UnitedHealth's Beat Boosts Shares

But some on the Street still see a cash flow problem.
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After warning about painful second-quarter results,

UnitedHealth

(UNH) - Get Report

has decided it's not so sick after all.

The giant health insurer did see profit tumble 73% to $337 million, as it paid out large sums for legal settlements and severance packages.

Excluding special charges, however, the company posted earnings of 67 cents a share that topped recently lowered forecasts by three pennies. Moreover, while the company continued to lose ground in the lucrative risk-based health insurance market, it managed to add customers in other segments -- particularly Medicaid -- and wind up with 2 million more members than it had a year ago.

Shares of UnitedHealth were up nearly 10% in recent trading to $26.11.

"During the first and second quarters, we initiated important actions to improve our performance," UnitedHealth CEO Stephen Hemsley stated on Tuesday. Now, "we are seeing progress on those actions that we expect will strengthen our company and our future financial results."

Goldman Sachs analyst Matthew Borsch said he spotted "no major surprises" in UnitedHealth's report -- with some key metrics actually beating Wall Street targets -- and predicted that the company's stock could trade higher as a result. Borsch has a neutral rating on UnitedHealth's stock. His firm has investment-banking ties to the company.

Although UnitedHealth beat Wall Street targets for both profit and sales, which rose 7% to $20.3 billion in the second quarter, the company reported some troubling trends as well. First and perhaps foremost, the company continues to watch its medical care ratio -- the amount of revenue spent on care -- climb higher and cut deeper into its once-generous margins.

UnitedHealth's consolidated MCR jumped almost 3% during the quarter, eating up 83.2% of its overall sales. The company's operating margins fell 3.7% to 7.2% -- even after favorable adjustments -- as a result.

Ultimately, UnitedHealth is retaining a smaller share of its premiums than it would like.

In the past, UnitedHealth often overestimated its medical costs and then later released reserves to provide a nice cushion to its earnings. A year ago, for example, the company posted a "favorable development" of more than $100 million. During the recent quarter, however, the company wound up with no extra reserve cushion at all.

Indeed, UnitedHealth actually had to establish a $50 million "deficiency reserve" to cover anticipated losses in its Medicare business. Both its Medicare "Special Needs Plans" and its Medicare Part D prescription drug policies have attracted particularly expensive customers this year.

Sheryl Skolnick, senior vice president of CRT Capital Group, sees widespread problems that could take years to fix. Going forward, Skolnick stresses, UnitedHealth must figure out how to better price its policies and convince healthier customers to buy them. Ultimately, she suspects, the company's plans to focus more on localized service may not work fast -- or well -- enough.

"How will UNH improve customer service with fewer employees?" Skolnick asked earlier this week. And "why should we believe that the turnaround plan will work this time?"

Skolnick posed these tough questions when forecasting dismal second-quarter results for the company. On several key metrics -- including earnings, revenue and even medical costs -- UnitedHealth fared better than she had expected. But on others, particularly cash flow, the company fared worse.

UnitedHealth reported cash flow of just $600 million for the second quarter -- down from $1.7 billion a year ago -- as the company watched its net income erode. To be fair, the timing of a big tax payment caused $700 million of that shortfall. But Skolnick seemed troubled nonetheless.

Indeed, Skolnick sounded worried even before UnitedHealth posted that dismal number."Even if cash flow from operations comes in near $1 billion, it would be a VERY weak result for this company," Skolnick wrote on Monday, "especially as UNH intends to continue to repurchase stock and especially as UNH has levered up ... to do it."

Going forward, Skolnick noted on Tuesday, United Health still expects to generate adjusted cash flows of $4.4 billion for the full year. In order to hit that target, she estimates, the company must deliver close to $2 billion in cash flow -- or more than three times the amount that it just did -- in both of the next two quarters.

Skolnick has already started to worry about UnitedHealth's balance sheet in the meantime. During the recent quarter, she points out, the company saw its cash balance fall by a full $1 billion as it continued to aggressively buy back huge chunks of its own stock. Meanwhile, she estimates, the company has watched its debt-to-capital ratio climb from 33% to 40% over the course of the past year.

Skolnick did acknowledge on Tuesday that UnitedHealth appears to be scaling back its buyback program. Specifically, she estimates, the company will now spend $3 billion -- down from $4 billion earlier -- on stock repurchases this year. Still, she warns, the company could see its stock lose some support as a result.

Skolnick, for one, sees no reason to buy UnitedHealth's stock right now. Rather, she is maintaining her "fair value" rating -- with a negative bias -- on UnitedHealth until the company can better prove itself.

"We are not excited by 3 cents per share of outperformance, when UNH should have been reporting something closer to 90 cents per share to begin with," Skolnick declared. Meanwhile, "there is not, in our view, a positive track record with respect to the implementation of turnaround plans.

"In short," she concluded, "UNH has to 'Show me' -- and the Street -- that it

can

achieve its turnaround goals through persistent evidence of success."