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The News

Investors turned queasy after

Coventry Health Care

The Bethesda, Md.-based insurer and operator of managed care plans warned late Wednesday that its second-quarter earnings will range from 55 cents to 57 cents a share. That's 30% lower than current Wall Street consensus estimate of 78 cents a share. In April, the company projected quarterly earnings of $1.03 to $1.04 a share. It's scheduled to report results on July 25.

For the full year, Coventry now expects to earn $3.65 to $3.75 a share, down from its already reduced forecast of $4.39 to $4.50. Wall Street's most recent consensus estimate was $3.03 a share, according to Thomson Financial.

"We are very disappointed with the April and May 2008 results and their anticipated effect on the second quarter and the full year," Coventry CEO Dale Wolf said. "We have implemented corrective actions that we anticipate will put us back on an acceptable EPS growth path for 2009 and beyond."

The news hobbled other health-care stocks, including Aetna and UnitedHealth Group. Five of the seven largest companies in the sector have cut forecasts in the last three months.

Coventry's management said in a Wednesday conference call that much of the shortfall came from a lag in claims processing for its Medicare Advantage private fee-for-service business.

"We've discovered that, too many times, our members go to a provider and present their traditional Medicare card as opposed to their Coventry private fee-for-service card," which can cause processing delays of 60 to 90 days, said Shawn Guertin.

In addition, high outpatient utilization and inpatient unit costs, coupled with emergency room visits, chemotherapy and radiology, squeezed margins in Coventry's commercial business.

Wachovia Capital Markets analyst Matt Perry on Thursday cut his rating on the stock to Market Perform from Outperform, as did BMO Capital Markets analyst Dave Shove.

The Analysis

The soul-crushing grind of slow health insurance paperwork is only part of Coventry's problem. Medical costs are rising, and insurers across the board are taking the hit.

"When nearly every major company has lowered earnings guidance over a three-month span, it becomes real difficult to argue that there isn't some kind of an industry issue, particularly when the guidance revisions are as significant as they've been in the managed care industry," Oppenheimer & Co. analyst Carl McDonald wrote in a Thursday note.

Coventry stands out for publicizing the fact that those rising costs have forced it to recalculate its business model. Management announced that it now expects costs to increase by 9% rather than 7.5% this year and is raising its premium prices accordingly, though the effects won't be felt until 2009.

"In fact, the pricing change will have a much smaller impact, if you will, on 2008," Guertin said.

Analyst Michael Baker, at Raymond James & Associates, says industry trends are catching up with different health-care companies in different ways, but there's a fundamental shift going on.

"The dynamics in the industry that have occurred in the last five or six years have shifted a lot of costs to members [of health-care plans], so you saw a lot of deceleration of costs which benefited managed care," he says. "But you still have competitive pricing pressures, and there's no cushion any more."

While Coventry's in a tough situation, Baker lauds its executives for being forthright about rising costs. "This is the first company [in the sector] to say they've seen a pickup in cost and will have to raise its cost trend line," he says. "But it takes a while for pricing to come through."

The Bottom Line

Expect the cost crunch to continue bugging the industry. Coventry's shares were already down by a third year-to-date before Wednesday's profit warning, and more investors have checked out today.

Health care used to be viewed as a defensive sector in tough times, because people get sick regardless of the health of the economy. But McDonald says the industry is no longer immune from the broader business trends.

"What we think is going on is that for the first time in many years, the group is not benefiting from a positive tailwind related to slowing medical cost trends," he wrote. In other words, there is no longer any cushion in the spread between pricing and cost trends, so whenever something goes against the group, like a worse than expected flu season, or falling interest rates, it shows up on the bottom line."

Smaller companies like Coventry are going to feel the impact more quickly than larger rivals, Baker says, and that means these stocks could stay sickly for a while.

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