Sudden Illness

William W. McGuire isn't pleased. Just two weeks ago, the chief executive officer of United HealthCare Corp. was basking in praise from investors impressed with the Minnetonka (Minn.) health-maintenance organization's growing membership rolls, strong earnings, and $1.8 billion in cash. Then, out of the blue came a couple of gloomy forecasts from his HMO rivals. In one day, United's stock price plunged 9%, to 391/4. "There's always an event that causes an overreaction in the market," McGuire laments. "Someone always yells, `The sky is falling! The sky is falling!"'

Well, perhaps it is. The days of unbridled growth in managed health care are coming to an end. Fueled by steady double-digit increases in medical costs, and then by the Clinton Administration's push for health reform, HMOs and their managed-care brethren enjoyed nearly a decade of heady expansion and robust profits. But with costs stabilizing and markets beginning to mature, competition suddenly has reached a boiling point. Profit margins likely will drop industrywide. Says Alan R. Hoops, CEO of PacifiCare Health Systems Inc., an HMO in Cypress, Calif.: "The high double-digit growth simply can't continue."

COLLAPSE. That became crystal clear on Apr. 24, when U.S. Healthcare Inc. reported disappointing first-quarter gains. The cause: price cuts to woo more members and higher-than-expected costs. The outfit's net profits rose just 5.8%, to $94.6 million, even while its sales jumped 16.5%, to $833.8 million. "The competition has stepped up a notch," says David F. Simon, senior vice-president of U.S. Healthcare. "Growth is important and can't be neglected just to satisfy profitability."

U.S. Healthcare, an industry bellwether, saw its stock collapse by nearly a third in the space of a week. Shares of such rivals as Humana, Oxford Health Plans, PacifiCare, and FHP International suffered similar pummelings. Helping to drag down HMO shares was word from HMO United Wisconsin Services Inc. on Apr. 19 of an expected 50% to 55% decline in first-quarter earnings. "I don't think this is unique to a couple of companies," says Kimberly Purvis, a health-care analyst with Donaldson, Lufkin & Jenrette Securities Corp. "It's an industry trend."

HMOs are being forced to confront the sobering reality that their business is getting crowded. Rather than competing against stodgy fee-for-service plans, HMOs today are slugging it out against each other and other forms of managed care in increasingly saturated markets. While enrollment in managed-care plans is rising, so are the costs of securing and keeping new customers. The upshot: "Every plan won't be a long-term survivor," says Alan Peres, manager of benefits planning for Ameritech. Earlier this year, WellPoint Health Networks Inc., a Woodland Hills (Calif.) HMO, announced that it would merge with Health Systems International Inc. in a $1.8 billion deal. Last year, FHP International Corp. engineered a $1.1 billion merger with TakeCare Inc.

Corporate America's infatuation with managed care is hardly ebbing. According to the Group Health Assn., nearly 50 million people are enrolled in HMOs in the U.S., with 6 million more expected by yearend. Although 66% of employees at companies of 10 or more workers are enrolled in some form of managed care, many geographical markets remain untapped, especially in the Northeast and Southeast. "There's still plenty of capacity," says David Wilson, managing director of Apex Management Group, a managed-care consultant and actuarial firm.

But a confluence of unexpected forces is pressuring profit margins. For one, many HMOs appear to have misjudged their costs this year. DLJ analyst Purvis says most HMO managers set 1995 premiums assuming a modest medical inflation rate of 0% to 2%. But in the first quarter alone, doctor charges in the U.S. are up 2.8%, compared with 3.9% for all of 1994. Similarly, overall hospital costs for HMOs are up 1.5% for the first quarter, compared with 4% throughout 1994. In addition, analysts speculate that as managed care plans expand, they are being forced to take on less healthy patients. Some plans also may be raising compensation to attract the physicians they need to accommodate new enrollees.

Stiff competition in saturated markets, moreover, is giving corporate purchasers clout to bargain prices down. Last year in California, the largest managed-care market, employers' average HMO premiums rose just 2%. One big buyer, the California Public Employees' Retirement System, saved $80 million this year by demanding a 5.2% premium rollback from Kaiser Foundation Health & Hospitals Group and other managed-care providers. "For years, the HMO business was really shooting fish in a barrel," says Uwe Reinhardt, a Princeton University economist. "For the first time, [HMOs] are actually facing a tough buyers' market."

In search of growth, managed-care companies are scrambling to win customers in the enormous, virtually untapped Medicare and Medicaid markets. Of the 70 million people covered under Medicaid and Medicare, fewer than 10 million are enrolled in managed care, estimates John S. Penshorn, a senior research analyst with Piper Jaffray Inc.

Here, the industry may get a boost from Washington. Republicans, scrambling to balance the budget, hope to get major savings from the $267 billion spent on Medicare and Medicaid. A draft budget by Senate Budget Committee Chairman Pete V. Domenici (R-N.M.) proposes encouraging Medicare recipients to sign up for managed-care programs. The GOP ultimately wants to replace Medicare with a voucher system that would allow seniors to buy whatever form of coverage they like.

ELDER COSTS. The risk is that HMOs may find the cost of elder care higher than anticipated. "If the premiums don't cover the costs of providing care for the elderly, no insurer is going to want to play ball," says Alan Hillman, director of the Center for Health Policy at the University of Pennsylvania. Indeed, Physician Corp. of America reported disappointing earnings in late March, citing higher than expected costs associated with its Medicare business.

Some investors continue to be bullish on the HMO industry. Steve Enos, a portfolio manager for Wells Fargo & Co., figures HMO enrollment will grow to 50% of the U.S. population over the next decade, with well-managed HMOs enjoying growth of 20% for years. "I see this as a great opportunity to buy HMO stocks," Enos says. But the skies certainly do look ominous. For every HMO growth stock in the years ahead, there likely will be plenty of casualties.

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