Recent weakness in MCOs present an good entry point for long term investors

Whenever I am attracted to a business that is trashed by the market and trades at a dirt cheap valuation, the first question is to be answered is why it is cheap...

Same applies to the MCOs. They are trading at 7-10 times P/E over their already lowered earning forecast. Why are they cheap? After I listened to 4Q 07 and 1Q 08 of most of the major MCOs (UNH, WLP, AET, CI, HUM and CVH), the most popular questions from the street analysts is the rising medical cost in the form of both unit cost inflation and utilization rate. UNH and WLP have been quite honest on this issue, while others deny. I have no doubt about the higher than expected cost trend. People tend to use more health care service before they lose their job. It is not unexpected that the utilization rate is lagging the economy. The street seems to equal higher cost to lower profits. This view is supported by the rising Medical Loss Ratio (MLR) from the first quarter earning report from the major MCOs.Thus the theory of underwriting downturn is spreading.

It is rather the lack of pricing discipline than the higher cost that leads to an underwriting downturn. As long as the insurers pass the cost onto consumers, higher cost means higher revenue. The managements of the major public MCOs have acknowledged their willingness to protect the margin, even if they are to sacrifice membership growth. I would take managements comment with a grain of salt. Since healthcare insurance is priced annually on a rolling basis, the expected higher trend will certain eat into margin until it is repriced. A positive note from several 1Q 08 call is that the major not-for-profit players who have been driving the price competition are backing off, because these players more heavily rely on investment income and have more exposure to equity investment. Their balance sheets are certainly worsened in the current environment. Hence I expect the pricing discipline will come back as the underwriting capacity of not-for-profit is limited by their balance sheet.

Although I do not have clear view of the profit margin of the MCOs in 08, the valuation is compelling enough to take a hard look. When stock price is depressed by short-term uncertainty not the long term change in fundamental of the business, it often present an attractive investment opportunity.The big picture is still bright for the MCOs. 1, the population in US is growing and getting older; 2,longer life expectancy increases the total medical service to be consumed over one's entire life; 3, advancing in medical technology increase cost; 4,consolidation in the space will continue, especially in the current environment where smaller MCOs are squeezed. If we think the MCOs as a retailer of medical service (as I mentioned in my previous post), these predictable trends are all working for their benefit.