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The financial outlook for HMOs is improving after the squeeze that intense competition and rising pharmaceutical and outpatient costs put on 1996 profits.

With the industry's move toward rate hikes that are averaging 3% to 5%, most HMOs and analysts anticipate this year is likely to be a better year for HMOs than 1996, and next year will be even stronger.

For 1997, "the outlook is for much more stable, perhaps improving, margins," said Mark Jamilkowski, an HMO analyst with Conning & Co. in Hartford, Conn.

In particular, "The large, more well-established and perhaps better managed companies appear to have an improving outlook for 1997, as their pricing is ahead of anticipated medical trends, and they seem to have a firmer grasp on the cost drivers both from the medical and administrative side," Mr. Jamilkowski said.

"The pricing trends are much better," said Todd Richter, an analyst with Dean Witter Reynolds in New York.

Much depends on the impact of cost trends when first-quarter results are released.,

Mr. Richter said. "The early indications are cost trends will be about the same as last year," he said. Because HMOs have raised their prices, though, this means "they are better prepared."

"This year looks good because the major companies have been able to get the price increases that they need to cover medical inflation, and that's very encouraging," said Ellie Kearns, an analyst with Alex. Brown & Sons in Boston.

"We're very bullish about the outlook for our own prospects," said Greg Baird, senior vp of group sales for Woodland Hills, Calif.-based Blue Cross of California, a subsidiary of WellPoint Health Networks Inc., which reported $202 million in net income in 1996, up 12.2% from 1995.

"I don't think we'll see deterioration," said a spokesman for Foundation Health Systems Inc. The merger between Rancho Cordova, Calif.-based Foundation Health Corp. and Woodland Hills, Calif.-based Health Systems International Inc., which led to Foundation Health Systems's creation, was completed last week (BI, Sept. 23, 1996).

Instead, the spokesman said, there will be a more stable environment for HMO earnings because the industry has been able to get at least some rate increases.

The "ultimate question" for the industry, though, is whether the rate hikes will be adequate in light of health care cost increases in some areas, said the Foundation spokesman, who noted the HMO*industry has just gone through three years of generally flat or declining rates.

"People are looking at this and just wondering whether the price increases will cover the cost increases, and I think that's an open question right now," he said. "I think we'll start to see in the first-quarter earnings reports and second-quarter earnings how this shakes out."

It may take more than a year to recover from 1996, say some observers.

"I think it'll be a rebuilding year," Michael LeConey, an analyst with National Securities Inc. in New York said of 1997.

"I think it's taking a while for them to get everything into place, to get higher prices up and sort of get things going at the rate they'd like," including gaining control of their costs, he said.

"I don't think it'll be just a dynamite year. They have a lot of work to do, and they know it," said Mr. LeConey, who added that a lot of people have finally concluded that every day is not New Year's Eve in this industry, which seemed to be the mind-set for a while. They realize that if you are "patient and stick to your knitting, you'll get there," said Mr. LeConey.

While 1997 will be better than 1996, it could be 1998 before the HMO*industry returns to good profits, said Manfred Nowacki, vp with A.M. Best Co. in Oldwick, N.J.

This year "could end up being a tough year in terms of net margins," with 1998 perhaps becoming the first time in a while that the industry "maybe gets back to some margin expansion," said Gary Frazier, managing director at Bear, Stearns & Co. in New York.

Renewal pricings were starting to improve even during the last couple of quarters of 1996, Mr. Frazier noted.

Observers say particularly outstanding results were reported by Norwalk, Conn.-based Oxford Health Plans Inc., which posted net income of $99.6 million, up 90.1% from 1995.

Many other companies posted more disappointing earnings, some of which were due to special charges. These included:

Miami-based Physicians Corp. of America, which reported a net loss of $277.7 million for the year, vs. a $24.6 million loss in 1995.

