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A Heady Time for HMOs

The last two years may have been a struggle for the economy, but they've been surprisingly strong for managed-care stocks. Since the New Millennium, most outfits in the sector have increased prices on their products and services, while their costs have been falling. The result is improved profit margins, and in 2003, earnings for the group rose 32%.

Yes, lost jobs and layoffs during the downturn resulted in HMO membership losses, but managed-care companies have found many ways to offset the lower subscriber rolls. The biggest gains have come from technology improvements and better designed plans that encourage consumers to be more thrifty. That's why HMO costs were lower than expected in 2003 and will likely decline again in 2004. And it explains why the Standard & Poor's Managed Health Index rose 64% since January 2003, compared with a 23% gain for S&P 500-stock index.

Analysts are starting to have doubts that 2005 will be so robust, however. "Costs are still moving down, but not as quickly as before. And pricing is not rising as much," says Brandon Carl, health-care analyst at BB&T Asset Management. The outlook is solid, but blowout results aren't likely, particularly as new-job creation remains lackluster and opportunities for lowering costs become fewer.

UNREALISTIC EXPECTATIONS? The stocks could be due for a break as a result. Signs of a pause are already appearing. In recent weeks, fear of rising rates have driven many investors from HMOs into drug stocks, which historically have done well during periods when interest rates are on the upswing, Carl says. "We've been positive on managed care, but we believe the magnitude of trends is declining, and we want to reduce exposure," he says.

A few large-cap names should continue to post gains, despite the short-term uncertainties. UnitedHealth (UNH), the nation's largest HMO, is "probably the best from a growth perspective," says Carl. (United is a holding in BB&T's growth funds.) The stock, at $64, recently lost some ground as investors were disappointed that the outlook for new membership growth wasn't stronger. Kris Jenner, health-care analyst at T. Rowe Price, says "there's nothing fundamentally wrong with United," although he's concerned that the market's expectations have become somewhat unrealistic. (Jenner owns United Health stock personally.)

Still, United has an anchor: A large part of its business lies in providing to large, self-insured corporations services like claims administration and management of mental-health benefits (see The BW50, 4/5/04, "Vim and Vigor at UnitedHealth"). Higher medical costs don't affect these services, which account for the majority of United's operating income, says Robert Mains, analyst at Advest in Hartford, Conn. And continued improvements with information technology will also save administrative costs over the next year or so, Mains says. He recently raised his 12-month price target on UnitedHealth to $71. (Mains doesn't personally own managed-care stocks.)

HOT ON THE STRIP. Another large-cap favorite is Anthem (ATH), which recently announced plans to buy rival WellPoint (WLP). The $16.4 billion merger will make Anthem the country's largest Blue Cross/Blue Shield insurer. "There is broad-based revenue opportunity that didn't exist when each company was on its own," Jenner says. At Anthem's current price of $88, it's trading at just under 12 times his estimated 2005 earnings per share of $7.50, while the broader stock market is trading at a forward p-e ratio of 17. For the long-term, the merged company should increase earnings at about 15% annually, says Jenner.

Among smaller companies, Sierra Health Services (SIE) is the top pick of BB&T's Carl. It has been shedding peripheral businesses to "really focus on the core business, which is providing traditional managed-care services to mid-market companies," Carl says. It's the biggest player in the burgeoning Las Vegas area and one of a few small-cap, publicly traded managed-care companies remaining in the industry. (Sierra is also a holding in BB&T's growth funds.)

That it hasn't yet been scooped up by a larger company makes Sierra an attractive holding. "It won't be a stand-alone company in a couple years," Carl predicts, offering much bigger outfits a quick and easy way to grow through acquisition. Its dominance in an attractive market and cheap valuation -- $36, or 12 times 2005 EPS -- make it a promising long-term investment.

ESCAPING CRITICISM. As consumers pay more for health care, the fundamentals for these companies should remain solid. "The industry will not lose as long as people are coming into the workforce," says Phil Seligman, analyst at S&P. A profitable, efficiently run managed-care industry is good for consumers in the long run, he says. "If you didn't have the incentive to keep costs down, you would end up paying a lot more for health care."

Managed care has also escaped the brunt of criticism for soaring health-care costs, which has fallen mostly on drug companies. The industry has deftly made its rules more flexible for patients to choose doctors and other services, offsetting ire about higher out-of-pocket expenses. "People certainly hate HMOs," says Mains. "But the realization is that we have to pay for services, and HMOs are just the middleman."

Still, in an election year where rising health-care costs are a focal point, HMOs could come for renewed criticism by campaigning pols. "I'd be surprised if it didn't become something of an issue," says Mains, especially as the profits of many managed-care providers continue to be strong while Jane and Joe Worker pay more across the board for premiums and co-pays. Already, Democratic Presidential candidate John Kerry vows not to allow seniors to be "forced into HMOs" in order to get prescription drugs.

Investors in the sector should probably anticipate volatility in the coming months, although the negative political attention probably won't be enough to send the industry back to its early days. At least not yet. By Amy Tsao in New York

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