HMO Stocks with Vigor

Rate hikes and cost controls should help most operators boost their bottom lines, says S&P analyst Phillip Seligman

By Sam Stovall

A recent addition to the list of industries with top Standard & Poor's is the managed health care group -- comprising companies that operate health-maintenance organizations (HMOs). Investors have poured money into the sector at a healthy clip: Year-to-date through Apr. 26, the S&P Managed Health Care index rose 26.7%, vs. a 5.0% decrease for the S&P 1500 (the combined S&P 500, S&P MidCap 400, and S&P SmallCap 600).

S&P analyst Phillip Seligman says although the group still faces a number of potential issues, including patients' rights legislation, litigation, and medical-cost inflation, he expects full-year 2002 earnings to increase 15% to 20% on average.

Seligman continues to recommend that investors focus on companies with a stable medical-cost ratio -- the measure of total health-care spending by an insurer as a percentage of total premium revenues. He also emphasizes companies with minimal exposure to the Medicare business, which can prove unprofitable because of low government reimbursement rates.


  Another criteria he looks for: A relatively low percentage of capitated provider agreements, under which doctors get a fixed fee for each patient, no matter how much care they provide -- an arrangement that can prove quite costly to doctors. Some physician groups have gone bankrupt under these arrangements, notes Seligman, leaving HMOs with the bills they owe. Seligman also thinks investors should focus on industry players with strong management.

He expects the group to continue delivering strong earnings growth, fueled by premium price hikes at percentages in the mid- to upper-teens. Those hikes should outpace medical costs rising at rates in the low- to mid-teens. However, with corporate earnings continuing to suffer, employers have been taking a stronger position against rising premiums, including cutting back on expensive coverage options (referred to as buydowns) and passing more of the costs to employees (see BW Online, 4/30/01, "Shifting Health-Care Costs to You").

Despite the rate hikes, most HMOs are likely to face increases in their medical-cost ratios, according to Seligman. Given buydowns, the premium rate yields -- premium rates, or original prices, minus the buydowns -- realized by HMO operators can be a couple of percentage points lower than the rate hikes. In addition, large-group accounts, which command lower rate increases than small-group and individual accounts, make up a larger percentage of membership.


  To offset the rising medical-cost ratios, HMOs have been focusing on reducing their selling, general, and administrative costs (SG&A) as a percentage of revenues. One effort along those lines: improving computer systems to further automate paper handling. Some HMOs are also consolidating their service operations through measures such as workforce reductions.

As for the potential impact of political developments, Seligman notes that President Bush has said he would veto the patients' rights bills being passed by the Senate because damage awards would be too costly, leading to higher premiums and higher levels of uninsured. In any event, the patients' rights bill and HMO reform have been put on the back burner by Congress.

Top choices in the group? Seligman has 5-STAR (buy) rankings on WellPoint (WLP ) and UnitedHealth (UNH ). He says both companies are well-managed and should see improved EBITDA (earnings before interest, taxes, depreciation, and amortization) margins because of effective cost controls.

His other picks include Coventry (CVH ), Mid Atlantic Medical (MME ), and Oxford (OHP ), each of which is ranked 4 STARS (accumulate).

S&P Relative Strength Rankings

These industries carry six-month relative strength rankings of "5" as of Apr. 26, 2002 -- meaning that they're in the top 10% of the 115 industries in the S&P Super 1500 (the combined S&P 500, S&P MidCap 400, and S&P SmallCap 600) based on prior six-month price performance.

Industry/Sector Largest Company (Market Cap.) S&P STARS* Rank
Air Freight & Logistics/Industrials FedEx (FDX) 5 STARS
Apparel, Accessories & Luxury Items/Consumer Discretionary VF Corp. (VFC) 4 STARS
Auto Parts & Equipment/Consumer Discretionary Gentex (GNTX) 4 STARS
Casinos & Gaming Park Place (PPE) 4 STARS
Catalog Retail/Consumer Discretionary Lands' End (LE) 3 STARS
Consumer Electronics/Consumer Discretionary Harman International (HAR) Not Ranked
Home Furnishings/Consumer Discretionary Leggett & Platt (LEG) 5 STARS
Homebuilding/Consumer Discretionary Clayton Homes (CMH) 5 STARS
Hotels, Resorts & Cruises/Consumer Discretionary Carnival (CCL) 3 STARS
Managed Health Care/Health Care UnitedHealth (UNH) 5 STARS
Specialty Stores/Consumer Discretionary Barnes & Noble (BKS) 5 STARS

*S&P's ranking system for the appreciation potential of stocks over a 6- to 12-month period: 5 STARS (buy), 4 STARS (accumulate), 3 STARS (hold), 2 STARS (avoid), 1 STAR (sell).

Stovall is chief sector strategist for Standard & Poor's

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