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The health care reform debate has captivated millions, or at least made us pay attention to what the folks in Washington are up to. Legislators have drawn their battle lines. The laws passed impact us all. The health care industry is in a state of flux with the effect of the health care law changes not yet fully known. For health insurance companies, the general consensus is that it will potentially bring price and margin pressures but may increase top line revenue as more people will be covered by some form of insurance. Some of the largest insurance companies, Wellpoint (NYSE:WLP), Humana (NYSE:HUM), United Health Group (NYSE:UNH), Cigna (NYSE:CI), and Aetna (NYSE:AET), and some related health care ETFs, Health Care Select Sect SPDR ETF (NYSEARCA:XLV), iShares Dow Jones US Healthcare Providers ETF (NYSEARCA:IHF) and iShares Dow Jones US Medical Devices ETF (NYSEARCA:IHI) have had a recent uptick and earnings surprises.

The trend seems to be that regulation initially appears to be stifling, and the market reacts strongly. Then, as the regulation actually rolls out, it is not as heavy-handed as it first appeared. In the health care industry, the major players seem to be wading through the regulations well, whether that is because of their sophistication, large lobbying resources, striking good looks, or a myriad of other reasons.

As an aside, this trend may occur as well in the financial sector as the Dodd-Frank law is applied. The market may have overreacted on bank valuations. As the new regulatory environment develops, large cap banks J.P. Morgan (NYSE:JPM), Wells Fargo (NYSE:WFC), Bank of America (NYSE:BAC), Citi (NYSE:C) and related ETF Financial Select Sector SPDR ETF (NYSEARCA:XLF), Vanguard Financials VIPERs ETF (NYSEARCA:VFH) and - SPDR KBW Bank ETF(NYSEARCA:KBE) specifically may stand to benefit most, or be hurt the least. The trend, along with the factors outlined here, make financials potentially a sector to overweight.

The recent stock price increases probably have not surprised many health care companies. They appear to believe they were undervalued, as showcased by numerous share buyback programs. The PowerShares Buyback Achievers Portfolio ETF (NYSEARCA:PKW) is an index of stocks that have repurchased at least 5% of their outstanding shares for the trailing 12 months. Health insurance companies are two of the five largest holdings. Health care providers and services make up 22%, the largest segment of the ETF. Whether or not they are right in the long-term, clearly the health care industry is buying.

Not only are they buying their own shares, insurance companies are also buying other companies. They are indicating an interest in complementary businesses. Wellpoint (WLP) is considering making an acquisition to ramp up its Medicare Advantage business. Medicare Advantage is basically a medicare supplemental insurance. Some companies WLP could acquire include HealthSpring (NYSE:HS-OLD), Kaiser Permanente, and divisions of UnitedHealth, Humana, and Aetna. Though it is still unclear how health care reform will impact the health care industry, if the largest insurance companies in the industry are giving government plans a buy rating, I am too.

Along with regulation appearing to be more tame than originally expected, the second trend is a move toward accountable care organizations (ACO’s) and global capitation payments. The general idea is for a health care provider to receive a set amount per patient and take responsibility for the patient’s medical care. This serves to transfer most, in some cases all, of the risk to the provider of health care services. The risk is that the patient may need more services than the provider budgeted. If the patient, however, requires fewer services, the provider receives the benefit.

While the big players in the industry appear to be achieving reasonable growth, there are smaller companies within the health care industry that also will benefit from the aforementioned trends. Two such companies are Continucare Corporation (NYSE:CNU) and Metropolitan Health Networks, Inc. (MDF). This article will give more detailed analysis on CNU.

From its annual report, “Continucare provides primary care physician services on an outpatient basis through a network of medical facilities in Florida…The company has 18 well-appointed medical offices… In addition, Continucare provides medical management services to independent primary care physicians in South Florida… Also, through its subsidiary, Seredor Corporation, Continucare operates or manages more than 70 sleep diagnostic centers in 15 states.”
Its business is primarily Medicare/Medicaid patients as a primary care provider for Humana plans. This represents approximately 70% of CNU’s revenue, which is not very diversified. It is making strides to diversify its revenue. In Q1 of this fiscal year, CNU spent approximately $11M to expand its sleep diagnostic centers business. Unfortunately, CNU did not give sufficient detail to analyze the merits of the acquisition as it did not break out revenue and expenses of the sleep centers post-acquisition. It did accrue $1.5M of the potential $2M earnout contingency.
CNU performs primary care, which was favored in the recent health care reform, but there are still price pressures. CNU performs most services at risk. It receives a fixed capitation payment, which is a percentage of what Humana receives, and then it is responsible to pay for all health care, even health care it doesn't personally administer. Basically, it has taken on the risk but hopefully has the opportunity for reward if costs come in lower.
Most CNU plans are Medicare Advantage plans. These plans were out of favor with the government five to ten years ago. Then, during President Bush’s term, the government passed a law favoring Medicare Advantage, and the plans have grown substantially. Under the recent health care reform, Medicare Advantage reimbursement rates were reduced by 2% for 2011, on top of a 5% decrease during 2010, while health care costs probably will continue to rise. This presents CNU with real margin pressures. On the other hand, the reform should bring a higher volume of patients. Per Humana’s Q1 press release May 2, 2011, retail Medicare Advantage participation grew by 9% from its previous quarter. This pricing decrease and volume increase presents a somewhat mixed picture for CNU.
CNU definitely is sending some buy signals. First, while it appears to have just recently started making money (accumulated deficit of $21M at 6/30/07), it does generate a lot of cash now with little capital expenditures required, no long term debt, and 46% insider ownership (no substantial buying or selling recently). It is using that excess cash to repurchase shares and to acquire companies- sleep center businesses and a large 2006 acquisition of Miami Dade Health Centers, Inc. CNU bought back $22M of shares in FY 2008 and 2009 at approximately $2.06/share. Based on the current stock price, this was a prudent use of cash. Second, CNU recently joined the New York Stock Exchange. Finally, it is highly rated in how it cares for patients.
Along with the margin pressure alluded to above, another negative is CNU generously giving stock options and diluting the company, including a 2% stock dilution in FY ’10. CNU has another 10M of options to grant as part of it stock compensation plan, which could further dilute the stock by as much as 15%. 2% dilution seems excessive in a year of moderate growth. The company needs to be more disciplined in its granting of stock options, preferably 1% dilution or less.

To wrap up, early signs point to health care and specifically health insurance companies having more positive results than originally anticipated when the health care reform was passed. While it is difficult to predict how health reform changes will impact them, the large companies are buying government plans and accountable care organizations. That being the case, there may be buying opportunities in the Medicare sector. While there will be margin pressures and potentially volatile valuations short term, Continucare Corporation and other Medicare Advantage insurance programs and providers are attractive long-term buys. They appear to be in a growing niche in the health care industry and will benefit as well from the general aging of the population.

Disclosure: I am long CNU, JPM, VFH, XLF.

Source: Health Care Rising - Along With Investment Opportunities