Description

Introduction

Humana (HUM) is a managed care organization (MCO) focused on the Medicare Advantage market, serving seniors.  HUM is the second largest Medicare Advantage insurer in the country, behind UnitedHealth Group (UNH).   The Medicare Advantage market has been the most attractive market in managed care for a decade.  We believe things are changing for the worse, due to slowing market growth, increasing competition and rising regulatory risk.  We see these headwinds pressuring HUM’s revenue growth rate and margins, leading to lower earnings and a rerating of its earnings multiple from 17x NTM EPS towards levels associated with low growth MCOs (10-12x).     

Slowing market growth

The Kaiser Family Foundation (KFF) is projecting a significant slowing in the rate of growth in Medicare Advantage:

Lives in the MA program have grown by ~13 MM over the last 10 years, an 8% CAGR.  This growth was driven by baby boomers aging into Medicare, and by the MA program taking share from Original (fee for service) Medicare.  This growth is projected to slow to 9 MM lives over the next ten years; given the larger base of MA members at baseline, this works out to a 3% CAGR. 

A significant driver of the lower growth is the slower rate at which Medicare Advantage is projected to take share from Original Medicare.  From 2010 to 2020, MA penetration of the Medicare program increased 15 percentage points, from a base of only 24%.  In the coming ten years, penetration is projected to increase 12 percentage points, but on a higher base of 39%.  Many believe that there is a natural ceiling for Medicare Advantage at 50%.  Original Medicare allows seniors to visit any doctor that accepts Medicare.  Medicare Advantage plans include narrower provider networks to keep costs down.  Thus, the appeal of Medicare Advantage is thought to be limited to healthier, more price sensitive seniors in urban areas (where networks can be narrowed without reducing access). 

It is harder for HUM to outgrow the market given its large starting market share.  KFF presents the market structure as follows:

Rising competition

In addition to a slowing market, the largest players – HUM, UNH and CVS/Aetna (CVS) – face rising competition from the second-tier players – Centene (CNC) and Anthem (ANTM), as well as from expanding not-for-profit MCOs, and a rapidly growing number of new entrants backed by private equity.  Based on initial 2022 guidance, UNH, HUM and CVS collectively would add 1.3 MM new lives this year, in line with their average over the last several years.  This translates to a lower growth rate, as the same number of lives are added to a larger base.  The second-tier players, on the other hand, will grow faster.  CNC will add 185K lives in 2022, versus 30K in 2020 (pro forma for their Wellcare acquisition).  ANTM will add nearly 400K, versus their average 100-200K over 2018-21.  CI and the four largest new entrants collectively will add 120K lives in 2022, versus ~10K in 2018.  Capital continues to flow into “insurtech” startups focused on Medicare Advantage, so competition seems likely to increase in the coming years. 

Additionally, not-for-profit MCOs are also expanding in MA.  The Blue Cross/Blue Shield branded MCOs, who traditionally focused on commercial insurance markets, are perhaps the biggest threat.  The largest of these “Blue-branded” MCOs - HCSC - announced a significant geographic expansion in MA in September 2021.

We saw the effect of this competition on January 6, 2021, when HUM announced that its membership growth would be ~4% in 2022.  This is far below its November 2021 expectations for 11% growth, and below its historical average of high-single to low-double digit growth.  At a broker conference later that day (GS), HUM spoke of intense competition in the Medicare Advantage market, of price competition and “commoditization” of the market by new entrants and established players alike.  CEO Broussard commented on market conditions:

“And we have a group of smaller companies that … traditionally [have] been not so much focused on the profitability of the business, but the top line growth. And I think the bell curve, a few in the middle that are really great competitors and then we have these smaller companies that are growing as a result of that's what the investors want them to do and more sacrificing profitability for revenue growth, and then we have a few competitors that are sizeable in scale that are really buying the market share to really have an entry into Medicare Advantage and then you combine that with a distribution channel that is really encouraging churn with a large marketing orientation to create shopping, that's sort of the perfect storm.”

Regulatory risk

The regulatory risk concerns the MA risk adjustment system.  The risk adjustment system provides for higher reimbursement to MA MCOs for insuring relatively sicker members.  There is a complicated formula for determining the adjustment to MCO payment for a particular member.  The calculation is based on diagnosed medical conditions.  Each diagnosed medical condition corresponds to a code.  Thus, the process of recording the diagnosed medical conditions is called coding.

