Description

Company Description:

Humana is a large managed care company with a focus on government business.  Most notably, Humana is the second largest provider of Medicare Advantage policies, insuring over 5mm members.  The company also competes in Medicaid, military, commercial, and specialty markets (dental, vision, pharmacy).  More recently, Humana has been building out a network of primary care and home health assets to supplement its health insurance operations.

Industry Background:

Medicare is federal health insurance for people 65 and older.  Medicare has three components.  Part A (hospitals, nursing homes, hospice), Part B (doctors, other providers, outpatient care, home health care, medical equipment, preventative services), and part D (drugs).  With each part there are premiums, deductibles, and cost sharing requirements that can vary depending on income.  Participants often purchase a Medigap supplemental insurance policy to help cover Medicare cost sharing requirements and other out of pocket costs.  

Every year, seniors are offered an alternative to Medicare called Medicare Advantage (also known as Part C).  These highly regulated, Medicare-approved plans are sponsored by companies like Humana.  MA plans generally bundle Parts A, B & D together.   MA plan sponsors are paid a set amount per beneficiary as determined annually by CMS (the Centers for Medicare & Medicaid Services).  In return, MA plan sponsors are responsible for all medical costs of the covered lives.  At least 85% of MA premiums must be spent on medical benefits.  

Seniors often choose MA vs. Original Medicare because MA plans offer lower-out-of-pocket costs and extra benefits (dental, vision, hearing, fitness, etc.).  As a tradeoff, MA plans manage utilization and require participants to use in-network providers.  

The ancillary benefits offered in a MA plan add ~$185 a month in value to members.  These enticements have driven the increased penetration of MA over time.  

Over the past 10 years, the population of seniors eligible for Medicare has grown at 2.6% per year.  In this same period, membership in MA plans has grown 8.2% per year.  MA participation now makes up ~49% of all eligible seniors (up from 28% a decade ago).  Given the attractive value proposition to plan participants, MA penetration is expected to continue to increase over the next decade.

An important component of MA is a quality assessment program called Stars.  Each year CMS assigns a Star rating to MA plans to indicate their performance relative to other plans.  Stars reflect plan performance on over forty metrics covering patient experience and health outcomes.  Plans awarded four or five Stars are paid a 5% bonus.  This is huge in a business with low-to-mid single digit margins.  

Humana is well positioned to benefit from the continued growth of MA.  The company has an unrivaled focus on MA which has resulted in superior execution over time.  This execution advantage is best exemplified by its Stars ratings vs. its peers.  

Higher Star ratings catalyze a virtuous cycle where the plan sponsor is paid more, which allows it to offer more robust benefits, which leads to higher member satisfaction, which results in higher Star ratings.  Given the above table, it will be unsurprising if CVS and CNC lose market share to HUM and others over the next several years.  

Scale is another important element for MA plan sponsors.  Gross margins are regulated and provider rates are often set by the Medicare fee schedule.  Therefore, leveraging SG&A is one of the few tools available to expand margins.  When Humana was ~1/2 the size, its operating ratio (OpEx as a % of revenue) was ~200bps higher than its current run rate.  This means that, all variables equal, if Humana writes business today earning it a 4.5% operating margin (and good returns on capital), a peer half its size would only earn a 2.5% operating margin.  Perhaps this explains why smaller competitors have been share donors over time.  Scale also helps with branding, distribution, and rate negotiations with ancillary benefit providers.  

Cigna’s experience in MA is a great example.  CI is a well-run, rational competitor that has repeatedly targeted 10-15% per year MA membership growth.  However, despite its best efforts, CI has consistently bled share in MA over time.  

CI management has often blamed intense competition on its membership shortfall.  However, since ’13 Humana has organically grown market share by ~100bps to 18% without any margin erosion.  And from the below chart you can see that the other larger competitors have also gained market share over time.  

