Earnings Vitality for Robust PacifiCare


By Phillip Seligman Managed-care outfit PacifiCare Health Systems (PHS

; recent price, $54) will continue to produce above-average revenue and earnings growth over at least the next three years, in Standard & Poor's Equity Research Services' view. We think PacifiCare will achieve this through disciplined premium pricing and medical and administrative cost control. Also, we think the company will benefit from expansion into additional states and the higher-margin and underpenetrated individual/small group (ISG) market segment, new products and services, and its new network of 30,000 licensed brokers, gained via a recent acquisition.

In addition, we believe PacifiCare will be a major beneficiary of the new Medicare drug benefit, which starts in 2006. S&P expects the company to attract more seniors seeking to avoid the benefit's "donut hole" (a gap in available coverage), compared to other health maintenance organizations, given PacifiCare's well-established and highly regarded Medicare program. The business also plans to offer a nationwide stand-alone prescription drug plan (PDP) for seniors, i.e., one not requiring enrollment in its HMOs.

Given what we see as PacifiCare's promising growth prospects and attractive valuation, we have a 5 STARS (strong) buy recommendation on its shares.

HMO GIANT. PacifiCare has a total health-plan enrollment of more than 3.3 million members. It's the largest Medicare HMO in the U.S., with 704,700 Medicare members at Dec. 31, 2004. California has been the company's principal geographic focus, accounting for 56% of total HMO membership, followed by Colorado (9.2%), Arizona (8.2%), Texas (6.2%), seven other states, and Guam.

The business primarily serves two types of HMO member groups -- commercial and Medicare. It also offers a preferred provider organization (PPO) product. Commercial members join mainly through employer groups, while PacifiCare provides health-care benefits to individual MedicareAdvantage and Medicare Supplement beneficiaries through its Secure Horizons programs.

At Dec. 31, 2004, commercial membership totaled 2.6 million (79% of total medical membership), including 665,100 enrollees in the PPO and employer self-funded products (312,000 of which are from the mid-December American Medical Security Group acquisition), while enrollment in MedicareAdvantage and Medicare Supplement programs totaled 743,400 (21%).

EXPANDED NETWORK. PacifiCare's HMOs contract with a broad network of providers, including primary-care physicians, specialist physicians, and hospitals, to arrange for a comprehensive range of health-care services for their members. Contracts are normally negotiated on an annual basis, and the majority is capitated, calling for a fixed fee to providers per member per month. The company's PPO product supplements the existing HMO network with additional health-care providers and doesn't require a primary-care physician to coordinate care.

PacifiCare also offers specialty managed-care products that supplement its HMO products and are primarily sold in the commercial plans. Products include pharmacy-benefit management, life and health insurance, dental and vision-care services, and behavioral health services.

In December, 2004, PacifiCare acquired American Medical Security Group (AMS). The deal added 310,000 members, raising PacifiCare's commercial enrollment by 14%, and strengthened its position in the ISG market segment. It also expanded the outfit's geographic presence to an additional 28 states. AMS's network of more than 30,000 licensed brokers and agents also expands the distribution network for several PacifiCare products. The company expects to achieve $14 million in annual cost synergies through the AMS deal.

LOWER MEDICAL LOSS RATIO. In November, 2004, PacifiCare said it agreed to purchase Pacific Life Insurance's group health-insurance business. The proposed deal, which awaits regulatory approvals, is expected to add mostly small group PPO members and provide additional network synergies owing to a 95% membership overlap in states where PacifiCare and Pacific Life have health-plan operations.

We look for PacifiCare to post overall revenue growth of about 17% in 2005, which includes an average commercial premium yield increase of about 7%, commercial enrollment gains of 1% to 2%, and 39,000 (5.5%) additional Medicare members. Interestingly, according to PacifiCare, in order to increase its Medicare enrollment by 39,000, it requires about 140,000 new members to offset the death rate (PacifiCare's average Medicare member is 76.5 years old).

We project further moderation of the medical cost trend and look for a consolidated medical loss ratio -- the measure of total costs that are expended on health care as a percentage of total premium revenues -- of about 84%, below 2004's 84.7%. Partly offsetting these advances should be a small rise in the ratio of selling, general, and administrative (SG&A) expenses ratio, as the company's investments in selling and marketing outweigh operating efficiency gains.

