We downgraded our recommendation on Humana Inc. (HUM) to Neutral based on higher expenses and lower operating cash flow in the third quarter, which were offset by strong top-line growth.
The company’s third-quarter operating earnings came in at $664.8 million or $2.54 per share, surpassing the Zacks Consensus Estimate of $2.02 per share. The figure also compares favorably with earnings of $538.5 million or $2.01 per share in the year-ago quarter.
On the positive side, Humana has surplus cash equivalents and investment securities, which have grown significantly over the years. The company’s investment portfolio also enjoys an investment-grade rating from most rating agencies.
Additionally, the affirmation of Humana’s issuer credit ratings and debt rating by A.M. Best in September 2011 reflect its consistent operating growth, high liquidity and low debt-to-capital ratio. The company witnessed steady membership growth, particularly in its Medicare Advantage business, despite the economic downturn, which reflects the company’s strong footing in the Medicare business.
Moreover, the company has been expanding its business platform and has widened the commercial product portfolio. With the acquisition of Concentra Inc., Arcadian Management Services (AMS) and MD Care, Humana has further increased its focus on its core business as a health care provider besides providing revenue diversification and opportunities for strategic expansion over the longer term.
The Concentra acquisition will also allow the company to enter the primary care market on a national scale. Additionally, the acquisitions of AMS and MD Care will be accretive to Humana’s Medicare membership and enhance the quality of its healthcare services. Humana is actively working on expanding its size, not just through acquisitions, but also by increasing its employee base.
However, Humana operates in a highly competitive industry. The company faces intense pricing pressure from competitors such as WellPoint Inc. (WLP) and Aetna Inc. (AET).
Moreover, since a significant portion of Humana’s revenues are related to federal government health care coverage programs, including the Medicare, Military and Medicaid programs, failure to provide ample financial stimulus in the ongoing sluggish economy could severely hamper the operating and financial leverage of the company.
Additionally, Humana has been incurring higher-than-expected expenses owing to higher depreciation and amortization, interest and tax expenses along with operating costs. Increased benefits have also led to deteriorating benefit ratios across most operating segments. Total operating expenses surged 8.9% year over year to $25.8 billion in the first nine months of 2011.
Further, some provisions of the health care reform legislation, such as the establishment of minimum medical loss ratios, significantly impact Humana’s operations.
Moreover, the adjustments required by the legislation are leading to additional expenses. Going ahead, the provisions of the new law are likely to pressure profits as Humana and other health insurers are tied to the ongoing weak demand for their products and services and uncertainties related to implementation of health insurance reforms.
Overall, we believe that the efficient growth strategy through acquisitions, stable ratings and a strong investment portfolio will likely attract long-term investors for Humana, which currently carries a Zacks #2 Rank, implying a short term Buy rating.
The Zacks Consensus Estimate for Humana’s third-quarter 2011 earnings is currently at $1.20 per share, down 27% year over year. For full year 2011, the Zacks Consensus Estimate stands at $8.43 per share, up about 17% from 2010.
On Friday, the shares of the company closed at $88.11, up 1.8%, on the New York Stock Exchange.
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