical-cost ratio rises higher than expected it could lower the value of WellPoint. Also, as is the case for all insurance companies, WellPoint has an investment portfolio, including in mortgage-backed securities. Almost all these securities are guaranteed by government-sponsored entities, but that doesn't preclude risk.
The Foolish Bottom Line
WellPoint is an extremely fit company selling at a significant discount to its true value, based on little more than uncertainty. In turn, Wall Street has priced the shares as though the business is in terminal decline. Underwriting results will inevitably wax and wane, but WellPoint's long-term prospects are anything but declining. It operates in an industry with long-term growth built in as baby boomers age, and WellPoint should produce healthy returns far in excess of the market.
I hope you've enjoyed this special report.
My name is Philip Durell. I'm the founder and senior advisor of Motley Fool Inside Value.
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