Health insurer Humana (HUM), at Friday's closing price of 24.43, offers an extremely attractive value proposition, but also involves a volatile mixture of political and regulatory risk. For investors who are interested in bearing and managing risk, the sale of options can be combined with share ownership to take advantage of the volatility.
The company describes itself as follows:
Headquartered in Louisville, Kentucky, Humana is one of the nation’s largest publicly traded health and supplemental benefits companies, based on our 2008 revenues of $28.9 billion. We are a full-service benefits solutions company, offering a wide array of health and supplemental benefit products for employer groups, government benefit programs, and individuals. As of December 31, 2008, we had approximately 11.6 million members enrolled in our medical benefit plans, as well as approximately 6.8 million members enrolled in our specialty products.
Based on recently reaffirmed 2009 guidance of 5.90 to 6.10 per share, Humana trades at a forward P/E of 4.1. Working with 5 year average EPS, updated with 2009 guidance, and applying a conservative multiple of 15 per share, $58 per share seems reasonable, and the stock has traded higher than that during each of the past three years.
Growth and Profitability
Five year revenue growth is 18.8% per year; EPS over the same period is up 22.1% per year. The question comes up: why does Humana trade at such a discount?
Political and Regulatory Risk
As a generalization, Democratic administrations are regarded as leaning toward views that may lead to legislative and regulatory actions reducing the profitability of health-care businesses. President Obama has announced his intention to tackle health-care reform this year, citing “the crushing cost of health-care.” A concerted effort to improve the availability and affordability of health care and insurance, to include squeezing waste and fraud out of the system, can be expected to pressure the profitability of health insurers along with everyone else in the business.
A present reality is the recent CMS preliminary announcement of Medicare Advantage rates for 2010, coming in at an increase of .5% per year, and drawing negative comment from Humana. The company has made Medicare Advantage a large and growing part of its business, and will be adversely affected by the meager rate increase. After a comment period, a final announcement is expected on April 6th.
Here is a link to a brief description of Medicare Advantage Plans. As a practical matter, Humana and other health insurers have the option of reducing benefits in order to meet the rate. Some analysts regard the dip caused by the CMS announcement as a buying opportunity, others are less optimistic.
From a long term perspective, the Medicare Advantage business is attractive due to demographics – the first of the baby boomers will soon be signing up for Medicare, to be followed by additional cohorts for decades as the U.S. population ages. Medicare Advantage has been growing as a percent of Medicare and has a value proposition and long term success driven by medical costs 15% below original Medicare, according to a company presentation.
The issues are complex and can be expected to play out over many years. One possible outcome is that the health-care industry, and insurance companies in particular, will be successful in maintaining diminished but reasonable profit margins in the face of political and regulatory developments. After all, the more responsible element in government is aware of their own limitations in managing any business, let alone a complex one like health-care, and will want to keep the private sector in the game, believing nothing is as effective as competition and the profit motive in controlling costs. The United States is a capitalist economy, and socialized medicine is politically unlikely.
Back to Basics
In their most recent 10-K, management defines what they will need to do to drive profitable growth.
Our results are impacted by many factors, but most notably are influenced by our ability to establish and maintain a competitive and efficient cost structure and to accurately and consistently establish competitive premium, ASO fee, and plan benefit levels that are commensurate with our benefit and administrative costs.
Based on past history, Humana has been successful at these fundamental tasks. Whatever political or regulatory headwinds may arise will apply equally to the competition.
At today's prices, Humana is an attractive long-term investment, based on its status as a large and well-managed player in a growing industry. Significant price appreciation is uncertain until there is more information about the future trajectory of health-care reform, so the challenge is how to buy at today's discounted prices and generate immediate returns.
Implied volatility has been very high for Humana over the past few weeks, and can be expected to stay at elevated levels at least until the 4/6 final announcement by CMS. Volatility may remain elevated until the political process yields clarity on likely health-care reform legislation. In order to harvest premium, a long position in the stock might be combined with a strangle in options, creating a covered combo along the following lines:
- Buy 100 Shares HUM @ 24.43
- Sell 1 HUMTD, HUM Aug09 20 put @ 2.60
- Sell 1 HUMHF, HUM Aug09 30 call @ 2.60
- Prices are Friday's close, options are mid bid/ask
If the shares are called away, the investor will realize a profit of 10.77 on an investment of 19.23, for an annualized return of over 100%. If assigned on the puts, he will own 200 shares at an average cost of 19.62, while looking at EPS of 6.00, according to guidance. If the stock goes nowhere, the static return is almost 50% annualized. If volatility declines after the 4/6 CMS announcement, the strangle may show a quick profit even if the share price remains unchanged.
Disclosure: The author intends to execute the above strategy during the coming week.