Over the last ten years, MA MCOs have become much more aggressive in generating diagnoses, a phenomenon referred to as upcoding.  In recent years, they have become particularly adept at using home visits by nurses and primary care visits to generate additional diagnoses to maximize reimbursement. 

This upcoding game is no secret.  All involved in the industry (regulators, health policy commentators, industry executives) understand it.  To date, the regulatory response has been focused on administrative audits, litigation against MCOs, and payment reductions to offset the effects.  In general, the response has been slow, backward looking, and small; so MCOs have managed effectively through it. 

The regulatory environment is changing, however.  Most importantly, we have a Democratic administration.  Democrats historically are much more aggressive in reducing MCO payment to offset upcoding.  Further, calls for reform of the risk adjustment system have reached a crescendo, at the very time when the Biden administration is writing its first payment regulation for Medicare Advantage plans.

Calls for risk adjustment reform are widespread – government offices, academic researchers, even industry participants.  Recently, government offices including the Government Accountability Office (GAO), and the Office of the Inspector General of the Department of Health and Human Services (HHS-OIG), have issued reports condemning MCO risk adjustment practices.  HHS-OIG in particular released a series of scathing reports alleging abuses by large MCOs of the risk adjustment system. 

Many health policy researchers hold the view that MCOs are abusing the system.  A recent article published in the respected journal Health Affairs, is titled, “Medicare Advantage … and the Medicare ‘Money Machine’ … Part 1: The Risk-Score Game.”  The article is a vociferous indictment of perceived MCO abuses of the risk adjustment system.  There are many other articles articulating a similar view. 

Complicating matters further, a newly public MA MCO – Clover Health (CLOV) – is calling for reform.  Clover is at a disadvantage versus MCO incumbents when it comes to risk adjustment, as they do not own the provider assets (home nursing and primary care) that give MCOs more control over coding.  So they have decided to push for reform of the system, arguing that its abuse is giving incumbents an unfair advantage. 

These calls for reform have pushed the press to question regulators what they plan to do about it.  In response, a prominent CMS representative commented in October 2021, that "We too are very concerned with the overall trend lines for code growth in the MA program versus the overall fee-for-service program.  We are looking at the same data as the oversight community and we are thinking carefully about how we will respond to that.…”

The timing of these recent calls for reform is not favorable for MA MCOs.  CMS will release a proposed MA payment rule next month.  CMS has the authority to reduce payment to the MCOs to offset perceived abuse of the risk adjustment system. 

How big might the payment reduction be?  Historically, a negative annual rate update is in the 3-5% range.  This is a large reduction for a business with 4-5% EBIT margins.  Rate cuts pressure both margins and membership growth, as lower rates require MCOs to reduce the value of the plans they offer.  The biggest risk is a multiyear negative rate cycle - that the 2022 rate update will be followed by negative rate updates in 2023 and 2024 as well, to offset the many years of membership gains and margin improvement enabled by more aggressive coding practices. 

Implications

We estimate that HUM’s MA business accounts for 70-80% of its operating income.  The range is a function of how one treats the earnings of its healthcare services business, the overwhelming majority of which are generated by serving HUM’s Medicare Advantage insurance business.  The other HUM businesses (e.g., commercial insurance, managed Medicaid) are either slow growth, too small to matter, or both.

HUM trades at 17x NTM EPS.  This is a 50% premium to the 11x multiple at which Cigna (CI) trades.  CI is perceived to be a low-growth MCO.  The combined effects of increasing competition and reimbursement rate declines would threaten HUM’s margins, opening up the possibility that HUM will trade at a much lower multiple of lower earnings. 

DISCLAIMERS: rf805 (“Author”) advises funds that have investments in the securities of HUM, and stands to benefit should the price of the security move in a direction favoring these investments.  Author may buy or sell securities of this issuer, and makes no representation that Author will inform the reader prior to, or after, making such transactions. While Author has tried to present facts it believes are accurate, the Author makes no representation as to the accuracy or completeness of any information contained in this post, and disclaims any obligation to update such information. The views expressed in this note are the sole opinion of Author, which may change at any time. Reader agrees not to invest based solely on this note, and to perform completely their own due diligence and research before taking a position in securities of this issuer. Reader agrees to hold Author harmless and hereby waives any causes of action against Author related to the above note. This written note should not be construed as a recommendation to buy or sell any security, or as investment advice.  Author does not hold a position with the issuer such as employment, directorship, or consultancy.

Catalyst

CMS announcement of proposed Medicare Advantage rates for 2023