Humana's Operations: Is it Worth It?

Humana HUM 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.

Porter's Five Forces plays an important role in understanding the healthcare industry. First, the threat of new entrants is low because the average entrepreneur cannot start an insurance company, there are some switching costs involved, and the industry is very competitive with somewhat limited margins. Second, the bargaining power of supplier is moderate. Suppliers of capital do not pose a big threat; however, the threat of suppliers luring away human capital does exist. For example, a talented insurance underwriter working for a small insurance company may be enticed to work for a larger company looking to move into a particular market.

Third, bargaining power of buyers is moderate to high, simply because the US Government segment accounts for much of Humana's business. Fourth, the availability of substitutes is high because there are plenty of substitutes in the insurance industry. However, there can be niches where certain firms do have a competitive advantage which blocks other firms from entering. Fifth, competitive rivalry is very high because the insurance industry is very competitive.

Over time, it is likely that Humana will see a consolidation of companies that will eliminate smaller competitors that are not as efficient. However, Humana should remain a larger player.

Humana has a number of key success factors. The first is that their EPS has exceeded analysts' expectations the past few years, which shows that their growth and profits are continuously higher than expected. In addition, their market share has been increasing, which in a very competitive market is excellent to show the health of the company. The US government has given them many contracts and stable support, thus keeping them very balanced. A last success factor is that with the “Graying of America,” the age of US citizens needing health care and services will be increasing at a rate of about three percent per year.

Humana also has some key risk factors. First, the government accounts for 76% of their business. Should the government ever switch companies, this would decimate Humana as a company. In addition, there is much uncertainty about future legislation and its effect on the health care industry. Lastly, should Humana get rid of its Litigation Insurance, all legal claims will fall directly on them, which could lead to a greater potential for increased liabilities.

Investors may believe that Humana's growth is sustainable at this time because with continued growth in the consumer market, as well as continued governmental support and growth, this trend may continue. Premiums will tighten over time due to increased regulations, but as a larger player in the industry, Humana should take this in stride.

Humana's financial performance certainly deems it to be undervalued compared to its competitors in the health care industry. According to the Morningstar database, HUM is cheaper than comparable companies via various measures. In terms of Price/Earnings, Price/Book, and Price/Sales, HUM is 10.8, 1.7, and 0.4 versus an industry average of 12.5, 2.0, and 0.5, respectively. Moreover, it has had higher revenue growth over a three year horizon compared to industry competitors. Debt/Equity is roughly half the industry average, indicating that leverage is not required to drive the business. Lastly, the return on equity is high in general, at 17.3%, compared to an industry average of 0.2%.

Analyzing Humana from a time-series perspective, its ratios have been performing quite well over the last ten years. Debt/Equity has decreased by about 25% since 2002; ROA has increased about three-fold from 2.8% to 7.3%, and ROE has increased from 8.2% to 17.5%. All of these measures prove that Humana has grown over the last decade, improving its business and streamlining itself financially by systematically reducing debt. Its increasing clientele has definitely buttressed its growth. Although the financial crisis in 2008 impeded its growth, the company sufficiently recovered in 2009.

Comparing its numbers to other health insurance companies, Humana still shows impressive growth and capabilities. When looking at the return on assets, its competitors are very inconsistent over the last 10 years. For example, Health Spring started at around 37% in 2002 and dropped to 5% in 2005, while Healthnet was about 10% in 2003 and dropped to about 1% in 2003. In contrast, Humana has been incrementally increasing, showing improvement in its use of assets. Supported by consistently increasing revenue, Humana has outperformed its competitors in terms of consistency, which is especially hard to accomplish for smaller insurance companies. Fluctuations are definitely common in the industry, but Humana has managed to overcome it, at least on a historical basis.

Like ROA, Humana's debt/equity ratio shows a clear trend. While Humana's debt load has been increasing for the majority of the last ten years, its equity growth has measurably surpassed it. As one measure of this fact, debt/assets has steadily decreased over time, indicating an increasing reinvestment of the company's profits into assets, even as its debt increases. Moreover, debt/equity has seen the same effect, showing that both asset growth and excess equity growth have faster rates than debt growth. Like ROA, debt/equity has a definite trend, whereas its competitors have rates that fluctuate greatly on a year by year basis. This trend definitely makes it seem like assets and equity will grow next year at a rate higher than debt.

As a function of the Company's clientele, Humana's loss ratio is also impressive compared to its competitors (refer to Exhibit 5). The loss ratio, which is frequently used by insurance companies, is the ratio of losses paid out in insurance claims to total earned premiums of these claims. In the health insurance industry, this ratio is typically quite high, with Humana having a loss ratio of 83%. While competitors are also in the 80%% range, from 84% to 88%, they have consistently been higher than Humana's ratio and have seen more fluctuations. This variance is probably a function of those other companies' clients, and as shown, Humana has definitely experienced better loss ratios than the majority of health insurance companies.

Correlating the fluctuations in the loss ratio to ROA is also possible, as claims paid out would be found in COGS, and if insurance claims paid out changes drastically year by year, so will the overall return of the firm on any basis. Lastly, ROE has been Humana's best selling point. Investors can also calculate ROE using the advanced dupont model. To compute the return on net operating assets (RNOA), net operating margin is multiplied with asset turnover (RNOA = 2.9%*2.2 = 6.38%). Then, using a spread value of 1.16 and a financial leverage ratio of 2.33, the ROE can be determined to be 17.3%. Not only does Humana have the highest ROE, it also has seen the steadiest trend compared to its competitors.

Analyzing the financial statements via common size analysis also helps understand operational trends over the years. Looking at the income statement, COGS has consistently been around 80% of sales while SG&A has consistently been around 14% of sales. These trends were preserved even during the financial crisis that started in 2008 where many consumers lost employment and were unable to afford health insurance. This indicates a healthy flow of customers for Humana, particularly when most companies suffered losses in clientele and operational ability during the peak of the crisis.

For the asset side of the balance sheet, cash and total current assets increased over the last five years, indicating a fairly conservative asset accumulation for HUM. Moreover, the acquisition of Concentra in 2010 led to a minor decrease in assets, albeit for a strategic maneuver to increase Humana's market share. PP&E and receivables have stayed fairly constant over the time period, indicating a steady state for the company in its daily operations. This is also a positive sign as Humana has been able to increase revenues without buying more office buildings or increasing employees to boost productivity.

When looking at liabilities, payables and total current liabilities have decreased over the last five years, meaning that Humana has improved its ability to pay its debts timely and more efficiently over time. Moreover, long term debt has increased, indicating the same trend with the company's creditors. Overall, Humana's management has been able to optimize its balance sheet and its overall health. It has skillfully weathered the financial crisis and shows no reason to reverse its optimization in bottom line in all areas.

Based on the company's operations and its financial position compared to its closest competitors, Humana may or may not be an appropriate long-term investment. It is currently trading at $74.16, up over 35% for the year.