Humana's Q2 Beats, Ups FY 2010 Outlook

| About: Humana Inc. (HUM)

On August 2, 2010, Humana Inc. (NYSE:HUM) reported its second-quarter earnings (excluding special items) of $2.11 per share, well ahead of the Zacks Consensus Estimate of $1.63. This also compares favorably with the earnings of $1.67 in the year-ago quarter.

Further, the adjusted earnings surpassed management’s guidance of $1.65-$1.70. The better-than-expected showing was attributable to strong performance at Humana’s Government segments along with Commercial segment’s improvement, helped by increased enrollment in its Medicare programs for the elderly.

On a reported basis, Humana earned $2.00 per share. Results included 55 cents from the write-down of certain deferred acquisition costs (“DAC”) coupled with 14 cents from higher-than-expected favorable prior-year medical claims reserve development, and 30 cents from higher-than-expected favorable first quarter 2010 medical claims reserve development.

Behind the Headlines

Consolidated revenues for the reported quarter climbed 10.0% year-over-year to $8.65 billion. Revenues from premium and administrative services fees also increased 10% year-over-year on the back of growth in membership for the health insurer’s Medicare Advantage plans and strict pricing across all lines of business. The increase was partially offset by the decline in membership in the stand-alone Prescription Drug Plan and commercial plans.

Government membership as of June 30, 2010, stood at 6,989,200, which reflected an increase of 1.4% year-over-year, while Commercial membership as of June 30, 2010, stood at 3,285,100, posting a decline of 4.7% year-over-year. Total medical membership however plunged 0.7% year-over-year to 10,274,300. Humana's Medicare Advantage membership at the end of the second quarter jumped nearly 17.4% from the prior-year quarter.

Humana reported selling, general & administrative (SG&A) expenses of $1.16 billion, up 15.7%, while benefit expenses increased only 7.7% to $6.86 billion. Depreciation jumped 19.8% year-over-year to $60.7 million coupled with a 12.6% decline of other intangible amortization to $8.6 million in the reported quarter.

Pretax income from the Government segment in the reported quarter was $451.2 million, while the Commercial segment witnessed a pretax income of $115.2 million in the reported quarter. Consolidated pretax income was $566.4 million in the quarter.

Consolidated benefit ratio, which reflects the percentage of benefit expenses in premium revenues, was unchanged at 83.3% from the prior-year quarter, while it shows the improvement in the benefit ratios in both the Government as well as the Commercial segment. Humana’s consolidated SG&A expense ratio improved 100 basis points to 11.8% in the current quarter, reflecting efficient scales of operations associated with higher average Medicare Advantage membership, along with continued focus on administrative cost reductions.

Evaluation of Capital and Balance Sheet

Cash flows from operations improved in the reported quarter and came in at $325.3 million, with cash flows provided by operations of $161.9 million in the prior-year quarter, owing to higher net income year-over-year. Humana exited the quarter with cash and cash equivalents of $2.0 billion and long-term debt of $1.7 billion.

As of June 30, 2010, debt-to-total capitalization declined 110 basis points from March 31, 2010 to 20.5%, primarily due to the increase in capitalization associated with increased net income during the quarter.

During the reported quarter, Humana repurchased 1,025,000 of its outstanding shares at an average price of $48.76, leaving approximately $200 million at the end of August 1, 2010 out of the $250 million authorized for repurchases in December 2009, which is effective until December 31, 2011.

As of June 30, 2010, Humana’s total assets were $15.7 billion and total shareholders’ equity was $6.5 billion.

Comparison with Competitors

Rival, Unitedhealth Group, Inc. (NYSE:UNH) reported its second quarter results on July 20, 2010. Unitedhealth’s second-quarter income from continuing operations was 99 cents per share, substantially better than the Zacks Consensus Estimate of 75 cents. This also compares favorably with 73 cents in the year-ago period.

Another competitor, Aetna Inc. (NYSE:AET), also reported a second quarter profit from continuing operations of 75 cents per share on July 27, well ahead of the Zacks Consensus Estimate of 73 cents. Aetna reported a profit of 77 cents in the year-ago quarter.

Other competitors of Humana such as WellPoint Inc. (WLP) reported its second-quarter earnings of $1.67 per share on July 28, surpassing the Zacks Consensus Estimate of $1.56 and the prior-year quarter’s earnings of $1.50 per share.

Outlook

For the third-quarter of 2010, Humana expects to earn in the range of $1.65-$1.75 per share. For fiscal 2010, the company has revised its outlook. It now expects to earn within $5.65 - $5.75 per share, compared to its previous guidance of $5.55 to $5.65 per share. The improved outlook is expected on account of better second quarter performance and its revised forecast for the second half of 2010.

However, the fiscal 2010 outlook includes favorable prior-year reserve development of 51 cents per share and 55 cents of DAC write down. Excluding these, Humana expects an adjusted earnings outlook for fiscal 2010 in the range of $5.69-$5.79.

Furthermore, the company reiterates its consolidated revenues in the range of $33.5 billion and $34.5 billion in 2010.

Humana’s Medicare Advantage membership is expected to increase 250,000 to 260,000 from the prior-year quarter.

Humana also anticipates the benefit costs ratio for the Government segment in the range of 84.5% to 85.0% and for the Commercial segment in the range of 78.5% to 79.5% for fiscal 2010. Humana expects the consolidated SG&A expense ratio within 13.5% to 14.0%.

Depreciation and interest expenses are expected to lie in the range of $250 million to $260 million and $105 million to $110 million, respectively for fiscal 2010.

Humana also projects cash flows from operations in the range of $1.3 billion to $1.5 billion, while it expects capital expenditure to be approximately $200 million.

Our Recommendation

Even though the second quarter fiscal 2010 results were favorable based on strong earnings from the Government segment, we remain concerned about the weakness in the Commercial segment, whose membership fell 4.7% year-over-year as the employer-sponsored insurance enrollments declined amid the sluggish economy.

Apart from the concerns of Commercial membership, Humana is also expected to face the headwinds of uncertainties related to the implementation of health insurance reforms recently passed into law. We expect them to stretch profit margins, with downward pressure likely to overshadow the stock.

Currently, Humana carries a Zacks #3 Rank, which translates into a short-term Hold recommendation, indicating no clear directional pressure on the shares over the near term.