No Rattle At HUM

By Stephen D. Simpson, CFA | November 01, 2011 AAA

Managed care, that bizarre euphemism for health insurance, has twisted up investors for a while now. Although there are ever-present worries about the future profitability of this industry, none of the plans on the table would seem to be all that big of a risk. So while Humana (NYSE:HUM) has joined many of its brothers in a healthy rally over the past year, Wall Street still does not seem to be giving full credit to this stock.

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Solid Third Quarter Results
Humana reported that overall revenue rose about 11% this quarter, with operating revenue up a like amount. Growth was underpinned by premium growth of nearly 9% and membership growth above 6%. Profitability was likewise encouraging. The company's medical loss ratio, that is, what it pays out in claims, improved by roughly a full point to 80.7%, and the company's earning before interest, taxes, depreciation and amortization (EBITDA) rose 13%. Operating income was up a similar amount, growing 12% from the year-ago level. (To know more about EBITDA, read: EBITDA: Challenging The Calculation.)

Ongoing Shuffling in the Membership Rolls
Every managed care company, from Aetna (NYSE:AET) to WellPoint (NYSE:WLP), sees turnover in its membership rolls, as contracts are signed or roll off. Overall, Humana added over 6% to its membership base and counts over 18 million members. Growth was strongest in the retail business, up over 28%, as Medicare grew almost 47% and Medicare Advantage rose over 10%. Employer plan membership was down almost 8%.

The Medicare Opportunity
Medicare, and Medicare Advantage, continues to be a major aspect to Humana's business model. Humana clearly depends a lot on this business; roughly one-third of its membership and over half of its revenue can be tied back to it, and it is the second-largest player in the market behind UnitedHealth (NYSE: UNH). In fact, the company continues to make acquisitions here and there, largely aimed at expanding this business even further. (To know more about acquisitions, check out: Mergers & Acquisitions: An Avenue For Profitable Trades. )

Although a lot of investors are disturbed by what looks like modest margins, it is a steady, growing business that is, in many respects, politically untouchable. It is largely a commoditized product, but one that rewards scale and operating experience. Moreover, a look at the population demographics of the U.S. suggests it's likely to be a growing market opportunity, for quite a few years.

Not All Government Programs are Equal
Some investors are down on the sector for fear that the government is going to step in and ruin its profitability. To be sure, there is some risk here. Medicare is a huge expenditure for the federal government and "something" will have to be done, but that something is a major unknown. The biggest risk would be in forcing insurers to take lower margins to administer the Medicare programs, but that's a politically difficult subject.

All things considered, companies like Humana aren't sitting too bad. Medicaid is a much tougher market and companies like Amerigroup (NYSE: AGP), Molina Healthcare (NYSE: MOH) and Centene (NYSE: CNC) are likely in for a harder time. Likewise, a company like Lincare Holdings (Nasdaq:LNCR), which depends upon favorable Medicare reimbursement rates, arguably has more at risk in the efforts to lower federal health care spending.

The Bottom Line
There has been a lot of consolidation in the health insurance industry and more could well be on the way. If the government wants to try to save itself some money by cutting insurer profit margins, scale and efficiency will become even more important. Smaller players like Coventry Health Care (NYSE:CVH) and Health Net (NYSE:HNT) would be obvious candidates, but investors shouldn't think that Humana couldn't get a bid as well. If WellPoint wants to leapfrog UnitedHealth in Medicare, buying Humana would do it.

Humana is the sort of stock that looks so cheap, by conventional means, that it should lead an investor to ask what he or she may be missing. In this case, it would seem to be the risk that future cash flows will be greatly imperiled by future changes to federal policy. Even with that unquantifiable risk hanging overhead, these shares look too cheap right now and investors should consider this name for some serious due diligence.

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At the time of writing, Stephen D. Simpson did not own shares in any of the companies mentioned in this article.

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