Market Overview

How Will Congress' Budget Cuts Affect Health Care?

The United States Congress appears to be failing to come up with an appropriate budget cutting decision in a timely manner. Especially in a time when Europe is struggling to find funding to support itself, the United States seems to be acting similarly. Regardless of when Congressional leaders start to work together, the federal government may be forced to cut down on certain programs like Medicare and Medicaid.

For health insurance companies, this could be a very bad thing. Ultimately, what could happen is that margins are driven down significantly, killing what little revenues existing insurers make. One company that fits this category is Humana (NYSE: HUM).

Humana is a health insurance company founded in 1964 and headquartered in Louisville, Kentucky. Humana is based into two segments: Government and Commercial. For the Government segment, Humana offers three lines of business: Medicare that offers hospital and medical insurance benefits to people over the age of 65 and some disabled people under the age of 65, Military that offers health insurance coverage to active and retired military personal as well as their families, and Medicaid which helps low-income individuals that meet certain federal guidelines. For the Commercial segment, Humana offers medical and specialty products marketed to both employer groups and individuals. Health maintenance is provided through independent primary care physicians. Humana has about 10.3 million members enrolled in medical benefit plans and about 7.2 million members enrolled in specialty products programs. It is also important to note that Humana has strategic alliances with Wal-Mart, State Farm, and United Services Automobile Association to market its products more effectively.

Before understanding what Congress' actions may do to Humana, it helps to understand what Humana's current position is like. Are there any ways that the company can improve itself, regardless of what the future climate of the health care industry may be like?

The factors to consider for an insurance company include: their recognition of litigation expenses, their recognition of revenue premiums, and their tests for impairment on intangible assets. By considering these three areas, a proper analysis can be performed on the areas that provide the most amount of ambiguity. Nevertheless, Humana does, in general, have sufficient accounting controls and standards for these three sections.

First, insurance companies will face litigation during the normal course of business. Humana recognizes this and understands that it may have a material adverse effect on the results of operations, financial position, and cash flows. Certain suits of these matters could also affect their reputation. However, future outcomes of litigation suits cannot be accurately predicted, nor can they predict any resulting penalties, fines, or other sanctions that may be imposed by the federal or state regulatory authorities. Therefore, Humana does not have an allowance account for litigation since it cannot be measured for a given year. This method is, however, normal for the industry. Humana has also successfully hedged against their litigation losses by buying litigation insurance from a third party. This is expensed yearly to SG&A, which has remained steady around 13.77% of revenue, while varying between 13.6% and 14.1% in the past five years. Despite having such insurance, Humana admits that insurance coverage for all or certain forms of liability has become increasingly costly and may become unavailable or prohibitively expensive in the future. In certain cases, litigation insurance does not cover certain claims. In that case, Humana must pay out of pocket itself, which it expenses to interest. In the past three years, interest expense has nearly doubled, while total debt has remained consistent. At $105,000,000, interest expense is not a large problem yet, but an increasing amount of claims are being paid out by Humana. As a result, Humana must monitor this expense, since it may become an issue if litigation insurance is not provided.

In regards to the manner that Humana recognizes its revenue premiums, Humana is in accordance with GAAP. Premiums are recognized in the period members can receive services, which is in line with the matching principle. The allowance for uncollectable revenues is just under 5%. Since the government makes up about 76% of Humana's business, it is safe to say that this is a reasonable estimate since they are such a creditable and consistent customer. Humana monitors its aging receivable accounts and current economic conditions while making adjustments based on the condition of both. Finally, Humana recognizes revenues in which a service was not provided as unearned revenue.

Lastly, Humana has proper controls on the way it checks for impairment on its intangible assets. Such intangible assets include customer relations and contracts. If applicable, these items are amortized using various methods, usually double declining for customer contracts and straight line for anything else. The assets are tested every year in the fourth quarter. The first step determines if there is impairment, while the second step calculates the amount. To put in relative terms, there have been no impairment losses in the past three years.

While Humana has some things that it could work on, what ramifications are most obvious when the budget committee finishes shedding costs? Cash flows and balance sheet changes are imminent given the current climate of cost cutting.

In terms of the balance sheet, some of the balance sheet ratios may stay at historical levels. Ending operating cash/sales increases a modest 0.4% in 2011 because of the TRICARE contract and a greater inflow of cash from contracts this year. It reverts to the previous years' level of 25.2% though, because as management cites in the 10-K, they feel that it provides an adequate level to fund operations, future expansion opportunities, capital expenditures, and to refinance or repay debt. Ending intangibles to sales ratio is higher than it had been because of the increased goodwill from the purchase of Concentra in December 2010. Due to the influx of cash, Humana may begin paying dividends as they have not issued dividends in years past.

The forecast gives implied cash flows from operations of $1,524,581. This number is driven primarily by a 2011 forecasted net income of $1,188,484. It is possible to see this strong growth in operating cash flows to Humana's contract with the Department of Defense, in addition to a modest growth in sales, both of which result in a strong, positive change in the net working capital. Cash flows from investing activities is an outflow of $670,033. This is driven by capital expenditures of at $297,384, which is slightly above managers estimated capex.

These capital expenditures include investments in infrastructure, as well as IT initiatives. We think that capital expenditures will be higher than the manager's estimates of $280 million primarily as a result of the Company's large cash on hand. Lastly, there could be a net inflow of cash from financing activities of $32,001. This net inflow is mainly caused by Humana taking on $109,788 of debt while simultaneously repurchasing $50,012 of undervalued stock. All of these numbers produce a net change in cash of $878,670, which is reflected in the 2011 estimated balance sheet number.

Humana has certain challenges that it faces, given the current cost-cutting fiasco taking place in the Congress. Whether or not an amicable deal is agreed upon, health insurance and other forms of aid or almost guaranteed to take a hit in terms of funding. Investors should learn more about Humana's particular plans going into the future. Investors could also apply this analysis to any number of small-cap pharmaceuticals, like Pacira Pharmaceuticals (NASDAQ: PCRX).

Humana is currently trading at about $84, up over 53% for the year.

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