Why HMOs are Cheap, Despite Rising Utilization


Utilization rises as the economy strengthens; with economic strength comes rising employment. For commercial HMOs, the question is whether the benefits of employment growth (which brings enrollment growth, sales growth, operating leverage, and improving underwriting risks at the margin) can more than offset the gross margin pressure of rising utilization. We say yes


The crucial distinction is between rising utilization for the average American, as compared to rising utilization for the average commercial beneficiary. As more households gain employment, household incomes rise, and households shift from less generous (e.g. un-insured, Medicaid) to more generous (e.g. employer-sponsored) forms of health insurance. It’s this national shift of households from under-employed, under-earning, and under-insured to normally employed / earning / insured that drives growth in utilization for the average American


The average commercial beneficiary is a different thing altogether. The modal commercial beneficiary has been employed before, during, and since the recession, and her levels of income and health insurance have not greatly changed. The marginal (new employee) commercial beneficiary will consume more than he did when under-employed and under-insured (driving national average utilization higher) – but less than the modal commercial beneficiary who’s been in the risk pool throughout the economic cycle. Thus the average commercial beneficiary isn’t really exposed to what’s driving utilization at the level of the average American


For completeness’ sake: rising consumer confidence, including among the constantly employed (i.e. commercial beneficiaries) does increase healthcare utilization, but this effect is smaller than that of shifting households to higher incomes and better health insurance, and in the context of HMOs’ margins more than offset by the benefits of rising enrollment


It’s not all good news; turning to the longer-term, we now believe integrated health networks (IHNs) will take a large chunk of enrollees from the commercial HMOs if the Affordable Care Act (and in particular the individual mandate) is upheld. This is plainly an incremental negative to our fundamental view, but there’s room for this news at current valuations


Ahead of the Court’s ruling, we believe fair value for commercial HMOs is roughly 0.9x the S&P 500 – a 50:50 weighting of fair values if the individual mandate falls (1.0x the S&P 500) or survives (0.8x the S&P 500). At current prices, the commercial HMOs trade at 0.76x the S&P 500 on FY + 1 consensus earnings, and 0.63x the S&P 500 on FY + 3

Print Friendly, PDF & Email