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A Long Road for HMOs

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Someone called it the "HMO Death March of California." Three days of investor conferences by three of the leading HMOs in California:

Pacificare

(PHSYB)

,

Wellpoint

(WLP)

and

Foundation Health

(FHS)

. All held their annual investor conferences last week on Tuesday through Thursday at various locations in Southern California.

The HMO industry suffered a horrifically dismal year in 1997, significantly underperforming the stock market. Blowups in information systems, rapidly increasing drug costs and acquisition integration troubles were just some of the problems. The theme of this year's meetings was an emphatic assertion that the tide has turned and these are now long-term growth stocks with a bright future.

But are they really?

Here is a brief review of some important issues discussed.

Drug pricing

This has always been a problem for medical providers and patients alike. Prescription outlays for major HMOs have been rising 15% to 20% per year, far faster than any other component of health care. In an oversimplified but telling analysis from one Wall Street analyst at the conference, "Drug companies are laughing all the way to the bank while the HMOs are bleeding red ink." This situation is clearly not sustainable, either from a free-market standpoint or from a legislative standpoint. Which one rectifies the situation first has yet to be seen.

Capitation

This is simply taking a premium from members and paying a fixed "percent of premium" fee to doctors and physician practice management companies like

Medpartners

(MDM)

. These physician groups then basically assume the medical-loss risk. Capitation is a very key business model because it offers more predictable margins going forward for the HMO.

More importantly, from the public's perspective, it puts medical delivery in the hands of physicians, not the big, bad HMOs, which have now become, in most cases, just marketing and insurance conduits with expertise in financial, network and membership management.

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Growth

The

Medicare HMO

business is in its infancy and expected to grow over 20% in the next 10 years. This is where the government pays the HMO 95% of the monthly amount that it estimates the HMO would normally have to spend per patient under current Medicare rules. The HMO takes complete responsibility for providing medical care under this arrangement, which saves the government money and offers the HMO a growth product with potentially higher margins than normal commercial business. And, considering the many extra free benefits that a Medicare HMO member would receive, this is a triple-win situation. A $24 billion business in 1997, Medicare managed care is expected to grow to approximately $160 billion in 2007 as acceptance becomes more widespread and America's aging population continues to get larger.

Public opinion

Public opinion is a very difficult and problematic issue for all HMOs. Outside of California and other certain highly penetrated states, HMOs are still completely misunderstood and feared. The general public, especially seniors, are fiercely opposed to the HMO concept because of fear of doctor restrictions and bad medical care.

Both fears are generally irrational, as satisfaction ratings in highly penetrated markets are still well above 80% to 90%, depending on the particular market. And there is no concrete evidence that tragic medical mistakes happen more frequently in HMOs than in the traditional fee-for-service system -- they are a type of risk that exists in any form of medical care. Of course, as any observer of local television news can attest, we don't see good stories on the benefits of HMOs, only the tragic ones. So it's a monumental effort to sway fierce public opinion. As

Gustave LeBon

once said, "The crowd has never thirsted for the truth."

Take Texas, for example, one of the lowest-penetrated HMO states in the United States. Pacificare's Secure Horizon unit, which markets the company's Medicare product, is facing incredible opposition from residents, doctors, hospitals and the press. I know that firsthand because my parents live in Texas and refuse to join any type of managed-care program. HMOs have become the personification of an evil, greedy empire. Once an opinion has been formed by a stubborn Texan, it's an almost futile to try and change it.

Management

Success in the HMO industry is ultimately a management story. You must have strong managerial skills in marketing, price theory, information systems, employee benefits as well as discipline not to do something totally stupid, for which there are plenty of opportunities. These are not companies that

Warren Buffett

would own ("You should own a business that could be run by any idiot, because eventually one will.").

Over the last three days, I became comfortable with these three organizations and their depth of management. I was particularly impressed with Pacificare management, largely due to one comment made by the CEO who said, "We take full responsibility for the mistakes we made in 1995 and 1996 and don't blame any outside forces or anybody but ourselves."

Complete and humble honesty among senior management is refreshing and somewhat rare in today's corporate world. This is a clear sign of a management team that recognizes what needs to be done to guarantee a positive future.

Overall, things are generally more positive than negative for this industry. These three California leaders -- even though they operate with slightly different strategies and offer significantly diverse products -- all have the same basic improved outlooks. All are making efforts to be strong regional or super-regional providers, and all three would probably make good long-term investments for those patient souls with long-term time horizons -- and those not bothered by occasional mild pricing cycles.

But what about those impatient investors? When is it really time? When will these stocks really move?

Easy answer: when your mom finally joins an HMO. That's one of the greatest signals you'll ever get that the industry's problems are behind it. If that ever happens, every stock in the group will go through the roof.

Tom Kerr is a portfolio manager and equity research analyst with the investment firm of Reed Conner & Birdwell. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. RCB is based in Los Angeles and manages about $1 billion of assets for institutions and taxable individuals.