AS WHAT WASHINGTON CALLS HEALTH-CARE reform moves closer to reality, the Obama administration and many members of Congress have found an easy target: health insurers.
The health-care bill that recently passed the Senate Finance Committee would do little to control costs, Wall Street analysts say. Yet it would sting health insurers with higher taxes, while hurting profits -- by forcing the companies to insure individuals at set rates, regardless of their health condition -- and would levy only modest penalties on people who don't buy a health policy. This could create a situation in which many Americans would buy insurance only when they needed it. That would crimp insurers' profits, while eroding the underlying principal of insurance: that risk is shared by many -- the healthy, the very sick, and everyone in between.
Odds are good that legislation of some sort will be enacted. Wall Street, understandably, doesn't like much of what it sees, including what amounts to a $6.7 billion annual windfall-profits tax that could be imposed on health insurers as early as 2010. And lurking out there is the remote risk of extinction for the managed-care business if the U.S. moves to a single-payer, European-style system and muscles out private health insurers altogether.
But the worst-case scenarios are unlikely to materialize, and it often pays to buy out-of-favor industries. That's why some of the companies look like buys for patient -- and brave -- investors. The best of them could rise 25% or more over the next year.
MANAGED-CARE SHARES HAVE languished since the summer. The S&P managed-care index stands at half its late 2007 high, and the industry carries one of the lowest price/earnings ratios of any major group. The five major stocks -- UnitedHealth Group, WellPoint, Humana, Aetna and Cigna -- trade at an average of only eight times estimated 2009 profits and eight times projected 2010 earnings. That's about half the P/E they've historically been accorded, and just over half the market multiple. Among the few industries with a comparable P/E are property-and-casualty insurers and major drug companies.
Charles Boorady, a Citigroup analyst, favors Aetna and WellPoint, while Goldman Sachs' Matthew Borsch likes Cigna and UnitedHealth. "Health-care reform will result in faster spending growth on health care. Almost nothing is being done to control costs," Boorady says.
Aetna, at a recent 25, is trading at nine times projected 2009 profits of $2.86 a share. Cigna, at 29, fetches seven times projected 2009 net of $3.85. UnitedHealth, at 25, trades at eight times estimated 2009 profits of $3.15 a share, while WellPoint, at 46, is at eight times projected earnings of $5.67 and Humana, at 37, commands just six times projected profits of $6.15.
A problem with the stocks is that they pay little or no dividends. "The capital management of this industry has been nothing short of disgraceful," says Leon Cooperman, the chief executive of Omega Advisors, a New York investment firm that holds UnitedHealth and WellPoint shares. UnitedHealth's dividend is just 0.1%; WellPoint has none.
These companies have wasted billions of dollars on aggressive share-repurchase programs at high prices, while management has cashed out options and sold stock. UnitedHealth, for instance, has bought back $15 billion of stock since 2005 at an average price of $42 a share, way above the current stock price.
"The industry is in an uncertain environment because the Obama administration is hostile to it," Cooperman says. "So why are they buying back stock? They should return money to shareholders in dividends, and let shareholders decide what to do with the money." Cooperman says both UnitedHealth and WellPoint would appreciate 20% if they paid 40% of profits in dividends. At current share prices, a 40% payout ratio would result in 5% dividend yields.
One of the arguments against high dividends is that they would play into the hands of political critics like House Speaker Nancy Pelosi, who has complained about the industry's "immoral profits." Cooperman opines that if this country has gotten to the point "that shareholders aren't entitled to a return on their investment, God help us all."
THE GROUP'S BEEN DEMONIZED in Washington for earning supposedly excessive profits, gouging consumers, stifling competition and routinely denying care to the deserving.
True, the industry earns a combined $15 billion to $20 billion annually. But that about equals Microsoft's yearly profits, and is less than 1% of total annual U.S. health-care spending. If the industry is so anticompetitive, why do major public insurers have an average net profit margin of 4%, about half the average for the S&P 500?
Even before health-care reform surfaced as a major issue during Barack Obama's election campaign, the stocks were under pressure -- due to deteriorating margins stemming from competitive pressures.
Goldman's Borsch figures that health-care legislation along the lines of the Senate Finance Committee's bill could cut profit growth among health insurers to an average of about 5% annually, from a potential 10% a year, if no health-care bill is passed in Washington this year. The nearby table shows four potential scenarios and what Borsch figures are the associated probabilities. He figures that there's a 75% chance of some reform bill being enacted this year. The Senate Finance Committee bill is his "base" scenario with a 55% probability, while he assigns a 10% probability to "bear case" reform that would include a public option: a government-run insurance program that would compete against private insurers.
CIGNA AND AETNA PROBABLY are the safest choices, because they get the lowest percentage of their revenue and profits from the two sectors most threatened by legislative reform: policies for individuals and small groups (meaning 50 or fewer people) and Medicare Advantage coverage, a privately administered alternative to traditional Medicare that covers 11 million seniors -- 25% of all Medicare participants.
Cigna gets just 2% of its revenue from individual and small-group plans and Medicare Advantage, while Aetna gets 21%. Most of Aetna's business is with large companies, which either purchase coverage from the insurer or pay it to administer self-insurance programs. Cigna gets significant revenue from self-insurance plans, and it has sizable non-health-care businesses, including group life insurance and international operations.
UnitedHealth and WellPoint, the industry leaders, get 33% and 42% of their profits, respectively, from individual and small-group policies, plus Medicare Advantage.
The profitability of individual and small-group health-insurance policies is threatened by the take-all-applicants mandate of the various reform proposals, combined with a weakening of the proposed penalty for not getting insurance. It originally was supposed to kick in by 2013 at $3,800 per family, but it was watered down to $1,500 by 2017 in the recent Senate bill. Congress also is targeting cuts to insurers that participate in Medicare Advantage, amid concern in Washington about the program's rising cost and its profitability for insurers, which earn allegedly outlandish 6% pretax margins on it.
Borsch is wary of Humana because it gets about 70% of its profits from Medicare Advantage. Humana carries the lowest valuation in the group for this very reason.
Borsch likes Cigna, which admittedly has a grab-bag of assets, because of its minimal exposure to at-risk insurance programs and its low valuation.
With greater exposure to health-care reform, UnitedHealth is riskier than Cigna, and it has more than $10 billion in debt. Next year's profits are expected to slip to about $3 a share, from $3.15 in 2009, although that's arguably reflected in UnitedHealth's low P/E.
Boorady likes Aetna because of its low-risk business, and is partial to WellPoint because of a low valuation. WellPoint should net $3 billion after taxes around year's end from the sale of its pharmacy-benefit-management business to Express Scripts, and plans to use the bulk of the proceeds for share buybacks.
It's always tough buying shares of companies in an unpopular industry that's under fire on Capitol Hill. Despite all the rhetoric in Washington, insurers have a real role to play in the health-care system, and their stocks already discount a dire scenario. They may remain ill for a while, but eventually most will walk out of the intensive-care ward.
The Bottom Line
Some managed-care companies will remain relatively unaffected by a new U.S. health-care regime. The shares of the most robust could gain 25% or more over the next year.