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.

Coventry Health Care lowers its guidance

Another shoe dropped in the managed healthcare space. Coventry(CVH) lowered its full year guidance to $3.65 to $3.75 from $ 4.39-$4.49. Higher than expected MLR is cited. The revision of Private Fee For Service (PFFS) seems to be firm specific driven by a negative development of its reserve (delayed claim submission is cited as the cause.). While the higher than expected MLR of its commercial business is quite a concern. Looking back to its 2008 1Q call, CFO, Shawn M. Guertin, confirmed a "stable trend at the neighborhood of 7.5%", after many of its major competitors (UNH, WLP) reported higher than expected inpatient unit cost. The management also backed its original guidance given the fact that most of its competitors lowered theirs. Management's credibility aside, this revision come barely as a surprise. It is merely a catch up with its competitors......

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.