Judged by its third-quarter earnings released Oct. 20, UnitedHealth Group (UNH) looks like a standout firm that knows how to blow away Wall Street expectations. But, in 2009, UnitedHealth and other giant health insurers have been anything but stock market stars.

The reason isn't the firms' profits, sales, or anything specific to UnitedHealth or its competitors. Rather, it's the health-care reform debate coming out of Washington.

UnitedHealth's third quarter earnings of 89¢ per share were 13¢ higher than Wall Street expectations. Despite a nasty recession, revenues at the giant health insurer were up 7.6% and operating earnings rose 4.9%.

Yet UnitedHealth shares are down more than 2% in 2009, even as the broader market is up almost 21% so far this year. Rivals like Humana (HUM), WellPoint (WLP) and Aetna (AET) have also lagged the market by a wide margin this year.

The positive third-quarter results did spark some buying—UnitedHealth jumped 4.2% to 25.96 on Oct. 20—but the stock remains dirt cheap by many measures. According to UBS (UBS), UnitedHealth's price-to-earnings ratio over the last five years has averaged above 17. But today, shares trade at about eight times estimated earnings in 2009 or 2010.

For UnitedHealth, "you have all these positives, but you still have that overhang of health-care reform," says Standard & Poor's equity analyst Phillip Seligman.

Right Now, Nothing Else Matters So many aspects of health-care reform in Washington remain open to debate, and for insurers like UnitedHealth the stakes could not be higher.

For example, on the same day that UnitedHealth reported earnings, leading Senate Democrats were reportedly indicating a greater openness to the possibility of a public insurance option as a part of health-care reform. UnitedHealth and other insurers have opposed a public option, which would directly compete with them, possibly at lower cost to consumers. They also oppose higher taxes on expensive health plans and other proposals that could cut into their profit margins.

The impact of health-care reform could be so significant that it is dominating almost every other consideration investors make when buying or selling health insurance stocks.

"That's pretty much the only thing investors need to worry about right now," Morningstar (MORN) analyst Matthew Coffina says of the debate about health care.

Health insurers don't oppose reform entirely. In fact, there could be a big upside for insurers if more uninsured Americans are forced or given incentives to buy health insurance. UnitedHealth Chief Executive Stephen Hemsley told analysts Oct. 20 that the company is lobbying for reform proposals to do more to expand coverage and control health-care costs.

"We're concerned about some directions health reform is taking, [but] we'll redouble our efforts to help achieve meaningful, sustainable changes that address fundamental issues of affordability and access," Hemsley said.

The health-care debate leaves health insurers and their stockholders in a political limbo. While praising third-quarter results, JPMorgan (JPM) analyst John Rex noted, "Health reform persists—by a very wide margin—[as] the main factor for the stocks still."

In such an uncertain position, health insurers need to maintain maximum flexibility, says Kunal Pandya, senior analyst at the Aite Group, a consulting firm.

"That has traditionally been the Achilles' heel of health plans," Pandya says. "They have not been very flexible or quick to react to change."

Healthy Cash Flow One way to prepare for a new era of health care is to cut costs and become more efficient. Several analysts praised UnitedHealth's cost-cutting, which has enabled the firm to maintain profit margins even as it loses insured workers on its rolls due to layoffs.

Good financial results may also help prepare the firm for whatever Washington decides. UnitedHealth had cash flow of $2.7 billion last quarter, up from $1.8 billion a year ago. "The company has very healthy cash flow, which gives it financial flexibility," S&P's Seligman says.

Even without health-care reform, UnitedHealth execs warned that 2010 could be a tougher year for the company than 2009 has been. Blame, among other factors, rising unemployment and cuts to Medicare reimbursements.

But if Congress passes and President Barack Obama signs a strong health-care reform bill, profit margins could be squeezed for many years to come—even after the economy recovers. Adding to the uncertainty, a final bill might not settle all or even most of investors' questions about health insurers.

"There are some things that will be immediately obvious," Morningstar's Coffina says, citing as an example the inclusion or exclusion of a public option. But, he adds, the full impact of a complex piece of legislation could take many years to become apparent. And nothing prevents Congress from returning to the issue in the future, with more reform proposals.

UnitedHealth's large size and the diverse nature of its businesses could give it an advantage after health care reform—at least compared to other managed-care providers, Seligman says.

Tough Waters to Navigate There are rare cases of stocks that can perform well even in a highly regulated environment. One example is Phillip Morris, now called Altria Group (MO), a tobacco firm that thrived despite new smoking regulations, higher taxes, and countless lawsuits starting in the 1990s and earlier.

If UnitedHealth can successfully navigate through the tough political climate, there could be a huge upside in its cheap shares. But if not, Oct. 20's strong earnings report may eventually be viewed as a last hurrah of the private insurance industry's good old days.

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