CA - Humana: Another Profit Warning - Should Investors Take Heed?

2024-01-19 10:40:31 ET

Summary

• Humana stock price experienced a major downward correction after the company issued a profit warning this week.
• HUM shares have fallen from ~$520 in November, to <$415 at the time of writing, but health insurer stock prices are volatile and tend to recover rapidly from setbacks.
• With that said, the market is anticipating Humana's 2024 guidance to fall short of expectations, and the company expects slower growth in Medicare Advantage membership.
• The situation Humana faces in 2024 looks more challenging than after previous downward stock price corrections, but I'd be relatively confident the insurance giant's stock can recover.
• The MA industry has been wildly popular and is still growing, but it is still in the early stages - major players will continue to find ways to make the industry work for all parties, I believe.

Investment Overview

Back in January 2022, the share price of the health insurance giant Humana Inc. ( HUM ) experienced a major downward correction, as management revised its expectations for newly enrolled members for that year from 325k - 375k, to 150k - 200k.

Overnight, Humana share price fell from ~$465, to $365, a loss of >20%. I wrote in a note for Seeking Alpha at the time:

The share prices of health insurance companies are generally quite volatile, and particularly vulnerable to adverse news flow, missed targets, and lowered guidance. Such news tends to make the market jittery, and the resultant sell-offs are usually intense and sudden. The good news is that health insurers' stock prices tend to recover.

I advised readers that "I would back investors to make a ~15% ROI on any Humana investment made today by the end of 2022," and in fact, by late December 2022 Humana stock had risen in value by >30%, reaching ~$475 per share. I also noted that back in March 2020, Humana stock sank from ~$365 per share, to $230 per share overnight, a loss of >35% - as the pandemic caused a mini-market crash - before rising to a high of >$410 less than 2 months later.

My point here is that, although health insurers may make the market jittery at times, they have a knack of recovering rapidly from selloffs, most likely due to the huge revenue figures they drive, and their profitability - if we take a look at Humana's historical performance, we can see how impressive this is.

Humana's Profit Warning - Filing Reveals Underperformance In Q4, Set To Continue Into 2024

Given the historic "bouncebackability" of Humana stock, it is tempting to view the profit warning issued by the company this week, and subsequent stock selloff, which has seen Humana shares fall in value from ~$458 per share, to $412 ahead of market open today, as a potential buying opportunity.

Before making any rash decisions, however, it's important to carry out some due diligence to determine whether this latest market selloff is another "knee jerk" reaction to negative but not catastrophic news, a bump in the road rather than a serious impediment to the long-term growth of Humana's business, or a sign that Humana's business is facing new threats and headwinds that may necessitate a long-term revaluation of the company?

Let's first break down the information provided by Humana. In a filing released yesterday , Humana writes:

As shared on the Company’s third quarter 2023 earnings call on November 1, 2023, the Company anticipated the higher level of medical utilization experienced during the third quarter in its Medicare Advantage business would continue for the remainder of the year.

Actual fourth quarter results reflect an additional increase in Medicare Advantage medical cost trends, driven by higher than anticipated inpatient utilization, primarily for the months of November and December, as well as a further increase in non-inpatient trends, predominantly in the categories of physician, outpatient surgeries and supplemental benefits, which emerged with the November and December paid claims data (received throughout December and January, respectively).

The higher than anticipated cost trends are expected to result in a fourth quarter 2023 Adjusted Insurance segment benefit ratio of approximately 91.4 percent as compared to the Company’s previous expectation of 89.5 percent, and a full year Adjusted Insurance segment benefit ratio of approximately 88.0 percent as compared to the Company’s previous expectation of 87.5 percent.

The medical benefit ratio is a key measure of a health insurer's performance and likely profitability, as it is the percentage of insurance premiums received by a health insurer that is spent on medical expenses. The lower the ratio, the more profitable a health insurer is likely to be, therefore, the fact that Humana's ratio has come in at 91.4%, as opposed to the forecast 89.5%, could be a concern, as the market clearly seems to believe.

Humana management has put the rise in medical expenses down to a surge in patients returning to consult physicians, or have elective surgeries that were postponed during the years of the pandemic, now that lockdown restrictions are no longer in place. As a result of this, Humana says it:

now expects to report GAAP EPS of approximately $20.00 in diluted earnings per common share (“EPS”), or approximately $26.09 in Adjusted earnings per common share (“Adjusted EPS”) for the year ended December 31, 2023.

Management also added in its filing yesterday that it is still

"assessing the expected impact of emerging utilization trends on its 2024 outlook, which is anticipated to be material if current trends continue."

