The managed care group still looks healthy for now.
The big health insurers are poised to meet Wall Street expectations when they begin reporting first-quarter results this week. But they could see their long rally end as they struggle to hit aggressive growth targets later this year.
Thus, Goldman Sachs analyst Matthew Borsch suggests that investors focus on the strongest names in the pack. He points to
-- which recently surpassed
in size -- as his favorite pick. Meanwhile, he singles out
as the most challenged player in the group. He views Coventry's own expansion plan as ill-conceived and believes the company faces major competitive challenges ahead.
Ultimately, Borsch foresees risks for the sector overall.
"We continue to see managed care stocks trading higher to midyear 2005, with bullish sentiment supported by continued rotation from other healthcare sectors," Borsch wrote last week. "However, we see downside risk to 2H2005, as we believe evidence of increasing price competition, from both public and not-for-profit health plans, will lead to somewhat lower valuations, offsetting stock upside potential from earnings growth."
Borsch has long warned that the industry's own profitability could come back to haunt it. In particular, he notes that nonprofit companies -- including powerful Blue Cross insurers -- face limits on how much money they should make. As a result, he says, they can introduce lower prices that hurt the entire group.
Indeed, Borsch expects the nonprofit Blues -- which control one-third of the market -- to slash their profit margins by half going forward. And he questions whether the for-profit stocks can maintain their lofty valuations if that happens.
"The current 'up cycle' has lasted six years, longer than any other cycle in history," noted Borsch, who has a neutral rating on the group. "We believe that, during long cycles, memories wear thin. However, we view the current managed care environment as one that combines risky peak valuations and peak margins and, therefore, should not be ignored."
But even Borsch expects the party to continue for now.
Like many, he looks for UnitedHealth to set a positive tone for the group when it kicks off the earnings season on Thursday. He believes the company will deliver "solid-to-strong results" -- possibly topping first-quarter profit expectations -- and offer "fairly upbeat commentary" for the year ahead. He also expresses "high confidence" in UnitedHealth's ability to meet first-quarter enrollment targets but questions whether the company will continue to reach its goals throughout the year.
Borsch notes that the entire industry -- and especially UnitedHealth -- fell short of commercial enrollment targets last year. And he says the group has now raised the bar even higher.
"Despite the risk of price competition, the pressure to attain commercial enrollment growth (or at least not lose market share) is significant, as articulated by company managements during many of the 4Q2004 earnings conference calls and subsequent investor presentations," Borsch wrote. But "our analysis of the commercial enrollment targets versus actual results for 2004 reaffirms our view that there appears to be inadequate commercial enrollment growth to go around."
Still, Borsch sees clear opportunities for some. He points out that WellPoint has already reported strong renewal rates for January. Going forward, he expects the company to achieve -- and possibly even surpass -- its enrollment targets for the year. He also believes that share repurchases could push the company's full-year profits ahead of expectations.
He favors WellPoint, in large part, due to its limited exposure to the non-profit Blues.
Meanwhile, Borsch expects
-- another top pick -- to deliver upside surprises as well. He points to share repurchases, once again, as a reason for his bullish forecast. He also says the company is best positioned for success if favorable industry fundamentals continue.
All told, Borsch looks for six companies -- Aetna,
, UnitedHealth and WellPoint -- to raise their 2005 earnings guidance when they issue first-quarter results this month.
Yet Borsch likes another company,
, as a mid-cap pick. He acknowledges that WellChoice fell short of profit expectations in the fourth quarter and commercial enrollment targets in January. But he also says the company "appears to be less aggressive in managing earnings than some" and has rebounded from shortfalls with strong results in the past.
Meanwhile, Borsch continues to voice concern about the rest of the group. He says he remains "cautiously optimistic" about Cigna's ability to stabilize its commercial enrollment this year. But he worries that Cigna could "add fuel to the fire of increasing competition" in the process.
At the same time, he frets over the political risks associated with companies -- like Humana and PacifiCare -- that rely heavily on Medicare business. But he reserves his greatest concern for Coventry, which recently joined forces with struggling First Health.
In recent months, Borsch notes, Coventry has already scaled back its commercial growth targets once and -- with competition mounting -- could very well do so again.
"We see high risk of a shortfall (in earnings) over the course of the year," he wrote, "with continued pressure on First Health as well as deterioration in the market environment for Coventry's core commercial risk business."
Thus, Borsch continues to direct investors away from the stock. But he indicates that Coventry simply faces greater challenges than most. He believes the entire industry could suffer under tough market conditions going forward.
"The competitive landscape has changed now that almost all companies are seeking growth, as compared with two to three years ago, when about half the public companies were still exiting unprofitable products and markets," he wrote. "This has led to companies setting growth targets that are, in aggregate, above the industry growth rate -- a classic recipe for price competition" in the end.