The recent failure of Bright Health Group is further evidence that subscale MA plan sponsors are at a disadvantage.  BHG went public in June ’21 with grand ambitions to become a major player in the MA market.  Its IPO priced at an $11.3b valuation and at one point rose above $12b.  However, its “tech-enabled” business model flopped.  In 2021 the medical cost ratio of its insurance segment was 98.9%.  The operating ratio was 29.9%.  When things got worse in ’22 they ran out of money and threw in the towel.  All MA members were transferred to Molina Health.  

Another MA startup Clover Health had a similar experience, although they are still limping along.  Clover went public via SPAC as another “tech-enabled” MA disruptor.  The deal closed in June ’21.  Its valuation peaked at $8.5b.  The company ran a medical care ratio of 106.0% in ’21 and 91.8% in ’22. On an LTM basis CLOV lost $351mm.  The stock now trades for ~$1 with an EV of $160mm.  

Shift to Value-Based Care:

A key trend in the MA space is plan sponsors gradually moving in-network providers towards risk-sharing payment models.  Since MA plans are paid on a capitated basis, if they can better align incentives to manage the cost of care, the savings will lead to either higher margins or the ability to provide better plan benefits (driving growth).  

While only a small minority of HUM’s plan members are enrolled in full value-based arrangements, early indications show potential.  HUM’s value-based members visited their primary care physicians more frequently, were more adherent to their medications, and experienced fewer complications with specialized care.  Based on 2021 data, HUM members supported by value-based providers experienced 9% fewer trips to the emergency room and 6% fewer hospital admissions than those in HUM’s fee-for-service arrangements.  HUM’s value-based members also incurred 0.6% less in total medical costs than HUM’s fee-for-service members.  

The uptake of this shift in care delivery has been gradual given the entrenched fee-for-service mentality of the current health care system.  To attempt to solve this, in recent years, MA plan sponsors have been aggressively vertically integrating into providers to catalyze a quicker shift to value-based care.  

Humana is participating in this trend.  In Dec ‘17, HUM acquired 40% of Kindred, the largest home health and hospice operator in the U.S.  In April ’21, HUM acquired the remaining 60% at an implied EV of $8.1b.  They have since sold 60% of the hospice portion of the business to CD&R at an implied EV of $3.4b.  Kindred has a national market share of ~6% in home health care.  

Humana has also been ramping up its owned-provider network.   While HUM has experimented with owning provider assets throughout its 60+ year history, in the past 7 years the company has stepped on the gas pedal to grow its footprint.  As of Q1’23, HUM has 191 wholly-owned medical clinics employing 586 primary care physicians and serving 180k patients.  The company plans to build/acquire 30+ clinics a year for the remainder of the decade.  Most of this footprint growth will come from an off-balance sheet arrangement with the P/E firm Welsh Carson Anderson & Stowe.  HUM will acquire up to 150 of these de novo clinics in phases starting in ’25.  

Humana claims that mature clinics produce $3mm of EBITDA.  Therefore, by 2025 management claims their footprint will have latent EBITDA potential of ~$900mm.  I am modeling in $125mm of contribution in ’25.  

If the strategy of vertical integration is financially successful, it will give the large vertically integrated plan sponsors (United Healthcare, Humana, CVS/Aetna), a further competitive advantage compared with sub-scale MA plan sponsors that do not have enough membership density to support an owned provider network.  It may even become table stakes. 

In an attempt to catch up to United Healthcare and Humana, CVS recently acquired Oak Street Health.  This is a direct comp to Humana’s owned clinics (same business model – primary care clinics that partner with MA plans to take on utilization risk).  In 2022 Oak Street had $2.2b of revenue and lost $505mm.  CVS paid $10.6b!  Humana’s clinics have a current run rate of ~$4b of revenue (including intercompany care) and are approaching breakeven (110 of 191 are contribution margin positive, up 25% YOY).  