A 2006 STORY. The company also expects to spend up to $15 million to prepare for Medicare Part D, also known as the drug benefit, including building the infrastructure and conducting initial customer service and advertising. However, PacifiCare intends to itemize these expenses as one-time investment costs and separate them from the rest of its earnings. All told, we look for the EBITDA (earnings before interest, taxes, depreciation, and amortization) margin to expand about 40 basis points.

In one way, we view PacifiCare as a 2006 story. This year's commercial enrollment was mostly set in 2004's final quarter. We see a bigger gain in the commercial arena, particularly in the ISG and midlevel, multistate employer market segments on almost a nationwide basis, as a result of PacifiCare's December, 2004 acquisition of AMS. Moreover, in 2006, we see an influx of seniors joining both PacifiCare's Medicare HMOs and its nationwide PDP, the latter of which we combine into the company's specialty segment.

On a consolidated basis, we see revenues up almost 20% in 2006. We think the consolidated medical loss ratio will rise modestly, as an improving economy is likely to lead to increased utilization, and as promising, yet more expensive therapies are introduced. We expect the SG&A cost ratio to decline on improving productivity and the leveraging of operating costs over higher revenues.

PREMIUM JUSTIFIED. All told, we look for operating per-share earnings of $3.80 in 2005 and $4.55 in 2006, representing EPS growth of 19% and 20%, respectively. We note that unlike PacifiCare's MCO peers, the company already includes stock-option expense in its income statement, and we're doing the same in our earnings model.

Going forward, we see similar revenue and earnings growth for another year or so before it decelerates, due mainly to the law of large numbers (i.e., growth off an expanding base). Our earnings model excludes future acquisitions, including the planned purchase of Pacific Life's health-plan operations.

S&P's 2005 and 2006 core earnings estimates for PacifiCare are $3.80 and $4.55 a share, respectively, the same as our operating EPS estimates, owing to the company's inclusion of stock-option expense in its income statement.

The shares recently traded at about 14 times our 2005 EPS estimate of $3.80, a 13% discount to the S&P 500-stock index and an 8.5% discount to the company's MCO peers. We believe the stock should trade at a premium to the S&P 500, as our estimated EPS growth rate of almost 19% in 2005 is well in excess of the 10% expansion that S&P sees for the index's operating earnings.

RESPECTABLE GOVERNANCE. We also think that PacifiCare should trade at a level that's higher than its current premium to peers, as our estimated three-year compounded annual growth rate for EPS of 20% is above its peers' 16% average. Our 12-month target price of $72 is based on our forward projected price-to-earnings multiple of 19 times and our 2005 EPS estimate.

Our

discounted cash-flow (DCF) model suggests that PacifiCare's intrinsic value is about $72. Both our p-e analysis and DCF model show the stock generating a total return of about 33% over the next 12 months.

PacifiCare meets most of the criteria we see for good corporate governance. Four of the many positive practices we note from the proxy are that the board is composed of a significant majority (80%) of independent directors; the full board of directors is elected annually; its governance guidelines are publicly disclosed; and it has a governance committee, although the latter is also the nominating committee.

On the negative side, a former CEO sits on the board and is a member of the compensation committee, as well as the governance and nominating committees, chairing the latter.

POSSIBLE RISKS. Risks to our recommendation and target price include competitive pricing, an unexpected rise in medical cost trends, unfavorable regulatory changes, poor new product positioning, headline risk (e.g., New York State Attorney General Eliot Spitzer's probe of property and casualty insurers), and a sharp decline in the job market, which could lead to declines in enrollment.

The company remains highly dependent on capitation contracts, which carry off-balance sheet insolvency risks, and on Medicare, which carries a risk should unexpected cutbacks in federal Medicare spending occur. In addition, PacifiCare has become a consolidator in the managed health-care subindustry, and, as such, it may face integration risks in future acquisitions. Analyst Seligman follows shares of managed-care organizations for Standard & Poor's Equity Research Services


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