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While higher rates may be unpleasant medicine for employers, they are restoring HMOs to healthier profits.

First-quarter earnings at health maintenance organizations suggest they are beginning to emerge from the trough of the competitive pricing cycle as rate hikes take hold, with profitability expected to continue improving into next year. HMOs this year introduced rate hikes of 1% to 6%, depending on the region.

Meanwhile, merger and acquisition activity in the managed care industry is expected to continue, despite a diminishing number of acquisition candidates.

HMO analysts were cheered by first-quarter results and expect even better results as the year continues.

"Generally, the first quarter was better than it has been, but the outlook for the second half is a lot better than for the first half, particularly when compared with last year," said Mary O'Connell, an HMO analyst with Louis Nicaud & Associates in San Francisco.

"First-quarter results were very good, obviously a lot better than last year," agreed Todd Richter, an analyst with Morgan Stanley & Co. in New York. "The pricing trends are the real difference," he said.

Noting that HMOs renew most of their accounts in January, Mr. Richter observed that "when you've got a good, strong first quarter, you're going to have a good, strong year."

The soft pricing cycle has turned, analysts say.

"We're on the upswing of the cycle," said Mark Jamilkowski, an HMO analyst with Conning & Co. in Hartford, Conn. "In other words, we're digging ourselves out of the trough."

"It's increasingly apparent that the pricing cycle has turned, and that the leading HMOs are obtaining rate increases of 3% to 6%, depending on where they are in the country," which foretells sustained or rising margins, said Clifford Hewitt, an analyst with Sanford Bernstein & Co. in New York.

The first quarter was "one of the first where we did not have a deluge of disappointments," said Gary Frazier, an HMO analyst with Bear Stearns in New York.

The results were "definite confirmation of pricing relief within all segments, and the medical cost side still seems relatively under control, despite recent data that shows early signs of upticks in medical cost inflation in different segments of the system," said Mr. Frazier.

Individual company results for the first quarter included:

Norwalk, Conn.-based Oxford Health Plans Inc. reported an 85.7% increase in net earnings to $34.4 million.

Cypress, Calif.-based PacifiCare Health Systems Inc. reported $43.5 million in net income, up 36.5%. Results reflect the company's acquisition of FHP International, effective Feb. 14.

Los Angeles-based Maxicare Health Plans Inc. reported $6.1 million in earnings before a $16 million charge for litigation stemming from a Medicaid managed care program in Pennsylvania. Earnings before the charge are up 7% over the first quarter of 1996.

Woodland Hills, Calif.-based WellPoint Health Networks Inc. reported $50.8 million in net income, down 15.6%.

St. Louis-based RightCHOICE Managed Care Inc. reported $6.2 million in net income for the first quarter, down 24.7%, which the company attributed to competition and cost trends.

Louisville, Ky.-based Humana Inc. posted $39 million in net income, down 26.4% from a year earlier, which it blamed on medical and administrative costs.

Foundation Health Systems in Los Angeles, which was formed by the April merger of Foundation Health Corp. and Health Systems International Inc., reported $58.5 million in net income, down 6.1% from 1996, which the company attributed to higher than anticipated medical costs, especially pharmacy costs.

"I think 1997 continues to be a year of dealing with very thin margins and looking toward 1998, when more of the books will be priced at better rates," said an FHS spokesman.

Greg Baird, senior vp of group sales for Woodland Hills, Calif.-based Blue Cross of California, a subsidiary of WellPoint Health Networks Inc., said that in light of increasing cost pressures, particularly in the prescription drug area, the 3% to 5% rate increases he has seen "will maintain the industry's margins. I don't think it's going to increase the industry's margins."

"The HMOs will continue to perform well in 1997 and improve into 1998," Conning's Mr. Jamilkowski predicted.

Other analysts also are optimistic about the rest of the year and beyond.

Michael LeConey, an analyst with National Securities Inc. in New York, observed that HMOs "increased their reserves generally in the fourth quarter to account for pricing and cost problems and tried to set the stage for a recovery year in terms of earnings."

"Certainly it will not be a record year, but it will probably be the first year in a couple of years where generally the companies report profits, albeit probably quite modest," said Mr. LeConey.

"I think 1997 will be a better year than 1996," said Manfred Nowacki, vp with A.M. Best Co. in Oldwick, N.J. The industry has been successful in getting 3% or 4% rate increases, though "that's come at some cost and that cost has been flat enrollment.

"As the companies price the business to be more profitable, there's been a willingness of some employers to go around to some other managed care companies to deal with. But clearly the industry is very interested in returning to profitability in 1997, and we see that in the rate increases that have been put in place," he said.

HMOs will "see pricing relief continue through the remainder of this year," said Mr. Frazier, who also anticipates the medical cost management strategies that HMOs have adopted will gain momentum.

Meanwhile, analysts expect more mergers and acquisitions.

A good example is Humana's plan to acquire Miami-based Physician Corp. of America for $400 million in cash and debt and ChoiceCare Corp. of Cincinnati for $250 million in cash (BI, June 9), said Mr. LeConey. "I think we've seen a good deal already. I wouldn't be surprised to see additional consolidation," though, he said.

The M&A activity will continue, predicted Mr. Baird. "I don't think there's any let-up in sight on that in California or nationally. I think that the economies that can be achieved with those mergers are going to drive it.

"Employers are still very demanding about cost structure and value and quality, and you can do a lot more as a larger company than you can as a smaller company," he said. Mr. Baird added he believes this activity will happen across the whole spectrum of the health care industry.

There are smaller, regional plans that might be interested in selling, said Louis Nicaud's Ms. O'Connell. "It's been a theme in the industry and it's going to continue to be a theme in the industry," she said.

Mergers and acquisitions occurred even when industry conditions were fairly weak, she said. And now that they have improved, "some of the buying companies feel more comfortable about their own prospects so they can take on someone else's problems," she said.

"When you see overall industry conditions improving, it helps the argument to take on other companies. With price increases, there's a wind at your back," she added.

Noting that "a lot of the companies that were available have been bought," A.M. Best's Mr. Nowacki said. "I think you're still going to see some selective acquisitions," especially "with some of the larger companies" that "truly want to be national players" yet have weak positions in some parts of the country.

"In general, we'll continue to see some of the regional HMOs being consolidated, particularly those that have had trouble achieving a dominant market position and need the infrastructure of a larger partner," said Mr. Hewitt.

In addition, "we'll continue to see indemnity insurance companies selling out to HMOs with the potential for converting those enrollees or covered lives to HMOs, so the pace of consolidation really shouldn't slow down," said Mr. Hewitt.

Multiline, indemnity insurers will continue to acquire managed care expertise by buying out entrepreneurial managed care companies, said Bear Stearns' Mr. Frazier. Other possibilities, he said, include a resurgence of "megamergers," or mergers of equals, and a diminishing number of smaller companies being bought out.