Humana Delivers Above Weakened Guidance

Last month, Humana Inc. (HUM) shocked the market by revising expectations for the rest of the year and slashing them almost in half. The stock dropped about by over 30% in the days surrounding the announcement; fear over rising health care costs and, more importantly, a mismanaged prescription drug plan hampered growth.

The stock regained some of that loss yesterday as the first quarter results topped the downward revision and analyst expectation (see conference call transcript). Net income rose by 13%, aided by a lower effective tax rate than anticipated, and Humana raised expectations for the second quarter as well as the rest of the year.

The brightest spot for Humana was the growth in the Medicare Advantage program, of which Humana is a main health care provider. Medicare Advantage offers comprehensive health care plans via the government. The government gives special benefits to insurers and it is one of the most profitable products Humana offers. The company reported that premiums were up 15% over first quarter last year, and membership was up 14%. On the other hand, Humana lost a bid for some 445,000 low-income prescription drug plan because the government thought the bid was too expensive.

Instead, Humana did gain 122,000 higher-income beneficiaries of the prescription drug plan, but they underestimated how much those newly insured would use their drug plans and lost $100 million because of the miscalculation. Humana stressed that the prescription drug plans like these will return to profitability by 2009, which would be a shot in the arm as these plans account for 11% of revenue.

Humana is very slightly undervalued by our methodology on a price-to-cash flow basis even after the stock was beaten down by the downward revision. Revenue growth has picked up especially in the last two years, and was the most impressive part of our analysis on Humana.

So, from a fundamental prospective, the underlying numbers suggest that Humana should be able to attract a price of $45-$59 to be within the range of what the market has traditionally been willing to pay for HUM given current sales and cash flow levels.

However, an investor must be able to overlay logical assumptions on top of the underlying math. The relationship between Humana and Medicare makes this too risky to justify the slightly undervalued price. For example, legislators will soon revisit the Medicare issue in Congress with the clear goal of cutting costs. It would not be a huge surprise for Humana and United Health (UNH) among others to find that Medicare Advantage plans are no longer as profitable.
Furthermore, it is a blow to our confidence in the management at Humana that they could have underestimated the cost of the drug plan by $100 million.

So, considering the risks of legislation and the past ineptitude of management, we advise a “Hold” in the current market environment.

Disclosure: none