Managed-Care's Iffy Prognosis


By Sam Stovall Please see the note below regarding changes to Standard & Poor's STARS ranking system.

When the S&P Managed Care subindustry index popped up on the most recent industry momentum list, I was taken aback. But then I thought that maybe there could be an investment opportunity in a group that was recently hammered by investor fears that the insurance-industry probe spearheaded by New York Attorney General Eliot Spitzer may extend to some managed-care outfits that maintain life-insurance operations -- and that John Kerry might prevail in the Presidential election.

Not so fast. Phillip Seligman, S&P's Managed Care analyst, is still neutral on the group. Seligman believes the strong year-to-date gain for the group -- the industry subindex is up 32% through Nov. 12 -- has reflected in part investor expectations of healthy earnings-per-share gains through 2005. He views the share-price advance, most of which occurred in the first quarter, as a result of investor optimism regarding a stronger economy, improving execution by management, and possible further industry consolidation.

SMALLER HIKES. That's the good news. But Seligman thinks investors have become concerned that state probes of the insurance industry may eventually look at health insurers. He also thinks investors are wary of lower premium price increases that S&P sees resulting from competition and pushback by accounts that view managed-care organization (MCO) profits as excessive. S&P believes lower price increases are already affecting margins. And those are key factors behind S&P's neutral investment outlook.

Seligman sees the group as likely to deliver strong earnings growth in 2004 and 2005, fueled mainly by premium price hikes that are outpacing medical cost inflation, which is averaging in the high single digits for MCOs under our analytical coverage. S&P believes employers continue to take stronger positions against rising premiums, primarily by means of reducing expensive options and cutting rate hikes in favor of higher co-payments (a practice known as buydowns).

S&P expects most MCOs to experience flat to modestly higher medical cost ratios -- the measure of direct costs expended on health care as a percentage of total premium revenues -- in 2004 and 2005, as it believes that, to attract and retain accounts, MCOs have cut premium-rate hikes to more closely match recent, more moderate medical cost trends. Seligman notes that many MCOs also now provide consumer-directed, more flexible health plans that have been effective thus far in driving down medical costs.

SLOWING EARNINGS GROWTH. MCOs are also seeking to reduce selling, general, and administrative (SG&A) cost ratios, in S&P's view, via improving information-technology systems to further automate transaction processing, and by consolidating service operations. Amid rising competition, Seligman sees some or most of the savings being invested in growth initiatives.

Earnings of publicly traded MCOs should grow 15% to 20% on average in 2004, according to S&P's forecasts, and at a modestly slower pace in 2005. Seligman thinks well-run MCOs, with strong underwriting skills, good cost controls, an array of attractive products, and growing fee-based, rather than risk-based, membership, should be able to maintain this earnings growth level for the longer term.

Industry Momentum List Update

For regular readers of the Sector Watch column, here is this week's list of the industries in the S&P 1500 with Relative Strength Rankings of "5" (price performances in the past 12 months that were among the top 10% of the industries in the S&P 1500) and their proxies (the highest STARS-ranked companies in the subindustry index; tie goes to the largest market value) as of November 12, 2004:

Industry

Company

Ticker

STARS

Price

Commodity Chemicals

Lyondell Chemical

LYO

3

$26

Consumer Electronics

Harman International

HAR

3

$131

Fertilizers & Agricultural Chemicals

Scott's Co.

SMG

4

$68

Internet Retail

EBay

EBAY

4

$110

Internet Software & Services

Yahoo!

YHOO

4

$38

Managed Health Care

Aetna

AET

3

$107

Office Electronics

Xerox

XRX

3

$16

Oil & Gas Equipment & Services

BJ Services

BJS

5

$47

Oil & Gas Exploration & Production

Apache

APA

5

$51

Oil & Gas Refining & Marketing & Transportation

Premcor

PCO

4

$43

Steel

Nucor

NUE

3

$51

Wireless Telecommunication Services

Nextel Partners

NXTP

5

$18

Note: Effective Novermber 12, 2004, Standard & Poor's has modified its Stock Appreciation Ranking System (STARS) nomenclature:

5 STARS now designates a stock ranked strong buy, instead of the previous buy;

4 STARS is now buy, instead of accumulate;

2 STARS is now sell, instead of avoid; and

1 STARS is now strong sell, instead of sell.

The 3 STARS ranking remains as hold.

Required Disclosures

Standard & Poor's Stock Appreciation Ranking System (STARS)

5-STARS (Strong Buy): Total return is expected to outperform the total return of the S&P 500 Index by a wide margin, with shares rising in price on an absolute basis.

4-STARS (Buy): Total return is expected to outperform the total return of the S&P 500 Index, with shares rising in price on an absolute basis.

3-STARS (Hold): Total return is expected to closely approximate that of the total return of the S&P 500 Index, with shares generally rising in price on an absolute basis.

2-STARS (Sell): Total return is expected to underperform the total return of the S&P 500 Index, and share price is not anticipated to show a gain.

1-STARS (Strong Sell): Total return is expected to underperform the total return of the S&P 500 Index by a wide margin, with shares falling in price on an absolute basis.

As of September 30, 2004, SPIAS and their U.S. research analysts have recommended 29.2% of issuers with buy recommendations, 58.5% with hold recommendations and 12.3% with sell recommendations.

All of the views expressed in this research report accurately reflect the research analysts' personal views regarding any and all of the subject securities or issuers. No part of the analysts' compensation was, is, or will be, directly or indirectly, related to the specific recommendations or views expressed in this research report.

Additional information is available upon request to Standard & Poor's.

Other Disclosures

This research report was prepared by Standard & Poor's Investment Advisory Services LLC ("SPIAS"), and may have been provided to you either by: (i) Standard & Poor's under a license agreement with The McGraw-Hill Companies, Inc., which holds the copyright to this report; or (ii) a Standard & Poor's client who is granted a sub-license by Standard & Poor's. This equity research report and recommendations are performed separately from any other analytic activity of Standard & Poor's. Standard & Poor's equity research analysts have no access to non-public information received by other units of Standard & Poor's.

Standard & Poor's does not trade in its own account. SPIAS is affiliated with various entities, which may perform services for companies covered by the recommendations in this report. Each such affiliate is operationally independent from SPIAS.

Disclaimers

This material is based upon information that we consider to be reliable, but neither SPIAS nor its affiliates warrant its completeness or accuracy, and it should not be relied upon as such. Assumptions, opinions and estimates constitute our judgment as of the date of this material and are subject to change without notice.

Past performance is not indicative of future results.

This material is not intended as an offer or solicitation for the purchase or sale so any security or other financial instrument. Securities, financial instruments or strategies mentioned herein may not be suitable for all investors. This material does not take into account your particular investment objectives, financial situations or needs and is not intended as a recommendation of particular securities, financial instruments or strategies to you. Before acting on any recommendation in this material, you should consider whether it is suitable for your particular circumstances and, if necessary, seek professional advice. Stovall is chief investment strategist for Standard & Poor's


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