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A year ago, SG Cowen predicted that managed care stocks -- among the healthiest performers in the market -- were about to take a sudden turn for the worse.

Instead, health maintenance organizations have gone on to deliver some of their strongest gains in an impressive four-year streak. Now SG Cowen is back with another warning.

"Were we wrong -- or just early?" analyst Edmund Kroll asked late last month. "Results of our ninth annual managed care pricing survey reinforce our cautious stance on HMO stocks."

Of course, it was SG Cowen's

eighth

annual pricing survey -- predicting "the first sequential downtick in HMO pricing" since 1996 -- that pushed the firm to downgrade the sector in the first place. And to be fair, HMO price hikes did in fact slow. But health care costs, which cut into HMO margins, slowed even more.

"For the most part, the spread between price and cost trends ... provided plenty of cushion for the managed care sector," Kroll acknowledged. "As 2004 approaches, however, talks of the 'spread' from the bull camp have diminished. ... Most

HMOs are pricing 'to trend,' which does not allow much room for errors."

In other words, Kroll believes, HMOs are securing price increases that -- if adequate -- will simply cover rising medical costs. Thus, any miscalculations could pressure future earnings. If nothing else, Kroll doubts that HMOs will keep toppling Wall Street estimates.

"Investors can no longer look at current 2004 forecasts and infer upside of 10% to 30%, as was the case in the past three years," he wrote. "In an environment of tighter spreads, we think that the days of significant

earnings-per-share upside are over."

Bernstein analyst Ellen Wilson also sees signs of a slowdown. She points to a looming industry merger, which will create the largest health insurance company in the country, as evidence that HMOs will soon need to find another way to grow.

Blue Giant

By the middle of next year, two for-profit Blue Cross giants should be operating under a single umbrella.

Anthem

(ATH) - Get Athene Holding Ltd. Class A Report

plans to shell out $16.4 billion to acquire

TheStreet Recommends

WellPoint

(WLP)

, its larger peer, in a transaction that will push the company past

UnitedHealth

(UNH) - Get UnitedHealth Group Incorporated Report

to become the biggest in the industry. Many on Wall Street have celebrated the deal as a particularly sound one. Utehdahl analyst James Morris is among those who believe the combined company -- which will adopt WellPoint's name -- can better compete in the rapidly consolidating industry.

"In our opinion, we believe this merger will add value relatively quickly," Morris wrote last month. "The merger will allow the new WellPoint to compete more effectively for national accounts, implement better medical management programs and realize synergy benefits."

But SEC Insight, a private research firm with no ties to the

Securities and Exchange Commission

, believes that challenges could erupt before the deal even goes through. In a report published early this month, the firm warned its clients that the SEC appears to be taking a close look at both companies involved in the pending transaction. The firm said that the SEC had used a "law enforcement related exemption" -- signaling a possible probe -- to deny a request for information on Anthem. In addition, the firm said, the SEC has supplied fresh documents that demonstrate "potentially meaningful pressure" on WellPoint's accounting and disclosure practices.

"SEC activity could spell longer-term problems for this merger," SEC Insight stated.

To some, the pending merger looks risky anyway. Even analysts at Banc of America, a co-adviser to Anthem, says they are "not big fans of the deal." Equity analyst Joseph France sees little opportunity for synergies, with savings of just $250 million annually two years down the road, because the companies currently operate in different geographic markets. Thus, he views UnitedHealth's acquisition of

Mid-Atlantic Medical

( MME) -- announced the same day as the Anthem/WellPoint deal -- as a more sensible combination, since their territories overlap.

Still, France has expressed some concern about the industry's merger activity in general.

"We ... view it as further evidence that the environment in the managed care industry is getting tougher and underlying growth is slower," he wrote, when commenting on the Anthem/WellPoint deal. And "for the most part, big mergers in this industry have not been successful."

Wilson echoed France's concerns.

"We view this move -- particularly when viewed alongside UNH's announcement to acquire MME -- as a signal that 2004 may bring a tougher HMO operating environment," she wrote last month. "Therefore, HMOs will have to seek growth via acquisitions, and we view this as a precursor to an industry cycle downturn."

Price Wars

Wilson went on to study the Blue Cross companies themselves in an effort to test her theory.

She described the Blue Cross/Blue Shield system as "a key indicator of overall HMO industry trend," because it commands nearly half the entire market. She went on to portray BSCS underwriting margins, which have risen from a 0.1% historical average to 2.9% in the first half of 2003, as currently near their peak. She then pointed out that some not-for-profit BCBS programs -- which still dominate the BCBS system -- have actually started refunding money to participants because they've been earning too much.

"When margins reach a high point, not-for-profit plans have limited options for redeploying the corresponding excess capital and have tended to use it as a growth currency via writing lower-margin business or, recently, via actions by some to return refund premiums to customers," Wilson wrote. "Because many local markets are dominated by a large, not-for-profit health insurer -- usually the Blues -- these not-for-profit plans have a disproportionate influence on local competitive dynamics and pricing levels and, as such, their actions to lower margins can ignite pricing wars."

Ultimately, Wilson believes industry margins will remain flat in 2004 and begin to compress the following year.

Lehman Brothers, which is advising WellPoint on its pending sale to Anthem, is considerably more upbeat. Equity analyst Joshua Raskin acknowledges that Blues' profits are "certainly at what appear to be peak levels." But he questions whether the Blues will -- or even can -- take active steps to trim their solid underwriting margins.

"The extremely low level of investment yields in the current environment is not allowing the Blues to give much in the way of underwriting concessions," Raskin wrote this month. "Inadequate investment income continues to pressure the Blues to maintain stronger underwriting margins."

Raskin concluded that worries about the "potential irrational behavior of nonprofit Blues" may be overblown. He also questioned rising concerns about HMO stocks in general.

"In 2001, operating margins were increasing to 'unsustainable' levels," Raskin reminded. "In 2002, operating margins were increasing to 'unsustainable' levels. Sounds familiar. ... Over the past several years, we have heard numerous reasons why investors should avoid the managed care group."

Meanwhile, Raskin noted, HMO stocks have gone on to deliver annual returns of nearly 50% -- compared with negative 7.7% for the

S&P 500

-- over the past four years. Thus, Raskin isn't buying the latest argument that "large merger activity surely signal

s the top of the cycle."

Merrill Lynch analyst Doug Simpson has a stable outlook on the HMO sector as well. He does, however, acknowledge that pricing could deteriorate.

"We believe that the most likely scenario under which we could see broad-based pricing pressure would be from either (1) irrational pricing by a player -- large enough to affect the industry -- in an attempt to gain share, or (2) aggressive pricing due to insufficient understanding of cost trends," Simpson wrote last month. But "we believe that this risk is partially mitigated by the better information available to the industry than had been the case historically."

Wilson is far more skeptical.

"The HMO industry risks significant backlash if margins stay at or increase from today's high levels, because of the perfect storm of employer profit pressures, government budget deficits and a growing public perception of overly rich HMO margins," she wrote.

Even Simpson believes that double-digit premium increases -- and the soaring hospital costs they are designed to cover -- are unsustainable. He says that hikes in both need to decline.

"Right now, neither employers, consumers nor providers appear to be satisfied with recent trends," he noted. "Ultimately, this situation -- the longer it persists -- presents a potential risk to the sector."