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Costs Crimp UnitedHealth

Shares drop 5% after a disturbing forecast on expense trends.

This quarter,

UnitedHealth Group

(UNH) - Get UnitedHealth Group Incorporated Report

missed expectations where it really hurts.

Although it topped profit estimates -- and even raised its outlook for the full year -- the giant health insurer reported higher medical costs than it had anticipated. It fell short of revenue targets and continued to lose some lucrative risk-based commercial business as well.

"Oh man," declared Sheryl Skolnick, senior vice president of CRT Capital Group. "They beat the Street and even guided up, but you have to look below that. And when you look below, you see some things that are very troubling."

Investors seemed a bit rattled, pushing shares of UnitedHealth down 5% to $51.50 early Thursday.

UnitedHealth posted first-quarter revenue of $19 billion, up 8% but shy of the $19.4 billion consensus estimate. Net income, hurt by charges related to controversial stock options grants from the past, inched up just 4% to $927 million. Excluding special items, however, earnings per share of 74 cents beat Wall Street targets by 3 cents. The company's new full-year earnings guidance of $3.42 to $3.46 a share allows room for further upside as well.

But investors will no doubt stew over another metric entirely. Notably, UnitedHealth's all-important medical-cost ratio -- reflecting the amount of each premium dollar spent on patient care -- for the commercial book of business ticked up to 81.2% in the latest quarter and forced the company to raise its MCR projection for the entire year.

UnitedHealth offered two major reasons for this troubling development, both of which could worry the market. The company blamed much of the change on inadequate reserves, signaling a rare misstep in this department, and the rest on higher utilization of consumer-directed health plans.

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"They're the leader" in consumer-directed healthcare, Skolnick said. "They have more lives than anybody else. One thing they should be able to do is estimate user trends. ...

But customers with high-deductible plans really used them and figured out how to game the system exactly right."

Skolnick, for one, feels that UnitedHealth should have seen this problem coming. After all, she says, this marks the second quarter in a row that the company has suffered from higher costs than it expected. She, in fact, questioned the company about its reserves last time around and came away feeling less than reassured.

Skolnick has a fair value rating on UnitedHealth's stock. Her firm has no business ties to the company.

In a prescient move three weeks ago, UBS analyst Justin Lake downgraded UnitedHealth from buy to neutral due in part to concerns about the company's commercial book of business. He dwelled on the company's MCR (also known as MLR, or medical loss ratio) in particular, forecasting a worrisome rise that actually came in even higher than he feared.

Lake predicted investor backlash as a result.

"This will be key to sentiment in our view, given that Q1 will represent the first time UnitedHealth has reported 'same-store' MLR since Q405 due to the addition of Pacificare into the mix in Q106," he wrote. "As PHS 'annualizes,' any deterioration in MLR will become more transparent, and investors will be unlikely to give the company the benefit of the doubt following modest commercial performance in 2006 and a 70-basis-point sequential increase in MLR in Q406."

Lake is worried about UnitedHealth's commercial business in general. Excluding boosts from acquisitions, he says, UnitedHealth has seen no commercial margin growth for five quarters in a row. He frets about the company's high exposure to the Medicare Advantage program -- ripe for cuts by the Democrat-led Congress -- as well.

"We look for 'lower-quality' growth, coupled with higher exposure to government businesses in an uncertain political environment, to put pressure on valuation," writes Lake , whose firm has providing investment banking services to the company in the past. "Given

the slowdown in businesses representing more than 50% of operating earnings, UNH will have to navigate flawlessly to meet investor expectations."