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What Health-Care Crisis?

DESPITE ALL THE worry in recent years about skyrocketing medical costs leading to a national health-care crisis, managed-care companies have never looked healthier. Monday's news that Anthem (ATH) is shelling out nearly $4 billion for Trigon Healthcare (TGH), a 25% premium from where the stock closed on Friday, is just the latest example of how a depressed sector has remade itself — and captured Wall Street's attention in the process.

It wasn't long ago that managed-care stocks were in intensive care. But they've popped 76% in the last year and 48% in 2002, according to Lehman Brothers. What's fueled the gains? In a word: earnings. In the last two years, health insurers have dramatically cut their administrative expenses while passing increasing health-care costs along to their customers. Health-insurance premiums will rise an average of 12% this year and another 12% to 15% next year, predicts Mercer Human Resource Consulting. And this estimate might prove to be conservative. Just last week, the California Public Employees' Retirement System, or Calpers, said its HMO raised premiums a whopping 25% for 2003. Thanks to these increases, health insurers are reporting record earnings growth and consistently beating Wall Street's profit expectations.

"[Health insurers] are no longer willing to sacrifice margins for market share," says Andrea Urban, an analyst at Merrill Lynch. These days, unlike in the past, insurers are willing to walk away from contracts when customers balk at higher premiums. And their pricing power should last at least through next year, says Urban.

This pricing environment has been especially beneficial for so-called Blues consolidators like Anthem. The managed-care company has made a name for itself by acquiring poorly performing Blue Cross & Blue Shield providers for bargain prices and implementing quick turnaround strategies. Over the past decade, the Indianapolis-based insurer has consolidated eight different plans into one, and now boasts nearly eight million members. Should its planned merger with Trigon go through, it would gain access to a ninth region, Virginia, and an additional 2.2 million members.

Since going public last October, Anthem's shares have soared nearly 65%. What has seduced investors? Anthem's strong business plan, which should deliver at least 21% earnings growth this year and an annual growth rate of 14% to 16% through 2006, according to Thomas Carroll of Legg Mason Wood Walker. (Carroll doesn't own shares of Anthem; his firm hasn't provided any investment-banking service.) On Monday, in addition to announcing its latest merger partner, Anthem reported earnings of 93 cents a share, blowing past the Thompson Financial/First Call estimate of 83 cents. The company also raised expectations for its 2002 earnings growth to $3.85 to $3.95 a share. Wall Street analysts had been expecting earnings of $3.74.

Since Anthem is a new name to investors, analysts believe it tries to be extremely conservative when forecasting its future profits. This leaves some room for more repeat performances of what analysts got on Monday: greater-than-anticipated earnings growth. Moreover, Joshua Raskin, an analyst with Lehman Brothers, points out that the company's operating margin is a bit lower than that of its competitors. If Anthem can improve it, there could be significant earnings improvement over the next year or two, he argues. (Raskin doesn't own shares of Anthem; Lehman participated in the company's IPO.) This would be good news for a company that trades at just 17 times the lower end of the company's 2002 earnings forecast of $3.85, vs. the Standard & Poor's 500's 2002 multiple of 21.

Healthy, Wealthy and Wise

Monthly data from April 30, 1992 through April 30, 2002  Sources: Dow Jones News Retrieval; Mercer Human Resource Consulting

Like Anthem, Wellpoint Health Networks (WLP) is a Blues consolidator on the rise. It now operates in nine states, boasts 13 million members and is expected to increase its earnings 26% this year. Last week, Wellpoint beat Wall Street's per-share earnings estimates of 93 cents by three pennies and raised its year-end target to $4.00 from $3.85 a share. And even though the company's shares have jumped 28% since January, Wellpoint still trades for just 18 times 2002 earnings.

Ask any analyst what makes Wellpoint stand out, and you're sure to get the same answer: The managed-care company is great at pricing its products. Not only does it keep up with health-care inflation, the company is also good at predicting cost trends, says Merrill Lynch's Urban. The result: Wellpoint boasts one of the lowest medical-loss ratios (medical costs divided by revenue) in the sector, at 80.6%. (Urban doesn't own shares of Wellpoint; Merrill Lynch has provided some investment-banking services for the company in the past.)

Wellpoint is so cost-conscious, in fact, that it has taken on the pharmaceutical industry in hopes of lowering its largest expense, prescription drugs. In 1998, the company filed a citizen petition with the Food and Drug Administration arguing that Schering-Plough's (SGP) allergy medicine Claritin, Pfizer's (PFE) Zyrtec and Aventis's (AVE) Allegra are safe medications and should be sold over-the-counter. Last month, Schering agreed to sell its blockbuster without a prescription. Now, Wellpoint is going after Schering's second-generation allergy pill, Clarinex. A Wellpoint spokesman contends that "Clarinex is just Claritin in drag" and shouldn't be priced like an expensive new medication. The managed-care company estimates it would save $45 million annually if patients could purchase these medications without a prescription.

There are some 40 remaining Blue Cross & Blue Shield plans that are still up for grabs, and investors can bet that both Anthem and Wellpoint will be looking at them with acquisitive eyes. Thus far, both companies have delivered on their promises and successfully turned around the plans they've purchased. But keep in mind that anytime a company makes an acquisition, there's the possibility that synergies and cost savings could take longer than planned. And remember also that the market has punished companies like Tyco International (TYC) that seem to be aggressive with their merger-related accounting practices.

If buying acquisitive companies makes you nervous, you may wish to consider some other health-care darlings on Wall Street, such as UnitedHealth Group (UNH) and Humana (HUM). On April 18, UnitedHealth reported earnings of 92 cents a share, beating Wall Street's estimates by seven cents. On Monday, Humana reported earnings growth 28 cents a share, a 75% jump over last year and in line with Wall Street estimates.

How will you know when these companies are losing steam? When your employer stops asking you to pay more for your health insurance. And experts will tell you not to expect that to happen any time soon.

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