A Health Check on HMO Stocks

Are they good defensive buys? Says CSFB's Joe France: In general, they don't do well when the economy is slowing

Managed-care companies had a stellar year in 2000 as the industry washed its hands of high-profile lawsuits and reaped the benefits of a soaring economy. Plus, in the second half, their stocks were boosted as investors turned to them as a defensive refuge amid the high-tech turmoil. The Amex Healthcare Payor index of managed-care stocks rose 115% over the year. So far, 2001 is shaping up to be a little less promising for HMOs, with the index having shed some 12% in the first few weeks of January.

How the overall U.S. economy holds up -- or doesn't -- is vital, since a broad economic slowdown will hit managed-care stocks where it hurts, says Joe France, HMO analyst with Credit Suisse First Boston. He spoke recently with Amy Tsao of BusinessWeek Online's Investing channel. Here are edited excerpts of their conversation:

Q: In a recent report, you say that the HMO industry's near-term fundamentals "don't look bad." But would you say they look good?


We're not seeing evidence of employers pushing back on what they're willing to pay, so the outlook is better than expected. At least for now, it doesn't seem likely to happen, and the rate increases [charged by HMOs] look like they were stronger than medical costs. In general, when the Federal Reserve cuts interest rates, the managed health-care sector doesn't perform that well since other sectors are seen as benefiting more [from] a rate cut than managed care. We think the outlook for managed-care stocks, certainly early in 2001, looks good -- although we're not anywhere near upgrading a half-dozen names.

Q: How does the slowing economy affect the HMO industry's performance?


It's the longer-term threat to the stocks. In general, they don't do well in an environment where the economy is slowing. A lot of investors view these as defensive issues. But in reality, HMOs can't raise prices much if employers are in financial difficulty.

A lot of these companies negotiated rates in August and September, which preceded the greater awareness that we were in an economic slowdown. Employers certainly can't abide 14% to 15% rate increases with a slowdown. The markets will begin to be more concerned about that in the summer. That will attract investors' attention. You should be focused on stocks that will do better than the group because valuations are low, and those that have shown in the past they can accurately price their products.

Q: How does drug-benefit legislation affect HMOs?


Most of this issue is focused on the Medicare side of health care. Companies like Humana and Pacificare are exposed to those issues. Humana has done a better job of navigating Medicare issues and is more diversified. It's more of a big deal for drug manufacturers and doesn't have as much of an impact on the managed-care industry. But if a drug benefit ended up reducing drug prices generally, we may see a benefit to HMOs.

Q: How long will it take for legislation on a Patient Bill of Rights to move through Congress? What would be the effect on HMOs, and would favorable stories in the media outweigh the prospect of more litigation allowed by the bill?


We believe the basic problem the industry faces is that the average person thinks the industry says "no" all the time. With the Patient Bill of Rights there will be greater disclosure and more accountability, and that improves the industry business model. And it doesn't cost the industry anything. The cost goes to employers since they set what the benefit levels are. The premiums going to employers will increase the next year to make up the litigation losses.

While it may or may not be a good policy decision, we're assuming it's one of the things that will actually get accomplished next year. It's not just a Republican or Democrat thing. There are differences between their versions, but I think it's something bipartisan that Congress and the President would like to do.

Q: You have four companies with buy ratings. Cigna, WellPoint, Oxford, and HealthNet. Which is your top pick and why?


Our top pick among big-cap HMOs is Cigna (CI ). Strategically, it's well positioned. Only about 20% of the company would be affected by a slowdown in medical spending. The rest of it is focused on processing claims for a fee. These businesses have a good return, and they're largely not exposed to adverse trends in medical costs.

There's also evidence that WellPoint WLP can deliver good results in difficult economic circumstances. WellPoint has always been a traditional insurance company. So it has been very careful to price for margin rather than some other metrics used by HMOs. The company has not had to take a charge to boost reserves for at least 10 years while all the other companies have had to take numerous charges over that time period.

Q: Of your hold-rated companies, which might move onto the buy list? A: Actually we recently upgraded RightChoice Managed Care Inc. RIT , a small-cap value name, to buy. The company has been public since May, 1995. It's a publicly owned Blue Cross plan that merged with its parent to create one for-profit company. The chief asset of the merger -- outstanding stock of RightChoice -- will be distributed over five to seven years. This is good because it increases the float, which has been quite limited. We're looking for $1.90 earnings per share for 2000 and $2.35 for 2001. RightChoice is like a mini-Wellpoint in that it is a Blue Cross organization that's doing well.

Q: What should investors in HMO stocks keep an eye out for in the immediate future?


The next big thing is what's going on with the economy. The success of HMO stocks has more to do with what the stocks aren't. The rotation into the group from technology helped the group in the second half of 2000 -- and if the economy continues to not look so exciting, they will be viewed as a good place to be. I don't see any major issues until they report second-quarter earnings. But we do have to look at this industry quarter-by-quarter.

Edited by Beth Belton

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