Los Angeles-based Maxicare Health Plans Inc., which reported $19.4 million in net income, down 29.8% from $27.7 million in 1995.

Rockville, Md.-based Mid Atlantic Medical Services Inc., which reported a $2.8 million net loss for the year vs. a $61.1 million profit in 1995.

Louisville, Ky.-based Humana Inc., which reported $12 million in net income, down from $190 million in 1995.

St. Louis-based RightCHOICE Managed Care Inc., which reported a $2 million net loss vs. $25.8 million in net income for 1995.

There were no surprises in fourth-quarter results, say observers.

"I think the fourth-quarter

results were as expected, weaker than you might have hoped

at the beginning of the year, but stronger than you might

have feared at the middle of the year," said Dean Witter's Mr. Richter.

"The problem was that HMOs, I think, underestimated their cost trends and, as a result, they didn't price the product properly," Mr. Richter said.

"I don't think anybody had any kind of high hopes for the fourth quarter," said Mary O'Connell, an HMO analyst with Louis Nicaud & Associates in San Francisco.

"Management and investors pretty much acknowledged '96 was a terrible year way before the fourth quarter," Ms. O'Connell said. "Basically premiums had been going down."

While pharmaceutical costs were a problem, "Most of it had to do with the underwriting cycle and a very competitive marketplace for premiums" that began in 1995 and continued into 1996, she said.

With a few exceptions, the HMO industry "did not have a very good year in 1996, and that was primarily due to companies trying to maintain market share or grow their business in certain geographic markets," said A.M. Best's Mr. Nowacki. "As a result there were a significant amount of HMOs chasing business, which drove premiums down, and that had a negative impact on overall profitability."

Last year "in general was a disappointing year," agreed Conning's Mr. Jamilkowski. "Virtually every HMO, except for perhaps Oxford, had troubles with decreasing margins as a result of escalating pharmacy and outpatient costs, which were compounded by aggressive pricing in 1995."

Results were "generally lousy," said National Securities' Mr. LeConey. "I think in most cases the companies used the opportunity to write off everything in sight" with the "objective of sort of cleaning house at the end of the year."

The stocks have been doing poorly, "and they'd decided it just made sense to get everything cleaned up at year end," said Mr. LeConey.

For example, he pointed to Hooksett, N.H.-based Healthsource Inc., which reported pretax, non-recurring 1996 charges of $53.4 million in connection with enhanced provider arrangements and for costs related to a restructuring of operations, including a $40.4 million charge in the fourth quarter alone.

The HMO, whose merger with CIGNA Corp. is expected to be completed this summer, reported a 1996 loss of $3.9 million vs. a $56.2 million profit in 1995.

CIGNA Corp. subsidiary CHC Acquisition Corp. last week extended its tender offer for Healthsource stock from April 2 to April 30 because certain required state and federal regulatory approvals have not yet been obtained, but this is not expected to have an impact on the merger, said a spokeswoman.

Observers expect additional merger and acquisition activity. "It's probably going to slow down" though, said Best's Mr. Nowacki.

"Most of the large ones have been acquired, and in California, where a lot of the M&A activity is taking place, it's being severely scrutinized because of antitrust concerns."

But Ms. Kearns of Alex. Brown disagreed: "Consolidation is likely to continue in the field. I don't see any reason to think it will slow down. The interest in acquisition, I think, is high and will continue."

She noted that there are many potential acquisition candidates still left among private companies.

At the same time, in essence "We are now seeing both a consolidation as well as a spreading out of the market" as providers perform functions traditionally done by health insurers and HMOs, said George Karahalis, a consultant with Towers Perrin in Atlanta.

Blue Cross of California's Mr. Baird agreed competition is coming from additional sources besides other HMOs, including providers attempting to get into the business by dealing directly with employers, brokers trying to create their own programs, and employers who are forming their own purchasing alliances.

"It's a pretty interesting marketplace, and I don't see any change in this trend," Mr. Baird said.