The Investment Opportunity:

Managed care stocks have been weak all year due to uncertainty regarding the impact of Medicaid redeterminations, increased PBM scrutiny, and the upcoming presidential election.  These issues are less concerning for HUM than some of the other managed care companies due to the business mix.  However, on 6/13/23, the group sold off yet again when UNH publicly stated that utilization trends were running higher than budgeted for their MA book.  UNH management blamed the higher cost trend on post-covid pent up demand for outpatient orthopedic procedures. This catalyzed a sharp decline in HUM shares (since HUM is most exposed to MA) and several analyst downgrades.  On 6/16, HUM put out an 8k confirming that MA utilization was indeed running higher than anticipated.  HUM noted emergency rooms, outpatient surgeries, and dental services were all seeing a material increase in patient volumes.  Since MA bids for ‘24 were due June 1, a few weeks before HUM’s 8k, there is lingering uncertainty whether or not HUM was able to incorporate the current utilization trends in its ’24 bids.  

Due to the selloff, HUM is now selling at the low end of its historic valuation range.  

HUM has historically traded at a median P/E of 19.1x and currently trades at 14.8x NTM consensus.  

HUM has historically traded at a median .99x the SPX multiple and now trades at .79x.

This dislocation provides an entry point.  While the increased utilization will hurt near term earnings, it is a temporary issue that doesn’t materially impact my fair value estimate.  MA is a short tail insurance product so the company will have the opportunity to fully re-price its book by 2025.  

My base case has HUM earning ~$36.2/share in ’25.  At the current price of ~$457 we are only paying 12.6x ’25 earnings.  HUM has a good balance sheet (~40% net debt to capital, ~2x net debt / EBITDA) so I think this multiple is unlikely to persist.  I expect HUM to give full year ’25 guidance in ~18 months and view it as a catalyst for share price appreciation.  

The most impactful variable on earnings is the medical loss ratio (MLR) for the insurance segment.  Another key assumption is membership growth.  Here are the assumptions in my current base case.  

IR has guided me to a normalized MLR range of 86-87% given the current business mix.  2020 was distorted by the lockdowns and 2021 was impacted by pent up demand.  2022 was a more normalized year, although HUM grew slower than the market.  This year at an 87.0% estimated MLR HUM is growing 13.9% vs. a market growing 9.6%.  Going forward I expect a softer MA rate environment to dampen overall MA membership growth to MSD%.  I expect HUM to continue to outgrow the market in ’24 due to the company’s superior Stars positioning and a less competitive environment vs. ’21-’22 when several new entrants were selling dollars for 90 cents.    

If my forecasts are correct and HUM trades at ~16.5x NTM earnings in 18 months (vs. 19x historical median NTM P/E), there is 32% upside including dividends. Any multiple expansion would be gravy. 

Therefore, I view this as an opportunity to establish a position in a high quality, well managed, acyclical business, with a strong balance sheet, that is only in the middle innings of its secular growth opportunity.  

Key risks:

- Buildout of provider network is financially unsuccessful.  The senior-focused, value-based, primary care clinic business model is still somewhat unproven.  While HUM’s strategy seems reasonable, we have yet to take a view that owning assets is superior to pursuing partnerships.  It’s possible that incremental returns on capital will be subpar for their expansion initiative.  As a mitigant, I put very little value on HUM’s provider assets.  

- Additional adverse MA rate actions could pressure industry margins.  Over the past few years there has been some criticism that MA plan sponsors are overpaid.  This year, the U.S. government made some changes to the MA risk adjustment mechanism and announced a 1.1% cut to reimbursement rates to bring them back in line with their intended parity with the per member cost of traditional Medicare.  

Given the above, it is likely MA plan sponsors will need to reduce benefits somewhat to maintain profit margins.  As a potential mitigant for HUM, industry wide benefit cuts create a greater likelihood that MA members will shop around.  Given its strong Stars position, HUM is well positioned to capture a disproportionate share of members that are looking to switch plans.  

- Upcoming election cycle creates uncertainty.  While MA receives strong bipartisan support, previous elections have featured candidates advocating for free government healthcare for everyone.  

- Execution stumbles.  Star ratings are assessed every year.  A material decline in Star ratings would hurt HUM’s competitive position.

- Increased competitive intensity in MA.

Catalyst

Full-year '25 guidance in February 2025