Jenks Healthcare Business Report August 2002

In the August 2002 issue:

Health Services Profits Strong, But For How Long?

The past month has been earnings season, and many of the pharmaceutical companies released somewhat poor results. Managed care and hospital companies, however, are flush with profits. Will something change? See page 1

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Public Equity Market

Although no one knows if the stock market has quite hit bottom, the IPO market certainly has. All pending health care IPOs have withdrawn their offerings until market conditions improve. See page 3

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Venture Capital Market

Venture capital investors continue to have a busy year, investing almost $400 million in 20 health care companies in the past month. With no IPO market, some may have no other choice for their existing portfolio companies. See page 6

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Merger & Acquisition Market

While the Pfizer/Pharmacia announcement in July generated a lot of buzz in the market, everyone is being cautious about future plans. The largest deal of the current month was for $3 billion, small compared to the $60 million Pharmacia price tag. See page 9

Jenks Healthcare Business Report

Health Services Profits Strong, But For How Long?

Weeks before reporting second quarter earnings,
many of the large pharmaceutical companies had warned that earnings would be down for the quarter. A combination of inventory issues, generic drug competition, delays in product approvals and manufacturing difficulties all contributed to one of the worst industry performances in recent memory.

Bristol-Myers Squibb (NYSE: BMY) reported a 63% plunge in profits, caused in part from a revenue drop of 14% and a decline in the company’s gross margin from 71.4% to 65.5%. Eli Lilly & Co.’s (NYSE: LLY) second quarter net income fell 20% on a revenue drop of 8.5%, hurt by lower sales of Prozac because of generic competition. Even Merck (NYSE: MRK), the country’s third largest drug company, suffered a small drop in earnings for the second quarter even though revenues jumped by 7.7%.

It was not all bad news, as Johnson & Johnson (NYSE: JNJ) reported an 11.6% increase in second quarter profits, while Pfizer (NYSE: PFE) announced a 10% increase in second quarter earnings to go along with its Pharmacia (NYSE: PHA) acquisition announcement. PHA had a 25% earnings increase on just a 4% rise in revenues, but much of the additional profits came from a gain on the sale of certain rights to a drug. From a public relations perspective, however, it is probably not a bad thing that the pharmaceutical industry as a whole has not turned in stellar performances recently, especially as Congress was unable to approve (yet again) a new Medicare prescription drug benefit.

The area to keep an eye on next year is the health services sector, which is consistently posting double-digit profit increases, and the second quarter was no exception. The two success stories as far as investors are concerned have been the hospital and managed care sectors. But like anything else, too much of a good thing can lead to future problems.

Earnings growth at managed care companies has been driven by back-to-back, double-digit premium increases, with an average increase of approximately 17% expected in 2003, according to preliminary results from Milliman USA’s eleventh annual HMO Intercompany Rate Survey. This will surely be a case of the managed care industry cutting off its nose to spite its face.

The companies with the largest earnings gains were UnitedHealth Group (NYSE: UNH) and Anthem (NYSE: ATH), both of which reported second quarter earnings growth in excess of 40%. UNH beat earnings estimates by six cents per share (a significant margin) on an increase in revenues of just 5%. It was the company’s fifteenth consecutive quarter of double-digit earnings growth, which is great for investors but something our legislators in Washington D.C. may have an opinion about as more working people find themselves unable to afford health care insurance. Anthem’s 47% jump in earnings excludes the recently closed acquisition of Trigon Healthcare, but the news that future growth would only be 15% sent ATH’s stock down by nearly 10%.

Aetna (NYSE: AET), which has been restructuring its operations, had a tenfold increase in earnings while revenues dropped by 22%, and Cigna (NYSE: CI) posted a 13% jump in operating income on a revenue increase of just 6.6%. Its net income, however, dropped because of losses in its investment portfolio. These kinds of results certainly do not foster any sympathy from consumers or corporate America which is footing part of the bill for their employees.

The hospital sector is the one that has benefited the most from soaring health insurance premiums, because it has encountered little or no resistance to increased pricing. Admissions are up and revenue per admission is up, especially among the baby boomer population. A case in point is Tenet Healthcare (NYSE: THC), the nation’s second largest for-profit hospital chain. For its fourth quarter ended May 31, 2002, THC reported a 42% jump in earnings, with same-facility net inpatient revenue per admission rising by 12.7%. While the company claims that this figure is the result of a shift in its business mix to higher acuity services, the mix usually can’t change that quickly at such a large company. Our guess is that it is a combination of some shift with little price sensitivity for lower acuity services, especially from the baby boomer set that is not yet on Medicare.

Meanwhile, HCA Inc. (NYSE: HCA), LifePoint Hospitals (NASDAQ: LPNT) and Universal Health Services (NYSE: UHS) all beat earnings estimates by a range of four cents to six cents per share, with operating profits rising by 23% to 35% for the quarter. In a normal environment, investors would be cheering these results. But with a weak economy, soaring health insurance premiums, drug costs that are taking an increasing bite of the health care economy and an ineffective Congress that does not know how to tackle the problems at hand, at some point something is going to break. By next year, we can expect the proverbial poop to start hitting the fan, especially if the economy, and the stock market, remain in their lackluster states.

Hospital stock prices already took a small hit when the FTC announced it was going to increase its scrutiny of past hospital mergers, but as we indicated in our August elert, little will come from this. An analyst at UBS Warburg, however, recently lowered his price targets for almost all hospital stocks by 10% to 20%, predicting a backlash against the industry. We would put managed care companies in that same boat, especially since consumers tend to have little regard for insurance companies in general. HMOs were ridiculed for not paying for care, and now they will hear similar complaints about charging too much for coverage. While it may be a damned-if-you-do, damned-if-you-don’t scenario for the managed care industry, something is going to give in the future, and our guess is that it will be profits.

Read the past headlines.