ALHC - Humana: Time To Adopt A More Defensive Portfolio Strategy

Summary

• Humana derives the majority of its revenue from government-sponsored health benefits programs, offering a sustainable, predictable revenue stream matched only by a few.
• The popularity of Medicare among voters shapes policy debate over healthcare fiscal spending. CMS is unlikely to cut reimbursement rates wherever it impacts service levels.
• Despite outperforming the market this year, HUM remains comparatively undervalued.

Investment Thesis

Stock prices are hard to predict, but the market is riskier at more times than others. With renewed political tension and macroeconomic uncertainty, it might be a good idea to adopt a more defensive strategy and buy shares in companies whose earnings remain stable through economic cycles. Humana ( HUM ) derives more than 90% of its income from government-sponsored benefits programs, offering a sustainable, predictable revenue stream matched only by a few. Adding to that is the inherent defensiveness of healthcare services, consumer behavior characterized by stickiness, and a leading market position as the second-largest Medicare provider, with an 18% market share as of 2021.

Revenue Trends

Most Americans agree that the Federal government should care for the elderly and the poor. The Medicare and Medicaid programs have been running since 1965, and Medicare, where HUM derives more than 80% of revenue, enjoys popularity among voters. This is useful to remember amid the heated debate over healthcare fiscal spending.

I don't believe that either the Republicans or Democrats have the will to cut Medicare payments to the extent it impacts service levels. Reimbursement rates have been increasing yearly, notwithstanding 2020, when the Center of Medicare and Medicaid Services "CMS" adjusted Medicare Advantage "MA" payments to reflect lower utilization due to lockdowns.

Current discussions at the CMS revolve around initiatives aiming at increasing efficiencies, such as facilitating the creation of integrated delivery systems for patients with Multiple Chronic Conditions "MCC," often requiring coordinated care from different care centers. Without coordination, inefficiencies occur, e.g., duplicate diagnostic testing, notwithstanding fragmented lines of therapy that aren't necessarily the optimal treatment course. HUM doesn't provide the number of MCC enrollees. However, the industry's expenses follow the 80/20 rule, where 20% of its enrollees are responsible for 80% of expenses.

The CMS also invests in preventive and primary care initiatives as means to lower hospitalization, as mandated by the ACA act. Investing in primary care as a way to reduce total healthcare costs is a strategy adopted by the class of managed care startups recently going public, including Alignment Healthcare ( ALHC ), which states:

If a single nurse visit to a high-risk senior's home prevents an avoidable hospitalization, then that visit represents a 30 to 1 return-on-investment. ALHC Annual Report

A lot is happening on the regulatory front regarding healthcare spending beyond the initiatives stated above, such as the Inflation Reduction Act and ACO Reach, both going into effect in 2023. Still, the point is, contrary to popular opinion, decreasing Medicare services to control costs isn't something that comes up often. These political dynamics are where HUM derives its revenue stability.

In addition to sales visibility, HUM enjoys benefits from its scale, granting it volume negotiating power matched by few. The ACA act set maximum gross profit margins for health insurers at 15%. However, HUM's cost savings allow it to reinvest in expanded coverage, far exceeding that of Traditional Medicare (Medicare offered directly by the CMS.) For example, Humana Gold Plus (H5619) offers free drug coverage, which would have cost an enrollee between $145 to $935 (depending on income) under Traditional Medicare. For this reason, an increasing number of people are opting for Medicare Advantage instead of Traditional Medicare.

Valuation

To the extent one is looking for pure MA plays, investors practically face two choices; HUM and UnitedHealth ( UNH ). Both companies have a stated target of 13% annual EPS growth. Still, HUM will most likely exceed this target, given the sale of Kindred hospice care assets and management's decision to use some of the proceeds to repurchase shares (in addition to lowering debt).

One can argue that UNH is more diversified than HUM, having maintained its commercial business segment, and expanded into healthcare providers' business. However, one can also say that these businesses are more risky and sensitive to economic trends than Medicare, which constitutes most of HUM's sales.

Both companies outperformed the market this year as fund managers adopted a defensive stance in their portfolios in light of increasing recession risks. However, unlike UnitedHealth ( UNH ), HUM's price multiples remain close to historical averages, making it our favorite pick between the two, with the highest probability of capital appreciation, as opposed to UNH, whose trade seems to have been exhausted.

Summary

HUM shares outperformed the market this year as smart money sought shelter from political and macroeconomic disruptions. Given the renewed political tensions and high level of uncertainty, it might be a good idea to adopt a more defensive strategy, gaining portfolio exposure to MA companies.

HUM enjoys a stable revenue stream derived mostly from government-sponsored healthcare benefit programs. Political risks exist, but so does lawmakers' support for the Medicare Advantage program. The program is unlikely to see foundational changes for at least the end of the current administration's presidency. Privatization of healthcare is also not practical for reasons beyond this article's scope. These dynamics, together with moderate price valuation multiples, at least compared to its closest peer, render HUM one of the top defensive trades on the market today.

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