Why Oxford Health Deserves Better
By Phillip Seligman
The shares of managed-care outfit Oxford Health Plans have some catching up to do. Oxford (OHP ) trades at a significant discount to the industry as a whole as measured by two key valuation gauges: its forward p-e (on estimated earnings for the next 12 months) and the ratio of its p-e to its estimated five-year long-term growth, based on Standard & Poor's current earnings-per-share estimates. We at S&P believe this discount is undeserved, given Oxford's competitive strengths and our expectation of improving financials. The stock carries our highest investment recommendation of 5 STARS, or strong buy.
Enhancing Oxford's marketplace position is the fact that it has the lowest medical loss ratio (MLR) -- health-care costs as a percentage of premium revenues -- among all for-profit managed-care companies that S&P covers analytically. We believe this is partly due to Oxford's relatively lower medical-cost trends -- the rate of growth of medical costs -- and its focus on small and midsize employers, where accounts tend to command higher premiums than large groups. Indeed, more than 40% of its accounts have 50 or fewer members, while only 20% to 25% are large groups accounting for 500 or more. The average size of all accounts is 25 members.
Partly enabled by its below-peer MLR, during the past three years Oxford raised premiums (which were never among the industry's lowest) at lesser rates than the competition. That trend combined with Oxford's large network of hospitals, clinics, and doctors (one of the largest, if not the largest, in its primary New York metro-area region), a well-known brand name, and, we believe, a strong reputation for service, should help Oxford continue to gain market share. At its last count in mid-2002, the markets Oxford served had 14.9 million members in total. Using that figure, Oxford, with slightly over 1.5 million commercial-risk members (encompassing HMOs, PPOs, and other fully insured plans) had a 10% market share as of Mar. 31.
IMPETUS TO SAVE.
Its medical-cost trends have been running in excess of 200 basis points below the blended medical-cost trends of its rivals. We believe its well-known brand name and market share provides some clout in negotiations with health-care providers. Competition among the many providers in the region Oxford serves may also be a contributing factor, in our view.
One impetus Oxford has in closely controlling medical costs is that it's almost wholly responsible for risks, unlike rivals with large businesses administering accounts that self-insure. Among the several health-care cost initiatives under way at Oxford are those addressing pricey therapies and services for congestive heart failure, chiropractic care, orthopedics, and radiology.
Oxford hopes to realize a 20- to 30-basis-point decline in selling, general, and administrative (SG&A) costs as a percentage of sales annually for the next few years. It could accomplish some of this by leveraging such costs over a growing membership base and continuing investment in its information systems. Oxford notes that by yearend 2002, more than 70% of its claims were submitted electronically and adjudicated automatically on an annualized basis, physician referrals were 100% electronic, and it had 7.5 million Web transactions, 50% more than in 2001.
Oxford doesn't see any additional net new commercial-risk members in 2003 following 3% enrollment growth in the first quarter. The tepid New York economy has resulted in a number of small and midsize companies going out of business. Another reason, says Oxford, is the entry into its New York-area small and midsize markets by certain national managed-care players that haven't traditionally targeted those markets. Oxford believes that when these new competitors' contracts are renewed, their premium rates will likely rise sharply. Some of their clients might then turn to Oxford and others that have historically served those markets.
S&P finds it encouraging that despite the weak economy and new competition, Oxford didn't see a commercial-risk enrollment decline. Total enrollment, however, grew 1% as gains in commercial-risk membership were partly offset by attrition in its small administrative-services business and at MedSpan, a small Connecticut managed-care company acquired in March, 2002, as Oxford corrected for prior inadequate premium pricing for certain MedSpan accounts. In any event, this situation suggests to us that once the economy begins to revive, Oxford will gain new market opportunities.
One potential growth market for Oxford: small Wall Street and law firms that now rely on higher-cost, traditional indemnity insurance. Oxford also sees a market opportunity with employers dropping self-insurance, though S&P believes it's too early to say whether such a trend is indeed under way. By Phillip Seligman
EXPANDING ITS TURF.
New products from Oxford that span a range of price points and could possibly help employers lower their own health-care costs should garner interest. In late 2002, responding to growing market interest in consumer-directed health plans, Oxford introduced its Oxford Consumer Options Suite, which enables employer groups to offer multiple health-plan options.
Oxford also seeks careful expansion into adjoining geographic areas, either organically or via small acquisitions. In New Hampshire, it's building a provider network prior to entering that state. It's also targeting Central and Southern New Jersey, Eastern Pennsylvania, the Lower Hudson Valley, and Fairfield County in Connecticut.
S&P believes Oxford is capable of generating 2003 operating revenues of at least $5.4 billion and EPS of $4.25, 2 cents below the high end of company guidance of $4.17 to $4.27 (based on generally accepted accounting principles, or GAAP). S&P believes that Oxford's EBITDA (earnings before interest, taxes, depreciation, and amortization) margin, which was 9.6%, excluding nonrecurring charges, in 2002, will remain at an approximate 10% rate over the next few years, as likely increases in MLR are offset by continuing improvements in SG&A expense leverage. For 2004, we see revenues of $6 billion and GAAP earnings per share of $4.75.
S&P believes Oxford has exceptionally high earnings quality. Based on our proprietary Standard & Poor's Core Earnings, we see 2003 EPS of $4.09, a 3.8% divergence from our GAAP EPS estimate. The S&P Core EPS estimate assumes stock-option expenses, under accounting regulation SFAS 123, of 16 cents, but no pension adjustment since Oxford doesn't have a defined-contribution pension plan.
Oxford sees $225 million in operating cash flow in 2003, after a $208 million one-time payment for a litigation settlement, vs. $371 million achieved in 2002. Absent this one-time event, operating cash flow would have risen more than 16.5%, and our earnings model conservatively assumes it will continue to grow, albeit at a significantly slower pace. Even so, this provides wide financial flexibility, including paydown of a recently acquired $400 million six-year loan, which was to help cover the litigation settlement payment, refinance $119 million of existing higher-cost debt, and possibly reduce Oxford's need to enter the credit markets to support geographic expansion while continuing share repurchases.
We also wouldn't be surprised if Oxford is considering a cash dividend, following the recent dividend-tax rate reduction. Capital spending is limited, and given our projection of growing free cash flow, we have become more bullish on the stock.
NICE PRICE TARGET.
Using S&P's proprietary discounted cash-flow model and making conservative assumptions (e.g., raising the beta slightly, which raised our estimated weighted average cost of capital, and projecting a rapid slowdown of free cash-flow growth to a level below our expectations of long-term economic growth), but excluding the one-time impact of the litigation payment, we have calculated an intrinsic value of about $54 a share. The stock was recently trading at 8.9 times our 2003 EPS estimate, vs. a peer average of 12.6. Assuming a p-e equal to the average, the shares should also be valued at $54, and that's our 12-month price target for Oxford shares.
The risks to Oxford achieving our earnings and price target include further deterioration of the U.S. economy, legislation or regulations affecting its operations, inability to control health-care costs, unforeseen difficulties in expaning into contiguous territories, broad weakness in the managed-care sector, and unfavorable conditions within U.S. equity markets.
Analyst Seligman follows managed-care stocks for Standard & Poor's
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