managed care organization (MCO) is getting interesting

I always like to take a careful look at business that possess a strong balance sheet and yet experienced significant drop in share price....MCOs apparently qualify....I will post a series review of MCO industry on this blog...

Industry Overview

The managed care organization (MCO) is basically a retail business (purchasing medical service in bulk and sell to individual customer) and an insurance business (additional compensation is rewarded for the risk assumed). It creates value for its customers by purchasing medical service in bulk at a lower price and by helping customers using their healthcare service more efficiently. The market divides into three major categories: Commercial Risk Management, Individual market and government sponsored program (Medicare, State Children's Health Insurance Program and Medicaid).The government and large corporations in the commercial risk management segment have a strong bargaining power and more price-sensitive. The individual and small businesses are generally price-taker and have very low bargaining power.

There are usually two or three major MCOs competing in a local market. The high market concentration renders the big firms strong bargaining power when negotiating reimbursement rates for healthcare providers. The rivalry in the industry is decreasing because of the on-going consolidation. I expect the consolidation to continue into the future, as the smaller players can not compete against the low cost large MCOs, especially in this tough economic environment. Due to the slower economy, commercial business is under pressure (both on pricing and membership growth). Higher unemployment rate will result in lower membership enrollment. As corporation customers trying to cut their medical cost, the smaller and high cost MCOs will take a harder hit. Healthcare insurance is largely a commodity business, therefore being a low cost producer is critical to the success of the company. The market share leader can always attract more doctors and negotiating for better rate by committing volume to the doctors. In turn more membership is attracted by low price and larger doctor network. The moat of the market share leader grows by widening gap in the membership counts. Due to such economics of scale in the MCO industry, the entry barrier is high.

In addition to favorable industry characteristics, the demand outlook is bright. The demographic trend driven growth is highly predictable. Healthcare cost is increasing at 7.5%-8% annually, driven by higher unit cost (more expensive new therapy, as medical technology advances) and utilization rate (more frequently using healthcare service). This rate will likely to increase because as the boomers get older, the utilization rate will be higher. Higher cost will be translated to higher revenue for the MCOs given their ability to pass cost inflation onto the end consumers. As people will live longer life, the total medical cost during one’s life will be certainly higher. Secondly 18% of the population are still uninsured, which represents a growth opportunity for individual market. Individual business is more profitable for the insurers since the consumers have less bargaining power, but the selling cost is also higher than dealing with big custromers. Companies who can achieve low selling cost, such as online direct sale, will likely to benefit the most from this opportunity. The fix cost (G&A) is pretty scalable in this business. There is more cost leverage as the topline keeps growing. Hence the bottom line should grow even faster.

The biggest concern in the industry is increased government regulation and uncertainty regarding universal converge policy. I believe universal coverage could be slightly positive for the industry. Although margin is likely to be depressed, it is likely to be compensated by greater volume influx from currently uninsured. Low cost provider will be likely to benefit. Massachusetts already operates under a universal coverage policy, under which insurers have demonstrated their ability to operate profitably. Auto Insurance industry has proven profitability under universal coverage model. Guaranteed issuance will certainly increase the premium, because those with pre-existing conditions that are not able to obtain coverage will be covered. Essentially healthy people are paying to cover the sick. If you think MCO as medical service retailer, larger volume is actually a good thing. Credit Suisse has a nice state-by-state analysis showing a strong positive correlation between government regulation and insurance premium. Given the market power of the insurance companies the higher regulation cost will be eventually passed on to consumer in the form of high revenue.

To be continued….

Please tell me want do you think.