Humana Inc.: The Way To Play Medicare Advantage

If you want to play the graying of America, Humana is a name to consider. This managed care provider may be as close as you can find to a pure play on Medicare Advantage, as this program is more than two-thirds of the company's earnings base. At the same time, Humana has joined Aetna and WellPoint as the most aggressive participants in the new public exchanges.

Humana apparently isn't afraid to take on risk, as Medicare Advantage rates have become a great deal more uncertain and nobody really knows how the new Obamacare-mandated exchanges are going to work out. Humana looks about as undervalued as Aetna or Cigna and could be priced to generate some solid long-term returns, but investors have to be comfortable with the risks and uncertainties that go with such a large commitment to the Medicare Advantage program.

Medicare Advantage Will Drive The Story
While Medicare Advantage (MA) represents only a little more than one-quarter of the covered lives at Humana, it makes up more than 60% of the company's premiums and earnings. With that, Humana has chosen to position itself as the name in MA - WellCare gets about a third of its premiums from MA, while Aetna, UnitedHealth , and Health Net all get about one-quarter of their premiums from this program.

I can understand why Humana has positioned itself this way. Overall, Medicare enrollment is projected to grow by around 3% a year for the next decade, and through pricing and better policies Humana should be able to double that underlying growth rate with its enrollment. At the same time, the company is hoping to offset costs through efforts like growing the percentage of MA enrollees covered through HMOs and building its own health care service facilities.

It's still a risky call. With regulatory uncertainties, next year is looking turbulent. Humana also recently announced that instead of an expected rate cut of 4% to 5% in 2015, the cut will likely be more on the order of 6% to 7%. Therein lies part of the problem with the MA business - Medicare may be an untouchable government program, but there is a long history of Congress and the Centers for Medicare and Medicaid Services putting the squeeze on companies involved in Medicare plans.

I'm also curious to see just how much benefit Humana gets from its in-house service facilities. Humana has over 300 clinics and close to 300 worksite facilities, many times more than UnitedHealth or WellPoint. While sending MA members to in-house facilities would seem to offer good cost-saving potential, it also sounds like a future Dateline expose in the making.

Public Exchanges Still A Gamble

The entire managed care industry is still trying to figure out what Obamacare is going to mean for their businesses on a long-term basis. With that, Cigna and UnitedHealth have chosen to play very defensively by participating in only a small number of exchanges. Humana is going the other way, though, and joining WellPoint and Aetna in participating in the largest number of states.

I understand WellPoint's participation, as it has a large Blue Cross/Blue Shield franchise to defend, but I find this a bold move for Humana. To that end, the early news on enrollment hasn't been particularly positive, as a smaller than expected percentage of those under the age of 34 signed up, skewing the risk pools worse. There are steps in place to mitigate some of this, but it isn't a great beginning for the program.

Strong growth, but will it be profitable growth?
I have little doubt that Humana will be posting some strong revenue and enrollment growth numbers in the coming years. Growing Medicare Advantage is a priority for the company, and improving the company's plan rankings (to earn quality bonuses) should make them more attractive to enrollees. The question is how profitable these new lines of business are. Humana has done a good job of offsetting cost and rate pressure in the past, but that is increasingly mission-critical as opposed to just "nice to have".

I'm valuing Humana on the basis of long-term free cash flow growth in the mid-single digits and a long-term return on equity of 15.5% (against a trailing 10-year ROE of 16.9%). If that target is valid, Humana should be trading closer to $120 today, while today's price assumes a long-term ROE of 13%.

The Bottom Line
UnitedHealth, Aetna, Cigna, and Humana all offer different business plans for the managed care industry, with UnitedHealth arguably the class of the industry and with a large non-insurance health care IT operation. Cigna offers growing overseas exposure, while Aetna offers sizable exposure to individual risk (including public exchanges) and accountable care organizations.

Humana is the big play on Medicare, and particularly Medicare Advantage. If you believe that Congress will find a way to make sure that private industry can make a buck in MA, Humana ought to do well, but there are definitely execution risks in play here.