The Affordable Care Act is a sea change for health insurers. The industry's available market will be expanded significantly. America's uninsured, estimated at 48 million, will have the opportunity to become paying customers. But the law also has a downside. Regulatory restrictions could force insurers to scramble for growth. This means that increased merger activity may be coming. The rationale for health insurer consolidation and some possible takeover candidates follows.
Increased governmental scrutiny could stymie growth in this industry. Premium rate increases have helped support insurer revenue and earnings advancement. Under the ACA, those increases will be harder to obtain. The new law requires companies to justify rate increase before they go into effect and provide customers a clear explanation for any premium jump. In addition to this increased transparency, the law also institutes an 80/20 rule that restricts bottom-line gains. This regulation requires that at least 80% -- 85% in the large group market -- of premiums go to spending on health care, rather than administrative costs or profits. Any excess will have to be returned to customers. Pressure on profits could force companies to satisfy investor expectations by seeking out efficiency gains. The best way to achieve efficiencies is usually through economies of scale, and the best way to gain economies of scale is often through a merger or acquisition.
Some potential merger candidates
Many health insurers are well acquainted with combinations and buyouts. Just about all of the major players have developed through acquisition. Here are a few that may be attractive merger targets.
Humana (NYSE:HUM) is a fairly large health care company with more than 12 million members. It is particularly focused on the Medicare and Medicaid market, making up around 47% of the customer base. Humana posted revenues of $10.3 billion in the latest quarter, an increase of 6.4% from 2012, mainly due to higher Medicare memberships. Diluted earnings per share came in at $2.63, versus $2.16 per share a year earlier, with profits helped by lower medical expenses as well as a reduced share count.
The insurer's size could make it either an acquirer or takeover victim. It's large enough and has the financial capability to pluck a smaller rival. In 2012, the company spent more than $1 billion in acquisitions. On the other hand, a roughly $15 billion market value is not large enough to dissuade larger competitors from an attempt on the company. In a scramble for growth, Humana might offer the most "bang for the buck" for an acquirer wanting to make a consequential deal.
WellCare Health Plans (NYSE:WCG) is a smaller insurer with around 2.8 million customers. It provides managed care services targeted to Medicaid and Medicare members, with the bulk in the Medicaid category. The insurer reported earnings of $1.35 per diluted share in the latest quarter, an 8.9% rise from 2012. Premium revenues jumped 29%, driven by a 67% increase in Medicare and 26% increase in Medicaid sales. Medicaid membership increased by 280,000, or 18%, with help from early 2013 acquisitions in Missouri and South Carolina. WellCare is also expanding its Medicare business. Membership almost doubled to 272,000, thanks to a 2012 acquisition in California and increased enrollment in key New York and Florida markets.
WellCare's government-payer specialization may give it a special appeal. Larger health-care firms looking for greater exposure to Medicaid and Medicare might find it easier to buy market share rather than build it. Those that already have a meaningful government-sponsored business might find the substantial economies of scale from a WellCare combination enticing.
Health Net (UNKNOWN:HNT.DL) is a managed care organization with approximately 5.4 million covered individuals. Nearly all of its revenues come from commercial, Medicare, and Medicaid business, which together holds almost 2.5 million members. The insurer's adjusted net income came in at $33.5 million in the latest quarter, a 79% increase from 2012, thanks to a sizable decrease in medical expense. Top line results were less favorable, however. Total revenues fell 3.6% due to a membership decrease of 3.2%. Though the Medicaid business grew about 5.5%, it was overshadowed by a 11.6% plunge in commercial enrollment.
Surprisingly, the contraction in the commercial business might make the company an appealing purchase. Health Net intentionally repositioned its marketing effort away from large commercial accounts to focus on the small group market. The strategy seems to make sense. The large account business is highly competitive and the ACA's 80/20 rule makes long term profitability uncertain. Early signs suggest the company's plan is working. Small group enrollment in California expanded 11.5% last quarter. Those types of gains might lure a merger partner looking to diversify into that underserved market.
While there are many positives aspects of the Affordable Care Act for insurers, it could also stifle some health insurers' growth prospects. To meet investor expectations, companies will likely look for beneficial acquisitions. Though merger activity doesn't look imminent, as the industry will need at least some time to deal with the implementation of the new law, investors may want to start considering some possible buyout targets now.
Bob Chandler has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.