Health Insurer Left Defenseless

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News last week that Health Net Inc. had lost its oldest and largest military contract could hasten the company’s transition to a largely regional health insurer.

The Woodland Hills company, which has had ambitions to become a large national player, even could find itself a candidate for acquisition.

“I think the loss of the federal contract strengthens Health Net’s position as a take-out candidate,” said Thomas Carroll, an equity analyst for Stifel Nicolaus & Co.

If it were acquired, Health Net would be the last of Southern California’s large for-profit health insurers to disappear. In recent years, both Wellpoint Health Networks Inc. and PacifiCare Health Systems Inc. were acquired.

Indeed, the same forces that led to the mergers of Wellpoint and PacifiCare the desire for heft and economies of scale may be at play in Health Net’s loss of its $2.8 billion Department of Defense contract to Aetna Inc., the nation’s No. 3 health insurer by revenue.

“As health reform progresses and the government becomes a larger customer, large managed care organizations are going to have the advantage,” Carroll said. “We don’t know why Aetna got the contract, but the government is looking to cut costs. And a company the size of Aetna is better able to offer a better deal and still be able to make money.”

Health Net has commercial managed care operations in seven states but only ranks No. 13 in total enrollment among all U.S. health plan providers. However, in California, where it derives more than 40 percent of its revenue, it is the No. 4 managed care insurer.

The loss of what is called its TriCare contract administered by 900 employees in Rancho Cordova, nearly 10 percent of Health Net’s workforce was a big blow for Health Net on multiple levels.

The contract is big, covering 3 million active-duty military personnel, including National Guard and Reserve members, retirees and dependents in 20 East Coast and Midwest states, and Washington, D.C.

The contract was expected to generate about 20 percent of Health Net’s projected annual revenues of more than $15 billion and contribute 40 cents to 80 cents per share in earnings because of its higher profit margin.

Moreover, except for a brief period earlier this decade, Health Net has had the contract since the company was formed in 1997 through the merger of Sacramento-based Foundation Health Corp. and Health Systems International Inc.

Indeed, Foundation was the initial contractor in 1988 on the pilot program that later became TriCare. (The military later divided the program into three regions to be split among three private-sector contractors, hence the program’s name.)

Losing the contract “was shocking and we’re obviously disappointed as we have been in this business for over 20 years,” Steven Tough, president of Health Net’s federal services unit, told the Business Journal. “The concern and disbelief we have is that we’ve achieved some of the highest satisfaction ratings in the history of the program and this still happened.”

Strategic decisions

Health Net declined to comment on the company’s possible acquisition or strategic plans and only provided Tough to comment on the TriCare contract.

But for Health Net’s leadership, which has long maintained the company’s independence, the unexpected setback could be a deciding factor on whether to follow the route of Pacificare and Wellpoint, which operated Blue Cross of California, now Anthem Blue Cross.

Wellpoint merged with Anthem Inc. in 2004, changed its name to Wellpoint Inc. and moved to Anthem’s Indianapolis headquarters. The following year, Minnesota-based UnitedHealth Group acquired Cypress-based PacifiCare.

Ironically, Aetna has long been considered the most likely suitor for Health Net. Based in Hartford, Conn. Aetna has sought a greater piece of the Southern California market. And with its rivals already swooping up Pacificare and Wellpoint, Health Net was seen as the easiest way for the company to gain market share.

Indeed, the loss of the TriCare contract renewed speculation on Wall Street, including in an article in the Wall Street Journal, that Health Net was ripe for a takeover. Companies that have been rumored to be possible acquirers include Cigna, based in Philadelphia.

Earlier this year, Health Net made some moves that could make its acquisition more likely. It publicized internal discussions about possibly selling its commercial businesses in New York and Arizona, where profitability has been disappointing.

Carroll said that pulling out of those areas might make Health Net a more attractive target to acquirers who simply want a greater piece of the Southern California market. The loss of the TriCare contract also could make the company a more attractive acquisition target, given the complexity of administering a far-flung federal contract under military rules.

“That would make Health Net a less complicated company and thus a great acquisition target,” Carroll said.

The Defense Department in its announcement did not say why it decided it was time for a change. Health Net had scored high in quality and satisfaction surveys. The company even won a “contractor of the year” award in April for its anti-fraud efforts.

Health Net has a right under federal rules to file a protest over the contract’s loss, but Tough said that decision will not be made until a Defense Department debriefing planned in the next few weeks. (Health Net will still administer four smaller defense contracts not affected by the TriCare loss.)

Unrestricted revenue

Since the loss of the contract, Wall Street analysts have cut their expectations for the company’s future earnings, but none so far have downgraded shares. However, the three top debt rating agencies reacted more harshly, either cutting credit ratings or putting the company under review for future downgrades.

The reason is that while the TriCare contract might be complicated to administer, it allowed Health Net unrestricted use of its program revenues. In contrast, states often regulate how much money can flow back to the corporate parent from commercial insurance contracts for such uses as debt payments.

Health Net now has about $400 million in senior debt, which is a manageable level, but Manish Patel, an analyst at Fitch Ratings, said that figure should come down if the company decides to sell more of its operations outside California and become a regional player.

“Losing the TriCare contract impacts how much money Health Net has for debt servicing,” Patel said.

UPDATE

UnitedHealth Group Inc. to Acquire Health Net’s Northeast Business

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