Humana Exceeds, Ups EPS Outlook

| About: Humana Inc. (HUM)

Humana Inc. (HUM) reported its third-quarter earnings (excluding special items) of $2.01 per share, well ahead of the Zacks Consensus Estimate of $1.67. This also compares favorably with earnings of $1.78 in the year-ago quarter.

Further, the adjusted earnings surpassed management’s guidance of $1.65-$1.75. The better-than-expected showing was attributable to a strong performance at Humana’s Government segments along with improvement in the Commercial segment, helped by increased enrollment in its Medicare Advantage programs.

On a reported basis, Humana earned $2.32 per share. Results included 21 cents from the benefits of higher-than-expected medical claims development related to prior years and 10 cents from higher-than-expected first half of 2010 medical claims development.

Behind the Headlines
Consolidated revenues for the reported quarter climbed 9.0% year-over-year to $8.42 billion. Revenues from premium and administrative services fees also increased 9% 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 lower average medical membership in the stand-alone Prescription Drug Plan and commercial fully-insured group plans.

Government membership as of September 30, 2010, stood at 6,989,500, which reflected an increase of 1.4% year-over-year, while Commercial membership as of September 30, 2010, stood at 3,130,900, posting a decline of 8.6% year-over-year. Total medical membership however, plunged 1.9% year-over-year to 10,120,400. Humana's Medicare Advantage membership at the end of the third quarter jumped nearly 16.5% from the prior-year quarter.

Humana reported selling, general & administrative (SG&A) expenses of $1.07 billion, up 2.5%, while benefit expenses increased 8.6% to $6.64 billion. Depreciation jumped 2.3% year-over-year to $54.1 million coupled with a 13.6% surge in other intangible amortization to $10.4 million in the reported quarter.

Pretax income from the Government segment in the reported quarter was $554.1 million, while the Commercial segment witnessed a pretax income of $68.1 million in the reported quarter. Consolidated pretax income was $622.3 million in the quarter.

Consolidated benefit ratio, which reflects the percentage of benefit expenses in premium revenues, plunged 50 basis points to 81.6% from the prior-year quarter. However, it included a 1% beneficial effect of higher-than-expected prior-period medical claims development in the reported quarter. The consolidated benefit ratio shows the improvement in the benefit ratios in both the Government as well as the Commercial segment.

Humana’s consolidated SG&A expense ratio declined 80 basis points to 12.9% 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 $1.21 billion, with cash flows provided by operations of $940.1 million in the prior-year quarter, owing to higher net income and the changes in working capital year-over-year. Humana exited the quarter with cash and cash equivalents of $2.92 billion and long-term debt of $1.67 billion.

During the reported quarter, Humana repurchased 968,000 of its outstanding shares at an average price of $51.66, leaving approximately $150 million at the end of November 1, 2010 out of the $250 million authorized for repurchase in December 2009, which is effective until end-December 2011.

As of September 30, 2010, Humana’s total assets were $16.4 billion and total shareholders’ equity was $6.94 billion.

Medicare Plan
On October 1, 2010, Humana and Wal-Mart Stores Inc. (WMT) launched a Medicare Part D prescription drug plan (NASDAQ:PDP) that will cost a monthly premium of $14.80 for prescription drugs, and the co-payments for generic drugs would be only $2 for Medicare beneficiaries who are using preferred pharmacies such as Walmart, Neighborhood Market and Sam's Club. Also, there will be no co-pays for some generic prescriptions filled through Humana's mail-delivery service.

Further, it provides Medicare beneficiaries including seniors and disabled to save more than $450 on average in 2011 on premiums, prescription medication co-payments and cost-shares than the drug plans in 2010.

The prescription drug plan has been designed to target the requirements of every individual within various income groups, regardless of their location.

Outlook for Fiscal 2010

For fiscal 2010, Humana expects to earn within $6.40 - $6.50 per share, compared to its previous guidance of $5.65 - $5.75 per share. The revised earnings reflect improved operating performance and the expectation of a TRICARE contract extension from April 1, 2011 through March 31, 2012.

However, the fiscal 2010 outlook includes a 72-cent per share beneficial effect from higher-than-expected prior-year medical claims reserve development and 55 cents per share in expenses associated with the write-down of certain deferred acquisition costs.

Furthermore, the company reiterates its consolidated revenues in the range of $33.5 billion and $34.0 billion in 2010.

Humana’s Medicare Advantage membership is expected to increase from 255,000 to 260,000 in the prior-year quarter.

Humana also anticipates the benefit costs ratio for the Government segment in the range of 84.0% to 84.5% and for the Commercial segment in the range of 77.0% to 78.0% for fiscal 2010. Humana expects the consolidated SG&A expense ratio within 13.5% to 14.0%.

Depreciation and interest expenses are expected 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 $2.1 billion to $2.3 billion, while it expects capital expenditure to be approximately $205 million.

Our Recommendation
Even though the third 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 8.6% year-over-year as the employer-sponsored insurance enrollments declined in a sluggish economy.

However, with the launch of Humana Walmart-PDP, the company will be able to provide an affordable prescription solution to desired individuals, by enhancing its membership in prescription coverage plans and boost its mail-order drug business.