Ever since health care became topic No.1 in Washington, an ominous cloud has hung over an array of companies, from drugmakers to insurers. But for investors in health-maintenance organizations, the debate has been a bonanza. Most reform proposals would encourage membership in managed-care arrangements such as HMOs. Even without legislation, businesses are pushing employees into these groups, which keep employers' costs low by charging a flat annual fee for each worker. Despite being buffeted by fears of price cuts early this summer, HMO stocks are up an average 17% for the year, vs. an overall market that's down 1%. And that's on top of a 25% jump last year and an 87% gain in 1992.
Despite these gains, some analysts still believe that the group is a buy. But the smart money is heading for the door. While some strong HMOs and those targeting underpenetrated markets may do well, many will see shrinking margins as large employers demand better deals. "We wouldn't even consider the HMOs at these prices," says Morton H. Sachs, who runs an investment-advisory firm that is selling some of its HMO holdings.
The squeeze from employers started in California and is spreading fast. In late June, 11 large employers in California won rate cuts of 5% to 10% for 1995 from 17 HMOs. And more recently, Helen Darling, Xerox Corp.'s manager for health-care strategy, won an average rate reduction from the company's HMOs of 1.7% for next year. Several plans cut rates by 14%. "Even I was amazed at that," says Darling.
BIG SQUEEZE. Such price cuts also reflect the start of fierce new competition for markets. Shares of Mid Atlantic Medical Services Inc., a Rockville (Md) HMO, have slid because of concerns about new competitors with the entry of Humana Inc. into the Washington market earlier this year and the continued expansion in the area by giant U.S. Healthcare Inc. Mid Atlantic's stock is now trading at 24 a share, off from a high of 271/2 in June. CEO George T. Jochum says the company doesn't expect the competition to hurt margins and insists that his sale of 130,000 shares so far this year was done to diversify his portfolio.
Despite the stock's decline and speculation that the company could be an acquisition target, Anne K. Anderson, president of Atlantis Investment Co. in Parsippany, N.J., believes Mid Atlantic is still overvalued and is recommending that clients sell the stock. In fact, according to HMO research firm Sherlock Co., the price per patient based on the company's market value is $1,902, while the industry average is $1,364. Similar share-price concerns have turned some institutions off to Oxford Health Plans Inc., which is selling at a price-earnings multiple of 52, despite explosive growth.
Some HMOs scrambling to diversify beyond hotly contested home markets are also risky plays. Foundation Health Corp. is expanding rapidly outside its California base through acquisitions. Two deals announced earlier this summer worth close to $1 billion would let the company enter such markets as Utah, Arizona, and Florida. But analyst Mary C. O'Connell of San Francisco's Louis Nicoud Associates warns that Foundation may have overpaid to penetrate these markets. At least one large institutional investor, who requested anonymity, has dumped about 700,000 shares since the beginning of the year, citing the risk of Foundation's aggressive acquisition binge. While the company has acknowledged that the acquisitions will dilute earnings in the near term, the deals, it claims, make economic sense over the longer haul.
Some big HMOs are likely to prosper, however, as membership surges. United Healthcare Corp. is expected to expand membership at a rate of 22% annually. A hefty cash reserve of $2.4 billion will give the company flexibility in making more acquisitions. And continued investment in its information systems should keep operating costs low. "The efficient, high-volume HMOs with good computer systems will have a real advantage," says Steve W. Enos, a portfolio manager with Wells Fargo Bank who has bought United stock for institutional clients.
Investors should also look past the giants for potential winners. One current favorite of Kidder, Peabody & Co. analyst Joel M. Ray is Healthsource Inc., a New England-based HMO that is targeting underpenetrated smaller markets, including Savannah, Ga., and Little Rock, through joint ventures with local doctors and hospitals. It has also started a new HMO with Chubb Life Insurance Co. to break into New York City.
Healthsource and other opportunistic operators should rack up respectable gains--for a while. "The game in HMOs isn't over," says Ray, "but it's probably in the seventh inning."
THE PROGNOSIS FOR HMO STOCKS Here's how some large publicly held HMO companies stack up: PICKS Company Price YTD P-E 8/16/94 change HEALTHSOURCE 30 8% 28 Innovative New Hampshire-based HMO looking to expand into New York City through a partnership with competitor Chubb Corp HUMANA 19 6% 22 Despite some recent regulatory problems, Humana is poised for cost reductions and market expansion UNITED 46 22% 34 HEALTHCARE Industry leader maintaining hefty growth rate by targeting new markets and small-business customers PANS Company Price YTD P-E 8/16/94 change FOUNDATION 34 10% 12 HEALTH Aggressive expansion outside its fiercely competitive home state of California raises concerns about earnings dilution MID ATLANTIC 24 88% 26 MEDICAL SERVICES Possible acquisition target now facing increased competition from big players moving into its market OXFORD 64 21% 52 HEALTH PLANS Aggressive expansion in New York, New Jersey, and Connecticut raises concerns about corporate controls and margin erosion DATA: BW SURVEY OF WALL STREET ANALYSTS; BRIDGE INFORMATION SYSTEMS INC. ROB DOYLE/BW