In other words, the market is now anticipating Humana's 2024 guidance, which will be provided on 25th January - next Thursday - is going to fall short of expectations.

Finally, Humana also revealed in its filing that it:

expects individual Medicare Advantage ("MA") growth of approximately 100,000 members for the year ending December 31, 2024, representing 1.8 percent growth over its membership as of December 31, 2023 of approximately 5.4 million members, compared to its previous commentary of "at or slightly above industry average growth".

Assessing The Longer-Term Implications Of Humana's Profit Warning

Back in June last year, a warning about escalating healthcare costs and a squeezed medical benefit ratio ("MBR") from one of Humana's rivals, UnitedHealth, which has a near 30% share of the Medicare Advantage market , with ~8.9m members, compared to Humana's 18% share (the second largest share), and ~5.5m members, sent multiple health insurers share prices into a downward spiral.

Humana stock sank from a value of ~$510 per share prior to the warning, to ~$425 by mid-July, but after some encouraging Q2 2023 earnings - with adjusted income of $3bn up ~10% year-on-year, and adjusted earnings per share ("EPS") of $18.32, up 11% year-on-year, on revenues of $53.5bn, up 12% year-on-year - was trading at $525 per share by the end of October.

On 1st November, however, after reporting a reasonably impressive set of Q3 earnings, with EPS of $7.78 per share beating analysts estimates, and 2023 guidance upheld, Humana stock found itself falling again, as unlike rivals such as UnitedHealth ( UNH ) and Elevance Health ( ELV ), who raised 2023 profit forecasts, Humana warned of rising medical costs that were expected to continue into 2024.

Once again, however, by the end of November shares were buoyant once again, trading close to all-time highs at ~$520 per share. Since that high water mark, however, the stock price has been on a more concerning bearish run, from which it has been struggling to recover, as the company has been unable to provide assurances that performance will soon be improving again.

Besides profitability issues and slowing membership growth, rumors that Humana looked likely to merge with rival health insurer Cigna ( CI ), in a move instigated by Cigna, also seemed to negatively affect the share price. Ultimately, the two companies could not agree a price , and that deal is seemingly dead in the water, with Cigna opting to spend $10bn on share buybacks instead.

Unlike in January 2022 and June 2023, the setbacks Humana is facing are arguably more protracted and concerning, and the share price is not recovering as rapidly. Might this suggest that this latest dip cannot be put down to volatility, or market jitters, and that Humana perhaps deserves a longer-term downward correction?

Analyzing Humana's Issues - Should Shareholders Be Preparing To Sell?

Humana stock experienced a sensational bull run throughout the vast majority of the last decade, rising in value from ~$25, to ~$350, for a gain of ~1,300% - an incredible return for investors lucky enough to be holding stock during that period.

Underpinning Humana's success over this period - and the first 2 years of this decade - has been the company's pioneering role in the emergence of the Medicare Advantage health insurance market. As I wrote in a recent post on UnitedHealth:

Medicare Advantage is a mechanism whereby private health insurers provide health benefits coverage in exchange for a fixed monthly premium per member from the Centers for Medicaid and Medicare ("CMS"), plus a monthly consumer premium. Medicare Advantage plans can offer seniors lower premiums, plus additional advantages such as basic vision and dental coverage, and gym memberships.

The CMS effectively pays private health insurers to take on the risk of the policyholders, and then it is up to the health insurers to earn a profit by administering the required care for less than they receive from the CMS. The payors earn a percentage of any money saved, and also receive additional bonuses if their plans are rated 4 out of 5 stars or higher.

With ~10k Americans turning sixty five, and becoming eligible for Medicare Advantage ("MA") every day, the flexibility of the plans offered has seen MA become extremely popular - according to Chartis.com :

this year saw record enrollment and pushed program penetration past 48%. This year’s growth increased overall Medicare Advantage program participation by 9.5% and added 2.7 million beneficiaries. A total of 30.7 million beneficiaries are now enrolled in a Medicare Advantage plan.

There are some potential clouds on the horizon, however. Historically, average gross margins that insurers can earn from MA have been estimated at around ~$1,600 per member, which is almost double what can be earned in the individual or group markets. This is great for Humana, UnitedHealth, and CVS Health ( CVS ), the three largest MA plan providers, but the CMS has begun to recognize that the rates it is paying per member, per month to health insurers - which are calculated based on previous year's spending, star ratings, patients risk assessments and other factors - may be too high.

