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PacifiCare in Grave Condition With No Quick Cure in Sight

Health services: Company sees business model crumble and stock drop more than 80%.


The nation's largest Medicare HMO is facing a financial crisis that might take years to resolve.

PacifiCare Health Systems, which covers 1.1 million Medicare members in its Secure Horizons plan and 3 million members in ordinary health plans, finds itself with a deteriorating business model and a stock that has fallen more than 80% in five months.

The company's prime source of revenue--Medicare--is disdained by Wall Street and most other health maintenance organizations, and its bonds have been downgraded to below investment grade by at least one major credit-rating service.

This week, the company said that it would either lose money or just break even for its third quarter, and analysts expect losses or small profits to continue--perhaps for several years. As a result, PacifiCare stock has plunged, closing Thursday at $10.86 on Nasdaq. It rebounded to $11.19 on Friday, still far from its high of $72.31 in June.

The company's problems are not likely to affect patients, at least in the near term. For the most part, physician groups still make decisions on who receives treatment, not the health plan.

Still, company insiders admit that the situation, particularly concerning Wall Street, is grave.

"What you're seeing here is a recognition that this is not a one-quarter or even a one-year problem," said Sheryl Skolnick, a health-care analyst with BancBoston Robertson Stephens in New York. "Does that mean that Wall Street is writing them off as an investable stock? Yes. Does does that mean that the company goes away? It's too soon for anybody to speculate on that."

Conventional wisdom says the company could be a takeover target, but most analysts are skeptical, saying that to buy PacifiCare would be to assume too many problems with too little hope for profit.

The company is reevaluating all aspects of its business--including its prized Medicare line--but even if a decision is made to exit the program, federal law would prohibit PacifiCare from doing so before the end of 2001.

"To a degree, Wall Street is right," said PacifiCare spokesman Ben Singer. "They have concerns about the Medicare business and about our ability to move quickly [to accommodate other changes] in a way that will sustain the company.

"Our job right now is to look at all aspects of our business for the near and long term. And that's what the company's leadership is doing."

Sources close to the company say layoffs and other cost-cutting measures are probably in the works.

One logical course might be for PacifiCare to buy back its own stock and go private, but that would cost a lot of money--and PacifiCare does not have the credit to do much borrowing now.

"There is no clear answer on the question of 'Now what,' " said Todd Richter, a health-care analyst with Banc of America Securities. "They [can't] answer what this company is going to look like in a year or two."

The problem is that PacifiCare has taken several financial and operational hits about the same time.

For years, the company relied on a system of paying doctors and hospitals that effectively insulated it from the vagaries of the health insurance market. Under that system, called capitation, a health plan would pay hospitals and doctors a set fee each month to take care of patients. If all those doctor visits, surgeries and medicines cost more than the set fee in any month, well, that was the provider's problem--not the health plan's.

Now that system has begun to crumble. About 40% of the hospitals and 6% to 8% of the doctors with PacifiCare patients no longer accept capitation. As a result, PacifiCare, rather than the providers, must pay those extra costs, which in its third quarter alone amounted to $70 million to $75 million.

So many medical groups have run aground under the capitation method, which at one time or another has been used by most health plans in California, that PacifiCare has been forced to put aside $25 million in the next quarter alone to cover unpaid claims and other costs.

To make matters worse, it was capitation, many analysts believe, that allowed PacifiCare to remain profitable in the underfunded Medicare program when other HMOs were losing money.

Seniors typically need more medical care than other segments of the population. And capitation allowed PacifiCare to shift responsibility for managing that care to the providers.

Now PacifiCare will have to handle those expenses.

Although it's possible that, with time and prudent management, it won't cost much more to pay for care than it did under capitation, PacifiCare does not have the expertise to do that sort of work. The company will be forced to hire actuaries and others to manage care and pay claims, and may incur dissatisfaction on the part of members if claims are denied or doctors are paid late.

"The company is going to have to make this transition away from capitation," said health-care analyst Douglas Meyer, of the bond-rating firm Fitch. "We think that they're going to do that, but there's going to be some significant destruction in the interim."

This week, Fitch downgraded PacifiCare's bonds to a grade of BB+, which means they are not recommended as investments.

The downgrade also means PacifiCare will have a hard time borrowing money, and will likely have to pay higher interest rates if it does seek loans or attempt to issue bonds.

The company is also behind the curve in its efforts to make changes, several analysts said, because executives misunderstood the underlying issues, believing instead that Wall Street investors misunderstood their company and were under-valuing it.

Still, most analysts believe that with time, the company could right itself.

"They have an opportunity to fix this business," said Skolnick. "But it's going to cost a lot."

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