Zacks.com reiterated its neutral rating on UnitedHealth Group (NYSE:UNH) on August 31, suggesting the managed care company will face higher operating costs throughout the remainder of 2011 due to the Affordable Health Care for America Act and the Mental Health Parity Act and Addiction Equity Act. It’s one of several reasons I believe UnitedHealth is actually a sell, not a buy.

Free Cash Flow

According to Zacks, UnitedHealth Group favors share repurchases and acquisitions over debt repayment and dividends when deploying capital. In the past five years, it has bought back $15.9 billion of its stock, reducing its share count by 200 million, to 1.33 billion. In that time, it also has completed $7.1 billion in acquisitions, paid $603 million in dividends, repaid $4.4 billion in debt and issued $11.6 billion in debt and stock. So what does this mean for shareholders? For starters, free cash flow over the last five year’s is $24.9 billion. Subtract the acquisitions, dividends and debt repayment and we’re left with $12.8 billion. But that has to cover $15.9 billion in share repurchases. UnitedHealth Group borrowed $3.1 billion to buy back stock between 2006 and 2010. That’s a no-no in my book. Most companies overpay for their shares and borrowing just makes it worse.

Return on Equity

Over the past half decade, return on equity was 19% annually. That’s not bad. But consider this: The company averaged net income over those five years of $4 billion. If it repurchased no shares, the book value would be $16 billion higher with a return on equity of 10.5% annually, almost half the advertised rate. Furthermore, net income cumulatively grew by 40.4% while earnings per share grew by 65.3%. Share repurchases accounted for 38% of its EPS growth. One might wonder what would have happened to UnitedHealth’s stock price if the $15.9 billion allocated to share repurchases instead were split evenly between dividends and debt repayment. First, there are studies that show companies accelerating dividend payments end up earning more. It’s conceivable that providing shareholders with 1,300% more in the way of dividends would have increased earnings per share at a similar or higher rate. Secondly, let’s assume that the share count from 2005 of 1.33 billion was the share count in 2010. Earnings per share would have been $3.48 instead of $4.10. However, the dividend would have been $1.20, or three times higher. You can talk all you want about share repurchases being a tax-free distribution versus dividends, which are not. But I’m inclined to believe higher dividends would have resulted in a higher total return.

Margins

UnitedHealth Group’s second quarter was stronger than expected due to lower claims paid. It seems its members aren’t utilizing their health care as much as they normally would, and that has brought earnings surprises on the upside. In these stressful times, I’m not sure it’s a good thing that Americans aren’t visiting their doctors as often as they have in the past. If common sense prevails, and I hope it does, its operating costs are going to rise. That could put a squeeze on margins already seemingly low. In recent years, its best operating margin was in 2007, at 10.4%. Comparing the second quarter this year with the same quarter in 2007, you’ll find its operating margin back then was 290 basis points higher, at 10.9%. Its operating profit in 2007 was the same as 2011 on $6 billion less revenue. It would seem that the only way the company can increase profits is by making a large number of acquisitions. Most of these will come from its health service business, which accounts for just 20% of operating profits currently but is expected to contribute up to 40% in the future. If these businesses don’t come with better margins, it won’t matter how diversified UnitedHealth’s revenues are.

Bottom Line

Over the last five years, UnitedHealth Group’s stock has spent most of its time under $50. Unless its margins suddenly improve, I don’t see things changing. The only exception would be if the company severely reduced its share repurchasing while simultaneously, and substantially, increasing the dividend. Otherwise, forget it.

As of this writing, Will Ashworth did not own a position in any of the stocks named here.