This has led to the CMS attempting to claw back billions of dollars from health insurers, and to readjust future rates (detailed discussion can be found in my note on UnitedHealth from April last year ), to try to prevent MA becoming a cash cow for the private insurance industry. In short, Humana is unlikely to be treated sympathetically by the CMS when it comes to a narrowing MBR - after all, an MBR of 91.4% is unlikely to be considered too high by the CMS, as it suggests Humana spends nearly 10% less on patients healthcare costs than the CMS pays it.

Ultimately, for MA to work, a fine balance needs to be struck between the CMS, patients, and private health insurers, to ensure that all parties are incentivized by the plans - the patients appreciate the flexibility and low premiums, the CMS can effectively outsource its healthcare management without paying over the odds, and the private health insurers can still realize a profit to keep the interested.

What seems to have happened is that while patients initially flocked to sign up to MA plans, restrictions on the way healthcare is administered introduced by MA plan providers like Humana, in order to maximize profitability, are causing plan popularity to fall, while the CMS is also putting pressure on plan administrators by offering lower rates of payment going forward, or smaller rises in rates.

As we can see above, Humana has massive exposure to MA, and it is the fastest growing element of its business, therefore changes to rates, lower volumes of new plan members, and competition - many upstart health insurance are offering absurdly low premium rates in order to attract new customers, which is creating issues for larger suppliers when it comes to enrolling new plan members - will create significant difficulties for the company going forward.

Conclusion - A Challenging Year Ahead, Or Another False Alarm

The rise of Medicare Advantage has clearly been a huge boon for Humana, and its stock price. An industry that Humana played a key role in creating has rewarded the company and its shareholders handsomely, but equally, it seems clear that Humana may need to re-evaluate the way it administers these plans going forward, to protect its profit margins, and keep its shareholders happy.

Or does it? Ultimately, the signs that MA plans are here to stay are evident, with the likes of CVS Health investing nearly $20bn in M&A at the start of last year to provide "value based care" services as opposed to "fee for service," and UnitedHealth making it central to its business going forward.

Both of these health insurance juggernauts are all-in on MA, but as well as focusing on the rates paid by the CMS, they are also focusing on how to provide traditional healthcare services for less money. This does not necessarily mean a lower standard of care for plan members, but it may mean, for example, that patients are visited at home for assessment as opposed to visiting a hospital - which represents a massive saving for the health insurer.

In fact, there are multiple ways in which private health insurers can explore how to create cost savings in a way that is not detrimental to the patient, and although the CMS may interpret rising MBRs as a sign it needs to cut payment rates again, the agency will also know that it cannot disincentivize private insurers too much or the system will fail.

While it's true Humana may not hit the membership numbers it has achieved in previous years, or extract the same profit per plan it has achieved in past years, only a weak company or business, or a far smaller and less influential one, would be derailed by a couple of poor quarter's performance and some minor policy changes.

When we consider Humana's forecast for EPS of $26 for the year, it is hardly a disastrous state of affairs, giving the company a forward price to earnings ("P/E") of ~16x, which ought to be considered a good score, at least as good as UnitedHealth, Cigna, and Elevance, in fact.

Although 2024 may not be the best year for Humana, the company is already looking forward to 2025 rate-setting, expecting the CMS to reevaluate rate-setting based on the higher than expected medical costs incurred in 2023. The CMS may be reluctant to pay over the odds, but ultimately, I believe the agency is cognizant of the fact that a successful, growing MA industry remains a strong benefit.

Humana will also have the opportunity to develop its value based care services in 2024 - perhaps the company has been less dynamic, or at least less vocal, than rivals in this field to date, but there is no reason to think it cannot strategize and achieve savings by doing what its rivals have.

Ultimately, given all of these factors - Humana's >5m MA membership, its historical - and ongoing - profitability, its influence over MA, an industry it helped design and build, in collaboration with the CMS, and its sheer size - and I'd be reasonably confident that Humana stock continues to retain its "bouncebackability."

That does not necessarily mean there will not be a reckoning on the MA market one day, as there has been on drug pricing say, but at the beginning of 2025, I'd expect to see Humana stock trade close to the $500 mark, primarily on optimism around fairer MA rates, an improved medical benefit ratio, growth in the MA industry, falling away of upstart competitors, an innovation around the transition from "fee for service," to "value based care."

To conclude, the current dip is one I'd be reasonably confident buying, although cautious investors should wait for the full 2023 earnings announcement due Thursday next week before buying, potentially, as things could get a little worse before they begin to get better, in my view.

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