Health Maintenance Organizations: How Will They Handle the New Regulations?

As we know, baby boomers are hitting their retirement age, and they are very likely to opt for managed care plans. This suggests that health maintenance organizations, or HMOs, have a big opportunity to grow.

However, new legislation in the U.S. is changing these companies' profitability. Health care reform regulated modifications in the health insurance rates putting a cap on revenues. Plus, the Affordable Care Act requires HMOs to meet minimum cost ratios, making it harder to benefit from cost reductions. So, margins will remain tight.

Finally, the low interest rate environment, which is expected to continue next year, has a negative impact on investment income for the companies involved.

How will these three American HMOs handle this context?

Government: A growing business
The first company to analyze is the third largest national Medicare Advantage provider, a huge player with a strong foot in the industry. We are talking about Aetna (NYSE: AET  ) , a diversified health care company that offers traditional and consumer-directed health insurance products and services.

The company announced operating earnings of $549 million, or $1.52 per share, for its second quarter 2013, a 16% increase year over year. Net income reached $536 million, up 17% compared to last year's.

Aetna has been performing strongly over the past years, and I believe it will continue to do so thanks to the growth in its Medicaid and Medicare segments, its health services segment, and a growing provider network. The Coventry acquisition is providing good results for Aetna as well, since it allowed it to position itself in the government business. The company's plan is to increase the number of providers of managed care plans in this segment, which should bring higher revenues.

Another good source of incremental revenue comes from fees from accountable care solutions, or ACO, and ACO partnerships. These collaborative efforts not only improve the health care quality, but also helps make prices more competitive. Aetna is considering more than 200 prospects for new partnerships, so this system should improve in the upcoming quarters.

Humana: Performing well despite rising risks
Strong operating performance across segments allowed Humana (NYSE: HUM  ) to have a good second quarter. Operating earnings reached $420 million, or $2.63 per share, surpassing the year-ago earnings of $356 million. Revenues climbed 6.4% year over year to $10.32 billion.

If you look at Humana's fundamentals, many numbers are positive: strong financial position, Medicare membership growth, stable ratings, and inorganic growth.

However, rising expenses and declining operating cash flow are affecting the company. In addition, the negative impact of health care reform along with Humana's dependence on its Medicare Advantage plans could raise risks going forward. Humana's Medicare business contributed almost 74% to the premium and service revenues in the first half of this year.

Health Net: In good shape
Another company that provides managed health care services through government-sponsored managed care plans is Health Net (NYSE: HNT  ) .

The most impressive things about this HMO are its healthy capital and liquidity positions. Total cash and investments reached $1.9 billion at the end of June 2013 while total long-term obligations were only $399.2 million. In addition, S&P has rated the company's investment portfolio with an A+ and Moody's with an A1. In other words, the company has sufficient working capital, lines of credit, and cash reserves to fund its existing obligations, repurchase shares, and introduce new products and services.

Plus, the company's margin has expanded thanks to improvements in health plan services premiums, which went up 5.9% last year and 4.1% in 2011. So, if Health Net manages to keep its costs contained, operating performance will continue to drive profits.

These are good facts for investors, because they will allow Health Net navigate future headwinds and remain in better shape compared to its competitors.

Bottom line
Despite the challenges, Aetna is well-positioned to remain profitable in the upcoming quarters. The new regulations will definitely put a cap on margins, but this company should be able to outperform its peers thanks to its growing ACO partnerships.

Humana might have to be prudent when it comes to its expenses and focus on diversifying its earning sources. Otherwise, I doubt it will remain highly profitable in this new context.

Health Net remains a safe investment due to its financials and solid position. However, a decline in memberships could alter this outlook and make the company more susceptible to the challenging economic environment ahead.

How health reform will affect you
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